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Free Test Prep CFA-Level-I Exam Questions (page: 44)

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Pierce Products is deciding whether it makes sense to purchase a new piece of equipment. The equipment costs $100,000 (payable at t = 0). The equipment will provide before-tax cash inflows of $45,000 a year at the end of each of the next four years (t = 1, 2, 3, 4). The equipment can be depreciated according to the following schedule:
t = 1: 0.33
t = 2: 0.45
t = 3: 0.15
t = 4: 0.07 At the end of four years the company expects to be able to sell the equipment for a salvage value of $10,000 (after-tax). The company is in the 40 percent tax bracket. The company has an after-tax cost of capital of 11 percent. Since there is more uncertainty about the salvage value, the company has chosen to discount the salvage value at 12 percent. What is the net present value of purchasing the equipment?

  1. $22,853.90
  2. $9,140.78
  3. $28.982.64
  4. $20,564.23
  5. $16,498.72

Answer(s): A

Explanation:

First, find the after-tax CFs associated with the project. This is accomplished by subtracting the depreciation expense from the raw CF, reducing this net CF by taxes and then adding back the depreciation expense.
For t = 1: ($45,000 - $33,000)(1 - 0.4) + $33,000 = $40,200.
Similarly, the after-tax CFs for t = 2, t = 3, and t = 4 are $45,000, $33,000, and $29,800, respectively.
Now, enter these CFs along with the cost of the equipment to find the pre-salvage NPV (note that the salvage value is not yet accounted for in these CFs). The appropriate discount rate for these CFs is 11%. This yields a pre-salvage NPV of $16,498.72. Finally, the salvage value must be discounted. The PV of the salvage value is:
N = 4, I = 12, PMT = 0, FV = -10,000, and PV = $6,355.18. Adding the PV of the salvage amount to the pre- salvage NPV yields the project NPV of $22,853.90.



Helms Aircraft has a capital structure, which consists of 60 percent debt and 40 percent common stock. The company's equity financing will come from issuing new common stock. The company recently issued bonds with a yield to maturity of 9 percent. The company's stock is currently trading at $40 a share. The year-end dividend is expected to be $4 a share (that is, D(1) = $4.00), and the dividend is expected to grow at a constant rate of 5 percent. The flotation costs associated with issuing new common stock are estimated to be 10 percent. The company's tax rate is 35 percent. What is the company's weighted average cost of capital?

  1. 11.84%
  2. 10.98%
  3. 8.33%
  4. 9.51%
  5. 9.95%

Answer(s): E

Explanation:

Calculate the after-tax cost of debt = (1 - 0.35) 9% = 5.85%.
Calculate the cost of new equity: k(e) = $4/[$40(1 - 0.1)] + 0.05 = 0.1611 or 16.11%. Compute WACC (Weighted Average Cost of Capital): 0.6(5.85%) + 0.4(16.11%) = 9.95%.



The capital budgeting director of Sparrow Corporation is evaluating a project, which costs $200,000, is expected to last for 10 years and produce after-tax cash flows, including depreciation, of $44,503 per year. If the firm's cost of capital is 14 percent and its tax rate is 40 percent, what is the project's IRR?

  1. 18%
  2. 8%
  3. 12%
  4. -5%
  5. 14%

Answer(s): A

Explanation:

$200,000 = $44,503(PVIFA(Irr,10))
PVIFA(Irr,10) = 4.49408 ;IRR = 18%.



Jackson Corporation is evaluating the following four independent, investment opportunities:
Project CostRate of Return
A$300,000 14%
B$150,000 10
C$200,000 13
D$400,000 11
Jackson's target capital structure is 60 percent debt and 40 percent equity. The yield to maturity on the company's debt is 10 percent. Jackson will incur flotation costs for a new equity issuance of 12 percent. The growth rate is a constant 6 percent. The stock price is currently $35 per share for each of the 10,000 shares outstanding. Jackson expects to earn net income of $100,000 this coming year and the dividend payout ratio will be 50 percent. If the company's tax rate is 30 percent, then which of the projects will be accepted?

  1. All of the investment projects will be taken.
  2. Projects A, C, and D.
  3. Projects A and
  4. None of the investment projects will be taken.
  5. Project A.

Answer(s): E

Explanation:

Calculate the after-tax component cost of debt as 10%(1 - 0.3) = 7%. If the company has earnings of $100,000 and pays out 50% or $50,000 in dividends, then it will retain earnings of $50,000. The retained earnings breakpoint is $50,000/0.4 = $125,000. Since it will require financing in excess of $125,000 to undertake any of the alternatives, we can conclude the firm must issue new equity. Therefore, the pertinent component cost of equity is the cost of new equity. Calculate the expected dividend per share as $50,000/10,000 = $5. Thus, the cost of new equity is $5/[($35(1 - 0.12)] + 6% = 22.23%. Jackson's WACC is 7%(0.6) + 22.23%(0.4) = 13.09%.
Only the return on Project A exceeds the WACC, so only Project A will be undertaken.



Your company is planning to open a new gold mine which will cost $3 million to build, with the expenditure occurring at the end of the year. The mine will bring year-end after-tax cash inflows of $2 million at the end of the two succeeding years, and then it will cost $0.5 million to close down the mine at the end of the third year of operation. What is this project's IRR?

  1. 12.70%
  2. 14.36%
  3. 10.17%
  4. 21.53%
  5. 17.42%

Answer(s): A

Explanation:

Time line:
-3,000,0002,000,0002,000,000-500,000
Financial calculator solution: (In millions)
Inputs: CF(0) = -3; CF(1) = 2; N(j) = 2; CF(2) = -.5.
Output: IRR% = 12.699%.



Under the Residual Dividend Policy, a firm pays out:

  1. none of these answers.
  2. only net earnings left over after financing the current optimal capital budget requirements, consistent with the target capital structure.
  3. all of its earnings left over after taxes and expenses as dividends.
  4. only net earnings from new projects as dividends, using the rest to finance current capital requirements.

Answer(s): B

Explanation:

Under the Residual Dividend Policy, a firm first determines the amount of capital it requires for sufficiently profitable projects. It then uses retained earnings to supply equity capital and raises debt in the proper amount to maintain the target capital structure. If any earnings are left over after this, they are paid out as dividends. If not, the firm will not only not pay any dividends but also issues new equity for financing.



In the calculation of WACC, which of the following should be ignored?

  1. none of these answers.
  2. long-term debt.
  3. current liabilities.
  4. preferred equity.

Answer(s): C

Explanation:

Short-term debt is not a part of the capital structure. The capital budgeting process allocates resources to long- term asset investments and as such is financed by liabilities/capital of similar maturity. Hence, short-term/ current liabilities do not enter into WACC calculations.



Which of the following is/are true about the MACRS?

  1. MACRS does not use economic life of an asset while calculating depreciation.
    II. Under the MACRS system, the depreciation expense is larger in the early years, leading to lower taxes.
    III. Depreciation under MACRS must be calculated using the accelerated depreciation method.
  2. III only
  3. II only
  4. I, II & III
  5. II & III
  6. I only
  7. I & II

Answer(s): F

Explanation:

MACRS classifies assets into several classes based on a pre-determined length of time called the "recovery period." The recovery period, while positively correlated with actual economic life, does not track the economic lives of individual assets precisely. In particular, recovery periods are shorter than actual economic lives, leading to higher depreciation expenses and lower taxes. For long-recovery period classes (>27 years), straight-line depreciation must be used while accelerated methods may be used for shorter life assets.



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