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Free Test Prep CFA-Level-I Exam Questions (page: 45)

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Which of the following statements is false?

  1. When IRR = k (the cost of capital), NPV = 0.
  2. If the multiple IRR problem does not exist, any independent project acceptable by the NPV method will also be acceptable by the IRR method.
  3. The IRR can be positive even if the NPV is negative.
  4. The NPV will be positive if the IRR is less than the cost of capital.
  5. The NPV method is not affected by the multiple IRR problem.

Answer(s): D

Explanation:

If the IRR is less than the cost of capital, then taking on the project imposes a cost on current stockholders. If the cost of capital is greater than the IRR, the NPV will be negative.



A firm's capital structure has a debt-to-equity ratio of 0.8. The pretax cost of debt is 7%. The beta of the stock is 1.3 in an environment with risk-free rate of 5.5% and an expected market return of 16%. The firm is in the 45% tax bracket. The weighted average cost of capital of the firm equals ________.

  1. 12.35%
  2. 9.43%
  3. 6.91%
  4. 13.81%

Answer(s): A

Explanation:

Using CAPM, the cost of equity equals 5.5% + 1.3*(16% - 5.5%) = 19.15%. Since the debt interest is tax deductible, the after-tax cost of debt equals 7%*(1-0.45) = 3.85%. Now, the D/E ratio = 0.8. Hence, (D+E)/E = 1.8, giving E/(D+E) = 0.556. Thus, equity forms 55.6% of the capital while debt forms 44.4%. The WACC is then equal to 0.556*19.15% + 0.444*3.85% = 12.35%.



A project has the following cash flows over the next 5 years: $800, $300, $400, $900 and $1,200. Assume all cash flows occur at the end of a year. The project requires an initial cash outlay of $1,750. The firm faces a marginal borrowing rate of 8%. The payback period for the project equals ________.

  1. 3.86 year
  2. 4.19 years
  3. 4 years
  4. 3.28 years

Answer(s): D

Explanation:

The payback period is defined as the expected number of years that would be required to recover the original investment. In particular,
Payback period = Years before full recovery +
(unrecovered cost at the start of payback year)/(net cash flow in the payback year) In this case, the recovery occurs in the 4th year. At the beginning of the 4th year, the unrecovered cost equals 1,750 - 800 - 300 - 400 = 250. Total cash flow in the 4th year equals 900. Therefore, payback period = 3 + 250/900 = 3.28 years. Note that the discount rate does not figure in the calculation of payback period.



While calculating the weights of various components of the capital structure, one must use:

  1. minimum of book or market values.
  2. book values.
  3. liquidation values.
  4. market values.

Answer(s): D

Explanation:

WACC calculations are based on current market values, not historical cost.



Assume the following information about two individual projects.
Project A
Initial cash outflow: $175,000
Expected cash inflows
t1: $75,000
t2: $65,000
t3: $35,000
t4: $35,000
t5: $15,000
Project B
Initial cash outflow: $100,000
Expected cash inflows
t1: $15,000
t2: $15,000
t3: $18,000
t4: $45,000
t5: $45,000
Assuming these projects are not mutually exclusive, and the cost of capital is 10%, which of the two should be undertaken according to NPV? Additionally, which of the two projects has the steeper NPV profile?

  1. Project B should be accepted, project A has a steeper NPV profile
  2. Project A should be accepted, project A has a steeper NPV profile
  3. Project B should be accepted, project B has a steeper NPV profile
  4. Both projects should be accepted, project A has a steeper NPV profile
  5. Project A should be accepted, project B has a steeper NPV profile
  6. Neither project should be accepted, project B has a steeper NPV profile

Answer(s): E

Explanation:

The NPV of project B is found to be ($1,766.21), and thus should not be accepted. However, project A has a positive NPV of $6,416.14, and should be accepted. Project B is characterized as having the majority of its cash inflows occurring in later time periods, and thus is more sensitive to changes in the cost of capital. This is exemplified by a steeper NPV profile for project B.



Which of the following equations correctly illustrates the calculation of the cost of equity using the Discounted Cash Flow approach?

  1. (Retention rate)*(ROE)
  2. Last annual dividend/(1 + required rate of return)
  3. Next annual dividend/current stock price
  4. (1-tax rate)
  5. (Next annual dividend/current stock price) + expected growth rate
  6. (Last annual dividend/[expected return - required return])
  7. expected growth rate
  8. Risk-free rate of return + beta(expected return on the market - risk-free rate of return)

Answer(s): E

Explanation:

The Dividend-Yield-plus-Growth-Rate approach calls for the following components: next annual dividend, current stock price, and expected growth rate. This approach, also known as the Discounted Cash Flow (DCF) method, is a flexible and very adept tool in the hands of the financial analyst, and is it is imperative that the CFA candidate fully understand both the applications and the methodology of this approach. The fourth choice illustrates the Capital Asset Pricing Model, while the fifth represents an approach for calculating sustainable growth rate. The remaining answers are somewhat fictitious.



Rollins Corporation is constructing its MCC schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock, which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm, which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk- premium method to find k(s). The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent. What is Rollins' WACC once it starts using new common stock financing?

  1. 16.6%
  2. 13.6%
  3. 14.1%
  4. 16.9%
  5. 16.0%

Answer(s): C

Explanation:

k(e) = $2.16/ $27.00(1-.10) + 0.08 = 0.08889 + 0.08 = 0.169 = 16.9%.
WACC = 0.2(12.0%)(0.6) + 0.2(12.6%) + 0.6(16.9%) = 14.1%.



Intelligent Semiconductor, a diversified technology company, is evaluating the sales of its cadmium silicon transistor coils, and has identified the following information:
Fixed production costs for these transistors: $750,000
Average sales price per unit: $405.00
Variable cost per unit: $313.60
Which of the following best describes the breakeven quantity for this product?

  1. The breakeven quantity for this product cannot be determined from the information provided.
  2. 8,206 units
  3. 1,044 units
  4. 5,397 units
  5. 7,397 units

Answer(s): B

Explanation:

To calculate the breakeven quantity for a product, use the following equation: {Fixed operating costs/[avg. sales price per unit - variable cost per unit]}. Incorporating the given information into this equation yields the following:
{$750,000/[$405 - $313.60]}=8,206 units.



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