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Free Test Prep CFA-Level-I Exam Questions (page: 46)

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The optimal debt ratio is the debt ratio that:

  1. minimizes the firm's bankruptcy costs.
  2. maximizes the firm's earnings per share and maximizes the firm's stock price.
  3. maximizes the firm's stock price.
  4. maximizes the firm's earnings per share.

Answer(s): C

Explanation:

The optimal debt ratio is defined as the debt level that maximizes the firm's stock price.



A cash outlay that has already been incurred and which cannot be recovered regardless of whether the project is accepted or rejected is known as which of the following terms?

  1. Incremental Cash Flow
  2. Externality
  3. Sunk Cost
  4. Opportunity Cost
  5. Cannibalization

Answer(s): C

Explanation:

Sunk cost is defined as a cash outlay that has already been incurred and which cannot be recovered regardless of whether a project is accepted or rejected.



The management of Intelligent Semiconductor is examining the asset structure of its superconductor division, and has ascertained the following annual financial information: Invoiced sales $6,850.000 EBITA $3,525,000
Interest expense $150,000
Amortization expense $245,000
Given this information, which of the following best characterizes the Degree of Financial Leverage for this division?

  1. 1.048
  2. None of these answers is correct.
  3. 1.044
  4. .0.488
  5. 2.03

Answer(s): A

Explanation:

To calculate the DFL, the financial analyst needs to determine the EBIT and interest paid for a predetermined time period. To calculate the Degree of Financial Leverage, the following equation is used: {EBIT/[EBIT - interest paid]}. In this example, EBITA is provided rather than EBIT. Thankfully, however, a figure is given for amortization expense. To determine the EBIT, subtract the amortization expense from then EBITA figure, which gives a figure of $3,280,000 for the EBIT. The next step is to incorporate the given information into the DFL equation as follows: {EBIT $3,280,000 / [EBIT $3,280,000 - interest expense $150,000]}=1.048 The Degree of Financial Leverage measures the percentage change in EPS which results from a given percentage change in EBIT. Remember that any preferred stock dividends must be incorporated into the DFL calculation, and that the DFL can never be less than one.



Sunk costs:

  1. should be ignored while evaluating a project.
  2. affect a project's desirability adversely.
  3. are incremental cash flows of the project under consideration.
  4. lower a project's NPV.

Answer(s): A

Explanation:

Sunk costs represent expenses that have already been incurred or committed to. Therefore, they are not pertinent to future decisions.



Becker Glass Corporation expects to have earnings before interest and taxes during the coming year of $1,000,000, and it expects its earnings and dividends to grow indefinitely at a constant annual rate of 12.5 percent. The firm has $5,000,000 of debt outstanding bearing a coupon interest rate of 8 percent, and it has 100,000 shares of common stock outstanding. Historically, Becker has paid 50 percent of net earnings to common shareholders in the form of dividends. The current price of Becker's common stock is $40, but it would incur a 10 percent flotation cost if it were to sell new stock. The firm's tax rate is 40 percent. What is Becker's cost of newly issued stock?

  1. 17.5%
  2. 16.5%
  3. 16.0%
  4. 17.0%
  5. 18.0%

Answer(s): A

Explanation:

Cost of new common equity:
k(e) = $1.80/$40.00(1-.10) + 0.125 = 17.5%.
The dividend of $1.80 was derived by:
EBIT$1,000,000
Interest 400,000
EBT$600,000
Taxes (40%)240,000
Net income$360,000
EPS(1) = $360,000/100,000 = $3.60.
D(1) = $3.60(0.5) = $1.80.



Which of the following statements is most correct?

  1. None of the answers are correct.
  2. All is these answers are correct.
  3. If Project A has a higher IRR than Project B, then Project A must also have a higher NPV.
  4. The IRR calculation implicitly assumes that all cash flows are reinvested at a rate of return equal to the cost of capital.
  5. If a project's internal rate of return (IRR) exceeds the cost of capital, then the project's net present value (NPV) must be positive.

Answer(s): E

Explanation:

The IRR on a project is its expected rate of return. If the return exceeds the cost of the funds used to finance the project, a surplus remains after paying for the capital, and this surplus accrues to the firm's stockholders.
Therefore, a project whose IRR exceeds its cost of capital increase shareholders' wealth, just as a positive NPV does.



The management of Microscam International, a large software manufacturer, is examining its capital structure. The firm is financed according to the following schedule based on market values:
40% debt
50% common stock
10% perpetual preferred stock
Additionally, consider the following information:
Yield on outstanding debt: 9.25%
Tax rate: 35%

Annual preferred dividend: $2.02
Preferred stock price: $17.44
Return on equity: 22%
Dividend payout ratio: 15%
Cost of common stock: 15.40%
Using this information, what is the Weighted Average Cost of Capital for Microscam?

  1. 11.08%
  2. 11.12%
  3. None of these answers.
  4. 10.88%
  5. 11.26%
  6. The answer cannot be completely calculated from the given information.

Answer(s): E

Explanation:

In order to calculate the WACC, it is necessary to first calculate the component after-tax cost of debt, common equity, and preferred equity. Once the cost of these components is determined, they are imputed into the WACC equation, which is as follows:
{WACC = [(% weight of debt securities * cost of debt) + (% weight of common stock * cost of common stock) + (% weight of preferred stock * cost of preferred stock)]}
To calculate the component cost of debt, use the following equation: {After-tax cost of debt = [yield on outstanding debt securities * (1 - tax rate)}
Factoring in the given information into this equation would yield the following:
{After-tax cost of debt = [9.25% * (1 - 0.35%)]} = 6.013%
To calculate the component cost of outstanding preferred stock, the following equation must be used:
{Cost of preferred stock = [annual dividend / preferred stock price]} {Cost of preferred stock - = [$2.02 / $17.44]} = 11.58%.
The final component of the WACC calculation, the cost of common equity, has been provided as 15.40%.
Now that the after-tax cost of debt, preferred stock, and common stock have been determined, the WACC calculation can be found. The calculation of the WACC is as follows: {[0.40 * 0.06013] + [0.50 * 0.1540] + [0.10
* 0.1158]} = 11.263%.



Firm A has just paid a cash dividend of $6.2 per share. If the growth rate is expected to be 6% and the price of the stock is $24.90, the expected return on the stock is:

  1. 32.39%
  2. 26.39%
  3. 20.39%
  4. 24.90%

Answer(s): A

Explanation:

Po = D1/(k-g). In this case, g = 6%, D1 = Do*(1+g) = 6.2*1.06 = $6.572 and Po = $24.90. Therefore, k = 32.39%. Note that Brigham & Houston refer to k as the cost of retained earnings; this is the same as the expected rate of return demanded by shareholders, which is the same as the rate of return on common equity.



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