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Free Test Prep CFA-Level-I Exam Questions (page: 47)

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When examining a capital project with non-normal cash flows from the perspective of IRR, some distinct problems can arise, which of the following choices best describes the problems that can occur when examining projects with non-normal cash flows using IRR?

  1. No IRR, an IRR which leads to an incorrect accept reject decision, concave MIRR profile
  2. Multiple IRRs, an IRR which leads to an incorrect accept/reject decision, convex MIRR profile
  3. Multiple IRRs, no IRR
  4. Multiple IRRs, no IRR, an IRR which leads to an incorrect accept/reject decision
  5. Timing differences, project scale differences, multiple IRRs

Answer(s): D

Explanation:

When examining capital projects with non-normal cash flows, three distinct problems can occur: the project can have multiple IRRs, no IRR, or the calculation can lead to the production of an IRR figure which leads to an incorrect accept/reject decision. Thus, the second choice represents the most correct answer. "Timing differences" and "project scale differences" are two reasons for a conflict in the NPV and IRR calculations, and "MIRR profile" is a fictitious term.



Consider the following two projects:
Project A
Initial cash outflow:$1,000,000
Cash inflows as follows
t1: $500,000
t2: $450,000
t3: $250,000
t4: $150,000
t5: $150,000
Project B
Initial cash outflow: $1,000,000
Cash inflows as follows
t1: $150,000
t2: $150,000
t3: $250,000
t4: $450,000
t5: $500,000
Assuming a cost of capital of 9%, no taxes, and a $0.00 salvage value for each project at the end of year 5, what is the NPV of each project? Additionally, which of the two projects has the steeper NPV profile?

  1. Project A NPV: $88,596.13, Project B NPV: $110,900.51, Project A has a steeper NPV profile
  2. Project A NPV: $114,078.88, Project B NPV: $100,669.59, Project has B has a steeper NPV profile
  3. Project A NPV: $234,270.95, Project B NPV: $100,669.59 , Project A has a steeper NPV profile
  4. Project A NPV: $234,270.95, Project B NPV: $100,669.59, Project B has a steeper NPV profile
  5. Project A NPV: $234,270.95, Project B NPV: $100,669.59, Project A has a steeper NPV profile

Answer(s): D

Explanation:

Due to the fact that project B has the majority of its cash inflows coming in later periods, it is more sensitive to changes in the cost of capital than is project A, which has the majority of its cash flows coming in earlier periods. This is exemplified by a steeper NPV profile.



Clay Industries, a large industrial firm, has begun the development of an underwater drilling system which will greatly increase the efficiency of deep-sea petroleum extraction. In their analysis of the project's cash-flow potential, the corporate finance division of Clay Industries does not factor in the initial R&D costs for the quarter, rather examines only the initial cash outlay and expected cash inflows specific to the underwater drilling system. The R&D costs involved for this quarter could best be described as which of the following?

  1. Externality
  2. None of these answers
  3. Opportunity cost
  4. Implicit cost
  5. Sunk cost
  6. Incremental cost

Answer(s): E

Explanation:

In this example, the R&D expenditures are an example of a sunk cost. In an analysis of any project, sunk costs are not included. This is because sunk costs represent outlays which have already occurred or have already been committed. These costs are not incremental, and hence are not affected by the decision under consideration.



Which of the following projects would likely result in multiple Internal Rates of Return? Project A
Initial investment outlay: ($450,000)
t1: $400,000
t2: ($40,000)
t3: $190,000
Project B
Initial investment outlay: ($50,000)
t1: $0.00
t2: $0.00
t3: $75,000
Project C
Initial investment outlay: ($300,000)
t1: $15,000
t2: ($34,000)
t3: $0.00
t4: $400,000
Project D
Initial investment outlay: ($100,000)
t1: $150,000
t2: $380,000
t3: $45,000
t4: $45,000
Project E
Initial investment outlay: ($1,000,000)

t1: $1,500,000
t2: $1,300
t3: $0.00
t4: $60,000

  1. None of these choices
  2. Project B, Project D
  3. The answer cannot be determined from the information provided
  4. Project C, Project E
  5. Project A, Project C,
  6. Project D, Project E

Answer(s): E

Explanation:

In evaluating projects with "non-normal cash flows" the Internal Rate of Return method will often produce multiple IRRs which leads to an incorrect accept/reject decision. Non-normal cash flows are defined as cash flows in which the sign changes more than once. Projects A, and C involve cash outflows superimposed within their cash inflows, resulting in a sign change from positive to negative and negative to positive. In examining projects such as these, it is advisable to use either the NPV or MIRR methods, which are not subject to the problem of multiple IRRs. From observation alone, we can determine that project A and C are non-normal projects, and are thus likely to result in multiple IRR calculations. While project B, D, and E have periods of zero cash flow, they have only one change of sign in the overall cash flow process, and therefore should be characterized as "normal." While the cost of capital has been provided, it is not necessary for the determination of the correct answer in this case. What you should look for are projects with non-normal cash flows, and this should not involve any computational analysis. Besides, the cost of capital is not incorporated into the Internal Rate of Return calculation, rather is a component of the NPV and MIRR.



The following information applies to a company's preferred stock:
Current price $105.00 per share
Par value $100.00 per share
Annual dividend $5.00 per share
The company issued the preferred stock at par and incurred a 10% floatation cost. If the company's marginal corporate tax rate is 40%, what is the after-tax cost of preferred stock?

  1. 5.0%
  2. 10.0%
  3. 3.0%
  4. 4.8%
  5. 5.6%
  6. 2.9%

Answer(s): E

Explanation:

The cost of preferred stock is calculated as the preferred stock dividend divided by the net issuing price. The dividend for this preferred stock is $5.00, and the net issuing price was $90.00. Thus the cost of preferred stock is 5 divided by 90 or 5.6%. There are no tax savings associated with the use of preferred stock, therefore no tax adjustments are made when calculating the cost.



Consider the following information:
Borrowing Rate 10%
Marginal Tax Rate 40%
Preferred Stock Par Price $50
Preferred Dividend $5
Preferred Stock floatation cost 2.0%
Cost of common equity 15.0%
Preferred Stock issued at Par
The Optimal Capital Structure is 45% debt, 50% common equity, and 5% preferred stock. Credit Rating BB+ What is the firm's Weighted Average Cost of Capital (WACC)?

  1. 9.0%
  2. 7.14%
  3. 9.06%
  4. 10.71%
  5. 2.5%
  6. 28.00%

Answer(s): D

Explanation:

The firm's Weighted Average Cost of Capital (WACC) is a weighted average of the component cost of capital.
In this case 10%(borrowing rate) x (1-.4)Tax savings = 6% is the component cost of debt. $5 (preferred dividend) / 49(Par minus floatation cost) = 10.2% is the component cost of preferred stock. Thus the WACC = .45(6%) + .5(15%) + .05(10.2%) = 10.71%



Which of the following is/are true for a project which needs only an initial outlay and no further expenses?

  1. The shorter the payback period, the greater the liquidity of the project.
    II. The discounted payback period is always more than the simple payback period.
    III. The payback period rule considers all the cash flows involved in a project.
  2. II & III
  3. II only
  4. I & II
  5. III only
  6. I & III
  7. I only
  8. I, II & III

Answer(s): C

Explanation:

The payback period measures how quickly you recover your initial investment. The shorter this period, the greater the liquidity in terms of cash recovery. The payback rule ignores cash flows beyond the payback period.
The discounted payback period is defined as the expected number of years that would be required to recover the original investment using discounted cash flows. Hence, (II) is true if there are no negative cash flows after the initial investment since discounting reduces the present value of the future cash flows.



Which of the following statements is correct?

  1. When the MCC (Marginal Cost of Capital) schedule is developed, the first break point always occurs as a result of using up retained earnings.
  2. Flotation costs must be included in the component cost of preferred stock.
  3. If a company with a debt ratio of 50 percent were suddenly exempted from all future income taxes, then, all other things held constant, this would cause its WACC to increase.
  4. The WACC (Weighted Average Cost of Capital) should include only after-tax component costs. Therefore, the required rates of return on debt, preferred, and common equity must be adjusted to an after-tax basis before they are used in the WACC equation.
  5. The cost of retained earnings is generally higher than the cost of new common stock.

Answer(s): C

Explanation:

If a firm paid no income taxes, its cost of debt would not be adjusted downward, hence the component cost of debt would be higher than if T (the firm's marginal tax rate) were greater than 0. With a higher component cost of debt, the WACC would be increased. Of course, the company would have higher earnings, and its cash flows from a given project would be high, so the higher WACC would not impede its investments, i.e., its capital budget would be larger than if it were taxed.



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