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Free Test Prep CFA-Level-I Exam Questions (page: 49)

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Which of the following terms describes the risk of individual projects to a corporation, taking into consideration that each project represents only one of the firm's portfolio of assets?

  1. Alpha coefficient
  2. Corporate risk
  3. Stand-alone risk
  4. Systematic risk
  5. Market risk

Answer(s): B

Explanation:

Corporate, or "within-firm" risk, is defined as the risk of individual projects to a corporation, taking into consideration the fact that each project represents only one of the firm's assets. In examining corporaterisk, there is an implicit assumption that some of the total risk to the firm's profits from the addition of new projects will be partially diversified away. Corporate risk is measured by the project's impact on uncertainty about the firm's future earnings.



Which of the following statements best describes the optimal capital structure?

  1. All of these answers are correct.
  2. None of these answers are correct.
  3. The optimal capital structure is the mix of debt, equity, and preferred stock, which maximizes the company's stock price.
  4. The optimal capital structure is the mix of debt, equity, and preferred stock which minimizes the company's cost of debt.
  5. The optimal capital structure is the mix of debt, equity, and preferred stock which maximizes the company's earnings per share (EPS).

Answer(s): C

Explanation:

The optimal capital structure is the one that maximizes the price of the firm's stock, and minimizes the firm's WACC.



Consider the following information:
30-day treasury rate (Risk Free rate) 6.4%
Company XYZ Bond yield 11.2%
Beta 1.1
Risk Premium 3.5%
Credit Rating B-
Marginal Tax Rate 40% Calculate Company XYZ's cost of retained earnings using the Bond-Yield-plus-Risk- Premium approach.

  1. 17.6%
  2. 15.2%
  3. 14.7%
  4. 8.82%
  5. 16.17%
  6. 11.36%

Answer(s): C

Explanation:

To estimate a firm's cost of retained earnings using the Bond-Yield-plus-Risk-Premium approach, simply take the company's bond yield and add the risk premium. In this case the cost of retained earnings = 11.2% + 3.5% = 14.7%.



An increase in which of the following, holding everything else equal, will cause a decrease in the theoretical growth rate of common stock dividends according to the Growth Rate of Dividends Model?

  1. Return on equity
    II. Tax rate
    III. Dividend payout ratio
    IV. Annual dividend
  2. Discount rate
    VI. Beta coefficient
    VII. Retention rate
  3. I, II, IV
  4. II, III, VI, V
  5. I, II, VI, V
  6. III
  7. III, VI, VII
  8. VII

Answer(s): D

Explanation:

III The equation used to determine the theoretical growth rate of common stock dividends is as follows: {Annual growth rate = [ROE * (1 - dividend payout ratio)]} As you can see, of the choices listed, only an increase in the dividend payout ratio will cause a decrease in the theoretical growth rate of common stock dividends.
Remember that the retention rate is equal to (1 - dividend payout ratio). Additionally, neither the discount rate nor the tax rate is explicitly factored into the dividend growth rate equation.



A stock has a beta of 0.85 and the risk-free rate is 6.95%. Its dividend growth rate is 5.2% and its P/E ratio is 11.6. If the firm has a dividend payout ratio of 63%, the market risk premium equals ________.

  1. 5.91%
  2. 6.54%
  3. 5.15%
  4. 4.33%

Answer(s): D

Explanation:

P0/E1 = dividend payout/(k - g) Therefore, 11.6 = 0.63/(k - 0.052), giving expected return = k = 10.63%. Now, the CAPM expected return on the stock is given by k = Rf + beta*(Rm - Rf). Therefore, 10.63% = 6.95% + 0.85*market premium, giving market premium = (10.63 - 6.95)%/0.85 = 4.33%.



Which of the following statements is most correct?

  1. Generally, we do not need to adjust project cash flows to take into account the effects of inflation, since inflation is not accounted for in the cost of capital.
  2. All of these statements are correct.
  3. For comparing mutually exclusive projects with unequal lives, replacement chain analysis leads to the same decision as obtained by calculating the equivalent annual annuity (EAA).
  4. In comparing mutually exclusive projects with unequal lives, you should always choose the project which has the highest NPV.
  5. The rate of depreciation affects accounting statements, but has no effect on the firm's capital budgeting decisions.

Answer(s): C

Explanation:

The replacement chain analysis and the equivalent annual annuity methods lead to the same decision.
Depreciation affects a firm's cash flow, which affects its capital budgeting decisions. The project with the highest extended NPV should be chosen. The cost of capital reflects inflation; therefore, project cash flows must be adjusted for inflation.



Which of the following figures is not explicitly incorporated into the earnings per share (EPS) calculation?

  1. Variable costs
  2. Common shares outstanding
  3. Interest expense
  4. None of these answers
  5. Fixed costs
  6. Sales

Answer(s): D

Explanation:

The EPS figure can be found using two principal equations. The first is illustrated as follows:
{EPS = [(Sales - Fixed Costs - Variable Costs - Interest Expense)(1 - Tax Rate)] / [# of Common Shares Outstanding]}
Additionally, the EPS figure can be found by:
{EPS = [(EBIT - Interest Expense)(1 - Tax Rate) / # of Common Shares Outstanding]} As you can see, all of the choices listed are expressly incorporated into the EPS calculation.



A firm's capital structure has a debt-to-equity ratio of 1.2. The pretax cost of debt is 6.8% and the weighted average cost of capital of the firm equals 9.8%. The risk-free rate in the economy is 6.2% the expected rate of return on the market is 14%. The firm must pay 35% of its gross income in taxes. The beta of the stock equals ________.

  1. 1.02
  2. 1.64
  3. 1.3
  4. 0.91

Answer(s): C

Explanation:

Since the debt interest is tax deductible, the after-tax cost of debt equals 6.8%*(1-0.35) = 4.42%. Since the D/E ratio = 1.2, (D+E)/E = 2.2, giving E/(D+E) = 0.455. Thus, equity forms 45.5% of the capital whiledebt forms 54.5%. The WACC is then equal to 0.455*RE + 0.545*4.42% = 9.8% (given). Solving gives RE = 16.24%. If B is the beta of the stock, then using CAPM, 16.24% = 6.2% + B*(14% - 6.2%), giving B = 1.29.



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