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Free Test Prep CFA-Level-I Exam Questions (page: 50)

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Which of the following equations correctly illustrates the calculation of the Weighted Average Cost of Capital (WACC)?

  1. None of these answers
  2. {{Percentage of debt* [coupon on outstanding debt * (1 - combined state/federal tax rate)]} + {percentage of preferred stock * [annual preferred dividend/(required rate of return)]} + {percentage of common equity * cost of common equity}}
  3. {{Percentage of debt * [coupon on outstanding debt * (1 + combined state/federal tax rate)]} + {percentage of preferred stock * [annual preferred dividend/(offering price - flotation costs)]} + {percentage of common equity * cost of common equity}}
  4. {{Percentage of debt* [yield to maturity of outstanding debt * (1 - combined state/federal tax rate)]} + {percentage of preferred stock * [annual preferred dividend/(offering price - flotation costs)]} + {percentage of common equity * cost of common equity}}
  5. {Average cost of equity + average cost of debt + average cost of preferred stock}* subjective divisor
  6. {Percentage of debt * [coupon on outstanding debt * (1 + combined state/federal tax rate)]} + {percentage of preferred stock * [annual preferred dividend/(offering price + flotation costs)]} + {percentage of common equity * cost of common equity}}

Answer(s): D

Explanation:

The Weighted Average Cost of Capital is a fundamentally important concept within the field of corporate finance, and the CFA candidate should have a complete understanding of both the mechanics of the WACC figure, as well as the relationships between its components. In calculating the cost of outstanding common equity, there exist three distinct methods, the Dividend-Yield-plus- Growth-Rate, or Discounted Cash Flow approach, the Capital Asset Pricing Model (CAPM), and the Bond-Yield-plus-Risk-Premium approach. It is important for the CFA candidate to have a complete understanding of each method, along with their weaknesses and advantages.



Lincoln Lodging Inc. estimates that if its sales increase 10 percent then its net income will increase 18 percent. The company's EBIT equals $2.4 million, and its interest expense is $400,000. The company's operating costs include fixed and variable costs. What is the level of the company's fixed operating costs?

  1. $2,125,000
  2. $2,000,000
  3. $1,200,000
  4. $666,667
  5. $450,000

Answer(s): C

Explanation:

We're given enough information to find both DFL and DTL.
DTL = .18/.10 = 1.8.
DFL = $2,400,000/($2,400,000 - $400,000) = 1.2
Given DTL = DFL x DOL, we can calculate DOL = 1.5. Recognizing S - VC - FC = EBIT, 1.5 = (S - VC)/$2,400,000 or S - VC = $3,600,000. The difference between (S - VC) and EBIT must represent fixed operating costs. Thus, FC = $3,600,000 - $2,400,000 = $1,200,000.



The Altman Company has a debt ratio of 33.33 percent, and it needs to raise $100,000 to expand. Management feels that an optimal debt ratio would be 16.67 percent. Sales are currently $750,000, and the total assets turnover is 7.5. How should the expansion be financed so as to produce the desired debt ratio?

  1. Finance 20 percent debt, 80 percent equity.
  2. Finance 40 percent debt, 60 percent equity.
  3. Finance it all with debt.
  4. Finance 50 percent debt, 50 percent equity.
  5. Finance it all with equity.

Answer(s): E

Explanation:

Old debt ratio = 0.3333; New debt ratio = 0.1667.
$750,000/TA= 7.5.
TA = $100,000.
Debt = 0.3333($100,000) = $33,330.
New TA = $100,000 + $100,000 = $200,000.
New Debt = $200,000(0.1667) = $33,340.
Altman's current debt of $33,330 represents approximately 16.67% of total assets following the expansion, thus the firm should finance with 100 percent equity.



Which of the following is a key determinant of operating leverage?

  1. Cost of debt.
  2. Technology.
  3. Level of debt.
  4. Capital structure.
  5. Physical location of production facilities.

Answer(s): B

Explanation:

If a high percentage of a firm's total costs are fixed, the firm has high operating leverage. Higher fixed costs are generally associated with more highly automated, capital-intensive firms and industries.



Which of the following statements is most correct?

  1. All of these answers are correct.
  2. An increase in the risk-free rate is likely to decrease the marginal cost of both debt and equity financing.
  3. The WACC is calculated on a before-tax basis.
  4. None of these answers are correct.
  5. The WACC (Weighted Average Cost of Capital) for a given capital budget level is a weighted average of the marginal cost of each relevant component which makes up the firm's target capital structure.

Answer(s): E

Explanation:

A value-maximizing firm will establish a target (optimal) capital structure and then raise new capital in a manner that will keep the actual capital structure on target over time. The target proportions of debt, preferred stock, and common equity, along with the component cost of capital, are used to calculate the firm's WACC.



Which of the following statements is most correct?

  1. The factors which affect a firm's business risk are determined partly by industry characteristics and partly by economic conditions. Unfortunately, these and other factors, which affect a firm's business risk, are not subject to any degree of managerial control.
  2. The firm's financial risk may have both market risk and diversifiable risk components.
  3. One of the benefits to a firm of being at or near its target capital structure are that financial flexibility becomes much less important.
  4. A firm's business risk is solely determined by the financial characteristics of its industry.
  5. All of these statements are false.

Answer(s): B

Explanation:

Financial risk is an increase in stockholders' risk, over and above the firm's basic business risk, resulting from the use of financial leverage, which refers to the use of fixed-income securities.



Jackson Jets is considering two mutually exclusive projects. The projects have the following cash flows:
Project A Project B
Time Cash FlowsC ash Flows
0-$10,000-$8,000
1 1,000 7,000
2 2,000 1,000
3 6,000 1,000
4 6,000 1,000
At what cost of capital, do the two projects have the same net present value?

  1. 13.03%
  2. 12.26%
  3. 11.20%
  4. 12.84%
  5. 14.15%

Answer(s): A

Explanation:

Find the differential cash flows by subtracting B's cash flows from A's cash flows for each year.
CF(0) = -2,000
CF(1) = -6,000
CF(2) = 1,000
CF(3) = 5,000
CF(4) = 5,000
Enter these cash flows and solve for the IRR = crossover rate = 13.03%.



Which of the following types of risk cannot be eliminated through diversification? Choose the best answer

  1. Unsystematic risk
  2. Market risk
  3. Corporate risk
  4. Alpha risk
  5. Gamma risk

Answer(s): B

Explanation:

Market risk is defined as that part of an asset's risk which cannot be eliminated through diversification. Market risk is measured by the Beta coefficient, and is commonly referred to as "systematic" or "nondiversifiable" risk.
Additionally, market risk is referred to as "beta risk." Corporate risk is defined as the variability of assets expected returns without taking into consideration the effects of shareholder diversification. This is one step away from Stand-alone Risk, which measures the risk of an asset, not only without taking into consideration the effect of shareholder diversification, but of company diversification as well. Stand-alone risk assumes that the asset in question is the only asset of the firm and that the securities of the firm are the only assets in investors' portfolios. Corporate risk takes into consideration that firms will diversify their asset bases.



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