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Free Test Prep CFA-Level-I Exam Questions (page: 52)

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Which of the following statements is most correct?

  1. All of these answers are correct.
  2. None of these answers are correct.
  3. The capital structure that maximizes stock price is also the capital structure, which maximizes earnings per share.
  4. The capital structure that maximizes stock price is also the capital structure, which maximizes the firm's times-interest-earned (TIE) ratio.
  5. The capital structure that maximizes stock price is also the capital structure, which minimizes the weighted average cost of capital (WACC).

Answer(s): E

Explanation:

The capital structure which maximizes the firm's stock price generally calls for a debt ratio which is lower than the one that maximizes EPS. The firm could maximize its TIE by having no debt (i.e. zero interest payments).
But, this capital structure would probably not maximize the firm's stock price.



Anderson Company has four investment opportunities with the following costs (all costs are paid at t=0) and estimated internal rates of return (IRR):
Project Cost IRR
A $2,000 16.0%
B $3,000 14.5
C $5,000 11.5
D $3,000 9.5
The company has a target capital structure, which consists of 40 percent common equity, 40 percent debt, and 20 percent preferred stock. The company has $1,000 in retained earnings. The company expects its year-end dividend to be $3.00 per share. The dividend is expected to grow at a constant rate of 5 percent a year. The company's stock price is currently $42.75. If the company issues new common stock, the company will pay its investment bankers a 10 percent flotation cost. The company can issue corporate bonds with a yield to maturity of 10 percent. The company is in the 35 percent tax bracket. How large can the cost of preferred stock be (including flotation costs) and it still be profitable for the company to invest in all four projects?

  1. 7.75%
  2. 12.68%
  3. 10.46%
  4. 8.90%
  5. 11.54%

Answer(s): D

Explanation:

We need to find k(ps) at the point where all 4 projects are accepted. In other words, the capital budget = $2,000 + $3,000 + $5,000 + $3,000 = $13,000. The WACC at that point is equal to IRR(D) = 9.5%.
Step 1 Find the retained earnings break point to determine whether k(s) or k(e) is used in the WACC calculation:
BP(RE) = $2,500.
Since the capital budget > the retained earnings break point, k(e) is used in the WACC calculation.
Step 2 Calculate k(e):
k(e) = [3.00/$42.75(1-.10)] + 5% = 12.80%.
Step 3 Find k(ps):
9.5% = 0.4(10%)(0.65) + 0.2(kps) + 0.4(12.80%)
9.5% = 2.60% + 0.2(kps) + 5.12%
1.78% = 0.2k(ps)
8.90% = k(ps).



Martin Fillmore is a big football star who has been offered contracts by two different teams. The payments (in millions of dollars) he receives under the two contracts are listed below:
Team A Team B
TimeCash FlowsCash Flows
08.02.5
14.04.0
24.04.0
34.08.0
44.08.0
Fillmore is committed to accepting the contract that provides him with the highest net present value (NPV). At what discount rate would he be indifferent between the two contracts?

  1. 16.49%
  2. 10.85%
  3. 11.35%
  4. 19.67%
  5. 21.03%

Answer(s): C

Explanation:

First, find the differential CFs by subtracting Team A CFs from Team B CFs (or vice versa). Enter these into the cash flow register; then solve to find IRR/YR to get the discount rate for which he is indifferent between the two contracts, 11.35%.



Zippy Pasta Corporation (ZPC) has a constant growth rate of 7 percent. The company retains 30 percent of its earnings to fund future growth. ZPC's expected EPS and k(s) for various capital structures are given below. What is the optimal capital structure for ZPC? Debt/AssetsExpected EPS ($)k(s) 20%2.5015.0%
303.0015.5
403.2516.0
503.7517.0
704.0018.0

  1. Debt/Total Assets = 20%
  2. Debt/Total Assets = 30%
  3. Debt/Total Assets = 70%
  4. Debt/Total Assets = 40%
  5. Debt/Total Assets = 50%

Answer(s): E

Explanation:

The optimal capital structure maximizes the firm's stock price. When the debt ratio is 20%, expected EPS is $2.50. Given the firm's policy of retaining 30% of earnings, the expected dividend per share D1 is $2.50 x 0.70 = $1.75. The stock price Po is $1.75/(15% - 7%) or $21.88. When the debt ratio is 30%, expected EPS is $3.00 and expected D1 is $3.00 x 0.70 = $2.10. The stock price Po is $2.10/(15.5% - 7%) =$24.71. Similarly, when the debt ratio is 40%, D1 = $2.275 and Po = $25.28. When the debt ratio is 50%, D1 = $2.625 and Po = $26.25.
When the debt ratio is 70%, D1 = $2.80 and Po = $25.45. The stock price is highest when the debt ratio is 50%.



A portfolio manager with Mally, Feasance, & Company is examining shares of Allcycles.com. Assume the following information:
Annual Dividend: $0.45
EPS: $2.15
Tax Rate: 35%
Discount Rate: 12.25%
ROE: 18%
Using this information, and assuming that ROE is expected to remain stable, what is the dividend growth rate for Clay Industries?

  1. 14.64%
  2. 15.51%
  3. 3.77%
  4. 12.67%
  5. The answer cannot be determined from the information provided.
  6. 14.23%

Answer(s): F

Explanation:

To calculate the growth rate, use the following equation: {g = ROE(1 - Dividend Payout Ratio)}.
While the ROE figure has been provided, the Dividend Payout Ratio must be calculated manually. To find the Dividend Payout Ratio, divide the annual dividend by the EPS figure, giving the following:
{Dividend Payout Ratio = ($0.45/$2.15)}
From this equation, we determine that the Dividend Payout Ratio for this firm is 20.93%. Inputting this figure into the growth rate equation will yield a dividend growth rate of 14.23% for this firm.
As you can see, tax rates and discount rates are not factored into the calculation.



Which of the following statements is correct?

  1. Due to the way the MCC (Marginal Cost of Capital) is constructed, the first break point in the MCC schedule must be associated with using up all available retained earnings and having to issue common stock.
  2. Normally, the cost of external equity raised by issuing new common stock is above the cost of retained earnings. Moreover, the higher the growth rate is relative to the dividend yield, the more the cost of external equity will exceed the cost of retained earnings.
  3. The lower a company's tax rate, the greater the advantage of using debt in terms of lowering its WAC
  4. Because we often need to make comparisons among firms that are in different income tax brackets, it is best to calculate the WACC (Weighted Average Cost of Capital) on a before-tax basis.
  5. If a firm has been suffering accounting losses and is expected to continue suffering such losses, and therefore its tax rate is zero. It is possible that its after-tax component cost of preferred stock as used to calculate the WACC will be less than its after-tax component cost of debt.

Answer(s): E

Explanation:

Because corporations can exclude dividends for tax purposes, preferred stock often has a market return that is less than the issuing company's cost of debt. Then, if the issuer's tax rate is zero, its component cost of preferred would be less than its cost of debt.



A financial analyst with Smith, Kleen, & Beetchnutty is examining shares of Clay Industries for possible investment. Assume the following information:
EPS: $4.19
ROE: 11.25%
Growth rate of dividends: 6.75%
Discount rate: 11.50%
Tax Rate 35%
Using this information, what is the dividend payout ratio for Clay Industries? Further, what is the annual dividend?

  1. 35.87%, $1.50
  2. 60.00%, $2.51
  3. 60.00%, $1.68
  4. The answer cannot be determined from the information provided.
  5. 40.00%, $1.68
  6. 40.00%, $2.51

Answer(s): E

Explanation:

To determine the dividend payout ratio, the equation used to determine the growth rate of dividends must be manipulated. This equation is originally structured as follows:
{g = ROE (1 - Dividend Payout Ratio)}
In order to determine the Dividend Payout Ratio, the equation must be rearranged to the following: {(1 - Dividend Payout Ratio) = Growth Rate of Dividends / ROE}.
Imputing the given information into this equation will yield:
{(1 - Dividend Payout Ratio) = 0.0675/0.1125)} = 0.60
Finally, subtracting this answer from 1 will yield the answer of 40%. We must subtract the first answer from one because the first answer represents the retention rate, i.e. the percentage of earnings that is retained and reinvested at the firm's ROE, and not the Dividend Payout Ratio. The retention rate and the payout ratio will always combine to equal positive one. In order to determine the annual dividend, take the Dividend Payout Ratio, which was found to be 40%, and multiply this figure by the Earnings Per Share calculation, which is given as $4.19. This will yield an annual dividend of $1.676. As you can see, neither the discount rate nor the tax rate is factored into the equation



Using the Security Market Line concept in capital budgeting, which of the following is correct?

  1. If two mutually exclusive projects' expected returns are both above the SML, the project with the lower risk should be accepted.
  2. If a project's expected rate of return is greater than the expected rate of return on an average project, it should be accepted.
  3. If a project's return lies below the SML, it should be rejected if it has a beta greater than the firm's existing beta but accepted if its beta is below the firm's beta.
  4. If the expected rate of return on a given capital project lies above the SML, the project should be accepted even if its beta is above the beta of the firm's average project.

Answer(s): D

Explanation:

If the expected rate of return on a given capital project lies above the SML, the expected rate of return on the project is more than enough to compensate for its risk, and the project should be accepted. Conversely, if the project's rate of return lies below the SML, it should be rejected.



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