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Free Test Prep CFA-Level-I Exam Questions (page: 53)

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Bouchard Company's stock sells for $20 per share, its last dividend was $1.00. Its growth rate is a constant 6 percent, and the company would incur a flotation cost of 20 percent if it sold new common stock. Retained earnings for the coming year are expected to be $1,000,000, and the amount of common equity in the capital structure is 60 percent. If Bouchard has a capital budget of $2,000,000, what component cost of common equity will be built into the WACC for the last dollar of capital the company raises?

  1. 12.15%
  2. 11.80%
  3. 11.30%
  4. 11.45%
  5. 12.63%

Answer(s): E

Explanation:

BP(RE) = RE/Equity fraction = $1,000,000/0.6 = $1,666,667.
Since the capital budget will be $2 million, and since all equity in the WACC (Weighted Average Cost of Capital) beyond $1,666,667 will be external equity, the WACC of the last dollar raised will include equity at a cost of k(e) (component cost of external equity obtained by issuing new common stock as opposed to retaining earnings):
k(e) = $1(1.06)/$20(1 - 0.2) + 0.06 = 0.0663 + 0.06 = 0.1263 = 12.63%.



A company is analyzing two mutually exclusive projects, S and L, whose cash flows are shown below:
Years01234
S-1,1009003505010
L-1,1000300500850
The company's cost of capital is 12 percent, and it can get an unlimited amount of capital at that cost. What is the regular IRR (not MIRR) of the better project?

  1. 12.00%
  2. 13.09%
  3. 17.46%
  4. 12.53%
  5. 13.88%

Answer(s): B

Explanation:

Time line:
0 k = 12%1234 Years
Cash flows S -1,1009003505010
NPV(S) = ? IRR(S) = ?
Cash flows L -1,1000300500850
NPV(L) = ? IRR(L) = ?
Financial calculator solution:
Calculate the NPV and IRR of each project then select the IRR of the higher NPV project Project S; Inputs: CF (0) = -1,100; CF(1) = 900; CF(2) = 350; CF(3) = 50; CF(4) = 10; I = 12 Output: NPV(S) = 24.53; IRR(S) = 13.88%.
Project L; Inputs: CF(0) = -1,100; CF(1) = 0; CF(2) = 300; CF(3) = 500; CF(4) = 850; I = 12 Output: NPVL = 35.24; IRR(L) = 13.09%.
Project L has the higher NPV and its IRR = 13.09%.



The market risk of a project is measured by:

  1. the project's impact on the systematic risk of the firm's stock.
  2. the variability of the project's projected returns.
  3. the project's impact on the uncertainty about the firm's future earnings.
  4. the project's impact on the unsystematic risk of the firm's stock.

Answer(s): A

Explanation:

Remember that it is the systematic risk that you must worry about.



Pickles Corp. is a company which sells bottled iced tea. The company is thinking about expanding its operations into the bottled lemonade business. Which of the following factors should the company incorporate into its capital budgeting decision as it decides whether or not to enter the lemonade business?

  1. All of the statements are correct.
  2. If the company doesn't produce lemonade, it can lease the building to another company and receive after- tax cash flows of $500,000 a year.
  3. The company will spend $3 million to renovate a building for the proposed project.
  4. If the company enters the lemonade business, its iced tea sales are expected to fall 5 percent as some consumers switch from iced tea to lemonade.
  5. None of the statements are correct.

Answer(s): A

Explanation:

These are all incremental cash flows and should be considered.



Which of the following projects is likely to have multiple Internal Rates of Return? Project A Initial investment outlay: ($1,000,000)
t1: $400,000
t2: $100
t3: $1,000,000
t4: $1,000,000
t5: $100
t6: $0.00
Project B
Initial investment outlay: ($1,000,000)
t1: $40,000
t2: $90,000
t3: $590,000
t4: ($105,000)
t5: ($10,000)
t6: $900,000
Project C
Initial investment outlay: ($500,000)
t1: $100,000
t2: $100,000
t3: $100,000
t4: $100,000
t5: $0.00
t6: $500,000
Project D

Initial investment outlay: ($500,000)
t1: $105,000
t2: ($40,000)
t3: $45,000)
t4: $400,000
t5: $400,000
t6: $65,000

  1. None of these answers
  2. Both Project B and D likely to have multiple IRRs
  3. Project C
  4. Project D
  5. Project B
  6. Project A

Answer(s): B

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 B and D involve cash outflows superimposed within the cash inflows, resulting in a sign change from positive to negative and negative to positive. In examining projects such as this, it is advisable to use either the NPV or MIRR methods. From observation alone, we can determine that project B and D are non-normal projects, and are thus likely to result in multiple IRR calculations. While projects A and C do involve periods of zero cash flow, this will not interfere with the IRR calculation to the extent of producing multiple IRRs.



Your company's stock sells for $50 per share, its last dividend was $2.00, its growth rate is a constant 5 percent, and the company would incur a flotation cost of 15 percent if it sold new common stock. Net income for the coming year is expected to be $500,000, the firm's payout ratio is 60 percent, and its common equity ratio is 30 percent. If the firm has a capital budget of $1,000,000, what component cost of common equity will be built into the WACC for the last dollar of capital the company raises?

  1. 12.30%
  2. 11.75%
  3. 10.50%
  4. 9.94%
  5. 9.20%

Answer(s): D

Explanation:

BP(RE) = RE/Equity fraction = $500,000(0.4)/0.3 = $666,667. BP = break point; RE = retained earnings
Since the capital budget will be $1 million, and since all equity in the WACC beyond $666,667 will be external equity, the WACC of the last dollar raised will include equity at a cost of k(e):
k(e) = $2(1.05)/$50(1 - 0.15) + .05 = 9.94%.



Consider the following characteristics of firm XYZ:
Stock price $50
Annual dividend $2
Debt rate 10%
Equity floatation cost 7%
Tax rate 40%
Preferred Stock Par value $100
What is the firm's after tax cost of debt?

  1. 60%
  2. 4.3%
  3. 10%
  4. 40%
  5. 6%
  6. 4%
  7. 5%

Answer(s): E

Explanation:

A firm's after tax cost of debt may be calculated using the following formula: After Tax Cost of Debt = Cost of Debt x (1 - Tax Rate). In this case the After Tax Cost of Debt = 10% x (1 - 40%) = 10% x 60% = 6%.



The Oneonta Chemical Company is evaluating two mutually exclusive pollution control systems. Since the company's revenue stream will not be affected by the choice of control systems, the projects are being evaluated by finding the PV of each set of costs. The firm's required rate of return is 13 percent, and it adds or subtracts 3 percentage points to adjust for project risk differences. System A is judged to be a high-risk project (it might end up costing much more to operate than is expected). System A's risk-adjusted cost of capital is

  1. 16 percent; since A is more risky, its cash flows should be discounted at a higher rate, because this correctly penalizes the project for its high risk.
  2. indeterminate, or, more accurately, irrelevant, because for such projects we would simply select the process that meets the requirements with the lowest required investment.
  3. 13 percent; the firms cost of capital should not be adjusted when evaluating outflow only projects.
  4. somewhere between 10 percent and 16 percent, with the answer depending on the riskiness of the relevant inflows.
  5. 10 percent; this might seem illogical at first, but it correctly adjusts for risk where outflows, rather than inflows, are being discounted.

Answer(s): E

Explanation:

k(A) = 13% - 3% = 10%. If the cash flows are cost only outflows, and the analyst wants to correctly reflect their risk, the discount rate should be adjusted downward (in this case by subtracting 3 percentage points) to make the discounted flows comparatively larger.



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