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Free Test Prep CFA-Level-I Exam Questions (page: 57)

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A firm has just issued 6%, 10-year coupon bonds, which have a yield-to-maturity of 7.1%. The firm has old debt, which pays a coupon of 8%. The firm is in the 45% tax bracket. Its marginal after-tax cost of debt equals ________.

  1. 3.3%
  2. 3.2%
  3. 4.4%
  4. 3.9%

Answer(s): D

Explanation:

Since debt interest is tax-deductible, the after-tax cost of debt equals 7.1%*(1-45%) = 3.9%. Note that you must use the yield-to-maturity of the new bonds while calculating the cost of debt since this is the rate at which interest expense is computed in maintaining the accounts. The coupon rate does not enter directly in this calculation (though it does matter since it affects the yield-to-maturity).



Mid-State Electric Company must clean up the water released from its generating plant. The company's cost of capital is 10 percent for average projects, and that rate is normally adjusted up or down by 2 percentage points for high- and low-risk projects. Clean-up Plan A, which is of average risk, has an initial cost of -$1,000 at Time 0, and its operating cost will be -$100 per year for its 10-year life. Plan B, which is a high-risk project, has an initial cost of -$300, and its annual operating cost over Years 1 to 10 will be -$200. What is the proper PV of costs for the better project?

  1. -$1,642.02
  2. -$1,430.04
  3. -$1,728.19
  4. -$1,525.88
  5. -$1,614.46

Answer(s): E

Explanation:

The first thing to note is that risky cash outflows should be discounted at a lower discount rate, so in this case we would discount the riskier Project B's cash flows at 10% - 2% = 8%. Project A's cash flows would be discounted at 10%.
Now we would find the PV of the costs as follows:
Project AProject B
CF(0) = -1,000CF(0) =-300
CF(1-10) = -100CF(1-10)=-200
I =10.0I= 8.0
Solve for NPV = -$1,614.46. Solve for NPV = -$1,642.02.
Project A has the lower PV of costs. If Project B had been evaluated with a 12% cost of capital, its PV of costs would have been -$1,430.04, but that would have been wrong.



After getting her degree in marketing and working for 5 years for a large department store, Sally started her own specialty shop in a regional mall. Sally's current lease calls for payments of $1,000 at the end of each month for the next 60 months. Now the landlord offers Sally a new 5-year lease which calls for zero rent for 6 months, then rental payments of $1,050 at the end of each month for the next 54 months. Sally's cost of capital is 11 percent. By what absolute dollar amount would accepting the new lease change Sally's theoretical net worth?

  1. $4,681.76
  2. $3,803.06
  3. $4,299.87
  4. $3,243.24
  5. $2,810.09

Answer(s): B

Explanation:

CF(0) = 0
CF(1-6) = 0
CF(7-60) = 1,050
I = 11/12 = 0.9167
Solve for NPV = -$42,189.97. Therefore, the PV of payments under the proposed lease would be less than the PV of payments under the old lease by $45,993.03 - $42,189.97 = $3,803.06. Sally should accept the new lease because it would raise her theoretical net worth by $3,803.06.



In comparing two mutually exclusive projects of equal size and equal life, which of the following statements is most correct?

  1. None of these answers are correct.
  2. The project with the higher NPV may not always be the project with the higher IRR.
  3. The project with the higher NPV may not always be the project with the higher MIRR.
  4. The project with the higher IRR will always be the project with the higher MIRR.
  5. All of the answers are correct.

Answer(s): B

Explanation:

Due to reinvestment rate assumptions, NPV and IRR can lead to conflicts; however, there will be no conflict between NPV and MIRR if the projects are equal in size (which is one of the assumptions in this question).



The Ace Company is considering investing in a piece of property, which costs $105,000. The property will return a constant cash flow forever. If the firm's cost of capital is 9 percent and the corporate tax rate is 40 percent, what is the minimum after-tax cash flow that would make the investment acceptable to Ace?

  1. $2,375
  2. $15,942
  3. $5,000
  4. $10,831
  5. $9,450

Answer(s): E

Explanation:

$105,000 = CF(AT)/0.09; CF(AT) = $9,450.



The percentage mix of debt, preferred stock, and common equity that will maximize a firm's stock price is known as:

  1. Marginal cost of capital
  2. Weighted average cost of capital (WACC)
  3. After tax cost of capital
  4. Marked to market value of equity
  5. Target (Optimal) Capital Structure

Answer(s): E

Explanation:

The target or optimal capital structure of a firm is that percentage mix of debt, preferred stock, and common equity that will maximize the firm's stock price.



Which of the following is false?

  1. The IRR rule is not dependable when applied to projects with non-normal cash flows.
  2. For independent projects with normal cash flows, the IRR and NPV rules give the same accept/reject results.
  3. For mutually exclusive projects, the IRR and NPV rules can give conflicting results.
  4. None of these answers.

Answer(s): D

Explanation:

Remember to always use the NPV result. There are quite a few problems with using other decision rules like IRR and payback period.



Calculate the cost of debt for the following firm:
Borrowing Rate 9.5%
Historical Beta .97
Marginal Tax Rate 40%
Credit Rating BB+
Owner's Equity 15%
Quick Ratio 1.7
EPS $1.70
P/E ratio 12
Estimated Dividends $.30

  1. 8.075%
  2. 6.27%
  3. 1.43%
  4. 5.7%
  5. 1.5%
  6. 9.5%

Answer(s): D

Explanation:

The cost of debt is simply the rate of borrowing less the tax savings. Due to the fact that interest expense is tax deductible, the cost of debt in this case is 9.5%(1 - .4) = 9.5%(.6) = 5.7%.



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