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Free Test Prep CFA-Level-I Exam Questions (page: 60)

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A project requires an initial outlay of 650. It also needs capital spending of 700 at the end of year 1 and 900 at the end of year 2. It has no revenues for the first 2 years but receives 1,200 in year 3, 1,600 in year 4 and 2,300 in year 5. The project's cost of capital is 10%. The discounted payback period equals ________.

  1. 2.26 years
  2. 4.02 years
  3. 3.19 years
  4. 3.46 years

Answer(s): B

Explanation:

The cash flows of the project starting at the end of year 1 are:
-700, -900, +1,200, +1,600, +2,300
The discounted payback period is defined as the expected number of years that would be required to recover the original investment using discounted cash flows. The discounted cash flow at the end of year N is obtained by dividing that year's cash flow by 1.1N, since the project's cost of capital is 10%. Using this, the discounted cash flows are:
-636, -744, +902, +1,093, +1,428.
Recovery occurs in the 5th year. At the beginning of the 5th year, the outstanding balance equals 650 + 636 + 744 - 902 - 1093 = 35. Therefore, the discounted payback period = 4 + 35/1428 = 4.02 years.



Which of the following choices correctly describes a project which will direct the operations of a company into a

new market or functional niche, is primarily enacted to expand revenues, and one in which the firm does not have an existing proxy?

  1. Marginal project
  2. Extraordinary item
  3. Retrenchment project
  4. Replacement project
  5. Expansion project

Answer(s): E

Explanation:

In an analysis of an expansion project, the relevant cash flows are those which apply wholly to the proposed project. There is no existing project whose cash flows must be incorporated into the analysis, as in the examination of a replacement project. "Marginal project" and "retrenchment project," are fictitious terms, and "extraordinary item" is an accounting classification referring to an event that is both unusual and nonrecurring.



According to the Signaling Theory of capital structure, an increase in bankruptcy costs:

  1. increases the debt ratio of a firm.
  2. none of these answers.
  3. may or may not affect the debt ratio of a firm.
  4. decreases the debt ratio of a firm.

Answer(s): C

Explanation:

The Signaling Theory of capital structure considers the decisions of a firm's manager to raise debt or equity capital as a function of the relative profitability prospects of the firm's projects. It does not use bankruptcy costs as an explanation of the debt ratios prevalent in various industries. Bankruptcy costs are used by the Trade-off Theory of capital structure.



Projects A and B are mutually exclusive and will be repeated. The company's cost of capital is 12.5 percent.
tProj. A-Cash FlowsProj. B-Cash Flows
0- 10,000- 10,000
1+ 40,000+ 30,000
2+ 50,000+ 30,000
3+ 30,000+ 30,000
4+ 20,000+ 30,000
5+ 30,000
What is the equivalent annual annuity (EAA) of the best project?

  1. $24,227
  2. $27,192
  3. $32,811
  4. $23,243
  5. $35,000

Answer(s): C

Explanation:

First find the NPV of each project, using the cash flow register:
Project A NPV = $98,617.59.
Project B NPV = $96,817.05.
Then find EAA:
Project A:
N = 4; I = 12.5; PV = -98,617.59; FV = 0; solve for PMT = $32,810.85.
Project B:
N = 5; I = 12.5; PV = -96,817.05; FV = 0; solve for PMT = $27,191.46.
Project A has the higher EA
F.



Project A has an internal rate of return of 18 percent, while Project B has an internal rate of return of 16 percent. However, if the company's cost of capital (WACC) is 12 percent, Project B has a higher net present value. Which of the following statements is most correct?

  1. All of these answers are correct.
  2. The crossover rate for the two project is less than 12 percent.
  3. None of these answers are correct.
  4. Assuming that the two projects have the same scale, Project A probably has a faster payback than Project
  6. Assuming the timing of the two projects is the same, Project A is probably of larger scale than Project B.

Answer(s): D

Explanation:

Draw out the NPV profiles of these two projects. As B's NPV declines more rapidly with an increase in discount rates, this implies that more of the cash flows are coming later on. Therefore, Project A has a faster payback than Project B.



Dorrie James, a financial analyst with consulting firm Brown, Ketchuppe & Company, is trying to determine the earnings per share (EPS) figure for Floweration.com. Assume the following information:
Sales: $4,500,000
Fixed costs: $2,000,000
Variable costs: $1,200,000
Interest expense: $40,000
Tax rate: 35%
Weighted Average Cost of Capital: 12.25%
Beta coefficient: 1.25
Common shares outstanding: 4,755,000
Using this information, what are the EPS for Floweration.com?

  1. $0.1492
  2. $0.1722
  3. $0.1676
  4. $0.2440
  5. $0.2360
  6. The answer cannot be calculated from the information provided.

Answer(s): B

Explanation:

The EPS figure is perhaps the single most popular term in the field of conventional equity investments. Any glance into financial media and business periodicals will undoubtedly uncover numerous instances in which the EPS figure is cited. While quite popular and useful, many individuals do not understand themechanics behind the EPS calculation, and an investigation into the components of EPS is a valuable learning experience. The EPS calculation is found by the following equation: {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]} Incorporating the given information into the first EPS equation will yield the following: {EPS = [($4,500,000 - $2,000,000 - $1,200,000 - $40,000)(1 - .35)] / 4,755,000}= $0.1722



The following information applies to a company's preferred stock:
Current price $101.00 per share
Par value $100.00 per share
Annual dividend $6.50 per share
The company issued the preferred stock at par and incurred a 10% floatation cost. If the company's marginal corporate tax rate is 34%, what is the after-tax cost of preferred stock?

  1. 4.3%
  2. 6.4%
  3. 13%
  4. 4.2%
  5. 6.5%
  6. 7.2%

Answer(s): F

Explanation:

The cost of preferred stock is calculated as the preferred stock dividend divided by the net issuing price. The dividend for this preferred stock is $6.50, and the net issuing price was $90.00. Thus the cost of preferred stock is 6.5 divided by 90 or 7.2%. There are no tax savings associated with the use of preferred stock, therefore no tax adjustments are made when calculating the cost.



Consider the following information:
30-day treasury rate (Risk Free rate) 5.2%
Company XYZ Bond yield 12.2%
Beta 1.2
Risk Premium 4.5%
Credit Rating BBB
Calculate Company XYZ's cost of retained earnings using the Bond-Yield-plus-Risk-Premium approach.

  1. 21.9%
  2. 16.7%
  3. 12.2%
  4. 5.2%
  5. 20.4%
  6. 9.7%

Answer(s): B

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 = 12.2% + 4.5% = 16.7%.



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