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Free Test Prep CFA-Level-I Exam Questions (page: 7)

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A firm's preferred equity has a face value of 100 and a 5.5% coupon. The equity is trading at $87.29 per share. The firm is in the 40% tax bracket. Its cost of preferred stock equals ________.

  1. 2.52%
  2. 3.30%
  3. 6.30%
  4. 3.78%

Answer(s): C

Explanation:

Preferred dividends are not tax-deductible. Hence, no tax adjustment is made while calculating the cost of preferred equity. The price of a perpetuity that pays C per year, at a discount rate of R, equals C/R. Hence, 87.29 = 5.5/R, giving R = 6.3%.



The common stock of Anthony Steel has a beta of 1.20. The risk-free rate is 5 percent, and the market risk premium is 6 percent. This year's addition to retained earnings is $3,000,000. The company's capital budget is $4,000,000 and its target capital structure is 50 percent debt and 50 percent equity. What is the company's cost of equity financing?

  1. 12.4%
  2. 7.0%
  3. 11.0%
  4. 12.2%
  5. 7.2%

Answer(s): D

Explanation:

Anthony Steel will use retained earnings to fund the equity portion of its capital budget. We can see this because the retained earnings break point is $3,000,000/0.5 = $6,000,000, which is greater than the capital budget.
The cost of equity from the CAPM (Capital Asset Pricing Model) is:
k(s) = krf) + (k(m) - k(rf))b(i) = 5% + (6%)1.2 = 12.2%.



Assume that a firm has a degree of financial leverage of 1.25. If sales increase by 20 percent, the firm will experience a 60 percent increase in EPS, and it will have an EBIT of $100,000. What will be the EBIT for this firm if sales do not increase?

  1. $42,115
  2. $84,375
  3. $67,568
  4. $100,000
  5. $113,412

Answer(s): C

Explanation:

DTL = % change EPS/% change Sales = 60%/20% = 3.0.
DOL = DTL/DFL = 3.0/1.25 = 2.40.
Old EBIT = $100,000/[1 + (0.20)(2.40)] = $100,000/1.48 = $67,568.
Alternate solution:
Use DFL expression to calculate change in EBIT and previous EBIT:
DFL = 1.25 = %change EPS/%change EBIT
= 0.60/[change EBIT/($100,000 - change EBIT)]
= [0.60($100,000) - 0.60(change EBIT)]/change EBIT
1.25 change EBIT = $60,000 - 0.60(change EBIT)
1.85 change EBIT = $60,000
change EBIT = $32,432.
Old EBIT = $100,000 - $32,432 = $67,568.



Returns on the market and Takeda Company's stock during the last 3 years are shown below:
YearMarketTakeda
1995-12%-14%
19962331
19971610
The risk-free rate is 7 percent, and the required return on the market is 12 percent. Takeda is considering a project whose market beta was found by adding 0.2 to the company's overall corporate beta. Takeda finances only with equity, all of which comes from retained earnings. The project has a cost of $100 million, and it is expected to provide cash flows of $20 million per year at the end of Years 1 through 5 and then $30 million per year at the end of Years 6 through 10. What is the project's NPV (in millions of dollars)?

  1. $23.11
  2. $22.55
  3. $28.12
  4. $20.89
  5. $25.76

Answer(s): A

Explanation:

1. Run a regression to find the corporate beta. It is 1.1633.
2. Find the project's estimated beta by adding 0.2 to the corporate beta. The project beta is thus 1.3633.
3. Find the company's cost of equity, which is its WACC because it uses no debt: k(s) = WACC = 7% + (12% - 7%)1.3633 = 13.8165%.
4. Now find NPV (in millions):
CF(0) = -100
CF(1-5) = 20
CF(6-10) = 30
I = 13.82 Solve for NPV = $23.11 million.



Which of the following statements is correct?

  1. Only if one attempts to calculate MIRRs does one have to worry about multiple IRRs.
  2. The discounted payback is generally shorter than the regular payback.
  3. The NPV and IRR methods can lead to conflicting accept/reject decisions only if (1) mutually exclusive projects are being evaluated and (2) if the projects' NPV profiles cross at a rate less than the firm's cost of capital.
  4. The NPV and IRR methods can lead to conflicting accept/reject decisions only if (1) mutually exclusive projects are being evaluated and (2) if the projects' NPV profiles cross at a rate greater than the firm's cost of capital.
  5. Any type of project might have multiple rates of return if the IRR is sufficiently high.

Answer(s): C

Explanation:

The two conditions which can cause NPV profiles to cross, and thus conflicts to arise between NPV and IRR: 1) when project size differences exists, or 2) when timing differences exist.



A company has determined that its optimal capital structure consists of 40 percent debt and 60 percent equity. Given the following information, calculate the marginal weighted average cost of capital when the capital budget is $40,000.
k(d) (interest rate on the firm's new date) = 10%
Net income = $40,000
Payout ratio = 50%
Tax rate = 40%
P(0) = $25
Growth = 0%
Shares outstanding = 10,000 Flotation cost on additional equity = 15%

  1. 13.69%
  2. 11.81%
  3. 8.05%
  4. 14.28%
  5. 7.20%

Answer(s): C

Explanation:

First, find the amount of equity and debt needed for a $40,000 budget:
Debt = 0.4 x $40,000 = $16,000; Equity = 0.6 x $40,000 = $24,000.
We can find the amount of retained earnings = Net Income(1 - Payout ratio), or RE = $40,000 x 0.5 = $20,000.
We will need to find the cost of new common equity, because we have only $20,000 of equity on hand, and we need $4,000 more!
Find the dividend, Do = [(0.5) $40,000]/# of Shares = $20,000/10,000 = $2.00.
Then, find the cost of new equity: k(e) = D1/[P0(1 - F)] + g = $2.00/[$25(1 - 0.15)] + 0% = 0.0941 = 9.41%.
Finally, calculate WACC, using k(e) = 0.0941, and k(d) = 0.10, so WACC = (D/A)(1 - Tax rate)k(d) + (E/A)k(e)
WACC = 0.4(1 - 0.4)(0.10) + 0.6(0.0941) = 0.0805, or 8.05%.



Which of the following statements is most correct?

  1. None of the statements are correct.
  2. When choosing between mutually exclusive projects, managers should accept all projects with IRRs greater than the weighted average cost of capital.
  3. Multiple IRRs can occur in cases when project cash flows are normal, but they are more common in cases where project cash flows are nonnormal.
  4. All of the statements are correct.
  5. One of the disadvantages of choosing between mutually exclusive projects on the basis of the discounted payback method is that you might choose the project with the faster payback period but with the lower total return.

Answer(s): E

Explanation:

The payback and discounted payback methods both ignore cash flows that are paid or received after the payback period. Concerning the other statements: Multiple IRRs can occur only for projects with nonnormal cash flows. Mutually exclusive projects implies that only one project should be chosen. The project with the highest NPV should be chosen.



Which of the following equations correctly illustrates the calculation of the cost of equity using the Bond-Yield- plus-Risk-Premium approach?

  1. Required rate of return on outstanding debt + subjective risk premium
  2. Before-tax yield on outstanding debt + subjective risk premium
  3. None of these answers
  4. After-tax cost of debt + subjective risk premium
  5. Annual dividend/current stock price + subjective risk premium
  6. Yield to maturity on outstanding long-term debt + subjective risk premium

Answer(s): F

Explanation:

The Bond-Yield-plus-Risk-Premium approach is a rather ad hoc method used by financial managers to determine the cost of common equity. Under this approach, a subjective risk premium is added to the yield to maturity of the firm's outstanding long-term debt. Typically, senior debt is used when possible, however, due to the ad hoc nature of this approach, there is abounding room for flexibility. This large degree of flexibility both adds to and detracts from the attractiveness of Bond-Yield-plus-Risk-Premium approach.



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