CFA Practice Exam: Part 1
1. Question 1:
Rollins Corporation is constructing its MCC schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid
semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100
preferred stock, which pays a 12 percent annual dividend, but flotation costs of 5 percent would be
incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent.
Rollins is a constant growth firm, which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find k(s) (component cost of retained earnings). The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent.
What is Rollins' cost of preferred stock?
* 12.6%
* 13.2%
* 11.0%
* 12.0%
* 10.0%
Correct answer:
K(ps) (cost of preferred stock) = $12/$100 (0.95) = 12.6%.
2. Question 2:
Despite relative congruence in their ranking methods, NPV and MIRR will sometimes produce conflicting answers. Which of the following correctly illustrates an example in which the two methods would likely produce conflicting rankings?
* I and III
* I and II
* II and IV
* II and IV
Correct answer:
II and IV
While the MIRR method is designed to tackle many of the problems associated with the traditional IRR calculation, there exist situations in which the MIRR will produce rankings which conflict with those produced by the NPV method. Specifically, when mutually-exclusive projects whose lifespans or scale differ substantially are being examined. In these situations, the NPV calculation should be relied on, as this method is considered to produce the correct results.
3. Question 3:
Monte Carlo simulation* All of the answers are correct.
* Is capable of using probability distributions for variables as input data instead of a single numerical
estimate for each variable.
* Produces both an expected NPV (or IRR) and a measure of the riskiness of the NPV or IRR.
* None of the answers are correct.
* Can be useful for estimating a project's stand-alone risk.
Correct answer:
These are all true.
4. Question 4:
Proponents of which of the following theories would claim that companies seek to balance the tax-shelter benefits of debt financing with the increased interest rates and risk of bankruptcy that come with increased debt levels?
* Modigliani & Miller's "with-taxes" Theory of Capital Structure
* Bird-in-the-Hand Theory
* Modigliani & Miller's Theory of Capital Structure
* Tax Preference Theory
* Signaling Theory
* Trade-off Theory of Leverage
Correct answer:Trade-off Theory of Leverage
The Trade-off Theory of Leverage claims that firms will seek to balance the tax-shelter benefits of debt financing with the increased interest costs and risk of bankruptcy that come with increased debt levels.
The Trade-off Theory of Leverage came about largely from criticisms raised against the Modigliani and Miller Theory of Capital Structure under the "with-taxes" assumption. M&M claimed that, under a restrictive set of assumptions, the value of firms would be maximized only when their capital structure is comprised of 100% debt.
The Trade-off Theory of Leverage proposed a more realistic and moderate answer to the Capital Structure debate, and remains an important milestone in the field of Pure Finance.
5. Question 5:
Photon Corporation has a target capital structure of 60 percent equity and 40 percent debt. The firm can raise an unlimited amount of debt at a before-tax cost of 9 percent. The company expects to retain
earnings of $300,000 in the coming year and to face a tax rate of 35 percent. The last dividend was $2 per share and the growth rate of the company is constant at 6 percent.
If the company needs to issue new equity, then the flotation cost will be $5 per share. The current stock price is $30. Photon has the following investment opportunities:
What is the company's optimal capital budget?
* $150,000
* $450,000
* $350,000
* $550,000
* $625,000
Correct answer:
$450,000
Calculate the retained earnings break point (BPRE) as $300,000/0.6 = $500,000. Calculate ks as D1/P0 + g = $2(1.06)/$30 + 6% = 13.07%. Calculate ke as D1/(P0 - F) + g = $2(1.06)/($30 - $5) + 6% = 14.48%.
Find WACC below BPRE as: WACC = 0.6(13.07%)+ 0.4(9%)(1 - 0.35) = 10.18%. Thus, up to $500,000 can be financed at 10.18%. Find WACC above BPRE as: WACC = 0.6(14.48%) + 0.4(9%)(1 - 0.35) = 11.03%.
Thus, financing in excess of $500,000 costs 11.03%. Projects 2, 3, and 4 all have IRRs exceeding either WACC and should be accepted.
These projects require $450,000 in financing. Project 1 is the next most profitable project.
Given its cost of $100,000, half or $50,000 can be financed at 10.18% and the other half must be financed at 11.03%.
The relevant cost of capital for Project 1 is then 0.5(10.18%) + 0.5(11.03%) = 10.61%. Since
Project 1's IRR is less than the cost of capital, it should not be accepted. The firm's optimal capital budget is $450,000.
6. Question 6:
A stock has an expected dividend growth rate of 4.9%. The firm has just paid a dividend of $2.5 per share.
With a required rate of return of 10%, the stock is trading at $42.8. The stock is:
* overpriced.
* insufficient information.
* fairly priced.
* under-priced.
Correct answer:
under-priced.
The fair price of the stock with a required rate of return, r and a dividend growth rate, g, is given by P = D1/(r-g), where D1 = Do*(1-g) = dividend to be paid next year.
In this case, the fair price of the stock equals 2.5*1.049/(10% - 4.9%) = $51.42.
Thus, the stock is under-priced by $(51.42 - 42.8) = $8.62.
7. Question 7:
Which of the following is not considered a capital component?
* All of these are considered capital components
* Preferred stock
* Common stock
* Long-term debt
* Retained earnings
Correct answer: All of these are considered capital components
The four major capital components are debt, preferred stock, retained earnings, and new issues of common stock.
8. Question 8:
Sun State Mining Inc., an all-equity firm, is considering the formation of a new division, which will increase the assets of the firm by 50 percent.
Sun State currently has a required rate of return of 18 percent, U.S.Treasury bonds yield 7 percent, and the market risk premium is 5 percent.
If Sun State wants to reduce its required rate of return to 16 percent, what is the maximum beta coefficient the new division could have?
* 2.0
* 1.0
* 2.2
* 1.6
* 1.8
Correct answer: 1.0
0.3333(b) = 0.3333
b = 1.0
Therefore, beta of the new division cannot exceed 1.0
9. Question 9:
Which of the following is not considered a relevant concern in determining incremental cash flows for a new product?
* The cost of a product analysis completed in the previous tax year and specific to the new product.
* All of these are relevant.
* The use of factory floor space which is currently unused but available for production of any product.
* Shipping and installation costs associated with preparing the machine to be used to produce the new product.
* Revenues from the existing product that would be lost as a result of some customers switching to the new product.
Correct answer:
The product analysis cost is considered a sunk cost and is not relevant.
10. Question 10:
Which of the following statements is correct?
* The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a relatively powerful computer, coupled with an efficient financial planning software package, whereas simulation analysis can be done using a PC with a spreadsheet program or even a calculator.
* All of these answers are correct.
* Sensitivity analysis is incomplete because it fails to consider the range of likely values of key variables as reflected in their probability distributions.
* In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less risky, because a small error in estimating a variable, such as unit sales, would produce only a small error in the project's NPV.
* Sensitivity analysis is a risk analysis technique that considers both the sensitivity of NPV to changes in key variables and the likely range of variable values.
Correct answer:Sensitivity analysis is incomplete because it fails to consider the range of likely values of key variables as reflected in their probability distributions.
A project's stand-alone risk depends on (1) the sensitivity of NPV to changes in key variables and (2) the range of likely values of these variables as reflected in their probability distribution. Sensitivity analysis considers only the first factor.
Rollins Corporation is constructing its MCC schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid
semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100
preferred stock, which pays a 12 percent annual dividend, but flotation costs of 5 percent would be
incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent.
Rollins is a constant growth firm, which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find k(s) (component cost of retained earnings). The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent.
What is Rollins' cost of preferred stock?
* 12.6%
* 13.2%
* 11.0%
* 12.0%
* 10.0%
Correct answer:
K(ps) (cost of preferred stock) = $12/$100 (0.95) = 12.6%.
2. Question 2:
Despite relative congruence in their ranking methods, NPV and MIRR will sometimes produce conflicting answers. Which of the following correctly illustrates an example in which the two methods would likely produce conflicting rankings?
| I. II. III. IV. | When examining projects with non-normal cash flows When examining projects that differ substantially in scale When examining independent projects When examining projects that differ substantially in their lifespan |
* I and II
* II and IV
* II and IV
Correct answer:
II and IV
While the MIRR method is designed to tackle many of the problems associated with the traditional IRR calculation, there exist situations in which the MIRR will produce rankings which conflict with those produced by the NPV method. Specifically, when mutually-exclusive projects whose lifespans or scale differ substantially are being examined. In these situations, the NPV calculation should be relied on, as this method is considered to produce the correct results.
3. Question 3:
Monte Carlo simulation* All of the answers are correct.
* Is capable of using probability distributions for variables as input data instead of a single numerical
estimate for each variable.
* Produces both an expected NPV (or IRR) and a measure of the riskiness of the NPV or IRR.
* None of the answers are correct.
* Can be useful for estimating a project's stand-alone risk.
Correct answer:
These are all true.
4. Question 4:
Proponents of which of the following theories would claim that companies seek to balance the tax-shelter benefits of debt financing with the increased interest rates and risk of bankruptcy that come with increased debt levels?
* Modigliani & Miller's "with-taxes" Theory of Capital Structure
* Bird-in-the-Hand Theory
* Modigliani & Miller's Theory of Capital Structure
* Tax Preference Theory
* Signaling Theory
* Trade-off Theory of Leverage
Correct answer:Trade-off Theory of Leverage
The Trade-off Theory of Leverage claims that firms will seek to balance the tax-shelter benefits of debt financing with the increased interest costs and risk of bankruptcy that come with increased debt levels.
The Trade-off Theory of Leverage came about largely from criticisms raised against the Modigliani and Miller Theory of Capital Structure under the "with-taxes" assumption. M&M claimed that, under a restrictive set of assumptions, the value of firms would be maximized only when their capital structure is comprised of 100% debt.
The Trade-off Theory of Leverage proposed a more realistic and moderate answer to the Capital Structure debate, and remains an important milestone in the field of Pure Finance.
5. Question 5:
Photon Corporation has a target capital structure of 60 percent equity and 40 percent debt. The firm can raise an unlimited amount of debt at a before-tax cost of 9 percent. The company expects to retain
earnings of $300,000 in the coming year and to face a tax rate of 35 percent. The last dividend was $2 per share and the growth rate of the company is constant at 6 percent.
If the company needs to issue new equity, then the flotation cost will be $5 per share. The current stock price is $30. Photon has the following investment opportunities:
* $150,000
* $450,000
* $350,000
* $550,000
* $625,000
Correct answer:
$450,000
Calculate the retained earnings break point (BPRE) as $300,000/0.6 = $500,000. Calculate ks as D1/P0 + g = $2(1.06)/$30 + 6% = 13.07%. Calculate ke as D1/(P0 - F) + g = $2(1.06)/($30 - $5) + 6% = 14.48%.
Find WACC below BPRE as: WACC = 0.6(13.07%)+ 0.4(9%)(1 - 0.35) = 10.18%. Thus, up to $500,000 can be financed at 10.18%. Find WACC above BPRE as: WACC = 0.6(14.48%) + 0.4(9%)(1 - 0.35) = 11.03%.
Thus, financing in excess of $500,000 costs 11.03%. Projects 2, 3, and 4 all have IRRs exceeding either WACC and should be accepted.
These projects require $450,000 in financing. Project 1 is the next most profitable project.
Given its cost of $100,000, half or $50,000 can be financed at 10.18% and the other half must be financed at 11.03%.
The relevant cost of capital for Project 1 is then 0.5(10.18%) + 0.5(11.03%) = 10.61%. Since
Project 1's IRR is less than the cost of capital, it should not be accepted. The firm's optimal capital budget is $450,000.
6. Question 6:
A stock has an expected dividend growth rate of 4.9%. The firm has just paid a dividend of $2.5 per share.
With a required rate of return of 10%, the stock is trading at $42.8. The stock is:
* overpriced.
* insufficient information.
* fairly priced.
* under-priced.
Correct answer:
under-priced.
The fair price of the stock with a required rate of return, r and a dividend growth rate, g, is given by P = D1/(r-g), where D1 = Do*(1-g) = dividend to be paid next year.
In this case, the fair price of the stock equals 2.5*1.049/(10% - 4.9%) = $51.42.
Thus, the stock is under-priced by $(51.42 - 42.8) = $8.62.
7. Question 7:
Which of the following is not considered a capital component?
* All of these are considered capital components
* Preferred stock
* Common stock
* Long-term debt
* Retained earnings
Correct answer: All of these are considered capital components
The four major capital components are debt, preferred stock, retained earnings, and new issues of common stock.
8. Question 8:
Sun State Mining Inc., an all-equity firm, is considering the formation of a new division, which will increase the assets of the firm by 50 percent.
Sun State currently has a required rate of return of 18 percent, U.S.Treasury bonds yield 7 percent, and the market risk premium is 5 percent.
If Sun State wants to reduce its required rate of return to 16 percent, what is the maximum beta coefficient the new division could have?
* 2.0
* 1.0
* 2.2
* 1.6
* 1.8
Correct answer: 1.0
| Old assets = 1.0 |
| New assets = 0.5 |
| Total assets = 1.5 |
Old required rate:
|
| New required rate: |
| 16% = 7% + (5%)b |
| beta = 1.8 |
| New b must not be greater than 1.8, therefore |
b = 1.0
Therefore, beta of the new division cannot exceed 1.0
9. Question 9:
Which of the following is not considered a relevant concern in determining incremental cash flows for a new product?
* The cost of a product analysis completed in the previous tax year and specific to the new product.
* All of these are relevant.
* The use of factory floor space which is currently unused but available for production of any product.
* Shipping and installation costs associated with preparing the machine to be used to produce the new product.
* Revenues from the existing product that would be lost as a result of some customers switching to the new product.
Correct answer:
The product analysis cost is considered a sunk cost and is not relevant.
10. Question 10:
Which of the following statements is correct?
* The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a relatively powerful computer, coupled with an efficient financial planning software package, whereas simulation analysis can be done using a PC with a spreadsheet program or even a calculator.
* All of these answers are correct.
* Sensitivity analysis is incomplete because it fails to consider the range of likely values of key variables as reflected in their probability distributions.
* In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less risky, because a small error in estimating a variable, such as unit sales, would produce only a small error in the project's NPV.
* Sensitivity analysis is a risk analysis technique that considers both the sensitivity of NPV to changes in key variables and the likely range of variable values.
Correct answer:Sensitivity analysis is incomplete because it fails to consider the range of likely values of key variables as reflected in their probability distributions.
A project's stand-alone risk depends on (1) the sensitivity of NPV to changes in key variables and (2) the range of likely values of these variables as reflected in their probability distribution. Sensitivity analysis considers only the first factor.
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