Finance & Accounting Dept John Gokongwei School of Management Corporate Finance Exam 1 SchweserPro 2011 CFA Level 1 The following information covers Questions 1 to 5: Bailey Manufacturing Co. (Bailey) designs and manufactures a hoses and fittings for a wide range of industrial applications. After closing the books on 2004, Bailey’s executive management team had a meeting to discuss their goals and priorities for 2005. This meeting, held every January, is an opportunity for each of Bailey’s division managers to present proposals for the projects that they are considering for investment during the upcoming year. Bradley Conover is the chief financial officer for Bailey Manufacturing Co. He has received proposals for five different projects that are deemed to have the highest priority from Bailey’s division managers. Before evaluating the projects, Conover must make some pro forma forecasts for 2005. According to Bailey’s 2005 pro forma income statement, Conover expects Bailey to earn a net profit of $7,000. He also expects the firm to maintain its current dividend payout ratio of 50%. The firm has a target capital structure of 70% equity and 30% debt. Conover estimates the applicable corporate tax rate to be 35%. Conover’s next step is to evaluate capital market conditions. Because Bailey is in an economically sensitive industry, the firm has a greater than average level of systematic risk. Conover estimates that the beta applicable for a standard project for the firm is 1.5. Over the last three years, the U.S. economy has been in a sustained expansion, and Bailey has enjoyed strong profit growth. This strong growth has allowed Bailey to fund most of its capital budget internally. However, many economists believe that growth will slow in 2005 despite the government’s accommodative fiscal policy. As a result, Conover believes that management’s aggressive goals and objectives imply that Bailey will need to seek external capital. Conover calls a meeting with Derek Munn, CFA, an investment banker with Lyndon Capital Corp. Using Conover’s forecasts, Munn believes that Bailey will be able to issue new debt at a cost of 9% and new equity at a cost of 18%. Munn also gives Conover a research report that says the 2005 expected return for the market is 11%, and three-month Treasury bills will yield 5%. The expected cash flows from the top five projects identified by Bailey’s division managers are shown in Figure 1 below. Projects A, C and E are independent projects and projects B and D are mutually exclusive. Figure 1 Year Project A Project B Project C Project D Project E 0 (1,000) (2,500) (1,750) (4,000) (2,000) 1 100 500 200 1,400 300 2 250 900 300 1,400 400 3 450 1,200 600 1,400 700 4 650 1,200 700 1,400 700 5 0 700 800 1,400 700 Question 1 - 97034 (Part 1) Conover starts his analysis by estimating the firm’s current weighted average cost of capital (WACC). What is the firm’s current WACC? CorFin 2011 Exam.docx Page 1 of 13 Finance & Accounting Dept John Gokongwei School of Management A) 18.00%. B) 15.30%. C) 11.56%. Question 2 - 97034 (Part 2) Assuming all of the projects have equal risk, Conover creates an investment opportunity set (IOS) by ranking the projects starting with the most favorable to the least favorable project as follows: A) DBACE. B) ABCDE. C) DBCAE. Question 3 - 97034 (Part 3) Conover calculates new WACC beyond the retained earnings break-even point as: A) 15.30%. B) 14.36%. C) 18.00%. Question 4 - 97034 (Part 4) Based on the investment opportunity schedule (IOS) and marginal cost of capital (MCC) schedule, which projects should be accepted? A) A, B, and D. B) A and D. C) A, B, C, and D. Question 5 - 97034 (Part 5) Conover uses a technique involving random variables in a simulation to estimate the NPV of the projects. This technique is known as: A) bootstrapping. B) scenario analysis. C) Monte Carlo. Question 6 - 97034 (Part 6) Project C is similar in risk to a company in their same industry that has an average leveraged beta of 1.2. If Conover uses a pure play method to evaluate project C, what is the appropriate cost of equity capital for the project? A) 11.2%. B) 12.2%. C) 10.3%. Question 7 - 93613 A 91-day Treasury bill has a holding period yield of 1.5%. What is the annual yield of this T-bill on a bondequivalent basis? CorFin 2011 Exam.docx Page 2 of 13 Finance & Accounting Dept John Gokongwei School of Management A) 6.65%. B) 6.02%. C) 6.24%. Question 8 - 97850 Jane Epworth, CFA, is preparing pro forma financial statements for Gavin Industries, a mature U.S. manufacturing firm with three distinct geographic divisions in the Midwest, South and West. Epworth prepares estimates of sales for each of Gavin’s divisions using economists’ estimates of next-period GDP growth and sums the three estimates to forecast Gavin’s sales. Epworth’s approach to estimating Gavin’s sales is: A) inappropriate, because sales should be forecast on a firm-wide basis and are unlikely to be related to GDP growth. B) inappropriate, because sales should be forecast on a firm-wide basis. C) appropriate. Question 9 - 96531 Which of the following statements regarding the net present value (NPV) and internal rate of return (IRR) is least accurate? A) For mutually exclusive projects, you must accept the project with the highest NPV regardless of the sign of the NPV calculation. B) For independent projects, the internal rate of return IRR and the NPV methods always yield the same accept/reject decisions. C) The NPV tells how much the value of the firm will increase if you accept the project. Question 10 - 87234 The two major types of risk affecting a firm are: A) financial risk and cash flow risk. B) business risk and collection risk. C) business risk and financial risk. Question 11 - 97457 A company has the following information: A target capital structure of 40% debt and 60% equity. $1,000 par value bonds pay 10% coupon (semi-annual payments), mature in 20 years, and sell for $849.54. The company stock beta is 1.2. Risk-free rate is 10%, and market risk premium is 5%. CorFin 2011 Exam.docx Page 3 of 13 Finance & Accounting Dept John Gokongwei School of Management The company's marginal tax rate is 40%. The weighted average cost of capital (WACC) is closest to: A) 12.5%. B) 13.0%. C) 13.5%. Question 12 - 127348 Which of the following policies regarding shareowner rights for equity investors is most likely detrimental to the shareowners’ interests? A) Shareowners can approve changes to the corporate structure only with a supermajority vote. B) The company uses a third-party entity to tabulate shareowner votes. C) Shareowners are permitted to vote either by paper ballot or a proxy voting service. Question 13 - 97778 Meredith Suresh, an analyst with Torch Electric, is evaluating two capital projects. Project 1 has an initial cost of $200,000 and is expected to produce cash flows of $55,000 per year for the next eight years. Project 2 has an initial cost of $100,000 and is expected to produce cash flows of $40,000 per year for the next four years. Both projects should be financed at Torch’s weighted average cost of capital. Torch’s current stock price is $40 per share, and next year’s expected dividend is $1.80. The firm’s growth rate is 5%, the current tax rate is 30%, and the pre-tax cost of debt is 8%. Torch has a target capital structure of 50% equity and 50% debt. If Torch takes on either project, it will need to be financed with externally generated equity which has flotation costs of 4%. Suresh is aware that there are two common methods for accounting for flotation costs. The first method, commonly used in textbooks, is to incorporate flotation costs directly into the cost of equity. The second, and more correct approach, is to subtract the dollar value of the flotation costs from the project NPV. If Suresh uses the cost of equity adjustment approach to account for flotation costs rather than the correct cash flow adjustment approach, will the NPV for each project be overstated or understated? Project 1 NPV Project 2 NPV A) Understated Overstated B) Understated Understated C) Overstated Overstated Question 14 - 96541 A large, creditworthy manufacturing firm would most likely get short-term financing by: A) factoring its receivables. B) entering into an agreement for a committed line of credit. C) issuing commercial paper. CorFin 2011 Exam.docx Page 4 of 13 Finance & Accounting Dept John Gokongwei School of Management Question 15 - 97208 Deighton Industries has 200,000 bonds outstanding. The par value of each corporate bond is $1,000, and the current market price of the bonds is $965. Deighton also has 6 million common shares outstanding, with a book value of $35 per share and a market price of $28 per share. At a recent board of directors meeting, Deighton board members decided not to change the company’s capital structure in a material way for the future. To calculate the weighted average cost of Deighton’s capital, what weights should be assigned to debt and to equity? Debt Equity A) 48.85% 51.15% B) 53.46% 46.54% C) 56.55% 43.45% Question 16 - 87175 The cut-off date for receiving the dividend is known as the: A) holder of record date. B) ex-dividend date. C) date of payment. Question 17 - 96783 A North American investment society held a panel discussion on the topics of capital costs and capital budgeting. Which of the following comments made during this discussion is the least accurate? A) An increase in the after-tax cost of debt may occur at a break point. B) A project’s internal rate of return decreases when a breakpoint is reached. C) Any given project’s NPV will decline when a breakpoint is reached. Question 18 - 87236 As financial leverage increases, what will be the impact on the expected rate of return and financial risk? A) Both will rise. B) Both will fall. C) One will rise while the other falls. Question 19 - 127347 Paying a cash dividend is most likely to result in: A) an increase in liquidity ratios. B) an increase in financial leverage ratios. C) the same impact on liquidity and leverage ratios as a stock dividend. CorFin 2011 Exam.docx Page 5 of 13 Finance & Accounting Dept John Gokongwei School of Management Question 20 - 87202 Which of the following statements regarding the impact of financial leverage on a company’s net income and return on equity (ROE) is most accurate? A) Using financial leverage increases the volatility of ROE for a level of volatility in operating income. B) If a firm has a positive operating profit margin, using financial leverage will always increase ROE. C) Increasing financial leverage increases both risk and potential return of existing bondholders. Question 21 - 96782 The before-tax cost of debt for Hardcastle Industries, Inc. is currently 8.0%, but it will increase to 8.25% when debt levels reach $600 million. The debt-to-total assets ratio for Hardcastle is 40% and its capital structure is composed of debt and common equity only. If Hardcastle changes its target capital structure to 50% debt / 50% equity, which of the following describes the effect on the level of new investment at which the cost of debt will increase? The level will: A) change, but can either increase or decrease. B) increase. C) decrease. Question 22 - 97585 A company has $5 million in debt outstanding with a coupon rate of 12%. Currently the YTM on these bonds is 14%. If the tax rate is 40%, what is the after tax cost of debt? A) 8.4%. B) 7.2%. C) 5.6%. Question 23 - 96785 The debt of Savanna Equipment, Inc. has an average maturity of ten years and a BBB rating. A market yield to maturity is not available because the debt is not publicly traded, but the market yield on debt with similar characteristics is 8.33%. Savanna is planning to issue new ten-year notes that would be subordinate to the firm’s existing debt. The company’s marginal tax rate is 40%. The most appropriate estimate of the after-tax cost of this new debt is: A) 5.0%. B) More than 5.0%. C) Between 3.3% and 5.0%. CorFin 2011 Exam.docx Page 6 of 13 Finance & Accounting Dept John Gokongwei School of Management Question 24 - 97192 Which of the following statements about the discounted payback period is least accurate? The discounted payback: A) frequently ignores terminal values. B) period is generally shorter than the regular payback. C) method can give conflicting results with the NPV. Question 25 - 87184 Which of the following statements about business risk and financial risk is least accurate? A) The greater a company's business risk, the higher its optimal debt ratio. B) Business risk is the riskiness of the company's assets if it uses no debt. C) Factors that affect business risk are demand, sales price, and input price variability. Question 26 - 96565 Compared to the prior period, a firm has greater days of receivables. The effect on the firm’s cash conversion cycle and operating cycle are most likely a(n): Cash conversion cycle Operating cycle A) Increase Increase B) Increase Decrease C) Decrease Increase Question 27 - 96568 Which of the following statements regarding the internal rate of return (IRR) is most accurate? The IRR: A) can lead to multiple IRR rates if the cash flows extend past the payback period. and the net present value (NPV) method lead to the same accept/reject decision for B) independent projects. C) assumes that the reinvestment rate of the cash flows is the cost of capital. Question 28 - 87170 The following information reflects the projected operating results for Opstalan, a catalog printer. Sales of $5.0 million. Variable Costs at 40% of sales. Fixed Costs of $1.0 million. CorFin 2011 Exam.docx Page 7 of 13 Finance & Accounting Dept John Gokongwei School of Management Debt interest payments on $1.5 million issued with an annual 7.0% coupon (current yield is 8.0%). Tax Rate of 0.0%. Opstalan’s degree of total leverage (DTL) is closest to: A) 2.58. B) 1.41. C) 1.59. Question 29 - 87194 All else equal, which of the following statements about operating leverage is least accurate? A) Operating leverage reflects the tradeoff between variable costs and fixed costs. B) Lower operating leverage generally results in a higher expected rate of return. C) Firms with high operating leverage experience greater variance in operating income. Question 30 - 97612 Rochelle Dixon is delivering a presentation on best practices for corporate governance. Two of her recommendations are as follows: Statement 1: To avoid the potential for harming shareholders’ interests by wasting company resources, the Board of Directors should get management’s approval before it hires outside consultants. Statement 2: The more members a Board of Directors has, the more likely it is to represent shareholders’ interests fairly. Are Dixon’s statements CORRECT? Statement 1 Statement 2 A) Incorrect Correct B) Correct Correct C) Incorrect Incorrect Question 31 - 97591 Which of the following statements related to corporate governance is least accurate? A) Board members should not have any material relationships with the firm’s advisers, auditors, and their families. B) It is desirable for the chairman of the board to be the firm’s current CEO or former CEO. C) It is desirable for board members to have board experience with other boards. CorFin 2011 Exam.docx Page 8 of 13 Finance & Accounting Dept John Gokongwei School of Management Question 32 - 96553 Which of the following projects would most likely have multiple internal rates of return (IRRs)? The cost of capital for all projects is 10.0%. Cash Flows South East West CF0 -15,000 -12,000 -8,000 CF1 10,000 7,000 4,000 CF2 -1,000 2,000 0 CF3 15,000 2,000 6,000 A) Projects East and West. B) Projects South and West. C) Project South only. Question 33 - 97917 Which of the following financial statement items is least likely proportional to sales in a sales-driven proforma financial statement? A) Operating margin. B) Selling, general and administrative expenses. C) Interest expense. Question 34 - 96600 A banker’s acceptance that is priced at $99,145 and matures in 72 days at $100,000 has a(n): A) discount yield greater than its bond equivalent yield. B) money market yield greater than its discount yield. C) bond equivalent yield greater than its effective annual yield. Question 35 - 97599 A $100 par, 8% preferred stock is currently selling for $80. What is the cost of preferred equity? A) 10.8%. B) 10.0%. C) 8.0%. CorFin 2011 Exam.docx Page 9 of 13 Finance & Accounting Dept John Gokongwei School of Management Question 36 - 100682 Utilitarian Co. is looking to expand its appliances division. It currently has a beta of 0.9, a D/E ratio of 2.5, a marginal tax rate of 30%, and its debt is currently yielding 7%. JF Black, Inc. is a publicly traded appliance firm with a beta of 0.7, a D/E ratio of 3, a marginal tax rate of 40%, and its debt is currently yielding 6.8%. The risk-free rate is currently 5% and the expected return on the market portfolio is 9%. Using this data, calculate Utilitarian’s weighted average cost of capital for this potential expansion. A) 4.2%. B) 5.7%. C) 7.1%. Question 37 - 97317 Justin Lopez, CFA, is the Chief Financial Officer of Waterbury Corporation. Lopez has just been informed that the U.S. Internal Revenue Code may be revised such that the maximum marginal corporate tax rate will be increased. Since Waterbury’s taxable income is routinely in the highest marginal tax bracket, Lopez is concerned about the potential impact of the proposed change. Assuming that Waterbury maintains its target capital structure, which of the following is least likely to be affected by the proposed tax change? A) Waterbury’s after-tax cost of noncallable, nonconvertible preferred stock. B) Waterbury’s return on equity (ROE). C) Waterbury’s after-tax cost of corporate debt. Question 38 - 100681 A publicly traded company has a beta of 1.2, a debt/equity ratio of 1.5, ROE of 8.1%, and a marginal tax rate of 40%. The unlevered beta for this company is closest to: A) 1.071. B) 0.632. C) 0.832. Question 39 - 97587 The expected annual dividend one year from today is $2.50 for a share of stock priced at $25. What is the cost of equity if the constant long-term growth in dividends is projected to be 8%? A) 18%. B) 19%. C) 15%. CorFin 2011 Exam.docx Page 10 of 13 Finance & Accounting Dept John Gokongwei School of Management Question 40 - 97186 Stolzenbach Technologies has a target capital structure of 60% equity and 40% debt. The schedule of financing costs for the Stolzenbach is shown in the table below: Amount of New Debt (in millions) After-tax Cost of Debt Amount of New Equity (in millions) Cost of Equity $0 to $199 4.5% $0 to $299 7.5% $200 to $399 5.0% $300 to $699 8.5% $400 to $599 5.5% $700 to $999 9.5% Stolzenbach Technologies has breakpoints for raising additional financing at both: A) $500 million and $700 million. B) $400 million and $700 million. C) $500 million and $1,000 million. Question 41 - 96619 Which of the following is NOT a limitation to financial ratio analysis? A) The need to use judgment. B) A firm that operates in only one industry. C) Differences in international accounting practices. Question 42 - 96596 A firm is choosing among three short-term investment securities: Security 1: A 30-day U.S. Treasury bill with a discount yield of 3.6%. Security 2: A 30-day banker’s acceptance selling at 99.65% of face value. Security 3: A 30-day time deposit with a bond equivalent yield of 3.65%. Based only on these securities’ yields, the firm would: A) prefer the U.S. Treasury bill. B) prefer the time deposit. C) prefer the banker’s acceptance. Question 43 - 97505 If a project has a negative cash flow during its life or at the end of its life, the project most likely has: A) more than one internal rate of return. B) a negative internal rate of return. C) multiple net present values. CorFin 2011 Exam.docx Page 11 of 13 Finance & Accounting Dept John Gokongwei School of Management Question 44 - 93552 Assume that a 30-day commercial paper security has a holding period yield of 0.80%. The bond equivalent yield of this security is: A) 9.60%. B) 10.12%. C) 9.73%. Question 45 - 97215 Levenworth Industries has the following capital structure on December 31, 2006: Book Value Market Value Debt outstanding $8 million $10.5 million Preferred stock outstanding $2 million $1.5 million Common stock outstanding $10 million $13.7 million Total capital $20 million $25.7 million What is the firm’s target debt and preferred stock portion of the capital structure based on existing capital structure? Debt Preferred Stock A) 0.40 0.10 B) 0.41 0.06 C) 0.41 0.10 Question 46 - 96598 Which of the following is least likely an indicator of a firm’s liquidity? A) Inventory turnover. B) Amount of credit sales. C) Cash as a percentage of sales. Question 47 - 96530 Which of the following is the most appropriate decision rule for mutually exclusive projects? A) Accept both projects if their internal rates of return exceed the firm’s hurdle rate. B) If the net present value method and the internal rate of return method give conflicting signals, CorFin 2011 Exam.docx Page 12 of 13 Finance & Accounting Dept John Gokongwei School of Management select the project with the highest internal rate of return. C) Accept the project with the highest net present value, subject to the condition that its net present value is greater than zero. Question 48 - 87216 Annual fixed costs at King Mattress amount to $325,000. The variable cost of raw materials and labor is $120 for the typical mattress. Sales prices for mattresses average $160. How many units must King Mattress sell to break even? A) 40. B) 2,708. C) 8,125. Question 49 - 97491 A firm is considering a $5,000 project that will generate an annual cash flow of $1,000 for the next 8 years. The firm has the following financial data: Debt/equity ratio is 50%. Cost of equity capital is 15%. Cost of new debt is 9%. Tax rate is 33%. Determine the project's net present value (NPV) and whether or not to accept it. NPV Accept / Reject A) -$33 Reject B) +$33 Accept C) +$4,968 Accept Question 50 - 97721 An analyst gathered the following data about a company: Capital Structure 30% debt 20% preferred stock 50% common stock Required Rate of Return 10% for debt 11% for preferred stock 18% for common stock Assuming a 40% tax rate, what after-tax rate of return must the company earn on its investments? A) 14.2%. B) 10.0%. C) 13.0%. © 2011 Schweser CorFin 2011 Exam.docx Page 13 of 13
