CFA Level 1 corporate finance questions

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Q1. American Outlook Inc. is issuing bonds to obtain the funding necessary to acquire a major
competitor. Review of the balance sheets indicates that American Outlook has also issued
preferred and common stock in the past. Which component cost(s) should American Outlook use
in evaluating the financial cost of acquiring the new firm?
A.The weighted average component cost of common stock, preferred stock, and debt.
B.The price the firm paid for its assets divided by their market value.
C
Shareholders' equity.
.
D.The cost of the new debt issue alone.
Answer: A
Hint: How a company raises capital and how they budget or invest it are considered
independently. The financing department is responsible for keeping costs low and using a balance
of funding sources. In the short term, a company may overemphasize the most recently issued
capital, but in the long run, the firm will ascribe to target weights for each capital type. The
investment decision should be made assuming a weighted average cost of capital including each of
the different sources of capital and long-run target weights.
Q2. National Auto uses debt, preferred stock, and common stock to finance operations.
Calculation of the cost of capital requires identification of the:
A.risk-free rate.
B.net present value of the project to be financed.
C
percentage of financing coming from each financing source.
.
D.company's product.

Answer: C
Hint: The weighted average cost of capital is a weighted average of the marginal costs of each
relevant component. The weights are based on the percentage each particular component
represents in the firms capital structure. Those sources providing more financing of firm assets
have a greater weight in calculation of the firms cost of capital. The risk-free rate only has an
impact in that it serves as a consideration of lenders in assigning an interest rate to the firm. The
net present value is used in capital budgeting decisions.
Q3. Which of the following influence the cost of capital?
A.All of these choices are correct.
B.General economic conditions.
C
Marketability of securities.
.
D.Amount of financing the firm requires.

Answer: A
Q4. An analyst has gathered the following information about a company:

stocks sells for $50 per share

last dividend (D 0) was $2.00

growth rate is a constant 5 percent

the company would incur a flotation cost of 15 percent if it sold new common stock

net income for the coming year is expected to be $500,000

the firm's payout ratio is 60 percent

its common equity ratio is 30 percent

If the firm has a capital budget of $1,000,000, what component cost of common equity will be
built into the weighted average cost of capital for the last dollar of capital the company raises?
A.9.94%
B.11.75%
C
10.50%
.
D.9.20%
Answer: A
Hint: ke = [D 1/( Po (1-F))] + g
D 1(2)(1.05) = 2.1
ke = [2.1/(50 (1- .15))]
+ .05 =

2.1

2.1
+ .05 =

50(.85)

+ .05 = .0494 + .05 = .0994or 9.94%

42.5

Q5. A company has $5 million in debt outstanding with a coupon rate of 12 percent. Currently the
YTM on these bonds is 14 percent. If the tax rate is 40 percent, what is the after tax cost of debt?
A.14.0%.
B.12.0%.
C
5.6%.
.
D.8.4%.
Answer: D