TRIAL QUESTION

The most likely cause for a shift in the supply curve for coffee is a change in the:
a.
b.
c.
d.

Price of coffee
Wages of coffee harvesters
Price of tea
Price of cream

Answer:

The supply curve shifts in response to a change in the cost of inputs, such as
the wages for coffee harvesters. A change in the price of the product is a
movement along the supply curve, not a shift in the curve. A change in the price of
a substitute would more likely influence the demand curve, not the supply curve.

EASY QUESTIONS
E-1 When modeling consumer decision making, indifference curves:
A.
represent the set of affordable consumption bundles.
B.
reflect an increasing marginal rate of substitution.
C.
represent consumption bundles that have equal total utility to the consumer.
D.
represent consumption bundles that have greater total utility to the
customer.
Answer:

Indifference curves reflect consumption bundles that have the same total
utility to the consumer, whether or not they are affordable. Indifference curves
reflect a diminishing marginal rate of substitution.

E-2 Reyes Motors signs a contract to sell a P100,000 luxury Sedan to be delivered
next month, and receives a P20,000 cash down payment from the buyer. How will
the transaction most likely affect Washburns assets and liabilities?
Assets

Liabilities

A.

Unchanged

Unchanged

B.

Increase

Increase

C.

Increase

Unchanged

D.

Decrease

Decrease

Answer:

The down payment will increase cash (an asset) and unearned revenue (a
liability). Revenues (and thus retained earnings and owners equity) will not
increase because the car has not been delivered.

E-3 The probability of a boom economy is 40 percent. The probability of Yacht Co.
having a 50 percent return given a boom economy is 80 percent. Find the joint
probability of a boom economy and a 50 percent return for Yacht Co.
A . 0.20
B . 0.40

C . 0.32
D . 0.50
Answer:

The joint probability of a boom economy and an 80 percent return for Yacht
Co. is 0.40 * 0.80 = 0.32.

E-4 Which of the following is/are true?

I. A project's sunk costs are irrelevant to the decision of accepting or rejecting
it.
II. A project's incremental cash flows are not affected by interest expenses.
III. Project rankings using incremental net income and incremental net cash
flows can be different.
a) III only
b) I, II & III
c) I & II
d) I only

Answer:

Incremental cash flows of a project are the cash flows that occur if and only if
the project is undertaken. Since the effects of debt financing are taken into account
through the discount rate used to discount the project cash flows, interest
payments are ignored while estimating the project's cash flows. Therefore, a
project's incremental cash flows are not affected by interest expenses.

E-5 When a mature firm raises the dividend, signaling theory implies that its stock
price ________. When a growth firm cuts the dividend, signaling theory implies that
its stock price ________.
a) will rise; may rise or fall
b) will fall; will rise
c) will fall; may rise or fall
d) will rise; will fall
Answer:

The signaling theory is properly applicable only to mature firms that have
had stable dividend policies because in its pure form, the theory regards dividend
changes as signals of management's forecasts of future earnings. Such an
assumption is not fully justifiable for young, growth firms, which may cut dividends
simply to supply retained earnings capital for expansion projects, without any
signaling about the firm's future earnings prospects. Indeed, many growth firms pay
no dividend at all for quite some time without an adverse effect on their stock
prices.
Hence, the increase in the dividend of a mature firm is taken as a signal by
investors - under the signaling hypothesis - that the management's forecasts of
future earnings are quite favorable, leading to a rise in the stock price. On the other
hand, for a growth firm, such a signaling conclusion does not necessarily hold.

E-6 The divisor for the Dow Jones Industrial Average (DJIA) is most likely to
decrease when a stock in the DJIA:
A . is removed and replaced.
B . pays a cash dividend.
C . has a reverse split.
D . has a stock split.

Answer:

E-7 In the calculation of the arithmetic mean for grouped data, which value is used
to represent all the values in a particular class?
a. The lower limit of the class
b. The cumulative frequency of the preceding class
c. The midpoint of the class
d. The frequency of the class

Answer:

The value that you would use is the midpoint of a particular class. This will be
the average of the upper and lower limits of the class.

E-8 Arellano Corp.s financial accounts for the year ended December 31 included
the following information:
Net Income:

P122,000

Preferred Stock Dividends Paid:

P35,000

Common Stock Dividends Paid:

P42,000

Common Shares outstanding at January 1:

50,000

10% preferred P100 par value shares outstanding at January 1: 3,500

No stock transactions occurred during the year and all preferred stock dividends
were paid. Basic earnings per share for Savannah are closest to:
A) P0.90.
B) P1.50.
C) P2.44.
D) P1.74.

Answer:

Arellano Corp.s basic EPS ((net income preferred dividends) / weighted

average number of common shares outstanding) was ((P122,000 P35,000) /
P50,000 =) P1.74.

E-9 Which of the following statements is FALSE?

A. Sunk costs are developmental costs that should be considered in the capital
budgeting decision.
B. Shipping and installation costs are part of the depreciable basis of a project.
C. Externalities refer to the cannibalization of sales that occurs when a new project
is initiated.
D. Opportunity costs are cash flows that a firm passes up by taking a project.
Answer:

Sunk costs are not considered.

E-10 Non-callable bond prices go up faster than they go down. This is referred to
as:
A. inverse features.
B. negative convexity
C. embedded benefits
D. positive convexity

Answer:

When bond prices go up faster than they go down, it is called positive

convexity.
E-11 An investment of $100 generates after-tax cash flows of $40 in Year 1, $80 in
Year , and $120 in Year 3. The required rate of return is 20 percent. The net present
value is closest to :
a. $ 42.22
b. $ 58.33
c. $ 68.52
d. $ 47.54
Answer: B. $ 58.33

E-12 Jadine Corporation is considering an investment of $20,000 will create a

perpetual after-tax cash flow of $2,000. The required rate of return is 8 percent.
What is the investments profitability index?
a. 1.08
b. 1.16
c. 1.5
d. 1.25
Answer: D. 1.25
Solution: The PV of Future Cash Flows = 2,000 = 25,000
0.08
The profitability index = 25,000/20,000= 1.25

E-13 NadzLustre Corporation is considering an investment of 750 million won with

expected after-tax cash inflows of 175 million per year for seven years. The required
rate of return is 10 percent. Expressed in years, the projects payback period and
discounted payback period, respectively, are closest to :
a. 4.3 years and 5.4 years
b. 4.8 years and 5.9 years
c. 4.3 years and 5.9 years
d. 4.8 years and 6.3 years
Answer: C
E-14 If the ending inventory is understated , then
a. Current ratio is overstated and EPS is understated
b. Current ratio is understated and EPS is overstated
c. Current ratio is overstated and EPS is overstated
d. Current ratio is understated and EPS is understated
Answer: D
"Current Ratio= Current Assets/Current Liabilities = CA
EPS = Net Income / Outstanding ordinary shares = NI

= lower Current Ratio

= lower EPS"

E-15 The difference between nominal GDP and real GDP is that real GDP
a. Measures the level of output including price changes, while nominal GDP hold
prices constant
b. Measures the price level and nominal GDP measures the level of output
c. Measures the level of output in constant prices , while nominal GDP includes price
changes
d. Measures the level of output and nominal GDP measure the price level
Answer: C
E-16 According to FASB, timeliness is a characteristic of _____.
a. reliability
b. relevance
c. Both relevance and reliability
d. faithful representation
ANSWER: B
E-17 In calculating the weighted average cost of capital (WACC) , which of the
following statements is least accurate?
a. Different methods for estimating the cost of common equity might produce
different results
b. The cost of preferred equity capital is the preferred dividend divided by the price
of preferred shares.
c. The cost of debt is equal to one minus the marginal tax rate multiplied by the
coupon rate on outstanding debt.
d. None of the above
Answer: C

E-18 Which of the following statements about the discounted payback period is
least accurate? The discounted payback:
a. frequently ignores terminal values
b. method can give conflicting results with the NPV
c. period is generally shorter than the regular payback
d. none of the above
Answer: C

E-19 Maine is the supervisor of her firms research department. Her firm has been
seeking the mandate to underwrite Alden Industries proposed secondary stock
offering. Without mentioning that the firm is seeking the mandate, she asks Lola
Nidora to analyze Alden common stock and prepare research report. After
reasonable effort, Lola Nidora produces a favourable report on Alden stocks. Maine
then adds a footnote describing the underwriting relationship with Alden and
disseminates the report to firm clients. According to CFA Institute Standards of
Professional Conduct, these actions are:
a. not a violation of any standard
b. a violation of Standard V (A), Diligence and Reasonable Basis
c. a violation of Standard VI (A), Disclosure of Conflicts
d. a violation of Standard VII (A), Standard Performance
Answer: A

E-20 Information on ArellanoReid Company s direct labor cost for the month of
January is as follows:
Actual direct labor hours
34,500
Standard direct labor hours
35,500
Total direct labor payroll
P 241,500
Direct labor efficiency varianceFavorable
P 3,200
What is Arellanos direct labor rate variance?
a. 17, 250 U
b. 20,700 U
c. 21,000 F
d. 21,000 U
Answer : B. 20,700 U
The direct labor rate variance is determined by multiplying the difference between
actual and standard rate times the actual hours: AH (AR-SR). To determine the
standard rate divided the direct labor efficiency variance by the difference between
the actual standard hours. To determine the actual rate, divide the total direct labor
payroll by the actual hours.

AVERAGE QUESTIONS
A-1 Which of the is/are FALSE?
I. A high p-value is necessary to reject a null hypothesis.
II The higher the significance level, the greater is the chance that the null will
be rejected when it is false.
III. The higher the probability of Type II error, the higher is the chance of
rejecting the null when it is false.
a) II only
b) I, II & III
c) I only
d) II & III

Answer:

You can think of the p-value as the maximum probability that the null
hypothesis is true despite observing the value of the test statistic that you have in
the sample at hand. Thus, the lower the p-value, the greater is your confidence in
rejecting the null hypothesis.
The significance level represents an upper bound on the probability that the null
hypothesis is true given the observed sample and the testing procedure. Hence, if
you reject the null at the 5% significance level, for e.g., then the probability that the
null is true despite your statistical evidence to the contrary could be as high as 5%
(but no more, under the assumptions of the test).
A Type II error refers to the event that we will fail to reject the null when it is false.
The higher the probability of a Type II error, the lower the chance of rejecting the
null when it is false.

A-2 Pevidal, Inc. is considering the issuance of some junior subordinated debt. The
Company's combined state/federal corporate tax rate is 30%, and the coupon on its
outstanding senior debt is 7.55%. The proposed debt would pay an annual coupon.
Very recently, Pevidal has met with a corporate finance firm, who advised the
Company that the pre-tax cost of a debt issuance would be 7.70%; Pevidals finance
division mirrored these findings. A month earlier, a study in a popular financial
magazine found that shareholders require a 7.95% rate of return on similar
investments.
Which of the following represents the best answer for Pevidals estimated after-tax
cost of debt for this proposed debt issuance?

a) 5.39%
b) 5.565%
c) 5.425%
d) 5.285%

Answer:

Remember that in calculating the after-tax cost of debt for new debt issues,
the MARGINAL cost of issuing new debt is the most relevant measure. In this
example, the marginal cost of debt is given as 7.70%, and the after-tax cost of debt
capital is found by multiplying (1 - corporate tax rate) by this figure. Specifically, the
calculation of the after-tax cost of debt for Pevidal is as follows: {pre-tax cost of
issuing new debt 7.70% * [1-combined state/federal tax rate 30%]} = 5.39%.

A-3 Assume that a firm used P60 million in labor and materials to generate P100
million in total revenues. Other costs included P200,000 in foregone interest,
economic depreciation of P40,000, and normal profit of P130,000. The economic
profit to this firm is closest to:
a. P39,712,000.
B. P40,000,000.
C. P39,630,000.
D. P39,000,000.

Answer:

Economic profit = total revenue opportunity costs = total revenue

(explicit + implicit costs). In this case, the labor and material cost of P60 million is
the explicit cost. Implicit costs include the P200,000 in foregone interest, economic
depreciation of P40,000, and normal profit of P130,000. So, total implicit costs
equal P370,000 = P200,000 + P40,000 + P130,000. Thus, economic profit is
P100,000,000 - P60,000,000 - P370,000 = P39,630,000.

A-4 Razel, a portfolio manager for FAR Investment Management Company, a

registered investment organization that advises investment companies and private
accounts, was promoted to that position three years ago. Alyza, her supervisor, is
responsible for reviewing Razel's portfolio account transactions and her required
monthly reports of personal stock transactions. Razel has been using Aprilyn, a
broker, almost exclusively for portfolio account brokerage transactions. For
securities in which Aprilyn's firm makes a market, Aprilyn has been giving Razel
lower prices for personal purchases and higher prices for personal sales than Aprilyn
gives to Razel's portfolio accounts and other investors. Razel has been filing
monthly reports with Alyza only for those months in which she has no personal
transactions, which is about every fourth month. Which of the following
applies/apply?
I. Razel violated the Code and Standards in that she failed to disclose to her
employer her personal transactions.
II. Razel violated the Code and Standards by breaching her fiduciary duty to her
clients.
III. Alyza violated the Code and Standards by failing to enforce reasonable
procedures for supervising and monitoring Razel in Razel's trading for her own
account.
a) I, II and III
b) I and III only
c) II and III only

d) I and II only

Answer:

This question involves three Standards. Razel, the portfolio manager, has
been obtaining lower prices for her personal securities transactions than she gets
for her clients, which is a violation of Standard IV (B.1), Fiduciary Duties. In addition,
she violated Standard II (B), Professional Misconduct, by failing to adhere to
company policy and hiding her personal transactions from her firm. Razel's
supervisor, Alyza, violated Standard III (E), Responsibilities of Supervisors, by failing
to enforce the procedures for reporting personal trading. Therefore, Statements I, II
and III are all correct.

A-5 If Rheden Ski Company issues common stock, and uses the proceeds to
purchase fixed assets such as equipment:
A) Both cash flow from operations and cash flow from financing would increase.
B) Cash flow from financing would decrease and cash flow from investing would
increase.
C) Cash flow from financing would increase and cash flow from investing would
decrease.
D) Both cash flow from operations and cash flow from financing would decrease.

Answer:

Cash flow from financing increases when stock is issued, while cash flow from
investing decreases when spending for purchases of fixed assets.

A-6 A mutual fund announces it is an aggressive fund with a beta of 1.2. The fund is
fully diversified, so its correlation to the index is 1. During the period the index
returns 12% and the risk free rate was 5%. What is the expected return on this
fund?
a) 8.40%
b) 13.40%
c) 12.0%
d) 14.20%

Answer:

Since the fund is fully diversified that means its correlation to the Index is 1,
thus the fund should fall on the SML. You can use the CAPM to project the fund's
performance.
X = .05 + 1.2(.12 - .05) X = 13.4

A-7 Which of the following statements about capital is FALSE?

a) If the firm needs more funding than can be supported by retained earnings the
firm's weighted average cost of capital (WACC) will increase.

b) As the firm raises more and more capital, market efficiency would indicate that
the firm's marginal weighted average cost of capital should fall.
c) Assuming constant risk, the correct discount rate to use in its capital budgeting
decision is the firm's marginal weighted average cost of capital.
d) If a firm earns exactly the marginal cost of capital on its new investment projects
it will satisfy the return requirements of its creditors and equity investors.

Answer:

WACC should rise.

A-8 Which of the following statements best describes the fund-of-funds (FOF) class
of hedge funds? A fund of funds:
a. allows smaller investors to access the hedge funds market.
b. is an open-end mutual fund that primarily invests in other open-end funds.
c. is open to institutional investors for the purpose of seeking arbitrage situations in
hedge fund pricing.
d. None of the above.

Answer:

A fund-of-funds (FOF) is a fund that invests in hedge funds. They are open to
both individual and institutional investors.

A-9 Faith, Inc. sells 10,000 units at a price of P5 per unit. Faiths fixed costs are
P8,000, interest expense is P2,000, variable costs are P3 per unit, and earnings
before interest and taxes (EBIT) is P12,000. What is Faiths degree of financial
leverage (DFL) and total leverage (DTL)?
DFL

DTL

A.

1.33

1.75

B.

1.33

2.00

C.

1.20

2.00

D.

1.33

1.75

Answer:

DOL = [Quantity(P-V)]/[Quantity(P-V)-F]
= [10,000(5-33)] / [10,000(5-3)-8,000] = 1.67
DFL = EBIT/(EBIT-1)
= 12,000 / (12,000 2,000) = 1.2
DTL = DOL *DFL
= 1.67 * 1.2 = 2.0

A-10 The GDP deflator is used to:

a. reduce the gross GDP to allow for net income earned abroad.
b. adjust the gross GDP for net exports and depreciation.
c. calculate the GDP in terms of base year currency value.
d. calculate net GDP given gross GDP.
Answer:

The GDP deflator is used to calculate real GDP from nominal GDP by
adjusting appropriately for inflation. For this, a base year is arbitrarily selected and
all values are expressed in terms of the base year currency value (e.g. 1990 U.S.
dollars). This is done by dividing the nominal GDP by the GDP deflator. The result
indicates the GDP in terms of the purchasing power which prevailed in the base
year.
A-11 If everything else remains constant and a firm increases its cash conversion
cycle, its profitability will likely
a. Increase
b. Increase if earnings are positive
c. Decrease
d. Not be affected
Answer: C
Cash conversion cycle is the period from which inventory is received and processed
(age of inventory, sold to outside party (age of receivable) and eventually paid (age
of accounts payable). Answer (c) is correct because the longer the cash conversion
cycle the greater the amount of time from when a firm pays its suppliers to the time
it ultimately collects receivables. The greater the time frame the more likely the firm
will have to borrow funds and incur interest expense which reduces profitability.
Answers (a), (b), and (d) are incorrect because the incurrence of interest will reduce
profitability.
A-12 Gamitin Company purchases merchandise from its supplier on credit terms of
3/10, net 30 . What is the equivalent annual interest rate ( use 360-day year) if the
company foregoes the discount and pays on the 30 th day?
a. 55.67%
b. 3%
c. 60%
d. 3.09%
Answer: A
Annual Interest Rate = (3/(100-3))x(360days/(30days-10days))
= (3/97)x(360/20)
= 55.67%
A-13 One key difference between the dividend discount and flows to equity models
is
a. the flows to equity model looks at the cash flows that would be available to fund
the dividend stream
b. the dividend discount model looks at the cash flows that would be available to
fund the dividend stream
c. the flows to equity model looks at the dividend stream itself
d. the dividend discount model discounts the free cash inflow into the equity
component of the firm
Answer: A

A-14 You are considering the purchase of a three-year annual coupon bond with a
par value of P1,000 and a coupon rate of 5.5%. You have determined that the spot
rate for year 1 is 5.2%, the spot rate for year two is 5.5%, and the spot rate for year
three is 5.7%. What would you be willing to pay for the bond now?
a. 937.66
b. 1,000
c. 995.06
d. 998.78
Answer: C

A-15 In order to test if the mean IQ of employees in an organization is greater than

100, a sample of 30 employees is taken. The sample value of the computed zstatistic is 3.4. The appropriate decision at 5% significance level is to ____ .
a. reject the null hypothesis and conclude that the population mean is greater than
100
b. reject the null hypothesis and conclude that the population mean is not equal to
100
c. reject the null hypothesis and conclude that the population mean is equal to 100
d. accept the null hypothesis and conclude that the population mean is equal to 100
Answer: A

DIFFICULT QUESTIONS
D-1 The management of Reyes Industries have adhered to the following capital
structure: 40% debt, 45% common equity, and 15% perpetual preferred equity. The
following information applies to the firm:
Yield to maturity of outstanding long-term debt = 9.5%
Expected return on the market = 14.5%
Annual risk-free rate of return = 6.25%
Historical Beta coefficient of Reyes Industries Common Stock = 1.24
Annual preferred dividend = P1.75
Preferred stock net offering price = P28.50
Combined state/federal corporate tax rate = 35%
Given this information, and using the Capital Asset Pricing Model to calculate the
component cost of common equity, what is the Weighted Average Cost of Capital for
Reyes Industries?
a) The WACC for Reyes Industries cannot be determined from the information
provided.
b) 8.54%
c) 14.45%
d) 10.81%
Answer:

The calculation of the Weighted Average Cost of Capital is as follows:

{fraction of debt * [yield to maturity on outstanding long-term debt] [1-combined
state/federal income tax rate]} + {fraction of preferred stock * [annual dividend/net
offering price]} + {fraction of common stock * cost of equity}. The cost of common
equity can be calculated using three methods, the Capital Asset Pricing Model
(CAPM), the Dividend-Yield-plus-Growth-Rate (or Discounted Cash Flow) approach,
and the Bond-Yield-plus-Risk-Premium approach. In this example, you are required
to calculate the cost of equity using the Capital Asset Pricing Model (CAPM), which is
illustrated as follows: {risk-free rate + beta (expected return on the market riskfree rate)}. Using this model, the cost of common equity can be found as 16.48%.
The cost of perpetual preferred stock can be found by dividing the annual dividend
by the net offering price, which is illustrated in this case as follows: {P1.75/28.50}
= 6.14%. The after-tax cost of debt can be found by taking the yield to maturity on
the firms outstanding long-term debt (9.5%), and multiplying this figure by (1
annual tax rate 35%) = 6.175%. Incorporating all of these figures into the WACC
equation gives a Weighted Average Cost of Capital of 10.807%

D-2 Michael Bellow, CFA, CAIA, is an investment banker who is involved with an
initial public offering (IPO) of NewCo. Because this is Bellows first involvement in an
IPO, he reports to an experienced supervisor. While reviewing past financial
statements provided by NewCo, Bellow suspects that NewCo deliberately overstated
its earnings for the past several quarters. Bellow seeks the advice of his firms
highly competent general counsel and follows the advice given without deviation.
Based on the general counsels advice, Bellow consults his immediate supervisor
about the suspected overstatement of earnings. After reviewing the situation,
Bellows supervisor explains why NewCos calculations of its earnings are correct.
Bellow realizes that his inexperience and exuberance initially led him to an incorrect
conclusion about NewCos earnings.
Which of the following statements about Bellows actions involving Standard I(A),
Knowledge of the law, and Standard I(C), Misrepresentation, is CORRECT? Bellow:
A) Did not violate either Standard I (A) or Standard I(C).
B) Violated both Standard I (A) and Standard I(C).
C) Violated Standard I (A) but did not violate Standard I(C).
D) Violated Standard I (C) but did not violate Standard I(A).

Answer:

Bellow did not violate Standard I(A), Knowledge of the law, because he
sought advice of counsel and followed that advice. Bellow did not violate Standard
I(C), Misrepresentation, because he made reasonable and diligent efforts to ensure
the accuracy of the information and to avoid any material representation.

D-3 Given a population of 10, 5, and 15, the coefficient of variation would be:
A) 30%.
B) 40%.
C) 60%.
D) 100%.

Answer:

CV = (/mean)(100)
= ((52 + 52 /3) = 16.67 = 4 plus a bit
(4/10)(100) = 40%

D-4 At a recent Haggerty Semiconductors Board of Directors meeting, Merle

Haggerty was asked to discuss the topic of the companys weighted average cost of
capital (WACC). At the meeting Haggerty made the following statements about the
companys WACC:
Statement 1: A company creates value by producing a higher return on its assets
than the cost of financing: those assets. As such, the WACC is the cost of financing
a firms assets and can be viewed as the firms opportunity cost of financing its
assets.
Statement 2: Since a firms WACC reflects the average risk of the projects that
make up the firm, it is not appropriate for evaluating all new projects. It should be
adjusted upward for projects with greater-than-average risk and downward for
projects less-than-average risk.
Are Statement 1 and Statement 2, as made by Haggerty CORRECT?
Statement 1 Statement 2
A)

Correct

B)

Incorrect

C)

Correct

D)

Incorrect

Answer:

Incorrect
Correct
Correct
Incorrect

Each statement that Haggerty has made to the board of Directors regarding
the weighted average cost of capital is correct. New projects should have a return
that is higher than the cost to finance those projects.

D-5 The correlation coefficient between stocks A and B is 0.75. The standard
deviation of stock As returns is 16% and the standard deviation of stock Bs returns
is 22%. What is the covariance between stock A and B?
A) 0.3750.
B) 0.0264.
C) 0.0352.
D) 0.1200.

Answer:

Cov1,2 = 0.75 x 0.16 x 0.22 = 00.0264 = covariance between A and B.

D-6 Assume a firm uses a constant WACC to select investment projects rather than
adjusting the projects for risk. If so, the firm will tend to:

A) reject profitable, low-risk projects and accept unprofitable, high-risk projects.

B) accept profitable, low-risk projects and accept unprofitable, high-risk projects.
C) accept profitable, low-risk projects and reject unprofitable, high-risk projects.
D) reject profitable, low-risk projects and reject unprofitable, high-risk projects.

Answer:

The firm will reject profitable, low-risk projects because it will use a hurdle
rate that is too high. The firm should lower the required rate of return for lower risk
projects. The firm will accept unprofitable, high-risk projects because the hurdle
rate of return used will be too low relative to the risk of the project. The firm should
increase the required rate of return for high-risk projects.

D-7 Evangelista Inc., is in a 40% marginal tax bracket. The firm can raise as much
capital as needed in the bond market at a cost of 10%. The preferred stock has a
fixed dividend of $4.00. The price of preferred stock is $31.50. The after-tax costs of
debt and preferred stock are closest to:
Debt

Preferred Stock

A)

10.0%

7.6%

B)

6.0%

12.7%

C)

6.0%

7.6%

D)

10.0%

40.0%

Answer:

After-tax cost of debt = 10% x (1-0.4) = 6%.

Cost of preferred stock = $4 / $31.50 = 12.70%

D-8 Mega Securities, a multinational investment advisor based in the United States,
employs the following analysts who practice in multiple jurisdictions.
Melissa Black, CFA, resides in Country N, which has no securities laws or regulations,
but does business in Country L, which has securities laws and regulations that are
less strict than the Code and Standards.
Tom White, a CFA Institute member, resides in Country L, but does business in
Country S, which has securities laws and regulations that are stricter than the Code
and Standards.
According to the CFA Institute Code and Standards, which of the following
statements about Black and White is CORRECT?
Black must adhere to the White must adhere to the
A)

Law of Country L

law of Country S

B)

Code and Standards

C)

Law of Country N

law of Country L

D)

Law of Country N

law of Country S

law of Country S

Answer:

Because the applicable law in Country L is less strict than the Code and
Standards, Black must adhere to the Code and Standards. Because the applicable
law is stricter than the Code and Standards, White must adhere to the stricter
applicable law of Country S.

D-9 A firm is planning a $25 million expansion project. The project will be financed
with $10 million debt and $15 million in equity stock (equal to the companys
current capital structure). The before-tax required return on debt is 10% and 15%
for equity. If the company is in the 35% tax bracket, what cost of capital should the
firm use to determine the projects net present value (NPV)?
A)

12.5%

B)

9.6%

C)

11.6%

D)

15%

Answer:

WACC = (E / V) (RE) + (D / V) (RD) (1 TC)

WACC = (15 / 25) (0.15) + (10 / 25) (00.10) (1 0.35)
= 0.09 + 0.026
= 0.116 or 11.6%

D-10 The capital budgeting director of Aprilyn Manufacturing is evaluating a laser

imaging project with the following characteristics:
Cost: $150,000
Expected Life: 3 years
After-tax cash flows: $30, 317 per year
Salvage Value: $0
IF Aprilyn Manufacturings cost of capital is 11.50%, what is the projects minimal
internal rate of return (IRR)?
A)

13.6%

B)

11.5%

C)

10.0%

D)

27.2%

Answer:

Since we are seeking the IRR, the answer has to be in terms of a rate of
return, this eliminates the option not written in a percentage.
Since the payments (cash flows) are equals, we can calculate the IRR as:
N=3
PV = 150,000

PMT = 60, 317

CPT I/Y = 9.9999

D-11 Dale Ferrarin , CFA, gathered the following information about a company:
The stock is currently trading a P31.00 per share
Estimated growth rate for the next three years is 25%
Beginning in the year 4, the growth rate is expected to decline and stabilize at 8%
The required return for this type of company is estimated at 15%
The dividend in year 1 is estimated at P2.00
The stock is undervalued by approximately:
a. 15.70
b.0
c. 6.40
d. 5.50
Answer: C

D-12 Assume the current price of a bond is 102.50. If interest rates increase by
0.5% the value of the bond decreases to 100 and if interest rates decrease by 0.5%
the price of the bond increases to 105.50 . What is the effective duration of the
bond?
a. 5.37
b. 5.50
c. 5.48
d. 5.28
Answer: A

D-13 The Asian Spec Fund, managed by Charlie Puth, CFA, engages in currency
speculation for its clients. Based in Paris, Yco believes that there is an opportunity to
speculate on the Malaysian Ringgit. The current spot exchange rate is 4.417
Malaysian Ringgit per euro. Assuming the one-year risk-free rate for the European
Economic Community is 11.76% and the Malaysian one-year risk-free interest rate is
7.6%, what should the one-year forward rate be for the Malaysian Ringgit?
a. 4.246 MR./ EUR.
b. 4.586 MR./ EUR.
c. 4.253 MR./ EUR.
d. 4.441 MR./ EUR.
Answer: C
D-14 Assume that Adelandas income increased from P20,000 per year to P30,000
per year, and his demand for store-brand bread decreased from 80 loaves to 40
loaves per year. Which of the following most accurately describes Adelandas
income elasticity for store-brand bread?
a. Income elasticity is -0.60 and store-brand bread is an inferior good

b. Income elasticity is -1.67 and store-brand bread is an inferior good

c. Income elasticity is +1 and store-brand bread is a complimentary good
d. Income elasticity is +0.60 and store-brand bread is a complimentary good
Answer: B

D-15 Jonas Products has just developed a new product with a manufacturing cost of
P30 . The marketing director has identified three marketing approaches for this new
product.
Approach X : Set a selling price of P36 and have the firms sales staff sell the
product at a 10% commission with no advertising program. Estimated annual sales
would be 10,000 units.
Approach Y : Set a selling price of P38,have the firms sales staff sell the product
at a 10% commission, and back them up with a P30,000 advertising program.
Estimated annual sales would be 12,000 units.
Approach Z : Rely on wholesalers to handle the product. Jonas would sell the new
product to the wholesalers at P32 per unit and incur no selling expenses. Estimated
annual sales would be 14,000 units.
Rank the three alternatives in order of net profit from highest net profit to lowest.
a. X,Y,Z
b. Y,Z,X
c.Z,X,Y
d. Z,Y,X
Answer: C

CLINCHER QUESTIONS
C-1 What would be the marginal tax rate for an investor to be indifferent between a
6% yield on tax exempt municipal bonds and a 10% corporate bond?
a. 40%
b. 60%
c. 20%
d. 80%
Answer: A. 40%
C-2 An analyst gathered the following information about an industry. The industry
beta is 0.9. The industry profit margin is 8%, the total asset turnover ratio is 1.5 and
the leverage multiplier is 22. The dividend payout ratio of the industry is 50%. The
risk-free rate is 7% and the expected market return is 15%. The industry P/E is
closest to:
a. 12.00
b. 22.73
c. 14.20

d. 18.21
Answer: B

C-3 Find the future value of the following uneven cash flow stream. Assume end of
the year payments. The discount rate is 12%.
Year
Year
Year
Year
Year
a. 65, 144.33
b. 33,004.15
c. 58,164.58
d. 60,273.12
Answer: C

1
2
3
4
5

-2000
-3,000
6,000
25,000
30,000