CFA Institute CFA Institute Certifications CFA-LEVEL-1 Questions & Answers

• Question 991:

  Interstate Transport has a target capital structure of 50 percent debt and 50 percent common equity. The firm is considering a new independent project which has an IRR of 13 percent and which is not related to transportation. However, a pure play proxy firm has been identified that is exclusively engaged in the new line of business. The proxy firm has a beta of 1.38. Both firms have a marginal tax rate of 40 percent, and Interstate's before-tax cost of debt is 12 percent. The risk-free rate is 10 percent, and the market risk premium is 5 percent. The firm should

  A. Be indifferent between accepting or rejecting; the firm's required rate of return on the project equals its expected return.

  B. Accept the project; its IRR exceeds the risk-free rate and the before-tax cost of debt.

  C. Accept the project; its IRR is greater than the firm's required rate of return on the project of 12.05 percent.

  D. Reject the project; its IRR is less than the firm's required rate of return on the project of 16.9 percent.

  E. Reject the project; its IRR is only 13 percent.

  Correct Answer: C

  Calculate the required return, k(s), and use to calculate the WACC:

  k(s) = 10% + 1.38(5%) = 16.9%.

  WACC = 0.5(12.0%)(0.6) + 0.5(16.9%) = 12.05%.

  Compare expected project return, to WACC:

  Accept the project since IRR (13%) is more than the WACC (12.05%).

• Question 992:

  The most commonly held view of capital structure, according to the text, is that the weighted average cost of capital ________.

  A. increases proportionately with increases in leverage

  B. does not change with leverage

  C. none of these answers

  D. increases with moderate amounts of leverage and then falls

  E. first falls with moderate levels of leverage and then increases

  Correct Answer: E

  The optimal capital structure must strike a balance between risk and return which maximizes the firm's stock price. Using more debt raises the risk borne by stockholders, however, using more debt leads to a higher expected rate of return.

• Question 993:

  Pierce Products is deciding whether it makes sense to purchase a new piece of equipment. The equipment costs $100,000 (payable at t = 0). The equipment will provide before-tax cash inflows of $45,000 a year at the end of each of the next four years (t = 1, 2, 3, 4). The equipment can be depreciated according to the following schedule: t = 1: 0.33 t = 2: 0.45 t = 3: 0.15 t = 4: 0.07 At the end of four years the company expects to be able to sell the equipment for a salvage value of $10,000 (after-tax). The company is in the 40 percent tax bracket. The company has an after-tax cost of capital of 11 percent. Since there is more uncertainty about the salvage value, the company has chosen to discount the salvage value at 12 percent. What is the net present value of purchasing the equipment?

  A. $22,853.90

  B. $9,140.78

  C. $28.982.64

  D. $20,564.23

  E. $16,498.72

  Correct Answer: A

  First, find the after-tax CFs associated with the project. This is accomplished by subtracting the

  depreciation expense from the raw CF, reducing this net CF by taxes and then adding back the

  depreciation expense.

  For t = 1: ($45,000 - $33,000)(1 - 0.4) + $33,000 = $40,200.

  Similarly, the after-tax CFs for t = 2, t = 3, and t = 4 are $45,000, $33,000, and $29,800, respectively.

  Now, enter these CFs along with the cost of the equipment to find the pre-salvage NPV (note that the

  salvage value is not yet accounted for in these CFs). The appropriate discount rate for these CFs is 11%.

  This yields a pre-salvage NPV of $16,498.72. Finally, the salvage value must be discounted. The PV of the

  salvage value is: N = 4, I = 12, PMT = 0, FV = -10,000, and PV = $6,355.18. Adding the PV of the salvage

  amount to the pre-salvage NPV yields the project NPV of $22,853.90.

• Question 994:

  The length of time required for an investment's cash flows, discounted at the investment's cost of capital, to cover its cost is known as ________.

  A. Weighted Average Cost of Capital (WACC)

  B. Payback Period

  C. Discounted Payback Period

  D. Net Present Valuing

  E. Optimal Capital Structure

  F. Capital Budgeting

  Correct Answer: C

  Discounted Payback Period is defined as the length of time required for an investment's cash flows, discounted at the investment's cost of capital, to cover its cost.

• Question 995:

  In an examination of several capital projects, the management of a large international conglomerate attempts to calculate the Weighted Average Cost of Capital for the firm. The Company is capitalized according to the following schedule based on market values: 55% debt 36% common stock

  9% perpetual preferred stock

  Additionally, assume the following information:

  Yield on outstanding debt: 8.95%

  Tax rate: 35%

  Annual preferred dividend: $0.70

  Preferred stock price: $8.90

  Return on equity: 17.36%

  Dividend payout ratio: 45%

  Cost of common stock: 15.10%

  Using this information, what is the WACC for this large multinational conglomerate?

  A. 10.11%

  B. 9.34%

  C. None of these answers.

  D. 9.29%

  E. 9.78%

  F. The answer cannot be completely calculated from the information provided.

  Correct Answer: B

  In order to calculate the WACC, it is necessary to first calculate the component cost of debt, common

  equity, and preferred equity. Once the cost of these components is determined, they are imputed into the

  WACC equation, which is as follows: {WACC = [(% weight of debt securities * cost of debt) + (% weight of

  common stock * cost of common stock) + (% weight of preferred stock * cost of preferred stock)]} To

  calculate the component cost of debt, use the following equation:

  {Cost of debt = [yield on outstanding debt securities * (1 - tax rate)}

  Factoring in the given information into this equation would yield the following:

  {After-tax cost of debt = [8.95% * (1 - 0.35%)]} = 5.818%

  To calculate the component cost of outstanding preferred stock, the following equation must be used:

  {Cost of preferred stock = [annual dividend / preferred stock price]}

  {Cost of preferred stock - = [$0.70 / $8.90]} = 7.865%.

  The final component of the WACC calculation, the cost of common equity, has been provided as 15.10%.

  Now that the after-tax costs of debt, preferred stock, and common stock have been determined, the WACC

  calculation can be found. The calculation of the WACC is as follows:

  {[0.55 * 0.05818] + [0.36 * 0.1510] + [0.09 * 0.07865]} = 9.344%.

• Question 996:

  Which of the following factors affect a firm's cost of capital?

  A. Tax rates

  B. Investment Policy

  C. All of these answers

  D. Dividend Policy

  E. The level of interest rates

  F. Capital Structure Policy

  Correct Answer: C

  Each of these factors may affect a firm's cost of capital. As interest rates rise, the cost of debt will also rise forcing firms to pay a higher rate of interest on debt capital (bonds). Tax rates also affect the cost of debt. Furthermore, a lower capital gains tax rate relative to ordinary income tax rates will affect the cost of equity capital relative to the cost of debt capital. Capital structure policy will affect the weighted average cost of capital (WACC), as well as affect the riskiness of both equity and debt capital. A change in the level of capital risk will in turn also affect the WACC. Dividend policy including the level of dividends and stability of dividends will have a direct affect on the cost of equity capital. Finally, a firm's WACC is affected by its investment policy. The types of investments that a firm undertakes and the riskiness of those investments are reflected in the WACC.

• Question 997:

  Which of the following firms has the highest degree of financial leverage? Firm A EBIT: $1,000,000 Interest Paid: $50,000 Total Operating Expenses: $900,000 Fixed Operating Expenses: $350,000 Firm B EBIT: $490,000 Interest Paid: $15,000 Total Operating Expenses: $300,000 Fixed Operating Expenses: $180,000 Firm C EBIT: $1,500,000 Interest Paid: $75,000 Total Operating Expenses: $3,000,000 Fixed Operating Expenses: $2,250,000 Firm D EBIT: $875,000 Interest Paid: $75,000 Total Operating Expenses: $3,000,000 Fixed Operating Expenses: $2,000,000 Firm E EBIT: $1,250,000 Interest Paid: $90,000 Total Operating Expenses: $2,900,000 Fixed Operating Expenses: $1,750,000

  A. Firm E

  B. Firm C

  C. Firm D

  D. Firm B

  E. Firm A

  Correct Answer: C

  The Degree of Financial Leverage (DFL) measures the percentage change in EPS that results from a given percentage change in EBIT. Financial Leverage is the second component of total leverage, along with Operating Leverage. The equation used to calculate the Degree of Financial Leverage is as follows: {DFL = [EBIT/(EBIT - Interest Paid)]}. In this example, Firm D has the highest DFL, with a figure of 1.09375. Remember that the Degree of Financial Leverage can never be less than one, and can never be negative In a situation where the company under examination has zero interest expense, the DFL would be equal to one, i.e. the EBIT is equal to the EBIT minus the interest expense. Another important note to remember is that in calculating the Degree of Financial Leverage, dividend payments to preferred stockholders should be included in the interest expense figure. Operating expenses are not factored into the DFL calculation, rather are used in the determination of Operating Leverage.

• Question 998:

  Which of the following cannot be eliminated through diversification?

  I. Stand-alone risk

  II. Unsystematic risk

  III. Systematic risk

  IV.

  Market risk

  V.

  Beta risk

  VI. Corporate risk

  VII. Alpha risk

  VIII.

  Gamma risk

  A.

  I, II, V, VII, VIII

  B.

  I, III, IV, VI, VII, VIII

  C.

  I, II, V, VI

  D.

  II, III, VI

  E.

  III, IV, V

  Correct Answer: E

  Of the various components of asset risk, only systematic risk cannot be diversified away. Systematic risk measures that part of asset risk that is inherent regardless of the level of diversification, and is measured by the Beta coefficient. Systematic risk is also referred to as "market risk" and "beta risk." Corporate risk is defined as the variability of an asset's expected returns without taking into consideration the effects of shareholder diversification. This is one step away from Stand-alone Risk, which measures the risk of an asset, not only without taking into consideration the effect of shareholder diversification, but of company diversification as well. Stand-alone risk assumes that the asset in question is the only asset of the firm and that the securities of the firm are the only assets in investors' portfolios. Corporate risk takes into consideration that firms will diversify their asset bases. Stand-alone risk is defined as the variability of an asset's expected returns if it were the only asset of a firm and the stock of that firm was the only security in an investor's portfolio. This type of risk is definitively reduced through diversification, and is commonly referred to as "unsystematic risk."

• Question 999:

  Which of the following is false?

  A. All of these answers.

  B. The IRR and NPV rules do not always give the same project rankings.

  C. A project with a higher IRR is always preferable to a project with a lower IRR.

  D. Both IRR and NPV rules are based on cash flow discounting.

  Correct Answer: C

  You should always use the NPV criterion for selecting projects. The IRR method can give project rankings different from the NPV criterion depending on the type of cash flows of the project as well as the cost of capital involved. Further, a project with a higher NPV at the project's cost of capital can have a lower IRR than another project with lower NPV. Therefore, (III) is false.

• Question 1000:

  Which of the following statements is most correct?

  A. Corporations should fully account for sunk costs when making investment decisions.

  B. All of the answers are correct.

  C. The rate of depreciation will not affect operating cash flows, because depreciation is not a cash expense.

  D. Corporations should fully account for opportunity costs when making investment decisions.

  E. None of the answers are correct.

  Correct Answer: D

  Cash flow = Net income + depreciation; therefore, depreciation affects operating cash flows. Sunk costs should be disregarded when making investment decisions, while opportunity costs should be considered when making investment decisions, as they represent the best alternative use of an asset.