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

• Question 1001:

  Of the commonly-employed methods for evaluating capital projects, which of the following offers the most useful, reliable, and germane results for the financial analyst?

  A. Internal Rate of Return

  B. Discounted Payback Period

  C. Net Present Value

  D. Payback Period

  Correct Answer: C

  In analyzing capital projects, particular weight should be given to Net Present Value (NPV) calculations, as this method is viewed as the most reliable and realistic of the four major capital budgeting analysis methods. Net Present Value calculations are superior to Internal Rate of Return calculations in that NPV works regardless of the size or timing of cash flows, and has a more flexible incorporation of the appropriate discount rate. Payback period should be viewed as the most inferior of the four methods, asit does not incorporate the "time-value of money" principle into its calculation. The Discounted Payback Period is only a slightly improved version of the basic Payback Period.

• Question 1002:

  Which of the following characteristics is not necessary for the NPV and MIRR calculations to consistently produce similar results?

  A. Projects must have cash flows

  B. Projects must have equal lifespans

  C. Project must be of equal scale

  D. Projects must be of equal size

  E. Projects must be independent

  Correct Answer: E

  When examining mutually-exclusive projects with normal cash flows, the MIRR and NPV methods will ALWAYS produce similar results as long as the projects being examined are equal in size and have the same life. It is not necessary for projects to be independent in order for the NPV and MIRR methods to produce similar results.

• Question 1003:

  Which of the following events is likely to encourage a corporation to increase its debt ratio?

  A. An increase in the personal tax rate.

  B. An increase in the expected cost of bankruptcy.

  C. Increased uncertainty about the level of sales and output prices.

  D. An increase in the corporate tax rate.

  E. An increase in the company's degree of operating leverage.

  Correct Answer: D

  A major reason for using debt is that interest is deductible, which lowers the effective cost of debt. An increase in the corporate tax rate will increase the tax savings from using debt. An interest increase in the personal tax rate will make interest income less attractive. An increase in operating leverage, bankruptcy costs, and uncertainty about sales and output prices will encourage the firm to decrease financial leverage.

• Question 1004:

  You have been asked by the president of your company to evaluate the proposed acquisition of a new special-purpose truck. The truck's basic price is $50,000, and it will cost another $10,000 to modify it for special use by your firm. The truck falls into the MACRS three-year class, and it will be sold after three years for $20,000. Use of the truck will require an increase in net working capital (spare parts inventory) of $2,000. The truck will have no effect on revenues, but it is expected to save the firm $20,000 per year in before-tax operating costs, mainly labor. The firm's marginal tax rate is 40 percent. What is the net investment in the truck?

  A. -$65,000

  B. -$50,000

  C. -$52,600

  D. -$55,800

  E. -$62,000

  Correct Answer: E

  Initial investment:

  Cost($50,000)

  Modification(10,000)

  Change in NWC(2,000)

  Total net investment =($62,000)

• Question 1005:

  Calculate the weighted average cost of capital (WACC) for a firm with the following capital structure:

  10% Preferred stock

  50% Common equity

  40% Debt

  Tax rate 40%

  Before tax cost of debt 12%

  The cost of common equity is 15%

  Cost of preferred stock 10%

  A. 7.2%

  B. 12.33%

  C. 11.38%

  D. 7.98%

  E. 13.3%

  Correct Answer: C

  A firm's weighted average cost of capital (WACC) = the cost of each component of capital weighted by the proportion of that component in the firm's capital structure. In this case WACC = (after tax cost of debt x 40%) + (cost of common equity x 50%) + (cost of preferred stock x 10%) = (12% x 60% x 40%) + (15% x 50%) + (10% x 10%) = 2.88% + 7.5% + 1% = 11.38%.

• Question 1006:

  Mooradian Corporation estimates that its cost of capital is 11 percent. The company is considering two mutually exclusive projects whose after-tax cash flows are as follows: Year Project SProject L 0-$3,000 -$9,000 12,500-1,000 21,500 5,000 31,500 5,000 4-500 5,000 What is the modified internal rate of return (MIRR) of the project with the highest NPV?

  A. 18.25%

  B. 11.89%

  C. 20.12%

  D. 16.01%

  E. 13.66%

  Correct Answer: C

  Use cash flow registers to determine the NPV of each project:

  NPV(S) = $1,237.11; NPV(L) = $1,106.82.

  Since NPV(S) > NPV(L) we need to calculate MIRR(S).

  Calculate the PV of cash outflows:

  CF(0) = -3,000; CF(1-3) = 0; CF(4) = -500; I = 11. Solve for NPV = $3,329.37.

  Calculate the TV of cash inflows:

  First find the cumulative PV, then take forward as a lump sum to find the TV.

  Solve for NPV = $4,566.47.

  Calculate TV or FV: N = 4; I = 11; PV = -4,566.47; PMT = 0.

  Solve for FV = $6,932.22.

  Calculate MIRR: N = 4; PV = -3,329.37; PMT = 0; FV = 6,932.22.

  Solve for MIRR = I = 20.12%.

• Question 1007:

  Which of the following statements is correct?

  A. To find a firm's marginal cost of capital for capital budgeting purposes, we would develop an MCC and an IOS schedule, find the WACC at the intersection of the two curves, and define that WACC to be the corporate cost of capital. However, this procedure will not lead to a meaningful answer if the firm uses debt.

  B. If a project has only costs (no revenues) as would certain environmental projects, then the project is likely to have two regular IRRs but only one MIRR.

  C. In general, the PVs of riskier cash flows should be found using relatively high discount rates. However, if a cash flow is non-normal (cash inflows followed by cash outflows, a lower discount rate should be used to evaluate risky projects.

  D. It is better to use the NPV method to evaluate independent projects, but for mutually exclusive projects, especially if projects vary greatly in size, the MIRR method is better.

  E. Firms A and B have identical balance sheets and income statements, pay the same rate of interest, have the same cost of retained earnings, k(s), and have the same very good set of investment opportunities. However, Firm A pays out only 20 percent of its earnings versus an 80 percent payout for Firm B. Firm A will probably have the higher marginal cost of capital schedule.

  Correct Answer: C

  The other statements are incorrect because of the following: A project that has only costs has no IRR. The WACC incorporates the cost of all capital: debt, preferred stock, and equity. The NPV method is best used to evaluate mutually exclusive projects of varying size because the MIRR method may produce a conflicting result from the NPV in this situation. Firm B will have the higher cost of capital because it has the higher payout forcing it to go to more costly equity capital before Firm A.

• Question 1008:

  Elephant Books sells paperback books for $7 each. The variable cost per book is $5. At current annual sales of 200,000 books, the publisher is just breaking even. It is estimated that if the authors' royalties are reduced, the variable cost per book will drop by $1. Assume authors' royalties are reduced and sales remain constant; how much more money can the publisher put into advertising (a fixed cost) and still break even?

  A. $175,225

  B. $200,000

  C. $600,000

  D. $333,333

  E. $466,667

  Correct Answer: B

  $7(200,000) - $5(200,000) - F = 0

  F = $400,000.

  $7(200,000) - $4(200,000) - F = 0

  F = $600,000.

  $600,000 - $400,000 = $200,000.

• Question 1009:

  Javier Corporation is considering a project with the following cash flows: Time Cash Flow 0-$13,000 112,000 28,000 37,000 4-1,500 The firm's cost of capital is 11 percent. What is the project's modified internal rate of return (MIRR)?

  A. 21.68%

  B. 23.78%

  C. 24.90%

  D. 25.93%

  E. 16.82%

  Correct Answer: C

  First, find PV of all cash outflows:

  PV of CF(0) is -$13,000. PV of CF(4) is -1,500 discounted at 11% for 4 periods or -$988.10. Thus, the PV

  of all cash outflows is -$13,988.10.

  Second, find the FV at t = 4 of all cash inflows:

  The sum of these cash inflows is the project's terminal value. FV of CF(1) at t = 4 is found by entering N =

  3, I = 11, PV = -12,000, and PMT = 0. Then solve for FV = $16,411.57. Similarly, the FVs at t = 4 of CF(2)

  and CF(3) are found to be $9,856.80 and $7,770.00, respectively. Thus, the projects TV = $16,411.57 +

  $9,856.80 + $7,770.00 = $34,038.37.

  To find the MIRR, enter N = 4, PV = -13,988.10, PMT = 0, and FV = 34,038.37, which yields I/YR = MIRR = 24.90%.

• Question 1010:

  Which of the following statements is correct?

  A. It is unrealistic to expect that increases in net working capital that are required at the start of an expansion project are simply recovered at the project's completion. Thus, these cash flows are included only at the start of a project.

  B. Equipment sold for more than its book value at the end of a project's life will increase income and, despite increasing taxes, will generate a greater cash flow than if the same asset is sold at book value.

  C. All of these statements are false.

  D. An asset that is sold for less than book value at the end of a project's life will generate a loss for the firm and will cause an actual cash outflow attributable to the project.

  E. Only incremental cash flows are relevant in project analysis and the proper incremental cash flows are the reported accounting profits because they form the true basis for investor and managerial decisions.

  Correct Answer: B

  A gain on the sale occurs when equipment is sold for more than its book value. This increases profit and cash flow.