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

• Question 1011:

  Which of the following is/are true about the DOL?

  I. The DOL measures the change in EBIT for a given change in the quantity sold.

  II. The DOL is zero at the break-even level.

  III.

  The DOL decreases as the level of sales increases.

  A.

  I only

  B.

  II and III

  C.

  I, II and III

  D.

  III only

  E.

  II only

  Correct Answer: D

  The DOL measures the percentage change in EBIT for a given percentage change in the quantity sold. At a sales level of Q units, DOL = Q(P-V)/[Q(P-V) - FC] Hence, at the break-even level, the DOL is infinite but decreases as the sales increase.

• Question 1012:

  Merryweather, a manufacturer of summer casual wear, has a return on equity of about 10.6%. It typically pays out about 27% of its earnings as dividends. The firm's stock has a beta of +0.23. The market has an expected return of 16.2% and the prevailing risk-free rate is 6.9%. Merryweather recently announced that last year's EPS was $4.3 per share. Given these data, Merryweather's share price should be:

  A. $91.19

  B. $84.84

  C. $96.07

  D. $78.29

  Correct Answer: C

  The dividend growth rate, g = ROE*(1-payout ratio) = 0.106*(1-0.27) = 7.738%.

  The dividend this year was 4.3*0.27 = $1.16. Therefore, expected dividend next year = D1 = (1+g)*Do =

  1.07738*1.16 = $1.25.

  The required rate of return on the stock can be found using CAPM, which gives Rstock = Rf + beta*(Rm Rf) = 6.9% + 0.23*(16.2% - 6.9%) = 9.039%.

  Therefore, Po = D1/(k-g) = 1.25/(9.039% - 7.738%) = $96.07.

• Question 1013:

  A firm has issued a perpetuity with a total face value of 100 million dollars and a coupon rate of 5.8%. If the risk free rate equals 5.8% and investors require a rate of return of 10.6% from the perpetuity, what's the amount the firm raised through the issue?

  A. $55.28 million

  B. none of these answers

  C. $100 million

  D. $54.72 million

  Correct Answer: D

  The price of a perpetuity that pays C per year, at a discount rate of R, equals C/R. Hence, the price of the perpetuity issue = $(100*5.8%/10.6% ) million = $54.72 million.

• Question 1014:

  Which of the following statements is most correct?

  A. Sunk costs should be ignored in capital budgeting.

  B. None of these answers are correct.

  C. Externalities should be ignored in capital budgeting.

  D. All of these answers are correct.

  E. Opportunity costs should be ignored in capital budgeting.

  Correct Answer: A

  Sunk costs should be ignored. The other statements are false.

• Question 1015:

  The management of Intelligent Semiconductor is considering the creation of a new manufacturing facility.

  The following information applies to the new facility:

  Initial investment outlay: ($50,200,000)

  t1: ($3,000,000)

  t2: ($1,500,000)

  t3: $12,000,000

  t4: $20,000,000

  t5: $25,000,000

  t6: $25,000,000

  t7: $20,000,000

  t8: ($1,500,000)

  t9: ($3,000,000)

  t10: $500,000

  Assuming a 15% discount rate, along with a $0.00 salvage value at the end of year 10, what is the

  Modified Internal Rate of Return for this project?

  A. 13.19%

  B. 9.88%

  C. 12.66%

  D. 14.61%

  E. 13.90%

  F. Because this is a non-normal project, the Modified Internal Rate of Return cannot be calculated.

  Correct Answer: E

  Remember that the Modified Internal Rate of Return escapes many of the pitfalls associated with the traditional Internal Rate of Return calculation. One such pitfall is the fact that the traditional IRR cannot produce reliable calculations for "non-normal" projects, such as the project illustrated in this example. The Modified Internal Rate of Return, however, escapes this basic flaw and can be used to evaluate virtually any project. The calculation of the answer in this example is as follows: Step 1: Determine the Future Value of the cash inflows by compounding each positive inflow by the cost of capital. This value is often referred to as the "Terminal Value." Remember that in this example, the positive cash inflows begin at period 3. Step 2: Determine the Present Value of the cash outflows by discounting each negative inflow by the cost of capital. The cash inflows to be discounted occur in periods 1, 2, 8, and 9. Step 3: Determine the rate that equates the PV of the cash outflows to the FV of the cash inflows. The calculation of the FV of the cash

  inflows is shown as follows:

  FV of the cash inflows = {[$12,000,000 * 2.660] + [$20,000,000 * 2.313] + [$25,000,000 * 2.011] +

  [$25,000,000 * 1.749] + [$20,000,000 * 1.521] + [$500,000 * 1]} = $203,100,000.

  This is the terminal value.

  The calculation of the PV of the cash outflows is calculated as follows:

  PV of the cash outflows = {$50,200,000 + [$3,000,000 / 1.15] + [$1,500,000 /1.323] + [$1,500,000 / 3.059]

  + [$3,000,000 / 3.518]} = $55,285,596.07 Now that the present and future (terminal) values of the cash flows have been determined, the Modified Internal Rate of Return can take place. The following values are imputed into the Present Value worksheet on your calculator: PV =($55,285,596), FV = $203,100,000, N = 10, PMT = $0.00, Compute I. Imputing these values will yield an answer of 13.896% for the Modified Internal Rate of Return.

• Question 1016:

  The management of Intelligent Semiconductor is considering two mutually exclusive projects, which are detailed below: Project A Electron looping apparatus Initial investment outlay ($6,000,000) t1: $2,750,000 t2: $1,250,000 t3: $1,250,000 t4: $2,750,000 Cost of capital of 10.55% Project B Optical switching apparatus Initial investment outlay ($5,040,000) t1: $1,000,000 t2: $1,000,000 t3: $1,500,000 t4: $1,500,000 t5: $1,500,000 t6: $750,000 t7: $300,000 t8: $50,000 Cost of capital of 10.55% Assuming no taxes, a $0.00 salvage value at the end of the each project's life, as well as the ability to replicate each project identically at the end of its lifespan, which is the superior investment according to the Common Life approach? Additionally, what are the NPV and IRR of the superior project over the common life?

  A. Project B, NPV $305,221; IRR 13.65%

  B. None of these answers

  C. Project B, NPV $287,725.32; IRR 12.38%

  D. Project A, NPV $465,515; IRR 12.78%

  E. Project A, NPV $462,038; IRR 12.72%

  Correct Answer: E

  The Replacement Chain, or "Common Life" approach, is a useful method which allows two or more projects with unequal lives to be examined. In the Replacement Chain approach, the lifespans of each project being examined are multiplied in such a way that the resulting projects share a "common life." In this example, the Optical Switching apparatus has a lifespan of eight periods, while the electron looping apparatus has a four-period lifespan. The common multiple of both projects is 8, and by replicating the cash flows of the electron looping project through period 4, i.e. by carrying out the project for an additional cycle, we can arrive at a "common life" for both projects. Carrying out the electron-looping project through eight periods will yield the following series of cash flows: Electron looping apparatus t0: ($6,000,000) t1: $2,750,000 t2: $1,250,000 t3: $1,250,000 t4: [$2,750,000 + ($6,000,000)]=($3,250,000) t5: $2,750,000 t6: $1,250,000 t7: $1,250,000 t8: $2,750,000 By incorporating these cash flows into your calculator, you will find a NPV of $462,038 for this project, as well as an IRR of 12.72%. The Optical Switching apparatus has a NPV of $287,725 and an IRR of 12.38%.

• Question 1017:

  Santorum Co. has a capital structure which consists of 50 percent debt, 30 percent common stock, and 20 percent preferred stock. The company's net income was just reported to be $1,000,000. The company pays out 40 percent of its net income as dividends. How large of a capital budget can the company have, without having to issue additional common stock or change its capital structure?

  A. $600,000

  B. $2,000,000

  C. $1,200,000

  D. $200,000 E. $180,000

  Correct Answer: B

  The retained earnings break point indicates the size of the capital budget when not issuing additional common stock. BP(RE) = ($1,000,000(1 - 0.4))/0.30 = $2,000,000. BP = break point; RE = retained earnings

• Question 1018:

  Clay Industries, a large industrial firm, is evaluating the sales of its existing line of coiled machine tubing. In their analysis, the operating managers of Clay Industries have identified the following information related to the coiled machine tubing division and its product: Average variable cost of $100.50 Average sales price of $167.75 Breakeven quantity of 15,985 units Which of the following best describes the total fixed cost for this product?

  A. $1,114,800

  B. The calculation of the total fixed production costs for this product cannot be calculated from the information given.

  C. $875,000

  D. None of these answers is correct.

  E. $925,000

  F. $1,075,000

  Correct Answer: F

  To calculate the breakeven quantity for a product, use the following equation: {Fixed operating costs/[avg. sales price per unit - variable cost per unit]}. To determine the total fixed production cost of this product, we must rearrange the standard equation using algebra, in a manner such that the resulting equation resembles the following: [$167.75 - $100.50]

  * 15,985 units = X. Solving for X, which represents the total fixed production costs, yields an answer of $1,075,000.

• Question 1019:

  Copybold Corporation is a start-up firm considering two alternative capital structures--one is conservative and the other aggressive. The conservative capital structure calls for a D/A ratio = 0.25, while the aggressive strategy call for D/A = 0.75. Once the firm selects its target capital structure it envisions two possible scenarios for its operations: Feast or Famine. The Feast scenario has a 60 percent probability of occurring and forecast EBIT in this state is $60,000. The Famine state has a 40 percent chance of occurring and the EBIT is expected to be $20,000. Further, if the firm selects the conservative capital structure its cost of debt will be 10 percent, while with the aggressive capital structure its debt cost will be 12 percent. The firm will have $400,000 in total assets, it will face a 40 percent marginal tax rate, and the book value of equity per share under either scenario is $10.00 per share. What is the coefficient of variation of expected EPS under the aggressive capital structure plan?

  A. 2.45

  B. 1.00

  C. 1.18

  D. 3.76

  E. 2.88

  Correct Answer: A

  Calculate coefficient of variation

  Expected EPS(Aggressive):

  E(EPS) = 0.6 EPS(Feast) + 0.4 EPS(Famine) = (0.6)($1.44) + 0.4(-$0.96) = $0.48. Standard deviation

  SD(EPS-aggressive) = [0.6($1.44 - $0.48)^2 + 0.4(-$0.96 - $0.48)^2]^1/2

  = [0.5530 + 0.8294]^1/2 = 1.176.

  CV(Aggressive) = 1.176/0.48 = 2.45.

• Question 1020:

  Helms Aircraft has a capital structure, which consists of 60 percent debt and 40 percent common stock. The company's equity financing will come from issuing new common stock. The company recently issued bonds with a yield to maturity of 9 percent. The company's stock is currently trading at $40 a share. The year-end dividend is expected to be $4 a share (that is, D(1) = $4.00), and the dividend is expected to grow at a constant rate of 5 percent. The flotation costs associated with issuing new common stock are estimated to be 10 percent. The company's tax rate is 35 percent. What is the company's weighted average cost of capital?

  A. 11.84%

  B. 10.98%

  C. 8.33%

  D. 9.51%

  E. 9.95%

  Correct Answer: E

  Calculate the after-tax cost of debt = (1 - 0.35) 9% = 5.85%.

  Calculate the cost of new equity: k(e) = $4/[$40(1 - 0.1)] + 0.05 = 0.1611 or 16.11%. Compute WACC

  (Weighted Average Cost of Capital): 0.6(5.85%) + 0.4(16.11%) = 9.95%.