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

• Question 1061:

  The management of Intelligent Semiconductor have adhered to the following capital structure: 40% debt,

  45% common equity, and 15% perpetual preferred equity. The following information applies to the firm:

  Before-tax cost of debt = 8.25%

  Combined state/federal tax rate = 33%

  Expected return on the market = 16.5%

  Annual risk-free rate of return = 6.25%

  Historical Beta coefficient of Intelligent Semiconductor's Common Stock = 1.34 Annual preferred dividend

  = $1.05

  Preferred stock net offering price = $18.90

  Expected annual common dividend = $0.20

  Common stock price = $100.90

  Expected growth rate = 9.75%

  Subjective risk premium = 5.3%

  Given this information, and using the Capital Asset Pricing Model (CAPM) to calculate the component cost

  of common equity, what is the Weighted Average Cost of Capital for Clay Industries?

  A. The WACC for Clay Industries cannot be calculated from the information.

  B. 12.94%

  C. 13.55%

  D. 12.03%

  E. 15.60%

  F. 11.92%

  Correct Answer: D

  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 DividendYield-plus-Growth-Rate (or Discounted Cash Flow) approach, and the Bond- Yield-plus-Risk-Premium approach. In this example, you are asked to calculate the cost of common equity using the Capital Asset Pricing Model. To calculate the cost of equity using this approach, use the following equation: {risk- free rate + beta(expected return on the market - risk-free rate). Incorporating the given information into this equation gives a cost of equity of 19.989% The after-tax cost of debt can be found by multiplying the yield to maturity on the firm's outstanding long-term debt (8.25%) by (1-tax rate). Using this method, the after-tax cost of debt is found as 5.50%. The calculation of the cost of perpetual preferred stock is relatively straightforward, simply divide the annual preferred dividend ($1.05) by the net offering price ($18.90). Using this method, the cost of preferred stock is found as 5.556%. Incorporating these figures into the WACC equation gives the answer of 12.027%.

• Question 1062:

  Incremental cash flows are

  A. cash flows that can be attributed to specific tax deductions like depreciation and interest expense.

  B. cash flows from a project that occur after the initial capital expense.

  C. cash flows that occur only if a project under consideration is accepted.

  D. the additional cash flows from a project for a given increase in capital invested.

  Correct Answer: C

  Incremental cash flows of a project are the cash flows that occur if and only if the project is undertaken.

• Question 1063:

  A company is analyzing two mutually exclusive projects, S and L, whose cash flows are shown below: Years0123 S-1,1001,00035050 L-1,10003001,500 The company's cost of capital is 12 percent, and it can get an unlimited amount of capital at that cost. What is the regular IRR (not MIRR) of the better project, i.e., the project which the company should choose if it wants to maximize its stock price?

  A. 12.00%

  B. 18.62%

  C. 20.46%

  D. 19.08%

  E. 15.53%

  Correct Answer: D

  Because the two projects are mutually exclusive, the project with the higher positive NPV is the "better"

  project.

  S-1,1001,00035050

  NPV(S) = $107.46

  IRR(S) = 20.46%

  L-1,10003001,500

  NPV(L) = $206.83

  IRR(L) = 19.08%

  Project L is the "better" project: its IRR = 19.08%.

• Question 1064:

  Scenario analysis ignores:

  A. the range of likely values that key variables can take.

  B. changes in some of the key variables.

  C. effect on the NPV of changes in project variables.

  D. none of these answers.

  Correct Answer: D

  It is the Sensitivity Analysis that ignores the range of likely values that key variables can take. This is rectified using Scenario Analysis.

• Question 1065:

  All else equal, which of the following is/are true?

  I. Firms with higher business risk tend to have lower debt ratios.

  II. The higher the tax rate imposed on a firm, the lower its optimal debt ratio.

  III.

  The lower a firm's future capital requirements, the lower its current debt ratio.

  A.

  II and III

  B.

  III only

  C.

  I only

  D.

  II only

  E.

  I, II and III

  F.

  I and II

  Correct Answer: C

  The higher the business risk and the future capital requirement, the stronger the balance sheet must be. This is accomplished through a lower reliance on debt. The higher the tax rate, the higher is the attractiveness of the tax-deductibility of the interest payments on debt. This lowers the after-tax cost of debt, raising the optimal debt ratio.

• Question 1066:

  The length of time required for an investment's net revenues to cover its cost is known as ________.

  A. Optimal Capital Structure

  B. Net Present Valuing

  C. Capital Budgeting

  D. Payback Period

  E. Weighted Average Cost of Capital (WACC)

  Correct Answer: D

  Payback Period is defined as the length of time required for an investment's net revenues to cover its cost.

• Question 1067:

  Which of the following is/are true about project risk analysis?

  I. Stand-alone risk is measured by the variability of the projects expected returns.

  II. Corporate risk measures the impact of the project's risk on the company's stock price variability.

  III.

  Market risk measures the impact of the project on the stock's unsystematic risk.

  A.

  I and II

  B.

  II and III

  C.

  III only

  D.

  I, II and III

  E.

  II only

  F.

  I only

  Correct Answer: F

  Standalone risk evaluates the risk of a project ignoring all portfolio aspects by looking at the variability of the project's projected returns. The corporate risk of a project is measured by the project's impact on the uncertainty about the firm's future earnings. The market risk of a project is measured by the project's impact on the systematic risk of the firm's stock.

• Question 1068:

  Which of the following firm's earnings per share (EPS) figure would be least sensitive to a percentage change in Earnings Before Interest and Taxes (EBIT)? Firm A EBIT: $6,800,000 Interest Paid: $505,000 Total Operating Expenses: $80,000,000 Fixed Operating Expenses: $50,250,000 Firm B EBIT: $20,000,000 Interest Paid: $600,000 Total Operating Expenses: $40,000,000 Fixed Operating Expenses: $30,250,000 Firm C EBIT: $50,500,000 Interest Paid: $3,500,000 Total Operating Expenses: $66,000,000 Fixed Operating Expenses: $30,750,000 Firm D EBIT: $49,700,000 Interest Paid: $7,750,000 Total Operating Expenses: $90,000,000 Fixed Operating Expenses: $75,000,000 Firm E EBIT: $43,000,000 Interest Paid: $7,000,000 Total Operating Expenses: $85,000,000 Fixed Operating Expenses: $60,500,000

  A. The answer cannot be determined from the information provided.

  B. Firm B

  C. Firm A

  D. Firm D

  E. Firm C

  F. Firm E

  Correct Answer: B

  This question is asking you to calculate the Degree of Financial Leverage for each company. 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)]}. As companies incorporate more debt in their capital structure, their EPS figure will become more sensitive to fluctuations occurring from interest payments, and this is evidenced by an increase in the Degree of Financial Leverage. In this example, Firm B has the lowest DFL with a figure of

  1.031. In light of this information, it can be concluded that firm B has an EPS figure which is the least sensitive to a given change in EBIT. When calculating the DFL figure, remember that the answer can never be less than one, and can never be negative. In a situation where the company under examination has zero debt, and no preferred stock dividends (and therefore no interest expense for purposes of the DFL equation), the DFL would be equal to one. It is 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 1069:

  A set of projects where only one can be accepted is known as ________.

  A. Project Net Worth Optimization

  B. Equity Enhancement

  C. Independent Projects

  D. Optimal Capital Budgeting

  E. Mutually Exclusive Projects

  Correct Answer: E

  Mutually Exclusive Projects are defined as a set of projects where only one can be accepted.

• Question 1070:

  Which of the following statements is most correct?

  A. None of these answers are correct.

  B. An increase in fixed costs, (holding sales and variable costs constant) will reduce the company's degree of operating leverage.

  C. If the company has no debt outstanding, then its degree of total leverage equals its degree of operating leverage.

  D. All of these answers are correct.

  E. An increase in interest expense will reduce the company's degree of financial leverage.

  Correct Answer: C

  The degree of financial leverage is the percentage change in EPS that results form a given percentage change in earnings before interest and taxes. If a firm has no debt outstanding the degree of financial leverage would be 1.0.