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

• Question 1071:

  A financial analyst with Smith, Kleen, and Beetchnutty is examining shares of Clever Industries, for

  possible investment. Clever Industries is involved in textile manufacturing, and the firm has been growing

  at a steady rate for much of the last nine decades. The analyst is trying to determine the appropriate

  current price range for Clever shares, and has ascertained the following information:

  Expected annual dividend = $0.35

  Expected sustainable annual growth rate = 15%

  Investors required rate of return = 18.6%

  Given this information, what is the appropriate current price for Clever Industries common stock?

  A. $10.28

  B. The current price of Clever Industries cannot be determined from the given information.

  C. $1.88

  D. $2.33

  E. $9.72

  Correct Answer: E

  To calculate the appropriate stock price for Clever using the given information, the appropriate equation is as follows: {expected annual dividend/[investor's required rate of return - expected growth rate]}. Incorporating the given information into this equation yields a stock price of $9.722. Remember that this model to stock valuations is most appropriate for firms who are in the constant growth stage. Another important note to remember is that this model will yield realistic results only in those instances in which the investor's required rate of return exceeds the expected growth rate.

• Question 1072:

  If the required rate of return on these projects is 10 percent, which would be chosen and why?

  A. Project B because it has the higher IRR.

  B. Neither, because both have IRRs less than the cost of capital.

  C. Project B because it has the higher NPV.

  D. Project A because it has the higher IRR.

  E. Project A because it has the higher NPV.

  Correct Answer: C

  NPV(A) = $15,625(PVIFA(10%,5)) - $50,000 = $15,625(3.7908) - $50,000 = $59,231.25 - $50,000 =

  $9,231.25.

  NPVB = $99,500(PVIF(10%,5)) - $50,000 = $99,500(0.6209) - $50,000 = $61,779.55 - $50,000 =

  $11,779.55.

  NPV(B) > NPV(A); $11,779.55 > $9,231.25; Choose Project B.

• Question 1073:

  Which of the following are practical difficulties associated with capital structure and degree of leverage analyses?

  A. All of these statements are correct.

  B. None of the statements represent a serious impediment to the practical application of leverage analysis in capital structure determination.

  C. Managers' attitudes toward risk differ and some managers may set a target capital structure other than the one that would maximize stock price.

  D. Managers often have a responsibility to provide continuous service; they must preserve the long-run viability of the enterprise. Thus, the goal of employing leverage to maximize short-run stock price and minimize capital cost may conflict with long-run viability.

  E. It is nearly impossible to determine exactly how P/E ratios or equity capitalization rates are affected by different degrees of financial leverage.

  Correct Answer: A

  Two projects being considered are mutually exclusive and have the following projected cash flows: Year Project AProject B 0-$50,000-$50,000 115,6250 215,6250 315,6250 415,6250 515,62599,500

• Question 1074:

  Which of the following affects a firm's business risk?

  A. The degree of operating leverage.

  B. The risk of adjusting sales prices.

  C. The level of uncertainty about future sales.

  D. All of these answers are correct.

  Correct Answer: D

  Business risk depends on: (1) unit sales variability, (2) sales price variability, (3) input price variability, (4) ability to adjust output prices for changes in input prices and, (5) the extent to which costs are fixed (operating leverage).

• Question 1075:

  Which of the following statements is correct?

  A. "Business risk" is differentiated from "financial risk" by the fact that financial risk reflects only the use of debt, while business risk reflects both the use of debt and such factors as sales variability, cost variability, and operating leverage.

  B. If corporate tax rates were decreased while other things were held constant, and if the Modigliani Miller tax-adjusted tradeoff theory of capital structure were correct, this would tend to cause corporations to increase their use of debt.

  C. The optimal capital structure is the one which simultaneously (1) maximizes the price of the firm's stock, (2) minimizes its WACC, and (3) maximizes its EPS.

  D. None of these statements are true.

  E. If corporate tax rates were decreased while other things were held constant, and if the Modigliani Miller tax-adjusted tradeoff theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt.

  Correct Answer: E

  If corporate tax rates were decreased while other things were held constant, and if the MM tax- adjusted tradeoff theory of capital structure were correct, corporations would decrease their use of debt because the tax shelter benefit would not be as great as when tax rates are high. Business risk is the riskiness of the firm's operations if it uses no debt. The optimal capital structure does not maximize EPS, and the degree of total leverage shows how a given change in sales will affect earnings per share.

• Question 1076:

  Which of the following statements is most correct?

  A. When equipment is sold, companies receive a tax credit as long as the salvage value is less than the initial cost of the equipment.

  B. None of the answers are correct.

  C. In estimating net cash flows for the purpose of capital budgeting, interest and dividend payments should not be included since the effects of these items are already included in the weighted average cost of capital.

  D. Capital budgeting analysis for expansion and replacement projects is essentially the same because the types of cash flows involved are the same.

  E. All of the answers are correct.

  Correct Answer: C

  Interest payments should not be included in the estimated cash flows because the effects of debt financing are reflected in the cost of capital used to discount the cash flows. If interest was subtracted from the cash flows, and then the remaining cash flows were discounted, the cost of debt would be double-counted.

• Question 1077:

  Seasons, Inc. has just decided to issue 1 million shares of new equity. The firm has had a steady dividend growth of 3% and is expected to continue along this path, having just paid a $3.23 per share dividend. The flotation costs for the new equity amount to 2.2% of the total capital raised and the firm receives $31.4 million before flotation costs, calculate the cost of external equity.

  A. 13.52%

  B. 14.19%

  C. 13.23%

  D. 13.83%

  Correct Answer: D

  IF F is the percentage flotation cost and P is the amount of new equity raised per new share, then Ke = D1/ [P(1-F)] + g, where Ke is the cost of external equity. Here, g = 3%, D1 = 3.23*(1+3%) = $3.32, P = $31.4 and F = 2.2%. Therefore, Ke = 3.32/(31.4*(1-0.022)) + 3% = 13.83%.

• Question 1078:

  A 5-year project requires an initial outlay of 650. It also needs capital spending of 700 at the end of year 1 and 900 at the end of year 2. It has no revenues for the first 2 years but receives 1,200 in year 3, 1,600 in year 4 and 2,300 in year 5. If the project's cost of capital is 7.5%, the project's MIRR equals ________.

  A. 21%

  B. 17%

  C. 14%

  D. 7.5%

  Correct Answer: A

  The MIRR is defined as that rate which discounts the terminal value of the cash inflows to equate to the present value of a project's costs (using the project's cost of capital). This can be better understood using actual numbers. The present value of the costs = 650 + 700/1.075 + 900/1.075^2 = 2,080. The terminal value (future value at the end of year 5) of the project equals 1,200*1.075^2 + 1,600*1.075 + 2,300 = 5406.75. Note that both these are calculated using the project's cost of capital. Then, MIRR satisfies 2,080 = 5406.75/(1+MIrr)^5. Solving gives MIRR = 21%.

• Question 1079:

  Longstreet Corporation has a target capital structure of 30 percent debt, 50 percent common equity, and 20 percent preferred stock. The tax rate is 30 percent. The company has an optimal capital budget of $1,500,000. Longstreet will retain $500,000 of after-tax earnings this year. The last dividend was $5, the current stock price is $75, and the growth rate of the company is 10 percent. If the company raises capital through a new equity issuance, then the flotation costs are 10 percent for the first $500,000. If the company issues more than $500,000 in new equity the flotation cost increases to 15 percent. The cost of preferred stock is 9 percent and the cost of debt is 7 percent. (Assume debt and preferred stock have no flotation costs.) What is the weighted average cost of capital at the firm's optimal capital budget?

  A. 12.18%

  B. 18.15%

  C. 12.34%

  D. 11.94%

  E. 12.58%

  Correct Answer: C

  First, calculate the after-tax component cost of debt as 7%(1 - 0.3) = 4.9%. Next, calculate the retained earnings breakpoint as $500,000/0.5 = $1,000,000. Thus, to finance its optimal capital budget, Longstreet must issue some new equity. Note, Longstreet needs $500,000 in financing beyond that which can be supported by retained earnings alone. However, of this additional $500,000, 50% will be new equity and the remaining 50% will represent preferred stock and debt. Thus, Longstreet will issue $250,000 in new equity and flotation costs of 10% will be incurred. The cost of new equity is then[$5(1.10%)/$75(1 - 0.1)] + 10% = 8.15% + 10% = 18.15%. Finally, the WACC = 4.9%(0.3) + 9%(0.2) + 18.15%(0.5) = 12.34%.

• Question 1080:

  Doering Computers is considering two mutually exclusive projects. Their cash flows are shown below: tProj. A Cash FlowsProj. B Cash Flows 0-$500-$700 1200 250 2400 475 3100 125 4----225 The company's cost of capital (WACC) is 10 percent. Each of the projects can be repeated. What is the equivalent annual annuity (EAA) of the project, which adds the most to shareholder value?

  A. $61.64

  B. $52.82

  C. $63.45

  D. $35.20

  E. $25.41

  Correct Answer: B

  Find NPV of each project.

  NPV(A) = $87.5282.

  NPV(B) = $167.4271.

  Find EAA:

  For Project A:

  N = 3; I = 10; PV = -87.5282; FV = 0; solve for PMT = EAA = $35.1964.

  For Project B:

  N = 4; I = 10; PV = -167.4271; FV = 0; solve for PMT = EAA = $52.8184.