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

• Question 1081:

  TCH Corporation is considering two alternative capital structures with the following characteristics.

  AB

  Debt/Assets ratio0.30.7

  kd10%14%

  The firm will have total assets of $500,000, a tax rate of 40 percent, and book value per share of $10,

  regardless of capital structure. EBIT is expected to be $200,000 for the coming year. What is the difference

  in earnings per share (EPS) between the two alternatives?

  A. $4.78

  B. $2.87

  C. $7.62

  D. $1.19

  E. $3.03

  Correct Answer: B

  Capital structure A: The firm will have debt of $500,000(0.3) = $150,000 and equity of $350,000. We're told the shares have a book value of $10 so the number of shares outstanding is $350,000/$10 = 35,000. Interest expense will be $150,000(10%) = $15,000. We can compute EBT as EBIT - I or $200,000 $15,000 = $185,000. Also, we can compute NI as EBT(1 - T) or $185,000(1 - 0.4) = $111,000. Finally, EPS = $111,000/35,000 = $3.17. Capital structure B: The firm will have debt of $500,000(0.7) = $350,000 and equity of $150,000. The number of shares outstanding is $150,000/$10 = 15,000. Interest expense will be $350,000(14%) = $49,000. We can compute EBT as $200,000 - $49,000 = $151,000. Also, we can compute NI as $151,000 (1 - 0.4) = $90,600. Finally, EPS = $90,600/15,000 = $6.04. The difference in EPS between capital structure A and capital structure B is $6.04 - $3.17 = $2.87.

• Question 1082:

  Ace Consulting, a multinational corporate finance consulting firm, is examining the sales potential for a new line of industrial motors developed by Clay Industries, a large industrial firm. In their analysis, Ace Consulting meets with the management of Clay Industries, and asks these individuals to specify the worst "reasonable" set of circumstances, along with the best "reasonable set." These figures are measured against the predetermined "base case" situation. Which of the following choices best describes this technique for measuring stand-alone risk?

  A. Case study analysis

  B. Sensitivity analysis

  C. Monte Carlo simulation

  D. Relational analysis

  E. Scenario analysis

  F. Regression analysis

  Correct Answer: E

  Scenario analysis is a risk analysis technique that considers both the sensitivity of NPV to changes in key variables and the likely range of key variable values. In a scenario analysis, a financial analyst asks operating or other managers to identify the best and worst "reasonable" situations, and these situations are examined against the predetermined "base case."

• Question 1083:

  Gibson Inc. is considering the following five independent projects: Project RequiredAmount of CapitalIRR A$20 0,000 20% B600,000 15 C400,000 12 D400,000 11 E400,000 10 The company has a target capital structure, which is 40 percent debt and 60 percent equity. The company can issue bonds with a yield to maturity of 11 percent. The company has $600,000 in retained earnings, and the current stock price is $42 per share. The flotation costs associated with issuing new equity are $2 per share. Gibson's earnings are expected to continue to grow at 6 percent per year. Next year's dividend is forecasted to be $4.00. The firm faces a 40 percent tax rate. What is the size of Gibson's capital budget?

  A. $200,000

  B. $1,200,000

  C. $800,000

  D. $1,600,000

  E. $2,000,000

  Correct Answer: C

  The size of Gibson's capital budget will be determined by the number of projects it can profitably undertake, i.e., those projects for which IRR > applicable WACC. First, find the costs of each type of financing: cost of retained earnings = k(s) = $4/$42 + 0.06 = 15.52% and cost of debt = k(d) = 11%. To calculate the cost of new equity, we solve for k(e) = $4/($42-$2) + 0.06 = 0.16 = 16%. Given the firm's target capital structure and its retained earnings balance of $600,000, the firm can raise $1,000,000 with debt and retained earnings before it must use outside equity. Therefore, the WACC for 0 - $1,000,000 of financing = 0.4(0.11)(1 - 0.4) + 0.6(0.1552) = 11.95%. Above $1,000,000, the firm must issue some new equity, so the WACC = 0.4(0.11)(1 - 0.4) + 0.6(0.16) = 12.24%. Obviously, Projects A and B will be undertaken. You must then determine whether Project C will be profitable. Since in taking A and B we will need financing of $800,000, the $400,000 needed for Project C would involve financing $200,000 with debt and retained earnings and $200,000 with debt and new equity. Thus, the WACC for Project C is ($200,000/$400,000) x 0.1195 + ($200,000/$400,000) x 0.1224 = 12.095% which is greater than Project C's IRR. Clearly, only Projects A and B should be accepted, and the firm's capital budget is $800,000.

• Question 1084:

  Which of the following statement completions is most correct? If investors prefer dividends to capital gains, then

  A. dividend policy as determined by the residual dividend policy is the only dividend policy which will maximize the price per share of common stock.

  B. k(s) will increase as dividends are reduced.

  C. k(s) will decrease as dividends are reduced.

  D. the equilibrium return, k(s), will not be affected by a change in dividend policy because tax effects will offset these preferences.

  E. k(s) will decrease as the retention rate increases.

  Correct Answer: B

  The main conclusion of MM's irrelevance theory is that dividend policy does not affect the required rate of return on equity. Gordon-Lintner disagreed stating that k(s) decreases as the dividend payout is increased because investors are less certain of receiving the capital gains which should result from retaining earnings than they are of receiving dividends. They said that investors value expected dividends more highly than expected capital gains because the dividend yield is less risky than the growth component in the total expected return equation, k(s) = D1/Po + g. MM disagreed and theorized that k(s) is independent of dividend policy, implying that investors are indifferent between dividends and capital gains.

• Question 1085:

  Which of the following equations correctly illustrates the calculation of the cost of equity using the Dividend-Yield-plus-Growth-Rate approach?

  A. Annual dividend/current stock price * (1-tax rate)

  B. (Next annual dividend/current stock price) + expected growth rate

  C. (Retention rate)*(ROE)

  D. Risk-free rate of return + beta(expected return on the market - risk-free rate of return)

  E. Payout ratio * (ROE/[expected return-required rate of return])

  F. (Last annual dividend/[expected return - required return]) * expected growth rate

  Correct Answer: C

  The Dividend-Yield-plus-Growth-Rate approach calls for the following components: next annual dividend, current stock price, and expected growth rate. This approach, also known as the Discounted Cash Flow (DCF) method, is a flexible and very adept tool in the hands of the financial analyst, and is it is imperative that the CFA candidate fully understand both the applications and the methodology of this approach. The first choice illustrates the Capital Asset Pricing Model, while the second represents an approach for calculating sustainable growth rate. The remaining answers are somewhat fictitious.

• Question 1086:

  Which of the following statements is correct?

  A. The rent referred to in the other statement is a sunk cost, and as such it should be ignored.

  B. The preceding statement would be true if "upward" were replaced with "downward."

  C. The existence of "externalities" reduces the NPV to a level below the value that would exist in the absence of externalities.

  D. If one of the assets that would be used by a potential project is already owned by the firm, and if that asset could be leased to another firm if the project is not undertaken, then the net rent that could be obtained should be charged as a cost to the project under consideration.

  E. In a capital budgeting analysis where part of the funds used to finance the project are raised as debt, failure to include interest expense as a cost in the cash flow statement when determining the project's cash flows will lead to an upward bias in the NPV.

  Correct Answer: D

  The foregone rent is an "opportunity cost" which should be charged to the project under consideration. The cash flows should not take account of interest, because financial costs are dealt with by discounting at the WACC. If interest were deducted to find cash flows, then this cost would be "double counted," and the NPV would be downward biased. Ignoring interest when determining cash flows produces no bias in the NPV whatever. Note also that externalities can be either positive or negative--they tend to be negative if the new project is a substitute for existing products, but positive if the new project is complementary to the firm's other products.

• Question 1087:

  Stargell Industries follows a strict residual dividend policy. The company has a capital budget of $3,000,000. It has a target capital structure, which consists of 30 percent debt and 70 percent equity. The company forecasts that its net income will be $3,500,000. What will be the company's expected dividend payout ratio this year?

  A. 40%

  B. 45%

  C. 30%

  D. 25%

  E. 35%

  Correct Answer: A

  Step 1 Find equity required to maintain capital budget:

  Capital budget$3,000,000

  % of budget financed with equityx 0.70

  $2,100,000

  Step 2 Calculate dividend:

  Earnings$3,500,000

  Less equity retained(2,100,000)

  Dividend$1,400,000

  Step 3 Find payout ratio:

  Dividend/Earnings = $1,400,000/$3,500,000 = 0.4000 = 40%.

• Question 1088:

  Projects whose cash flows are not affected by the acceptance or rejection of other projects are known as ________.

  A. independent projects

  B. project net worth optimization

  C. optimal capital budgeting

  D. equity enhancement

  E. mutually exclusive projects

  Correct Answer: A

  Independent Projects are defined as projects whose cash flows are not affected by the acceptance or rejection of other projects.

• Question 1089:

  Brock Brothers wants to maintain its capital structure, which is 30 percent debt, and 70 percent equity. The company forecasts that its net income this year will be $1,000,000. The company follows a residual dividend policy, and anticipates a dividend payout ratio of 40 percent. What is the size of the company's capital budget?

  A. $857,143

  B. $1,428,571

  C. $1,000,000

  D. $600,000

  E. $2,000,000

  Correct Answer: A

  Since the company expects to pay out 40% of net income or $400,000, it must expect to have $600,000 of retained earnings available for capital investment. Given that the firm will finance new investment with 70% equity and 30% debt, $600,000 must represent 70% of the firm's capital budget, that is, $600,000 = (0.7) CB or CB = $857,143.

• Question 1090:

  Which of the following statements is most correct?

  A. Investors can interpret a stock repurchase by a firm as a signal that the firm's managers believe the stock is underpriced.

  B. None of these statements are correct.

  C. After a 3-for-1 stock split, a company's price per share will fall and it's number of shares outstanding will rise.

  D. Stock repurchases can be used by firms to defend against hostile takeovers since they increase the proportion of debt in a firm's capital structure.

  E. All of these statements are correct.

  Correct Answer: E

  These are all correct.