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

• Question 1091:

  In his determination of a project's NPV and IRR, a financial analyst with Smith, Kleen, and Beetchnutty indexes the project's anticipated cash flows for the expected effects of inflation. However, the discount rate applied to these cash flows does not factor an adjustment for inflation. Assuming a positive inflation figure for the every period in the project's lifespan, which of the following correctly describes the effects of the omission on the NPV and IRR calculations?

  A. NPV and IRR will be biased upward

  B. NPV and IRR will be biased downward

  C. NPV will be biased downward, IRR will be biased upward

  D. NPV will be biased upward, IRR will be unaffected

  E. NPV will remain unaffected, IRR will be biased downward

  F. NPV will be biased downward, IRR will be unaffected

  Correct Answer: D

  By failing to include an the effects of anticipated inflation in the discount rate applied to the project's cash inflows, this analyst is creating a situation in which the NPV calculations will be biased upward. This is due to the fact that the project's inflows have been adjusted for the anticipated effects of POSITIVE inflation,

  i.e. these cash flows have been indexed upward, while at the same time the rate at which these cash flows are being discounted has not increased. In effect, the cash inflows of the project are being overstated, and this will lead to an upward bias in the NPV calculation. Remember that the Internal Rate of Return calculation does not specify an explicit discount rate, rather calculates the discount rate that equates the cash inflows of a project with its cash outflows. The fact that this analyst has not incorporated the effects of inflation into the discount rate has no bearing on IRR, because the IRR equation does not call for a discount rate.

• Question 1092:

  Which of the following methods involves calculating an average beta for firms in a similar business and then applying that beta to determine the beta of its own project?

  A. Risk premium method.

  B. CAPM method.

  C. Accounting beta method.

  D. Pure play method.

  E. All of these answers are correct.

  Correct Answer: D

  The pure play method is used for estimating the beta of a project in which a firm identifies several companies whose only business is the product in question, then calculates the beta for each firm, and finally, averages the betas to find an approximation to its own project's beta.

• Question 1093:

  A firm needs to raise $123 million for a proposed capital expansion project. It's earnings breakpoint is $178 million and it is committed to maintaining a debt-to-equity ratio of 1.2. Its after-tax cost of debt is6.2% and the required rate of return on its equity is 13.2%. The firm's marginal cost of capital for the project equals ________.

  A. 7.12%

  B. 6.89%

  C. 9.38%

  D. 12.19%

  Correct Answer: C

  Since the proposed capital requirement of $123 million is less than the earnings breakpoint, the firm's marginal cost of capital for the project equals its WACC. With D/E = 1.2, E/(D+E) = 1/(1+1.2) = 0.455. The WACC then equals 0.455*13.2% + 0.545*6.2% = 9.38%.

• Question 1094:

  Clay Industries, a diversified industrial firm, is considering investing into a new manufacturing facility which would allow the Company to expand its operations into a promising new market for industrial motors, specifically the High Temperature Superconducting, or HTS motors. This project is one of many currently under consideration for Clay Industries, and the amount of RandD expense allocated toward researching this new manufacturing facility is residual in nature. The following information applies to this new project. RandD expense for the quarter $15,000 Initial cash outlay $45,000 t1: ($40,000) t2: ($10,000) t3: $40,000 t4: $40,000 t5: $16,000 t6: $25,000 Assuming no taxes and a $0.00 salvage value at t6, what is the MIRR of this project?

  A. This project will have multiple MIRR at any discount rate

  B. 7.038%

  C. The MIRR cannot be calculated due to the fact that no discount rate has been provided

  D. The MIRR cannot be calculated due to the fact that the project has uneven cash flows

  E. 2.639%

  Correct Answer: C

  In order to calculate the Modified Internal Rate of Return, a explicit discount rate must be given. In this example, the MIRR cannot be calculated due to the fact that no discount rate has been provided. Remember that while the Internal Rate of Return is calculated without the use of an explicit discount rate, the Modified Internal Rate of Return requires some figure for the cost of capital.

• Question 1095:

  Rollins Corporation is constructing its MCC (Marginal Cost of Capital) schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock, which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm, which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk- premium method to find k(s) (component cost of retained earnings). The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent. What is Rollins' component cost of debt?

  A. 8.6%

  B. 7.2%

  C. 10.0%

  D. 8.0%

  E. 9.1%

  Correct Answer: B

  Since the bond sells at par of $1,000, its YTM and coupon rate (12 percent) are equal. Thus, the before-tax cost of debt to Rollins is 12.0 percent. The after-tax cost of debt equals = 12.0%(1 - 0.40) = 7.2%.

• Question 1096:

  The degree of financial leverage is defined as:

  A. the change in EPS for a unit change in EBIT.

  B. the percentage change in EBIT for a 1% change in EPS.

  C. none of these answers.

  D. the percentage change in EBIT for a 1% change in the quantity sold.

  Correct Answer: C

  The degree of financial leverage is defined as the percentage change in EPS for a 1% change in EBIT.

• Question 1097:

  Grant Grocers is considering the following investment projects:

  Project Size of Project IRR of Project

  V 1.0 million12.0%

  W 1.2 million11.5%

  X 1.2 million11.0%

  Y 1.2 million10.5%

  Z 1.0 million10.0%

  The company has a target capital structure, which is 50 percent debt and 50 percent equity. The after- tax

  cost of debt is 8 percent. The cost of retained earnings is estimated to be 13.5 percent. The cost of equity

  is estimated to be 14.5 percent if the company issues new common stock. The company's net income is

  $2.5 million. If the company follows a residual dividend policy, what will be its payout ratio?

  A. 66%

  B. 12%

  C. 32%

  D. 54%

  E. 100%

  Correct Answer: C

  The company's WACC (provided no new equity is issued) is 8%(0.5) + 13.5%(0.5) = 10.75%. Comparing the WACC with the project IRRs reveals that the company will undertake projects V, W, and X. Total financing costs for these projects is $3,400,000. Of this amount, 0.5($3,400,000) = $1,700,000 will be financed from retained earnings. Thus, $2,500,000 - $1,700,000 = $800,000 will be available for dividends. The payout ratio is then $800,000/$2,500,000 = 32%.

• Question 1098:

  Given the following information, what is the required cash outflow associated with the acquisition of a new machine; that is, in a project analysis, what is the cash outflow at t = 0? Purchase price of new machine $8,000 Installation charge 2,000 Market value of old machine 2,000 Book value of old machine 1,000 Inventory decrease if new machine is installed 1,000 Accounts payable increase if new machine is installed 500 Tax rate 35% Cost of capital 15%

  A. -$6,460

  B. -$8,980

  C. -$12,020

  D. -$5,200

  E. -$6,850

  Correct Answer: E

  Cost plus installation($10,000)

  Sale of old machine+2,000

  Tax effect of sale ($1,000 x 0.34)(350)

  Decrease in working capital1,500

  Total investment at t = 0($6,850)

• Question 1099:

  Los Angeles Lumber Company (LALC) is considering a project with a cost of $1,000 at time = 0 and inflows of $300 at the end of Years 1 - 5. LALC's cost of capital is 10 percent. What is the project's modified IRR (MIRR)?

  A. 15.2%

  B. 12.9%

  C. 20.7%

  D. 10.0%

  E. 18.3%

  Correct Answer: B

  Tabular/Numerical solution:

  TV = $300(FVIFA(10%,5)) = $300(6.1051) = $1,831.53.

  $1,000 = TV/(1 + MIRR)^5

  $1,000 = $1,831.53/(1 + MIRR)^5

  (1 + MIRR)^5 = 1.83153

  MIRR = 12.866%.

• Question 1100:

  Intelligent Semiconductor is considering issuing additional common stock. The firm has an after-tax cost of debt of 8.55%, and the company's combined federal/state income tax is 35%. The risk-free rate of return is 5.6%, and the annual return on the broadest market index is expected to be 13.5%. Shares of Intelligent Semiconductor have a historical beta of 1.6. What is the cost of equity for this proposed common stock issue using the Capital Asset Pricing Model?

  A. 18.24%

  B. 4.09%

  C. 12.64%

  D. 7.04%

  E. 5.56%

  Correct Answer: A

  The cost of issuing common stock can be calculated using several methods, including the Bond-YieldPlus-Risk-Premium approach, Discounted Cash Flow method, or by using the Capital Asset Pricing Model. The latter is illustrated in this example. To calculate the cost of common equity using the CAPM, use the following formula: {cost of common equity = [risk free rate of return + beta(expected return on the market risk free rate of return)}. Incorporating the appropriate figures into this example will yield a cost of common equity at 18.24%.