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

• Question 1111:

  Which of the following conditions are necessary for the IRR and NPV calculations to produce similar ranking decisions. Choose the best possible answer.

  A. Projects must have equal lifespans, projects must be of equal scale

  B. Projects must be independent, have equal lifespans, and must be equal in scale

  C. Projects must be of equal size and have equal life, and must have normal cash flows

  D. Projects must have equal lifespans, projects must have normal cash flows

  E. Projects must be mutually exclusive, have equal lifespans, and must be of equal scale

  Correct Answer: C

  When examining mutually-exclusive projects with equal lifespans and of equal size, the IRR and NPV calculations will produce similar ranking results as long as the projects under examination have "normal" cash flows. It is when the projects under examination have "non-normal" cash flows that IRR calculations can experience difficulty. Non-normal cash flows are defined as cash flows in which negative flows are juxtaposed within a series of positive cash inflows, creating a situation in which the sign will change more than once. When examining these "non-normal" projects, the Internal Rate of Return method will often produce multiple answers which leads to an incorrect accept/reject decision.

• Question 1112:

  Ludicrous Telecom, an international telecommunications company, has recently announced its plans to issue additional common stock. The company has been publicly traded for over 25 years, and currently has a capital structure consisting of 35% debt, 55% equity, and 10% preferred stock. This is the first time since its initial public offering that the company has announced its intention to issue common stock. According to the Signaling Theory, this announcement should be viewed as which of the following? Choose the best answer.

  A. Bullish, because the company will be provided with additional capital from the share offering.

  B. Bullish, because it indicates superior investment prospects for the firm.

  C. Bullish, because it indicates a shift toward a more conservative capital structure.

  D. Bearish, because it indicates poor investment prospects for the firm.

  E. Bearish, because it indicates an shift toward a more radical capital structure.

  F. The signaling theory would not apply to this announcement.

  Correct Answer: D

  According to the Signaling Theory, the management of companies send implicit signals to investors by their capital budgeting decisions. Believers of this theory feel that corporate managers have access to superior information, and are allowed to exploit this information asymmetry through their capital budgeting decisions. According to the signaling theory, when investment prospects are good, companies will prefer to raise capital first by using internally generated funds, i.e. retained earnings and marketable securities investments. If this source of capital is unavailable, then companies will prefer to issue debt rather than common or preferred equity. The reasoning behind this is the fact that by raising debt, the company will not dilute the ROE figure, which is expected to be high due to favorable investment prospects. In contrast, when investment prospects are poor, the Signaling Theory states that companies will prefer to raise funds first by issuing common equity. The reasoning behind this is the fact that by issuing additional equity when investment prospects are poor, companies will be able to "spread the losses" amongst a greater pool of investors, thereby lessening the overall negative effect. In this example, the management of Ludicrous Telecom have announced their intention on issuing additional common equity, and the Signaling Theory would state that this is sending a bearish signal as to the investment prospects of the firm.

• Question 1113:

  In examining the beta for its machine tools division, the management of Clay Industries has regressed the division's ROA against that of the SandP 500. Which of the following best characterize this method of calculating project beta?

  A. None of these answers

  B. Project Beta Method

  C. Monte Carlo Regression

  D. Pure Play Method

  E. Regression of the Poisson Distribution

  F. Accounting Beta Method

  Correct Answer: F

  In this example, the management of Clay Industries has determined the Beta coefficient for its machine tools division using the Accounting Beta Method. In using the Accounting Beta Method, the monthly (or quarterly) ROE or ROA of a specific division/project is compared to that of a large group of firms. This "large group of firms" is frequently characterized by a major market index, such as the SandP 500 or the Wilshire 5000. The Accounting Beta Method is used more frequently than the Pure Play Method, primarily because it is often difficult to find "pure-play" firms.

• Question 1114:

  Intelligent Semiconductor is considering the development of a new data storage medium, which will allow tremendous increases in the efficiency of its customer's high-end server lines. The development of the new system will take place in the firm's existing facilities, and the storage costs for the additional equipment are expected to be residual in nature. The following information applies to this project: Rent expense for the firm's existing facilities ($10,500) Initial cash outlay ($50,000) t1: $15,000 t2: $11,000 t3: $11,000 t4: $15,000 t5 ($10,000) t6 ($10,000) t7 $25,000 Discount rate: 9% Assuming no taxes or related charges, that the initial cash outlay does not include any sunk costs, and a $0.00 salvage value at t7, what is the MIRR of this project?

  A. 7.262%

  B. 6.231%

  C. None of these answers

  D. 12.461%

  E. This problem has more than one MIRR

  F. 14.606%

  Correct Answer: A

  In this example, you are asked to calculate the Modified Internal Rate of Return for a project. In calculating the MIRR for this project, the rent cost of $10,500 is ignored because this expense represents a sunk cost. Remember that sunk costs are irrelevant in capital budgeting decisions, and should not beincorporated into the calculation. This is due to the fact that sunk costs are not incremental in nature, and are not directly related to the acceptance of the project in question, i.e. these costs have already been incurred or have been earmarked for payment. The following illustration details the calculation of the Terminal Value (TV) for the MIRR calculation in this case: {[$15,000 *1.6771] + [11,000 * 1.53862] + [11,000 * 1.41158] + [$15,000 * 1.29503] + [$25,000 * 1]}= TV $102,034.15. The calculation of the present value of the cash outflows is found by discounting the cash outflows of periods 5 and 6 and adding them to the initial cash outlay as follows: {-$50,000 + [- $10,000/1.53862] + [-$10,000/1.6771]= PV of cash outflows ($62,462.00). Incorporating these figures into your calculator's cash flow worksheet will yield the MIRR of 7.2623%. The calculation is found by the following: PV= ($62,462.00), FV= $102,034.15, PMT=0, N=7, CPT I/Y ---7.2623%. The modified IRR has a significant advantage over the regular IRR, in the fact that MIRR assumes cash flows from all projects are reinvested at some explicit rate, while the regular IRR assumes that all cash flows are reinvested at the project's IRR. This allows for much greater flexibility.

• Question 1115:

  Alabama Pulp Company (APC) can control its environmental pollution using either "Project Old Tech" or "Project New Tech." Both will do the job, but the actual costs involved with Project New Tech, which uses unproved, new state-of-the-art technology, could be much higher than the expected cost levels. The cash outflows associated with Project Old Tech, which uses standard proven technology, are less risky--they are about as uncertain as the cash flows associated with an average project. APC's cost of capital for average risk projects is normally set at 12 percent, and the company adds 3 percent for high risk projects but subtracts 3 percent for low risk projects. The two projects in question meet the criteriafor high and average risk, but the financial manager is concerned about applying the normal rule to such cost-only projects. You must decide which project to recommend, and you should recommend the one with the lower PV of costs. What is the PV of costs of the better project? Cash Outflows Years:01234 Project New Tech1,500315315315315 Project Old Tech600600600600600

  A. 2,399

  B. 2,521

  C. 2,457

  D. 2,422

  E. 2,543

  Correct Answer: D

  Recognize that (1) risky outflows must be discounted at lower rates, and (2) since Project New Tech is

  risky, it must be discounted at a rate of 12% - 3% = 9%. Project Old Tech must be discounted at 12%.

  Tabular solution:

  PV(New Tech) = -$1,500 - $315(PVIFA9%,4) = -$1,500 - $315(3.2397) = -$2,520.51. PV(Old Tech) =

  -$600 - $600(PVIFA12%,4) = -$600 - $600(3.0373) = -$2,422.38. PV(Old Tech) is a smaller outflow than

  NPV(New Tech), thus, Project Old Tech is the better project.

• Question 1116:

  A stock has a beta of 1.1 and the risk-free rate is 5.5%. Its dividend growth rate is 4.1% and the dividend payout ratio is 38%. If the market risk premium is 7.3%, the P/E ratio of the stock equals ________.

  A. 7.19

  B. 6.73

  C. 3.86

  D. 4.03

  Correct Answer: D

  The required rate of return on the stock can be found using CAPM, which gives Rstock = k = Rf + beta* (Rm - Rf) = 5.5% + 1.1*7.3% = 13.53%. Therefore, P0/E1 = dividend payout/(k - g) = 0.38/(0.1353 - 0.041) = 4.03.

• Question 1117:

  Projects L and S each have an initial cost of $10,000, followed by a series of positive cash inflows. Project L has total, undiscounted cash inflows of $16,000, while S has total undiscounted inflows of $15,000. Further, at a discount rate of 10 percent, the two projects have identical NPVs. Which project's NPV will be more sensitive to changes in the discount rate?

  A. Both projects are equally sensitive to changes in the discount rate since their NPVs are equal at all costs of capital.

  B. Neither project is sensitive to changes in the discount rate, since both have NPV profiles which are horizontal.

  C. Project S.

  D. The solution cannot be determined unless the timing of the cash flows is known.

  E. Project L.

  Correct Answer: E

  The NPV profile plots a project's NPV against the discount rates. The higher the undiscounted inflows, the steeper the NPV profile, and the steeper the NPV profiles, the more sensitive the project is to discount rate changes.

• Question 1118:

  The internal rate of return of a capital investment

  A. changes when the cost of capital changes.

  B. must exceed the cost of capital in order for the firm to accept the investment.

  C. is equal to the annual net cash flows divided by one half of the project's cost when the cash flows are an annuity.

  D. all of the answers are correct.

  Correct Answer: B

  The IRR is calculated by finding the discount rate that equates the present value of future cash inflows to the project's cost. The IRR is the project's expected rate of return. If the IRR exceeds the cost of the funds used to finance the project, a surplus accrues. Thus, accepting a project whose IRR exceeds its cost of capital increases shareholder wealth.

• Question 1119:

  An increase in the tax rate ________ the optimal debt-to-equity ratio. It ________ the after-tax cost of debt. Assume all else equal.

  A. this answer cannot be generated because "tax" is not a factor in the optimal debt-to-equity ratio

  B. increases; increases

  C. this answer cannot be generated because "tax" is not a factor in after-tax cost of debt

  D. decreases; increases

  E. increases; decreases

  F. decreases; decreases

  Correct Answer: E

  Since interest payments are tax deductible, higher tax rates make debt more attractive relative to equity, increasing the optimal D/E ratio. The after-tax cost of debt decrease, assuming that the pre-tax cost of debt is not affected by the change in the tax rate (in reality, it could increase due to decreased profitability of the firm and the resultant decrease in its solvency).

• Question 1120:

  Howell Enterprises is forecasting EPS of $4.00 per share for next year. The firm has 10,000 shares outstanding, it pays 12 percent interest on its debt, and it faces a 40 percent marginal tax rate. Its estimated fixed costs are $80,000 while its variable costs are estimated at 40 percent of revenue. The firm's target capital structure is 40 percent equity and 60 percent debt and it has total assets of $400,000. On what level of sales is Howell basing its EPS forecast?

  A. $105,280

  B. $292,444

  C. $1,000,000

  D. $480,400

  E. $316,722

  Correct Answer: B

  EPS = (Sales - Fixed costs- Variable costs - Interest)(1 - T)/Shares outstanding.

  Step 1 Calculate interest expense

  Debt = 0.60 x $400,000 = $240,000.

  Interest = 0.12 x $240,000 = $28,800.

  Step 2 Solve for Sales (S)

  EPS = $4.00 = (S - 0.40S - $80,000 - $28,800) x (1 - 0.40)/10,000

  = (0.60S - $108,800)(0.6)/10,000

  $4.00 = (0.36S - $65,280)/10,000

  $105,280 = 0.36S

  Sales = $292,444.44.

  Alternative method

  EPS = (EBIT - Interest)(1 - T)/Shares outstanding.

  Solve for EBIT

  Net Income = EPS x Shares outstanding = $4.00 x 10,000 = $40,000.

  EBT = NI/(1 - T) = $40,000/(0.6) = $66,667.

  Interest (from above) = $28,800.

  EBIT = EBT + Interest = $66,667 + $28,800 = $95,467.

  S = 0.40S + $95,467 + $80,000

  0.6S = $175,467

  S = $175,467/0.6 = $292,445.