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

• Question 1121:

  In an investigation of Clay Industries, Marcus Litton, a financial analyst, has determined the following information: Sales: $300,000,000 Fixed costs: $100,000,000 Variable costs: $115,200,000 Interest expense: $1,800,000 Tax rate: 35% Weighted Average Cost of Capital: 10.15% Beta coefficient: 0.80 Common shares outstanding: 10,000,000 Mr. Litton has asked for your assistance in determining the earnings per share (EPS) of Clay Industries. Using this information, which of the following answers correctly illustrates this EPS calculation?

  A. $2.91

  B. $6.17

  C. $6.80

  D. The EPS figure cannot be completely determined from the information provided.

  E. $4.90

  F. $5.40

  Correct Answer: F

  The EPS figure is perhaps the single most popular term in the field of conventional equity investments. Any glance into financial media and business periodicals will undoubtedly uncover numerous instances in which the EPS figure is cited. While quite popular and useful, many individuals do not understand the mechanics behind the EPS calculation, and an investigation into the components of EPS is a valuable learning experience. The EPS calculation is found by the following equation: {EPS = [(Sales - Fixed Costs Variable Costs - Interest Expense)(1 - Tax Rate)] / [# of Common Shares Outstanding]} Additionally, the EPS figure can be found by: {EPS = [(EBIT - Interest Expense)(1 - Tax Rate) / # of Common Shares Outstanding]} Incorporating the given information into the first EPS equation will yield the following: {EPS = {[($300,000,000 - $100,000,000 - $115,200,000 - $1,800,000)(1 - 0.35)] / 10,000,000]} = $5.40.

• Question 1122:

  Which of the following are objectives of conducting a post audit? Choose the best answer.

  I. Identifying arbitrage opportunities

  II. Improving forecasts

  III. Identifying expansion opportunities

  IV.

  Improve operations

  V.

  Adhering to governmental guidelines for performance presentation

  A.

  I, II, V

  B.

  I, II, III, IV

  C.

  I, II, VII

  D.

  II, IV

  E.

  I, II, III, IV, V

  F.

  I, III, IV

  Correct Answer: D

  The post-audit is an important aspect of the capital budgeting process, and involves two steps. Specifically, the post audit involves comparing actual results with forecasted results and determining why any differences exist. There are numerous specific reasons why companies conduct post-audits, but these reasons can be assimilated into two main objectives. Specifically, the objectives of the postaudit are to improve forecasting capacity and improve operations.

• Question 1123:

  Which of the following statements is most correct?

  A. The optimal capital structure simultaneously maximizes EPS and minimizes the WACC.

  B. As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS.

  C. The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price.

  D. All of these statements are false.

  E. The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC.

  Correct Answer: D

  The optimal capital structure is the one that maximizes the price of the firm's stock, and minimizes the firm's WACC.

• Question 1124:

  Foundation Systems, a software engineering company, is considering the acceptance of two mutually exclusive projects. Assume the following information: Project A Initial cash outlay ($40,000) t1: $8,000 t2: $14,000 t3: $13,000 t4: $12,000 t5: $11,000 t6: $10,000 cost of capital is 11.5% Project B Initial cash outlay ($20,000) t1: $7,000 t2: $13,000 t3 $12,000 cost of capital is 11.5% Assuming no taxes, a $0.00 salvage value at the end of each project, and the fact that both projects can be replicated identically at the end of their lives, which is the superior project according to the Common Life approach? Additionally, what is the NPV of the superior project over the common life?

  A. Project A, NPV $7,165.11

  B. Project A, NPV $9,280.90

  C. The Common Life approach cannot be applied to these two projects, due to the fact that the projects share unequal lives.

  D. Project B, NPV $9,280.90

  E. Project B, NPV $5,391.49

  Correct Answer: D

  The Common Life, or "Replacement Chain" approach is a method which allows two projects with differing lives to be compared on the basis of NPV or IRR. In analyzing two or more projects using theCommon Life approach, the two projects are multiplied in such a way that each comprises the same amount of time periods. In this example, you are provided with one project that is three periods long, and another which is six periods. By multiplying the three-period project by two, then we are able to formulate a situation in which both projects share a "common life." The calculation of the NPV for Project B assumes the following series of cash flows: t0: ($20,000) t1: $7,000 t2: $13,000 t3: [$12,000 + ($20,000)]= ($8,000) t4: $7,000 t5: $13,000 t6: $12,000 During t3, the project is "replaced," and the $12,000 inflow is offset by the ($20,000) required to implement the project once again. Incorporating this series of cash flows into your calculator will yield a NPV of $9,280.90 for project B, and this is higher than the NPV of $7,165.11 for project A.

• Question 1125:

  Which of the following statements is most correct?

  A. If it could be demonstrated that a clientele effect exists, this would suggest that firms could alter their dividend payment policies from year to year to take advantage of investment opportunities without having to worry about the effects of changing dividends on capital costs.

  B. Each of these statements are false.

  C. If a company raises its dividend by an unexpectedly large amount, the announcement of this new and higher dividend is generally accompanied by an increase in the stock price. This is consistent with the bird-in-the-hand theory, and Modigliani and Miller used these findings to support their position on dividend theory.

  D. If the dividend irrelevance theory (which is associated with the names Modigliani and Miller) were exactly correct, and if this theory could be tested with "clean" data, then we would find, in a regression of dividend yield and capital gains, a line with a slope of -1.0.

  E. The tax preference and bird-in-the-hand theories lead to identical conclusions as to the optimal dividend policy.

  Correct Answer: D

  The main conclusion of MM's irrelevance theory is that dividend policy does not affect the required rate of return on equity. MM theorized that k(s) is independent of dividend policy, implying that investors are indifferent between dividends and capital gains.

• Question 1126:

  A project has a high correlation with the firm's other projects. It also has a low CAPM beta. The project will have ________ corporate risk and ________ market risk.

  A. high; high

  B. high; low

  C. low; low

  D. low; high

  Correct Answer: B

  Corporate risk measures the impact of a project on the corporate earnings while market risk measures its effect on the systematic risk of the stock. Since the project's returns are highly correlated with those of the firm's other projects, it will increase the earnings volatility. At the same time, due to low beta, the project will have a low market risk.

• Question 1127:

  A firm is considering a project whose estimated cash flows have indicated a payback period of 3.68 years. It requires an initial outlay of $1,000 and has end-of-year cash flows of $350, $270 and $225 in the first 3 years. The firm's marginal discount rate is 9%. The project's projected cash flow for year 4 equals ________.

  A. 373

  B. 514

  C. 495

  D. 228

  Correct Answer: D

  The payback period is defined as the expected number of years that would be required to recover the original investment. In particular, Payback period = Years before full recovery + (unrecovered cost at the start of payback year)/(net cash flow in the payback year) In this case, the recovery occurs in the 3rd year. At the beginning of the 3rd year, the unrecovered cost equals 1,000 - 350 - 270 - 225 = 155. If total cash flow in the 4th year equals C, then payback period = 3 + 155/ C = 3.68 years. Solving for C gives C = 228. Note that the discount rate does not figure in the calculation of payback period.

• Question 1128:

  A firm has a target dividend payout ratio of 36% and net income of $1.7 million. It is committed to maintaining an optimal capital structure consisting of 63% debt and 37% equity. The firm is in the 40% tax bracket. Its retained earnings breakpoint equals ________.

  A. $1.89 million

  B. $2.58 million

  C. $1.31 million

  D. $2.75 million

  E. $2.94 million

  F. $3.41 million

  G. $4.64 million

  Correct Answer: E

  The retained earnings breakpoint refers to the maximum amount of capital that can be raised using retained earnings, assuming a constant capital structure and dividend payout ratio. In other words, it is the maximum amount of capital that can be raised without increasing the marginal cost of capital. In the present example, the maximum internal equity capital equals 1.7 * 0.64 = $1.088 million. To maintain a D/E ratio of 63/37 = 1.7, the amount of debt to be issued equals 1.088

  * 1.7 = $1.85 million. Therefore, earnings break-point equals (1.088 + 1.85) million = $2.938 million.

• Question 1129:

  Bell Brothers has $3,000,000 in sales. Its fixed costs are estimated to be $100,000, and its variable costs are equal to fifty cents for every dollar of sales. The company has $1,000,000 in debt outstanding at a before-tax cost of 10 percent. If Bell Brothers' sales were to increase by 20 percent, how much of a percentage increase would you expect in the company's net income?

  A. 15.66%

  B. 18.33%

  C. 19.24%

  D. 23.08%

  E. 21.50%

  Correct Answer: D

  Step 1 Find Degree of Total Leverage (DTL)

  DTL = (S-VC)/(S-VC-F-I) = ($3,000,000-$1,500,000)/($3,000,000-$1,500,000-$100,000-$100,000 =

  1.1538.

  Step 2 Find percentage increase in net income:

  %Change NI = (0.20)(DTL) = (0.20)(1.1538) = 0.2308 = 23.08%.

• Question 1130:

  Which of the following is false?

  A. The IRR rule is not dependable when applied to projects with non-normal cash flows.

  B. For independent projects with normal cash flows, the IRR and NPV rules give the same accept/reject results.

  C. For mutually exclusive projects, the IRR and NPV rules can give conflicting results.

  D. None of these answers.

  Correct Answer: D

  Remember to always use the NPV result. There are quite a few problems with using other decision rules like IRR and payback period.