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

• Question 1161:

  If the firm is being operated so as to maximize shareholder wealth, and if our basic assumptions concerning the relationship between risk and return are true, then which of the following should be true?

  A. If the beta of the asset is greater than the corporate beta prior to the addition of that asset, then the corporate beta after the purchase of the asset will be smaller than the original corporate beta.

  B. If the beta of the asset is smaller than the firm's beta, then the required return on the asset is greater than the required return on the firm.

  C. None of these answers are true.

  D. If the beta of an asset is larger than the corporate beta prior to the addition of that asset, then the required return on the firm will be greater after the purchase of that asset than prior to its purchase.

  E. If the beta of the asset is larger than the firm's beta, then the required return on the asset is less than the required return on the firm.

  Correct Answer: D

  An increase in a project's beta will cause its stock price to decrease unless the increased beta were offset by a higher expected rate of return. Therefore, high-risk investments require higher rates of return, whereas low-risk investments require lower rates of return.

  Exam O

• Question 1162:

  Ace Consulting, a multinational corporate finance consulting firm, is examining the operations of Minishabby Farms, an Irish conglomerate who is considering the development of a new distilling process for their specialty spirits division. In order to determine the feasibility of the new distilling process, Ace Consulting is trying to determine the beta of the proposed project. In their analysis, Ace Consulting begins by identifying publicly-traded companies whose operations are solely within the distilling business. Ace identifies four such firms, determines the beta of each Company, and averages them together. This figure is used as the beta of the proposed project. Which of the following techniques most correctly describes this method of identifying individual project betas?

  A. Monte Carlo simulation

  B. Empirical smoothing

  C. Accounting beta method

  D. Relational method

  E. Pure play method

  F. Case study analysis

  Correct Answer: E

  In this example, Ace Consulting has used the beta coefficient of four firms whose business is solely within the distilling process. These firms are "pure plays" in the distilling field. The Pure Play method of determining project betas is a popular technique in corporate finance, most likely due to its ease of use. However, the identification of "pure play" firms is often difficult for certain projects. In these cases, the second method of determining project betas is employed, the Accounting Beta method. "Monte Carlo simulation" is a method for evaluating stand-alone risk, and "empirical smoothing" is a fictitious term.

• Question 1163:

  A firm initially has no debt in its capital structure. As it starts increasing its debt, the stock price begins to rise because of ________. After a threshold, an increase in debt reduces the stock price due to ________.

  A. none of these answers

  B. higher leverage; higher probability of default

  C. tax deductions; expected default and bankruptcy costs

  D. lower cost of retained earnings; higher cost of debt

  Correct Answer: C

  Debt offers tax shelter for income that equity does not since interest paid on debt is tax deductible. Therefore, as the firm starts adding debt to its capital structure in lieu of equity, the stock price starts rising. However, at a threshold debt-to- equity level, the higher probability of default offsets the value of the debt shield. Beyond this, addition of more debt reduces the stock price.

• Question 1164:

  Consider the following information:

  30 day T-Bill rate (Risk free rate) 7.2%

  Common Stock Beta 0.8

  Expected Rate of return for the market 15.0%

  Net Worth to Total Asset Multiple .25

  Calculate this firm's cost of retained earnings using the CAPM approach.

  A. 7.2%

  B. 13.44%

  C. 12.0%

  D. 9.6%

  E. 22.2%

  F. 10.2%

  Correct Answer: B

  To calculate the cost of retained earnings for a firm using CAPM, one may use the following formula: Cost of retained earnings = risk free rate + ((expected rate of return on the market - risk free rate) x Beta). In this case the cost of retained earnings = 7.2% + ((15.0% - 7.2%) x 0.8 = 13.44%.

• Question 1165:

  Lloyd Enterprises has a project, which has the following cash flows: Year Cash Flows 0-$200,000 1 50,000 2 100,000 3 150,000 4 40,000 5 25,000 The cost of capital is 10 percent. What is the project's discounted payback?

  A. 2.3333 years

  B. 1.8763 years

  C. 2.4793 years

  D. 2.0000 years

  E. 2.6380 years

  Correct Answer: E

  Discounted CFCumulative CF 0-200,000.00-200,000.00 145,454.55-154,545.45 282,644.63-71,900.82 Payback 3112,697.22+40,796.40 427,320.54+68,116.94 515,523.03+83,639.97 Payback period = 2 years + (71,900.82/112,697.22) = 2.638 years.

• Question 1166:

  Which of the following is not a cash flow that results from the decision to accept a project?

  A. Externalities.

  B. Shipping and installation costs.

  C. Opportunity costs.

  D. Changes in working capital.

  E. Sunk costs.

  Correct Answer: E

  Sunk cost is not a relevant cash flow.

• Question 1167:

  A stock split will cause a change in the total dollar amounts shown in which of the following balance sheet accounts?

  A. Retained earnings

  B. Cash

  C. None of these will change

  D. Paid-in capital

  E. Common stock

  Correct Answer: C

  If a stock rises above a specific amount, management may declare, for example, a two-for-one stock split, where the number of shares outstanding doubles and the stock price is halved. Each stockholder would have more shares, but each share is worth less. Theoretically, a stock split should not affect the value of the firm. They are generally used after a sharp price run-up to produce a large price reduction.

• Question 1168:

  Consider the following information:

  30-day treasury rate (Risk Free rate) 5.2%

  Company XYZ Bond yield 12.2%

  Beta 1.2

  Risk Premium 4.5%

  Credit Rating BBB

  Calculate Company XYZ's cost of retained earnings using the Bond-Yield-plus-Risk-Premium approach.

  A. 21.9%

  B. 16.7%

  C. 12.2%

  D. 5.2%

  E. 20.4%

  F. 9.7%

  Correct Answer: B

  To estimate a firm's cost of retained earnings using the Bond-Yield-plus-Risk-Premium approach, simply take the company's bond yield and add the risk premium. In this case the cost of retained earnings = 12.2% + 4.5% = 16.7%.

• Question 1169:

  The following information applies to a company's preferred stock: Current price $101.00 per share Par value $100.00 per share Annual dividend $6.50 per share The company issued the preferred stock at par and incurred a 10% floatation cost. If the company's marginal corporate tax rate is 34%, what is the after-tax cost of preferred stock?

  A. 4.3%

  B. 6.4%

  C. 13%

  D. 4.2%

  E. 6.5%

  F. 7.2%

  Correct Answer: F

  The cost of preferred stock is calculated as the preferred stock dividend divided by the net issuing price. The dividend for this preferred stock is $6.50, and the net issuing price was $90.00. Thus the cost of preferred stock is 6.5 divided by 90 or 7.2%. There are no tax savings associated with the use of preferred stock, therefore no tax adjustments are made when calculating the cost.

• Question 1170:

  Dorrie James, a financial analyst with consulting firm Brown, Ketchuppe and Company, is trying to determine the earnings per share (EPS) figure for Floweration.com. Assume the following information: Sales: $4,500,000 Fixed costs: $2,000,000 Variable costs: $1,200,000 Interest expense: $40,000 Tax rate: 35% Weighted Average Cost of Capital: 12.25% Beta coefficient: 1.25 Common shares outstanding: 4,755,000 Using this information, what are the EPS for Floweration.com?

  A. $0.1492

  B. $0.1722

  C. $0.1676

  D. $0.2440

  E. $0.2360

  F. The answer cannot be calculated from the information provided.

  Correct Answer: B

  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 themechanics 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 = [($4,500,000 - $2,000,000 $1,200,000 - $40,000)(1 - .35)] / 4,755,000}= $0.1722