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

• Question 1171:

  Project A has an internal rate of return of 18 percent, while Project B has an internal rate of return of 16 percent. However, if the company's cost of capital (WACC) is 12 percent, Project B has a higher net present value. Which of the following statements is most correct?

  A. All of these answers are correct.

  B. The crossover rate for the two project is less than 12 percent.

  C. None of these answers are correct.

  D. Assuming that the two projects have the same scale, Project A probably has a faster payback than Project B.

  E. Assuming the timing of the two projects is the same, Project A is probably of larger scale than Project

  B.

  Correct Answer: D

  Draw out the NPV profiles of these two projects. As B's NPV declines more rapidly with an increase in discount rates, this implies that more of the cash flows are coming later on. Therefore, Project A has a faster payback than Project B.

• Question 1172:

  According to the Signaling Theory of capital structure, an increase in bankruptcy costs:

  A. increases the debt ratio of a firm.

  B. none of these answers.

  C. may or may not affect the debt ratio of a firm.

  D. decreases the debt ratio of a firm.

  Correct Answer: C

  The Signaling Theory of capital structure considers the decisions of a firm's manager to raise debt or equity capital as a function of the relative profitability prospects of the firm's projects. It does not use bankruptcy costs as an explanation of the debt ratios prevalent in various industries. Bankruptcy costs are used by the Trade-off Theory of capital structure.

• Question 1173:

  Projects A and B are mutually exclusive and will be repeated. The company's cost of capital is 12.5 percent. tProj. A-Cash FlowsProj. B-Cash Flows 0- 10,000- 10,000 1+ 40,000+ 30,000 2+ 50,000+ 30,000 3+ 30,000+ 30,000 4+ 20,000+ 30,000 5+ 30,000 What is the equivalent annual annuity (EAA) of the best project?

  A. $24,227

  B. $27,192

  C. $32,811

  D. $23,243

  E. $35,000

  Correct Answer: C

  First find the NPV of each project, using the cash flow register:

  Project A NPV = $98,617.59.

  Project B NPV = $96,817.05.

  Then find EAA:

  Project A:

  N = 4; I = 12.5; PV = -98,617.59; FV = 0; solve for PMT = $32,810.85.

  Project B:

  N = 5; I = 12.5; PV = -96,817.05; FV = 0; solve for PMT = $27,191.46.

  Project A has the higher EA

  A.

• Question 1174:

  Which of the following choices correctly describes a project which will direct the operations of a company into a new market or functional niche, is primarily enacted to expand revenues, and one in which the firm does not have an existing proxy?

  A. Marginal project

  B. Extraordinary item

  C. Retrenchment project

  D. Replacement project

  E. Expansion project

  Correct Answer: E

  In an analysis of an expansion project, the relevant cash flows are those which apply wholly to the proposed project. There is no existing project whose cash flows must be incorporated into the analysis, as in the examination of a replacement project. "Marginal project" and "retrenchment project," are fictitious terms, and "extraordinary item" is an accounting classification referring to an event that is both unusual and nonrecurring.

• Question 1175:

  Buchanan Brothers anticipates that its net income at the end of the year will be $3.6 million (before any recapitalization). The company currently has 900,000 shares of common stock outstanding and has no debt. The company's stock trades at $40 a share. The company is considering a recapitalization where it will issue $10 million worth of debt at a yield to maturity of 10 percent, and use the proceeds to repurchase common stock. Assume the stock price remains unchanged by the transaction, and the company's tax rate is 34 percent. What will be the company's earnings per share if it proceeds with the recapitalization?

  A. $4.52

  B. $5.54

  C. $2.23

  D. $3.26

  E. $2.45

  Correct Answer: A

  After issuing the debt, the company can repurchase $10,000,000/$40 = 250,000 shares leaving 650,000 shares outstanding. We still need to find the expected NI after issuing the debt. We're given the anticipated NI is $3.6 million. Thus, the EBIT (before the debt issue) can be found as follows: $3,600,000 = EBIT(1 0.34) or EBIT = $5,454,545.45. The company will pay $1,000,000 in interest after issuing the debt so the new EBT will be $5,454,545.45 - $1,000,000 = $4,454,545.45. Also, the new NI figure will be: $4,454,545.45(1 - 0.34) = $2,940,000. Finally, $2,940,000/650,000 = $4.52 is the EPS after the recapitalization.

• Question 1176:

  The president of Real Time Inc. has asked you to evaluate the proposed acquisition of a new computer. The computer's price is $40,000, and it falls into the MACRS 3-year class. Purchase of the computer would require an increase in net working capital of $2,000. The computer would increase the firm's before-tax revenues by $20,000 per year but would also increase operating costs by $5,000 per year. The computer is expected to be used for 3 years and then be sold for $25,000. The firm's marginal tax rate is 40 percent, and the project's cost of capital is 14 percent. What is the net investment required at t = 0?

  A. -$36,600

  B. -$40,000

  C. -$38,600

  D. -$42,000

  E. -$37,600

  Correct Answer: D

  Initial investment:

  Cost($40,000)

  Change in NWC(2,000)

  ($42,000)

• Question 1177:

  The management of Clay Industries have adhered to the following capital structure: 50% debt, 45% common equity, and 5% perpetual preferred equity. The following information applies to the firm: Before-tax cost of debt = 7.5% Combined state/federal tax rate = 35% Expected return on the market = 14.5% Annual risk-free rate of return = 5.25% Historical Beta coefficient of Clay Industries Common Stock = 1.15 Annual preferred dividend = $1.35 Preferred stock net offering price = $17.70 Expected annual common dividend = $0.45 Common stock price = $30.90 Expected growth rate = 11.75% Subjective risk premium = 3.8% Given this information, and using the Capital Asset Pricing Model to calculate the component cost of common equity, what is the Weighted Average Cost of Capital for Clay Industries?

  A. 15.31%

  B. 11.30%

  C. 9.92%

  D. 9.968%

  E. The WACC for Clay Industries cannot be calculated from the information.

  F. 10.05%

  Correct Answer: D

  The calculation of the Weighted Average Cost of Capital is as follows: {fraction of debt * [yield to maturity on outstanding long-term debt][1-combined state/federal income tax rate]} + {fraction of preferred stock * [annual dividend/net offering price]} + {fraction of common stock * cost of equity}. The cost of common equity can be calculated using three methods, the Capital Asset Pricing Model (CAPM), the DividendYield-plus-Growth-Rate (or Discounted Cash Flow) approach, and the Bond- Yield-plus-Risk-Premium approach. In this example, you are asked to calculate the cost of common equity using the Capital Asset Pricing Model (CAPM). This approach involves the following equation: {risk-free rate +beta[expected return on the market - risk-free rate]}. Specifically, the calculation of the component cost of common equity using the CAPM is as follows: {[5.25% + 1.15(14.5%-5.25%]} = 15.888%. The after-tax cost of debt can be found by multiplying the yield to maturity on the firm's outstanding long-term debt (7.5%) by (1-tax rate). Using this method, the after-tax cost of debt is found as 4.875%. The calculation of the cost of perpetual preferred stock is relatively straightforward, simply divide the annual preferred dividend by the net offering price. Using this method, the cost of preferred stock is found as 7.627%. Incorporating these figures into the WACC equation gives the answer of 9.968%.

• Question 1178:

  Which of the following statements is most correct?

  A. All of these answers are correct.

  B. None of these answers are correct.

  C. The capital structure that maximizes stock price is also the capital structure, which maximizes earnings per share.

  D. The capital structure that maximizes stock price is also the capital structure, which maximizes the firm's times-interest-earned (TIE) ratio.

  E. The capital structure that maximizes stock price is also the capital structure, which minimizes the weighted average cost of capital (WACC).

  Correct Answer: E

  The capital structure which maximizes the firm's stock price generally calls for a debt ratio which is lower than the one that maximizes EPS. The firm could maximize its TIE by having no debt (i.e. zero interest payments). But, this capital structure would probably not maximize the firm's stock price.

• Question 1179:

  Clay Industries, a large industrial firm, is examining the operating leverage of its tooling division during the

  last year. Consider the following information:

  % change in EBIT during the last year 28%

  Sales for period 1$435,000

  Sales for period 2$578,000

  Cost of debt 7.75%

  Expected return on the market 15%

  Risk-free rate 4.55%

  Beta 1.05

  Given this information, what is the operating leverage of this division during the time period in question?

  A. 0.8518

  B. 1.1741

  C. 0.9178

  D. The degree of operating leverage for this firm cannot be calculated from the information provided.

  E. 0.1322

  F. 0.98402

  Correct Answer: A

  To calculate the degree of operating leverage, use the following equation: {% change in EBIT/% change in sales}. In this example, the percentage change in EBIT is provided. However, the percentage change in sales must be calculated, and can be found by the following: {[sales in period 2 - sales in period 1]/sales in period 1}. Incorporating the given information into this equation yields a percentage change in sales of 32.87%. From this point on, the calculation of the DOL is straightforward, and can be found as follows: {% change in EBIT 28%/% change in sales 32.87%}= 0.8518. In attempt to trick you, the cost of debt, along with the components of the Capital Asset Pricing Model have been provided. None of these figures are relevant in the calculation of the Degree of Operating Leverage.

• Question 1180:

  Which of the following statements is/are true about observed capital structures?

  I. Firms with higher stability in sales tend to use higher debt ratios.

  II. Firms with a higher ratio of general-purpose assets to special-purpose assets tend to have higher debt ratios.

  III.

  Young firms with higher growth rates tend to have higher debt ratios.

  A.

  II only

  B.

  I and II

  C.

  I only

  D.

  I, II and III

  E.

  I and III

  F.

  III only

  Correct Answer: B

  Stability of sales implies a stability in profitability. This allows firms to service higher levels of debt without worrying about bankruptcy. Similarly, since general-purpose assets are more valuable as collateral than firm-specific assets, firms with a higher ratio of general-purpose assets to special- purpose assets tend to have higher debt ratios. However, young firms which face higher uncertainty in their project payoffs tend to favor equity financing.