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

• Question 1181:

  Ranking conflicts occur between the NPV and IRR methods because I NPV profiles have differing slopes. II IRR assumes reinvestment of intermediate cash flows at the IRR rate. III IRR doesn't take into account cash flows occurring far in the future. IV NPV incorrectly uses the same discount rate for all cash flows.

  A. I, II and III only

  B. II only

  C. I only

  D. II, III and IV only

  E. All of these are correct

  F. I and II only

  Correct Answer: F

  Project with differing initial investments and cash flow patterns may have NPV profiles with differing slopes. The point at which the NPV profiles cross represents the discount rate at which the NPV of both projects is the same. There will be ranking conflicts between NPV and IRR at discount rates below this point. The NPV method implicitly assumes that the rate at which cash flows can be reinvested is the cost of capital, whereas the IRR method assumes that the firm can reinvest at the IRR. IRR does take all cash flows into account, even those far in the future. It is correct to use the same discount rate for all project cash flows, unless you know project risk will change in the future.

• Question 1182:

  Which of the following statements is most correct?

  A. An increase in the flotation cost incurred in selling new stock will reduce the retained earnings break point, as long as the dollar level of retained earnings and the fraction of capital which is equity financed remains constant.

  B. None of these answers are correct.

  C. All of these answers are correct.

  D. An increase in a firm's corporate tax rate, will increase the firm s cost of debt capital, as long as the yield to maturity on the company's bonds remains constant or falls.

  E. An increase in the flotation cost incurred in selling new stock will increase the cost of retained earnings.

  Correct Answer: B

  An increase in the flotation cost has no effect on the cost of retained earnings or the retained earnings break point. An increase in the firm's corporate tax rate reduces the after-tax component cost of debt.

• Question 1183:

  Consider the following information for a company.

  Common Stock Price $53.25

  Preferred Stock Par Price $50

  Preferred Dividend $3.5

  Debt Rating BB+

  Owners Equity 25%

  Preferred Stock Flotation Cost 2.0%

  The Preferred Stock is issued at Par

  Calculate the component cost of this newly issued preferred stock. (Note that for existing preferred stock,

  flotation costs may be ignored.)

  A. 18.78%

  B. 7.14%

  C. 6.57%

  D. 7.0%

  E. 10%

  F. 3.5%

  G. 12.5%

  Correct Answer: B

  The component cost of preferred stock is the dividend divided by issue price minus floatation cost. In this case the component cost of preferred stock = $3.50 / (50 - 1) = 7.14%.

• Question 1184:

  A project has the following cash flows over the next 5 years: $1,000, $600, $300, $1,200 and $1,400.

  Assume all cash flows occur at the end of a year. The project requires an initial cash outlay of $2,900. The

  project's cost of capital is 8%.

  The NPV of the project equals ________.

  A. $1,194

  B. $1,735

  C. $3,513

  D. $613

  Correct Answer: D

  The discounted cash flow at the end of year N is obtained by dividing that year's cash flow by 1.08N, since

  the project's cost of capital is 8%. Using this, the discounted cash flows are:

  $926, $514, $238, $882 and $953.

  The present value of all the future cash flows = $(926 + 514 + 238 + 882 + 953) = $3,513. The NPV is then

  equal to $(3,513 - 2,900) = $613.

• Question 1185:

  Dumb and Dumber Development Company has two mutually exclusive investment projects to evaluate. Assume both projects can be repeated indefinitely. The following cash flows are associated with each project: Time Project A Project B 0-$100,000-$70,000 1 30,000 30,000 2 50,000 30,000 3 70,000 30,000 4-30,000 5-10,000 The project types are equally risky and the firm's cost of capital is 12 percent. What is the EAA of the higher valued project? (Round your final answer to the nearest whole dollar.)

  A. $16,470

  B. $7,433

  C. $11,325

  D. $6,857

  E. None of the answers

  Correct Answer: B

  Step 1 Calculate the NPV for both projects:

  A:CF(0) = -100,000; CF(1) = 30,000; CF(2) = 50,000; CF(3) = 70,000; I/YR = 12; solve for NPV = $16,470.

  B:CF(0) = -70,000; CF(1) = 30,000; CF(2) = 30,000; CF(3) = 30,000;CF(4) = 30,000; CF(5) = 10,000; I/YR

  = 12; NPV = $26,795.

  Step 2 Calculate the EAA for both projects:

  A: N = 3; I/YR = 12; PV = -16,470; FV = 0; solve for PMT = $6,857.

  B: N = 5; I/YR = 12; PV = -26,795; FV = 0; solve for PMT = $7,433.

  The PMT is the EAA for each project. Since Project B has the larger EAA $7,433 is the correct answer.

• Question 1186:

  Which of the following types of risk cannot be eliminated through diversification? Choose the best answer

  A. Unsystematic risk

  B. Market risk

  C. Corporate risk

  D. Alpha risk

  E. Gamma risk

  Correct Answer: B

  Market risk is defined as that part of an asset's risk which cannot be eliminated through diversification. Market risk is measured by the Beta coefficient, and is commonly referred to as "systematic" or "nondiversifiable" risk. Additionally, market risk is referred to as "beta risk." Corporate risk is defined as the variability of assets expected returns without taking into consideration the effects of shareholder diversification. This is one step away from Stand-alone Risk, which measures the risk of an asset, not only without taking into consideration the effect of shareholder diversification, but of company diversification as well. Stand-alone risk assumes that the asset in question is the only asset of the firm and that the securities of the firm are the only assets in investors' portfolios. Corporate risk takes into consideration that firms will diversify their asset bases.

• Question 1187:

  Jackson Jets is considering two mutually exclusive projects. The projects have the following cash flows: Project A Project B Time Cash FlowsC ash Flows 0-$10,000-$8,000 1 1,000 7,000 2 2,000 1,000 3 6,000 1,000 4 6,000 1,000 At what cost of capital, do the two projects have the same net present value?

  A. 13.03%

  B. 12.26%

  C. 11.20%

  D. 12.84%

  E. 14.15%

  Correct Answer: A

  Find the differential cash flows by subtracting B's cash flows from A's cash flows for each year. CF(0) = -2,000 CF(1) = -6,000 CF(2) = 1,000 CF(3) = 5,000 CF(4) = 5,000 Enter these cash flows and solve for the IRR = crossover rate = 13.03%.

• Question 1188:

  Which of the following statements is most correct?

  A. All of these answers are correct.

  B. An increase in the risk-free rate is likely to decrease the marginal cost of both debt and equity financing.

  C. The WACC is calculated on a before-tax basis.

  D. None of these answers are correct.

  E. The WACC (Weighted Average Cost of Capital) for a given capital budget level is a weighted average of the marginal cost of each relevant component which makes up the firm's target capital structure.

  Correct Answer: E

  A value-maximizing firm will establish a target (optimal) capital structure and then raise new capital in a manner that will keep the actual capital structure on target over time. The target proportions of debt, preferred stock, and common equity, along with the component cost of capital, are used to calculate the firm's WACC.

• Question 1189:

  Which of the following statements is most correct?

  A. The factors which affect a firm's business risk are determined partly by industry characteristics and partly by economic conditions. Unfortunately, these and other factors, which affect a firm's business risk, are not subject to any degree of managerial control.

  B. The firm's financial risk may have both market risk and diversifiable risk components.

  C. One of the benefits to a firm of being at or near its target capital structure are that financial flexibility becomes much less important.

  D. A firm's business risk is solely determined by the financial characteristics of its industry.

  E. All of these statements are false.

  Correct Answer: B

  Financial risk is an increase in stockholders' risk, over and above the firm's basic business risk, resulting from the use of financial leverage, which refers to the use of fixed-income securities.

• Question 1190:

  Which of the following is a key determinant of operating leverage?

  A. Cost of debt.

  B. Technology.

  C. Level of debt.

  D. Capital structure.

  E. Physical location of production facilities.

  Correct Answer: B

  If a high percentage of a firm's total costs are fixed, the firm has high operating leverage. Higher fixed costs are generally associated with more highly automated, capital-intensive firms and industries.