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

• Question 1191:

  The Altman Company has a debt ratio of 33.33 percent, and it needs to raise $100,000 to expand. Management feels that an optimal debt ratio would be 16.67 percent. Sales are currently $750,000, and the total assets turnover is 7.5. How should the expansion be financed so as to produce the desired debt ratio?

  A. Finance 20 percent debt, 80 percent equity.

  B. Finance 40 percent debt, 60 percent equity.

  C. Finance it all with debt.

  D. Finance 50 percent debt, 50 percent equity.

  E. Finance it all with equity.

  Correct Answer: E

  Old debt ratio = 0.3333; New debt ratio = 0.1667.

  $750,000/TA= 7.5.

  TA = $100,000.

  Debt = 0.3333($100,000) = $33,330.

  New TA = $100,000 + $100,000 = $200,000.

  New Debt = $200,000(0.1667) = $33,340.

  Altman's current debt of $33,330 represents approximately 16.67% of total assets following the expansion,

  thus the firm should finance with 100 percent equity.

• Question 1192:

  Lincoln Lodging Inc. estimates that if its sales increase 10 percent then its net income will increase 18 percent. The company's EBIT equals $2.4 million, and its interest expense is $400,000. The company's operating costs include fixed and variable costs. What is the level of the company's fixed operating costs?

  A. $2,125,000

  B. $2,000,000

  C. $1,200,000

  D. $666,667

  E. $450,000

  Correct Answer: C

  We're given enough information to find both DFL and DTL.

  DTL = .18/.10 = 1.8.

  DFL = $2,400,000/($2,400,000 - $400,000) = 1.2

  Given DTL = DFL x DOL, we can calculate DOL = 1.5. Recognizing S - VC - FC = EBIT, 1.5 = (S VC)/$2,400,000 or S - VC = $3,600,000. The difference between (S - VC) and EBIT must represent fixed

  operating costs. Thus, FC = $3,600,000 - $2,400,000 = $1,200,000.

• Question 1193:

  Which of the following equations correctly illustrates the calculation of the Weighted Average Cost of Capital (WACC)?

  A. None of these answers

  B. {{Percentage of debt* [coupon on outstanding debt * (1 - combined state/federal tax rate)]} + {percentage of preferred stock * [annual preferred dividend/(required rate of return)]} + {percentage of common equity * cost of common equity}}

  C. {{Percentage of debt * [coupon on outstanding debt * (1 + combined state/federal tax rate)]} + {percentage of preferred stock * [annual preferred dividend/(offering price - flotation costs)]} + {percentage of common equity * cost of common equity}}

  D. {{Percentage of debt* [yield to maturity of outstanding debt * (1 - combined state/federal tax rate)]} + {percentage of preferred stock * [annual preferred dividend/(offering price - flotation costs)]} + {percentage of common equity * cost of common equity}}

  E. {Average cost of equity + average cost of debt + average cost of preferred stock}* subjective divisor

  F. {Percentage of debt * [coupon on outstanding debt * (1 + combined state/federal tax rate)]} + {percentage of preferred stock * [annual preferred dividend/(offering price + flotation costs)]} + {percentage of common equity * cost of common equity}}

  Correct Answer: D

  The Weighted Average Cost of Capital is a fundamentally important concept within the field of corporate finance, and the CFA candidate should have a complete understanding of both the mechanics of the WACC figure, as well as the relationships between its components. In calculating the cost of outstanding common equity, there exist three distinct methods, the Dividend-Yield-plus- Growth-Rate, or Discounted Cash Flow approach, the Capital Asset Pricing Model (CAPM), and the Bond-Yield-plus-Risk-Premium approach. It is important for the CFA candidate to have a complete understanding of each method, along with their weaknesses and advantages.

• Question 1194:

  A firm's capital structure has a debt-to-equity ratio of 1.2. The pretax cost of debt is 6.8% and the weighted average cost of capital of the firm equals 9.8%. The risk-free rate in the economy is 6.2% the expected rate of return on the market is 14%. The firm must pay 35% of its gross income in taxes. The beta of the stock equals ________.

  A. 1.02

  B. 1.64

  C. 1.3

  D. 0.91

  Correct Answer: C

  Since the debt interest is tax deductible, the after-tax cost of debt equals 6.8%*(1-0.35) = 4.42%. Since the D/E ratio = 1.2, (D+E)/E = 2.2, giving E/(D+E) = 0.455. Thus, equity forms 45.5% of the capital whiledebt forms 54.5%. The WACC is then equal to 0.455*RE + 0.545*4.42% = 9.8% (given). Solving gives RE = 16.24%. If B is the beta of the stock, then using CAPM, 16.24% = 6.2% + B*(14% - 6.2%), giving B = 1.29.

• Question 1195:

  Which of the following figures is not explicitly incorporated into the earnings per share (EPS) calculation?

  A. Variable costs

  B. Common shares outstanding

  C. Interest expense

  D. None of these answers

  E. Fixed costs

  F. Sales

  Correct Answer: D

  The EPS figure can be found using two principal equations. The first is illustrated as follows:

  {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]} As you can see, all

  of the choices listed are expressly incorporated into the EPS calculation.

• Question 1196:

  Which of the following statements is most correct?

  A. Generally, we do not need to adjust project cash flows to take into account the effects of inflation, since inflation is not accounted for in the cost of capital.

  B. All of these statements are correct.

  C. For comparing mutually exclusive projects with unequal lives, replacement chain analysis leads to the same decision as obtained by calculating the equivalent annual annuity (EAA).

  D. In comparing mutually exclusive projects with unequal lives, you should always choose the project which has the highest NPV.

  E. The rate of depreciation affects accounting statements, but has no effect on the firm's capital budgeting decisions.

  Correct Answer: C

  The replacement chain analysis and the equivalent annual annuity methods lead to the same decision. Depreciation affects a firm's cash flow, which affects its capital budgeting decisions. The project with the highest extended NPV should be chosen. The cost of capital reflects inflation; therefore, project cash flows must be adjusted for inflation.

• Question 1197:

  A stock has a beta of 0.85 and the risk-free rate is 6.95%. Its dividend growth rate is 5.2% and its P/E ratio is 11.6. If the firm has a dividend payout ratio of 63%, the market risk premium equals ________.

  A. 5.91%

  B. 6.54%

  C. 5.15%

  D. 4.33%

  Correct Answer: D

  P0/E1 = dividend payout/(k - g) Therefore, 11.6 = 0.63/(k - 0.052), giving expected return = k = 10.63%. Now, the CAPM expected return on the stock is given by k = Rf + beta*(Rm - Rf). Therefore, 10.63% = 6.95% + 0.85*market premium, giving market premium = (10.63 - 6.95)%/0.85 = 4.33%.

• Question 1198:

  An increase in which of the following, holding everything else equal, will cause a decrease in the theoretical growth rate of common stock dividends according to the Growth Rate of Dividends Model?

  I. Return on equity

  II. Tax rate

  III. Dividend payout ratio

  IV.

  Annual dividend

  V.

  Discount rate

  VI. Beta coefficient

  VII.

  Retention rate

  A.

  I, II, IV

  B.

  II, III, VI, V

  C.

  I, II, VI, V

  D.

  III

  E.

  III, VI, VII

  F.

  VII

  Correct Answer: D

  III The equation used to determine the theoretical growth rate of common stock dividends is as follows: {Annual growth rate = [ROE * (1 - dividend payout ratio)]} As you can see, of the choices listed, only an increase in the dividend payout ratio will cause a decrease in the theoretical growth rate of common stock dividends. Remember that the retention rate is equal to (1 - dividend payout ratio). Additionally, neither the discount rate nor the tax rate is explicitly factored into the dividend growth rate equation.

• Question 1199:

  Consider the following information:

  30-day treasury rate (Risk Free rate) 6.4%

  Company XYZ Bond yield 11.2%

  Beta 1.1

  Risk Premium 3.5%

  Credit Rating B-

  Marginal Tax Rate 40% Calculate Company XYZ's cost of retained earnings using the Bond-Yield-plusRisk-Premium approach.

  A. 17.6%

  B. 15.2%

  C. 14.7%

  D. 8.82%

  E. 16.17%

  F. 11.36%

  Correct Answer: C

  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 = 11.2% + 3.5% = 14.7%.

• Question 1200:

  Which of the following statements best describes the optimal capital structure?

  A. All of these answers are correct.

  B. None of these answers are correct.

  C. The optimal capital structure is the mix of debt, equity, and preferred stock, which maximizes the company's stock price.

  D. The optimal capital structure is the mix of debt, equity, and preferred stock which minimizes the company's cost of debt.

  E. The optimal capital structure is the mix of debt, equity, and preferred stock which maximizes the company's earnings per share (EPS).

  Correct Answer: C

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