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

• Question 1201:

  Which of the following terms describes the risk of individual projects to a corporation, taking into consideration that each project represents only one of the firm's portfolio of assets?

  A. Alpha coefficient

  B. Corporate risk

  C. Stand-alone risk

  D. Systematic risk

  E. Market risk

  Correct Answer: B

  Corporate, or "within-firm" risk, is defined as the risk of individual projects to a corporation, taking into consideration the fact that each project represents only one of the firm's assets. In examining corporaterisk, there is an implicit assumption that some of the total risk to the firm's profits from the addition of new projects will be partially diversified away. Corporate risk is measured by the project's impact on uncertainty about the firm's future earnings.

• Question 1202:

  Chandler Communications' CFO has provided the following information:

  *

  The company's capital budget is expected to be $5,000,000.

  *

  The company's target capital structure is 70 percent debt and 30 percent equity.

  *

  The company's net income is $4,500,000. If the company follows a residual dividend policy, what portion of its net income should it pay out as dividends this year?

  A.

  66.67%

  B.

  40.00%

  C.

  33.33%

  D.

  60.00%

  E.

  50.00%

  Correct Answer: A

  $5,000,000 x 0.3 = $1,500,000 of retained earnings needed to fund the capital budget. $4,500,000 $1,500,000 = $3,000,000 of net income available for dividends. Dividend payout ratio = $3,000,000/$4,500,000 = 0.6667, or 66.67%.

• Question 1203:

  If the MM hypothesis about dividends is correct, and if one found a group of companies which differed only with respect to dividend policy, which of the following statements would be most correct?

  A. All of these statements are true.

  B. The residual dividend model should not be used, because it is inconsistent with the MM dividend hypothesis.

  C. The total expected return, which in equilibrium is also equal to the required return, would be higher for those companies with lower payout ratios because of the greater risk associated with capital gains versus dividends.

  D. None of these statements are true.

  E. If the expected total return of each of the sample companies were divided into a dividend yield and a growth rate, and then a scatter diagram (or regression) analysis were undertaken, then the slope of the regression line (or b in the equation D1/Po = a + b(g)) would be equal to +1.0.

  Correct Answer: D

  None of these statements are correct. Miller and Modigliani argued that the value of the firm depends only on the income produced by its assets, not on how this income is divided between dividends and retained earnings.

• Question 1204:

  Foxglove Corp. is faced with an investment project. The following information is associated with this project: Allowable Depreciation YearNet Income*for 3-Yr. MACRS class 1 $50,000 0.33 2 60,000 0.45 3 70,000 0.15 4 60,000 0.07 *Assume no interest expenses and a zero tax rate. The project involves an initial investment of $100,000 in equipment that falls in the 3-year MACRS class and has an estimated salvage value of $15,000. In addition, the company expects an initial increase in net working capital of $5,000, which will be recovered in year 4. The cost of capital for the project is 12 percent. What is the project's net present value? (Round your final answer to the nearest whole dollar.)

  A. $153,840

  B. $168,604

  C. $162,409

  D. $159,071

  E. $182,344

  Correct Answer: B

  Step 1 Calculate depreciation:

  Dep 1 = 100,000(0.33) = 33,000.

  Dep 2 = 100,000(0.45) = 45,000.

  Dep 3 = 100,000(0.15) = 15,000.

  Dep 4 = 100,000(0.07) = 7,000.

  Step 2 Calculate cash flows:

  CF 0 = -100,000 - 5,000 = -105,000.

  CF 1 = 50,000 + 33,000 = 83,000.

  CF 2 = 60,000 + 45,000 = 105,000.

  CF 3 = 70,000 + 15,000 = 85,000.

  CF 4 = 60,000 + 7,000 + 5,000 + 15,000 = 87,000.

  Step 3 Calculate NPV:

  Use CF key on calculator. Enter cash flows shown above. Enter I/YR = 12%. Solve for NPV = $168,604.

• Question 1205:

  Which of the following statements is correct?

  A. The cost of debt used in calculating the WACC is an average of the after-tax cost of new debt and of outstanding debt.

  B. Preferred stock does not involve any adjustment for flotation cost since the dividend and price are fixed.

  C. The cost of new common equity includes an adjustment for flotation costs which is expressed as a fixed percentage of the current stock price. The flotation percentage is determined jointly by the current price of the firm's stock and its growth rate.

  D. The opportunity cost principle implies that if the firm cannot invest retained earnings and earn at least k

  (s) (component cost of retained earnings or internal equity), it should pay these funds to its

  stockholders and let them invest directly in other assets that do provide this return.

  E. Capital components are the types of capital used by firms to raise money. All capital comes from one of three types: long-term debt, preferred stock, and equity.

  Correct Answer: D

  The firm's after-tax earnings belong to its stockholders. All earnings remaining after interest and preferred dividends belong to them, and these earnings serve to compensate stockholders for the use of their capital. The firm may either pay out earnings as dividends or retain them and reinvest them in the firm. If the firm retains earnings, there is an opportunity cost involved - stockholders could have received the earnings as dividends and invested the money in other investments. Thus, the firm should earn on its retained earnings at least as much as the stockholders themselves could have earned on alternative investments of comparable risk.

• Question 1206:

  Assume that all the assumptions of Modigliani and Miller hold. In particular, there are no taxes and transaction costs. A firm has a policy of paying out 5% of the stock price as dividends. However, an investor would like to receive a 7% dividend. For this, he should:

  A. liquidate 7% of his stock holding after receiving the dividend.

  B. liquidate 2% of his stock holding after receiving the dividend.

  C. use the dividend to buy 2% of the stock after receiving the dividend.

  D. none of these answers.

  Correct Answer: D

  Suppose the investor is holding stocks worth $100. The company then pays $5 as dividends. When the dividend is paid out, the stock price falls to $95 (in the absence of tax effects, as assumed). To increase his income to $7, the investor must sell off stocks worth $2. This corresponds to 2/95 = 2.105% of the post dividend stock holding.

• Question 1207:

  Which of the following statements is incorrect?

  A. NPV can be negative if the IRR is positive.

  B. Assuming a project has normal cash flows, the NPV will be positive if the IRR is less than the cost of capital.

  C. If IRR = k (the cost of capital), then NPV = 0.

  D. If the multiple IRR problem does not exist, any independent project acceptable by the NPV method will also be acceptable by the IRR method.

  E. The NPV method is not affected by the multiple IRR problem.

  Correct Answer: B

  NPV is positive if IRR is greater than the cost of capital.

• Question 1208:

  Anderson Company has four investment opportunities with the following costs (all costs are paid at t=0) and estimated internal rates of return (IRR): Project Cost IRR A $2,000 16.0% B $3,000 14.5 C $5,000 11.5 D $3,000 9.5 The company has a target capital structure, which consists of 40 percent common equity, 40 percent debt, and 20 percent preferred stock. The company has $1,000 in retained earnings. The company expects its year-end dividend to be $3.00 per share. The dividend is expected to grow at a constant rate of 5 percent a year. The company's stock price is currently $42.75. If the company issues new common stock, the company will pay its investment bankers a 10 percent flotation cost. The company can issue corporate bonds with a yield to maturity of 10 percent. The company is in the 35 percent tax bracket. How large can the cost of preferred stock be (including flotation costs) and it still be profitable for the company to invest in all four projects?

  A. 7.75%

  B. 12.68%

  C. 10.46%

  D. 8.90%

  E. 11.54%

  Correct Answer: D

  We need to find k(ps) at the point where all 4 projects are accepted. In other words, the capital budget =

  $2,000 + $3,000 + $5,000 + $3,000 = $13,000. The WACC at that point is equal to IRR(D) = 9.5%.

  Step 1 Find the retained earnings break point to determine whether k(s) or k(e) is used in the WACC

  calculation:

  BP(RE) = $2,500.

  Since the capital budget > the retained earnings break point, k(e) is used in the WACC calculation.

  Step 2 Calculate k(e):

  k(e) = [3.00/$42.75(1-.10)] + 5% = 12.80%.

  Step 3 Find k(ps):

  9.5% = 0.4(10%)(0.65) + 0.2(kps) + 0.4(12.80%)

  9.5% = 2.60% + 0.2(kps) + 5.12%

  1.78% = 0.2k(ps)

  8.90% = k(ps).

• Question 1209:

  Martin Fillmore is a big football star who has been offered contracts by two different teams. The payments (in millions of dollars) he receives under the two contracts are listed below: Team A Team B TimeCash FlowsCash Flows

  08.02.5

  14.04.0

  24.04.0

  34.08.0

  44.08.0

  Fillmore is committed to accepting the contract that provides him with the highest net present value (NPV).

  At what discount rate would he be indifferent between the two contracts?

  A. 16.49%

  B. 10.85%

  C. 11.35%

  D. 19.67%

  E. 21.03%

  Correct Answer: C

  First, find the differential CFs by subtracting Team A CFs from Team B CFs (or vice versa). Enter these into the cash flow register; then solve to find IRR/YR to get the discount rate for which he is indifferent between the two contracts, 11.35% .

• Question 1210:

  Which of the following is/are advantages of stock repurchases?

  I. Stock repurchases increase the price per share by reducing the number of shares.

  II. Stock repurchases are often viewed as a positive signal by investors, raising the intrinsic value of each share and increasing shareholder value.

  III.

  Stock repurchases allow firms to distribute funds to shareholders without raising "sticky" dividends.

  A.

  II only

  B.

  II and III

  C.

  I only

  D.

  I and III

  E.

  I, II and III

  F.

  III only

  G.

  I and II

  Correct Answer: B

  The value of a stock repurchase does not come from a simple reduction in the number of shares outstanding. Remember that for this reduction, the firm must pay out part of its assets in the buy-back process. If such a buyback takes place at a fair price, the shareholder value is completely unaffected, for all you have done is exchanged cash for an equivalent value of common stock. The real wealth increase through a repurchase program arises from real and tangible effects like the interpretation of the program as a positive signal about future prospects. Further, if the management thinks that excess cash reserves are only temporary, then they would be reluctant to raise dividends and add instability to dividend policy. Repurchase programs allow them to distribute excess funds without paying them as dividends.