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

• Question 1211:

  Consider the following information for Company ABC:

  Current Price of Stock $25.5

  Expected dividend in 1 Year $1.00

  Growth rate 8.0%

  Beta 1.2

  Risk Free Rate 4.5%

  Calculate this company's cost of retained earnings using the Discounted Cash Flow (DCF) method.

  A. 13.30%

  B. 8.0%

  C. 12.0%

  D. 11.92%

  E. 12.2%

  Correct Answer: D

  The DCF method for estimating the cost of retained earnings states: Cost of Retained Earnings = (Dividend for period 1 / Current Price) + Growth Rate. In this case the estimated Cost of Retained Earnings = (1 / 25.5) + 8.0% = 3.92 + 8.00 = 11.92%

• Question 1212:

  If you know that your firm is facing relatively poor prospects but needs new capital, and you know that investors do not have this information, signaling theory would predict that you would

  A. postpone going into capital markets until your firm's prospects improve.

  B. be indifferent between issuing debt and equity.

  C. issue debt to maintain the returns of equity holders.

  D. issue equity to share the burden of decreased equity returns between old and new shareholders.

  E. convey your inside information to investors using the media to eliminate the information asymmetry.

  Correct Answer: D

  The announcement of a stock offering is generally taken as a signal that the firm's prospects as seen by its management are not bright.

• Question 1213:

  Your assistant has just completed an analysis of two mutually exclusive projects. You must now take her report to a board of directors meeting and present the alternatives for the board's consideration. To help you with your presentation, your assistant also constructed a graph with NPV profiles for the two projects. However, she forgot to label the profiles, so you do not know which line applies to which project. Of the following statements regarding the profiles, which one is most reasonable?

  A. If one of the projects has a NPV profile which crosses the X-axis twice, hence the project appears to have two IRRs, your assistant must have made a mistake.

  B. If the two projects' NPV profiles cross once, in the upper left quadrant, at a discount rate of minus 10 percent, then there will probably not be a NPV versus IRR conflict, irrespective of the relative sizes of the two projects, in any meaningful, practical sense (that is, a conflict which will affect the actual investment decision).

  C. If the two projects both have a single outlay at t = 0, followed by a series of positive cash inflows, and if their NPV profiles cross in the lower left quadrant, then one of the projects should be accepted. Both would be accepted if they were not mutually exclusive.

  D. Whenever a conflict between NPV and IRR exist, then, if the two projects have the same initial cost, the one with the steeper NPV profile probably has less rapid cash flows. However, if they have identical cash flow patterns, then the one with the steeper profile probably has the lower initial cost.

  E. If the two projects have the same investment cost, and if their NPV profiles cross once in the upper right quadrant, at a discount rate of 40 percent, this suggests that a NPV versus IRR conflict is not likely to exist.

  Correct Answer: B

  A conflict will exist if the cost of capital is less than the crossover rate. In this case the cost of capital must be greater than minus 10 percent and, therefore, there will probably not be a NPV versus IRR conflict.

• Question 1214:

  Martin Corporation currently sells 180,000 units per year at a price of $7.00 per unit; its variable cost is $4.20 per unit; and fixed costs are $400,000. Martin is considering expanding into two additional states which would increase its fixed costs to $650,000 and would increase its variable unit cost to an average of $4.48 per unit. If Martin expands it expects to sell 270,000 units at $7.00 per unit. By how much will Martin's break-even sales dollar level change?

  A. $910,667

  B. $183,333

  C. $456,500

  D. $1,200,000 E. $805,556

  Correct Answer: E

  Calculate the initial breakeven volume in dollars:

  Old S(BE) = FC/(1-(VC/S)) = $400,000/1-(4.20/7.00) = $1,000,000.

  Calculate the new breakeven volume in sales dollars:

  New S(BE) = FC/(1-(VC/S)) $650,000/1-(4.48/7.00) = $1,805,556.

  The increase in SB = $1,805,556 - $1,000,000 = $805,556.

• Question 1215:

  When a firm uses no debt,

  A. its financial risk equals its business risk.

  B. its business risk equals the market risk.

  C. all of these answers.

  D. its ROA equals its ROE.

  Correct Answer: D

  With no debt, total capital equals total equity, giving ROA = ROE. Note that without debt, financial risk is zero since financial risk is defined as the additional risk caused due to debt in the capital structure. Market risk is the systematic risk arising from the correlation of the firm's stock price with the market and is different from business risk.

• Question 1216:

  It has been observed in the market that most of the increases in dividends are followed by an increase in the stock price and vice-versa. This implies that:

  I. at least one of the MandM assumptions must be false.

  II. there must be signaling effects involved.

  III.

  investors are behaving irrationally.

  A.

  II only

  B.

  III only

  C.

  I, II and III

  D.

  II and III

  E.

  I and II

  F.

  I only

  Correct Answer: F

  If all of the MandM assumptions held, a change in dividend policy would not cause the stock price to change; dividend policy would be irrelevant. However, one does not necessarily need signaling effects to account for market behavior. Other theories like the Bird-in-the-Hand theories can also explain the phenomenon in the presence of transaction costs. In itself, then, the phenomenon does not imply that the market is behaving irrationally.

• Question 1217:

  Which of the following is/are true about operating cash flows of a project?

  I. The annual operating cash flow equals operating income minus net non-cash expenses.

  II. Financing costs are excluded from the operating cash flows.

  III.

  Project evaluation is based on net cash flows, not net income.

  A.

  III only

  B.

  I, II and III

  C.

  I only

  D.

  II and III

  E.

  I and III

  F.

  II only

  G.

  I and II

  Correct Answer: D

  The annual operating cash flow equals operating income plus net non-cash expenses. Financing costs are excluded since they are accounted for in the discounting process through the use of WACC.

• Question 1218:

  Vanderheiden Inc. is considering two average-risk alternative ways of producing its patented polo shirts. Process S has a cost of $8,000 and will produce net cash flows of $5,000 per year for 2 years. Process L will cost $11,500 and will produce cash flows of $4,000 per year for 4 years. The company has a contract that requires it to produce the shirts for 4 years, but the patent will expire after 4 years, so the shirts will not be produced after 4 years. Inflation is expected to be zero during the next 4 years. If cash inflows occur at the end of each year, and if Vanderheiden's cost of capital is 10 percent, by what amount will the better project increase Vanderheiden's value?

  A. $1,179.46

  B. $1,237.76

  C. $677.69

  D. $1,312.31

  E. $1,098.89

  Correct Answer: B

  0 k = 10%1234 S -8,0005,0005,0005,0005,000 -8,000 -3,000 IRR(S) = 16.26%. NPV(S) = $1,237.76. (extended NPV) 0 k = 10%1234 L -11,5004,0004,0004,0004,000 IRR(L) = 14.66%. NPV(L) = $1,179.46.

• Question 1219:

  Intelligent Semiconductor, a diversified technology company, is evaluating the sales of its cadmium silicon transistor coils, and has identified the following information: Fixed production costs for these transistors are $800,000 Average sales price per unit is $505.50 Break-even quantity of 4,084 Which of the following best describes the average variable cost for this product?

  A. $424.16

  B. $195.89

  C. $20.84

  D. $309.61

  E. The average variable cost cannot be determined from the information provided.

  Correct Answer: D

  To calculate the break-even quantity for a product, use the following equation: {Fixed operating costs/[avg. sales price per unit - variable cost per unit]}. To determine the average variable cost of this product, we must rearrange the standard equation using algebra, in a manner such that the resulting equation resembles the following: {[$800,000/4,084] + X = $505.50}. This equation is further rearranged into the following: {$195.89 + X = $505.50}. Finally, the ending equation becomes:{X = $505.50 - $195.89}. Solving for X yields an average variable cost per unit of $309.61.

• Question 1220:

  A financial analyst with Mally, Feasance and Company is examining shares of Microscam International.

  Assume the following information:

  Retention Rate: 72%

  EPS: $2.16

  Growth Rate: 21%

  Discount Rate: 14.50%

  Tax Rate: 35%

  Using this information, what is the ROE for Microscam International?

  A. 5.88%

  B. 15.12%

  C. 56.88%

  D. 33.40%

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

  F. 29.17%

  Correct Answer: F

  To determine the ROE for Intelligent, the equation used to determine the dividend growth rate must be manipulated. The dividend growth rate equation to be used is originally structured as follows: {g = ROE(1 Dividend Payout Ratio)}. The original equation must be rearranged using algebra, and will yield the following: {ROE = g / Retention Rate of Dividends}. Imputing the given information into this equation will yield the following:

  {ROE = 0.21 / 0.72}.

  Solving for ROE will yield a figure of 29.17%.

  As you can see, neither the discount rate nor the tax rate is incorporated into the equation. Additionally,

  remember that (1 - Dividend Payout Ratio) is the same thing as the Retention Rate of Dividends.