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

• Question 1221:

  Congress considered a tax plan that would reduce capital gains tax rates from the existing levels. The current maximum capital gains rate is 28 percent compared with a maximum rate of 31 percent for ordinary personal income. With this tax bill, which of the following statements is least correct for an investor in a high personal tax bracket?

  A. A 2-for-1 stock split is announced for a stock that the investor currently holds. The company had split the stock because the stock price had increased beyond the desired price range and is expected to continue to grow. This is good news to the investor because it means that any gains from increased stock value will be taxed at a new lower capital gains rate when the stock is sold.

  B. None of these statements are correct.

  C. One of the companies in the investor's portfolio recently announced that it will embark on a stock repurchase plan. The lower capital gains tax rate will reduce the investor's taxes if he/she decides to tender some shares of stock in the company.

  D. All of these statements are correct.

  E. The stock of a company that pays high cash dividends and has a dividend reinvestment plan (DRIP) is a good investment for this individual because he/she will receive more money that can then be reinvested in the company's stock.

  Correct Answer: E

  In a dividend reinvestment plan, the stockholder must pay taxes on the dividend amount, even though stock and not cash has been received.

• Question 1222:

  Intelligent Semiconductor is considering the development of a new data storage medium, which will allow tremendous increases in the efficiency of its customer's high-end server lines. The development of the new system will take place in Intelligent's existing facilities, and the storage costs for the additional equipment are expected to be residual in nature. The following information applies to this project: Rent expense for existing facilities ($10,500) Initial cash outlay ($50,000) t1: $15,000 t2: $11,000 t3: $11,000 t4: $15,000 t5 $25,000 Discount rate: 9% Assuming no taxes or related charges, that the initial cash outlay does not include any sunk costs, and a $0.00 salvage value at after the fifth year, which of the following choices best represents the payback period for this investment?

  A. 4 years

  B. 3.75 years

  C. 3.13 years

  D. 3.87 years

  E. 4.23 years

  Correct Answer: D

  Remember that the rental expense of the firm's existing facilities is a sunk cost, and should not be incorporated into the calculation. This is due to the fact that the rental expense is not incremental in nature, and is unaffected by the acceptance of the project in question. In this example, the payback period is approximately 3.87 years. After the third year, $37,000 of the initial $50,000 investment has been recouped, leaving $13,000 to be recovered. The following period has a cash inflow of $15,000, exceeding the $13,000 amount required to completely "pay back" the initial investment. To calculate the period required, divide the $13,000 left to be recouped by the $15,000 cash inflow during period 4. This will yield an answer of 0.8667, which is added to the three-year period already passed, giving an answer of 3.87 years. While somewhat appealing in a simplistic sense, the payback period is not an advisable method for valuation and analysis of capital projects, primarily due to the fact that this method completely ignores the time value of money principle which governs the field of finance.

• Question 1223:

  Two projects being considered are mutually exclusive and have the following projected cash flows: Year Project A Project B 0-$50,000-$50,000 115,9900 215,9900 315,9900 415,9900 515,990100,560 At what rate (approximately) do the NPV profiles of Projects A and B cross?

  A. The NPV profiles of these two projects do not cross.

  B. 11.5%

  C. 6.5%

  D. 16.5%

  E. 20.0%

  Correct Answer: B

  Solve for numerical PVIFA and PVIF and obtain corresponding interest rates from table. Project A:50,000 =

  15,990(PVIFA(Irr,5))

  3.12695 = PVIFA(IrrA,5)

  IRR(A) = 18%

  Project B:50,000 = 100,560(PVIF(IrrB,5)0

  0.49722 = PVIF(IrrB,5)

  IRR(B) = 15%

  Solving for the crossover rate of 11.49% requires interpolation, which is not covered in the text. However,

  by using trial and error and an NPV profile drawing, the student can select the correct multiple choice

  answer, 11.5%. Drawing an NPV profile drawing using the calculated IRRs, and the NPVs at k = 0%,

  shows that there is a crossover rate. Of the responses listed in the problem, 16.5% and 20.0% are clearly

  too high, since the IRR(B) is 15%. At k = 6.5% the NPVs are not equal, thus 11.5% must be the correct

  response.

• Question 1224:

  Your company's stock sells for $50 per share, its last dividend was $2.00, its growth rate is a constant 5 percent, and the company would incur a flotation cost of 15 percent if it sold new common stock. Net income for the coming year is expected to be $500,000, the firm's payout ratio is 60 percent, and its common equity ratio is 30 percent. If the firm has a capital budget of $1,000,000, what component cost of common equity will be built into the WACC for the last dollar of capital the company raises?

  A. 12.30%

  B. 11.75%

  C. 10.50%

  D. 9.94%

  E. 9.20%

  Correct Answer: D

  BP(RE) = RE/Equity fraction = $500,000(0.4)/0.3 = $666,667. BP = break point; RE = retained earnings Since the capital budget will be $1 million, and since all equity in the WACC beyond $666,667 will be external equity, the WACC of the last dollar raised will include equity at a cost of k(e): k(e) = $2(1.05)/$50(1 - 0.15) + .05 = 9.94%.

• Question 1225:

  Consider the following characteristics of firm XYZ:

  Stock price $50

  Annual dividend $2

  Debt rate 10%

  Equity floatation cost 7%

  Tax rate 40%

  Preferred Stock Par value $100

  What is the firm's after tax cost of debt?

  A. 60%

  B. 4.3%

  C. 10%

  D. 40%

  E. 6%

  F. 4%

  G. 5%

  Correct Answer: E

  A firm's after tax cost of debt may be calculated using the following formula: After Tax Cost of Debt = Cost of Debt x (1 - Tax Rate). In this case the After Tax Cost of Debt = 10% x (1 - 40%) = 10% x 60% = 6%.

• Question 1226:

  The Oneonta Chemical Company is evaluating two mutually exclusive pollution control systems. Since the company's revenue stream will not be affected by the choice of control systems, the projects are being evaluated by finding the PV of each set of costs. The firm's required rate of return is 13 percent, and it adds or subtracts 3 percentage points to adjust for project risk differences. System A is judged to be a high-risk project (it might end up costing much more to operate than is expected). System A's risk-adjusted cost of capital is

  A. 16 percent; since A is more risky, its cash flows should be discounted at a higher rate, because this correctly penalizes the project for its high risk.

  B. indeterminate, or, more accurately, irrelevant, because for such projects we would simply select the process that meets the requirements with the lowest required investment.

  C. 13 percent; the firms cost of capital should not be adjusted when evaluating outflow only projects.

  D. somewhere between 10 percent and 16 percent, with the answer depending on the riskiness of the relevant inflows.

  E. 10 percent; this might seem illogical at first, but it correctly adjusts for risk where outflows, rather than inflows, are being discounted.

  Correct Answer: E

  k(A) = 13% - 3% = 10%. If the cash flows are cost only outflows, and the analyst wants to correctly reflect their risk, the discount rate should be adjusted downward (in this case by subtracting 3 percentage points) to make the discounted flows comparatively larger.

• Question 1227:

  Which of the following projects is likely to have multiple Internal Rates of Return? Project A Initial investment outlay: ($1,000,000) t1: $400,000 t2: $100 t3: $1,000,000 t4: $1,000,000 t5: $100 t6: $0.00 Project B Initial investment outlay: ($1,000,000) t1: $40,000 t2: $90,000 t3: $590,000 t4: ($105,000) t5: ($10,000) t6: $900,000 Project C Initial investment outlay: ($500,000) t1: $100,000 t2: $100,000 t3: $100,000 t4: $100,000 t5: $0.00 t6: $500,000 Project D Initial investment outlay: ($500,000) t1: $105,000 t2: ($40,000) t3: $45,000) t4: $400,000 t5: $400,000 t6: $65,000

  A. None of these answers

  B. Both Project B and D likely to have multiple IRRs

  C. Project C

  D. Project D

  E. Project B

  F. Project A

  Correct Answer: B

  In evaluating projects with "non-normal cash flows" the Internal Rate of Return method will often produce multiple IRRs which leads to an incorrect accept/reject decision. Non-normal cash flows are defined as cash flows in which the sign changes more than once. Projects B and D involve cash outflows superimposed within the cash inflows, resulting in a sign change from positive to negative and negative to positive. In examining projects such as this, it is advisable to use either the NPV or MIRR methods. From observation alone, we can determine that project B and D are non-normal projects, and are thus likely to result in multiple IRR calculations. While projects A and C do involve periods of zero cash flow, this will not interfere with the IRR calculation to the extent of producing multiple IRRs.

• Question 1228:

  The market risk of a project is measured by:

  A. the project's impact on the systematic risk of the firm's stock.

  B. the variability of the project's projected returns.

  C. the project's impact on the uncertainty about the firm's future earnings.

  D. the project's impact on the unsystematic risk of the firm's stock.

  Correct Answer: A

  Remember that it is the systematic risk that you must worry about.

• Question 1229:

  Pickles Corp. is a company which sells bottled iced tea. The company is thinking about expanding its operations into the bottled lemonade business. Which of the following factors should the company incorporate into its capital budgeting decision as it decides whether or not to enter the lemonade business?

  A. All of the statements are correct.

  B. If the company doesn't produce lemonade, it can lease the building to another company and receive after-tax cash flows of $500,000 a year.

  C. The company will spend $3 million to renovate a building for the proposed project.

  D. If the company enters the lemonade business, its iced tea sales are expected to fall 5 percent as some consumers switch from iced tea to lemonade.

  E. None of the statements are correct.

  Correct Answer: A

  These are all incremental cash flows and should be considered.

• Question 1230:

  A company is analyzing two mutually exclusive projects, S and L, whose cash flows are shown below: Years01234 S-1,1009003505010 L-1,1000300500850 The company's cost of capital is 12 percent, and it can get an unlimited amount of capital at that cost. What is the regular IRR (not MIRR) of the better project?

  A. 12.00%

  B. 13.09%

  C. 17.46%

  D. 12.53%

  E. 13.88%

  Correct Answer: B

  Time line:

  0 k = 12%1234 Years

  Cash flows S -1,1009003505010

  NPV(S) = ? IRR(S) = ?

  Cash flows L -1,1000300500850

  NPV(L) = ? IRR(L) = ?

  Financial calculator solution:

  Calculate the NPV and IRR of each project then select the IRR of the higher NPV project Project S; Inputs:

  CF(0) = -1,100; CF(1) = 900; CF(2) = 350; CF(3) = 50; CF(4) = 10; I = 12 Output: NPV(S) = 24.53; IRR(S)

  = 13.88%.

  Project L; Inputs: CF(0) = -1,100; CF(1) = 0; CF(2) = 300; CF(3) = 500; CF(4) = 850; I = 12

  Output: NPVL = 35.24; IRR(L) = 13.09%.

  Project L has the higher NPV and its IRR = 13.09%.