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

• Question 1291:

  Which of the following factors in the discounted cash flow approach to estimating the cost of common equity is the least difficult to estimate?

  A. All of these answers are equally difficult to estimate.

  B. Expected rate of return.

  C. Required return.

  D. Dividend yield.

  E. Expected growth rate.

  Correct Answer: D

  It is easy to determine the dividend yield since the dividend and the price of the stock are known. It is more difficult to establish a proper growth rate or beta as required in the other factors.

• Question 1292:

  A firm has to pay 1.5% fee to underwriters when it issues new equity. The firm has a dividend payout ratio of 37% and a return on equity of 13.9%. The firm has just announced earnings of $3.27 per share. If the stock's cost of external equity is 14.9%, how much capital would the firm raise by issuing 6 million shares?

  A. $111.12 million

  B. none of these answers

  C. $98.33 million

  D. $130.55 million

  Correct Answer: D

  IF F is the percentage flotation cost and P is the amount of new equity raised per new share, then

  P = D1/[(Ke - g)(1-F)], where Ke is the cost of external equity and D1 is next year's expected dividend.

  Also, g = ROE*retention ratio = ROE*(1-payout ratio) = 13.9%*(1-37%) = 8.76%. D1 = 3.27*0.37*(1

  +8.76%) = $1.316. Therefore, P = 1.316/[(1-1.5%)*(14.9% - 8.76%) = $21.76. By issuing 6 million shares,

  the firm will therefore raise 6*21.74 = $130.55 million.

• Question 1293:

  Clay Industries, a large industrial firm, is examining the capital structure of one of its Lebanese subsidiaries. The management of Clay Industries has identified the following information: EBIT $1,000,000 EPS $1.88 Interest paid $121,590 Sales $1,940,000 Cost of debt 6.60% Given this information, what is the Degree of Financial Leverage for this operating division?

  A. 1.940

  B. 1.138

  C. 1.551

  D. The Degree of Financial Leverage cannot be calculated from the information provided.

  E. 1.197

  F. 1.063

  Correct Answer: B

  To calculate the DFL, the financial analyst needs to determine the EBIT and interest paid for a predetermined time period. To calculate the Degree of Financial Leverage, the following equation is used: {EBIT/[EBIT - interest paid]}. Incorporating the given information into this equation yields the following: {EBIT $1,000,000 / [EBIT $1,000,000 - interest paid $121,590]}= 1.138. The Degree of Financial Leverage measures the percentage change in EPS which results from a given percentage change in EBIT. Remember that any preferred stock dividends must be incorporated into the DFL calculation, and that the DFL can never be less than one.

• Question 1294:

  Suppose capital gains are taxed at 32% and realized income is taxed at 38%. The tax preference theory implies that as the dividend pay-out ratio is increased, the cost of equity:

  A. increases or decreases.

  B. increases.

  C. remains unaffected.

  D. decreases.

  Correct Answer: B

  Since the capital gains tax rate is lower than the realized income tax rate, investors would prefer to defer the realization of this income through the capital gains component. Hence, increasing the payout ratio will make the stock less attractive and depress the price, raising the cost of equity.

• Question 1295:

  Rapacity Consultants has just finished a project feasibility study for a cash-rich firm at a cost of $3 million. The consultants have concluded after much analysis that the project's cash flows have a net present value of $1.3 million and a payback period of 5.3 years. The firm should:

  A. reject the project since it has a long payback period.

  B. reject the project since it has a negative NPV.

  C. none of these answers.

  D. accept the project since it has a positive NPV.

  Correct Answer: D

  The $3 million spent on consultants represent sunk costs and must be ignored while looking toward the future. In that direction, the project has a positive NPV and should be accepted.

• Question 1296:

  The firm's target capital structure is consistent with which of the following?

  A. Minimum cost of equity.

  B. Maximum earnings per share (EPS).

  C. Minimum cost of debt.

  D. Minimum risk.

  E. Minimum weighted average cost of capital (WACC).

  Correct Answer: E

  The target capital structure is the mix of debt, preferred stock, and common equity with which the firm plans to raise capital.

• Question 1297:

  Consider the following three projects: Project A Initial cash outflow: $1,000,000 Cash inflows as follows t1: $500,000 t2: $450,000 t3: $150,000 t4: $150,000 t5: $150,000 Project B Initial cash outflow: $1,000,000 Cash inflows as follows t1: $150,000 t2: $150,000 t3: $150,000 t4: $450,000 t5: $500,000 Project C Initial cash outflow $1,000,000 Cash inflows as follows t1: $280,000 t2: $280,000 t3: $280,000 t4: $280,000 t5: $280,000 Assuming no taxes, an 8.5% cost of capital, along with a $0.00 salvage value at the end of the fifth year, what is the NPV of each project? Additionally, which of the three projects has the steepest NPV profile?

  A. Project A NPV: $276,837; Project B NPV: $40,334; Project C NPV: $103,380; Project A has a steepest NPV profile

  B. Project A NPV: $ 267,837; Project B NPV: $44,330, Project C NPV: $135,820; Project A has a steepest NPV profile

  C. Project A NPV: $168,513.54 Project B NPV: $40,334; Project C NPV: $103,380; Project B has a steepest NPV profile

  D. Project A NPV: $168,531.54; Project B NPV: $40,334; Project C NPV: $103,380; Project C has a steepest NPV profile

  E. Project A NPV: $168,513.54, Project B NPV: $14,550; Project C NPV: $103,380; Project B has the steepest NPV profile

  F. Project A NPV: $276,837; Project B NPV: $114,550; Project C NPV: $135,820; Project A has a steepest NPV profile

  Correct Answer: C

  Due to the fact that project B is characterized by having the majority of its cash inflows occurring during later time periods, it is more sensitive to changes in the cost of capital. This fact is exemplified by a steeper NPV profile.

• Question 1298:

  Intelligent Semiconductor, a diversified technology company, is considering two mutually-exclusive projects. Assume the following information: Project A Initial cash outlay: ($500,000) t1: $125,000 t2: $125,000 t3: $155,000 t4: $285,000

  Cost of capital 11.35%

  Project B

  Initial cash outlay ($395,000)

  t1: $170,000

  t2: $160,000

  t3: $175,000

  Cost of capital 11.35%

  Assuming no taxes, a $0.00 salvage value at the end of each projects' life, and the ability for each project

  to be replicated identically, identify the superior project according to the Replacement Chain approach.

  Additionally, what is the NPV and IRR of the superior project over the common life?

  A. Project B, NPV $25,577.90, IRR 13.30%

  B. Project A, NPV $18,954.46, IRR 10.33%

  C. Project B, NPV $35, 417.16, IRR 15.67%

  D. Project B, NPV $35,417.16, IRR 13.30%

  E. The Replacement Chain approach cannot be applied to these projects.

  F. Project A, NPV $22,256.14, IRR 12.22%

  Correct Answer: D

  The Replacement Chain, or "Common Life" approach, is a useful analysis method which allows two or more projects with unequal lives to be examined. In the Replacement Chain approach, the lifespans of each project being examined are multiplied in such a way that the resulting projects share a "common life." In this example, Project A has a lifespan of 4 periods, whereas Project B has a lifespan of 3. The common multiple of both is 12, and to transform each project into one which has a twelve period lifespan, multiply project A by 3 and Project B by 4. Doing so will result in the following series of cash flows for Project A: Project A t0 ($500,000) t1: $125,000 t2: $125,000 t3: $155,000 t4: [$285,000 + ($500,000)]=($215,000) t5: $125,000 t6: $125,000 t7: $155,000 t8: [$285,000 + ($500,000)]=($215,000) t9: $125,000 t10 $125,000 t11: $155,000 t12: $285,000 Multiplying project B by 4 will result in the following cash flows: t0 ($395,000) t1: $170,000 t2: $160,000 t3: [$175,000 + ($395,000)]=($220,000) t4: $170,000 t5: $160,000 t6: [$175,000 + ($395,000)]=($220,000) t7: $170,000 t8: $160,000 t9: [$175,000 + ($395,000)]=($220,000) t10: $170,000 t11: $160,000 t12 $175,000 Solving for NPV and IRR will determine that Project B is superior on both figures, with an NPV of $35,417.16, and an IRR of 13.301%. Project A has a NPV of $22,256.14 and an IRR of 12.22%.

• Question 1299:

  International Transport Company is considering building a new facility in Seattle. If the company goes ahead with the project, it will spend $2 million immediately (at t = 0) and another $2 million at the end of Year 1 (t = 1). It will then receive net cash flows of $1 million at the end of Years 2 - 5, and it expects to sell the property for $2 million at the end of Year 6. The company's cost of capital is 12 percent, and it uses the modified IRR criterion for capital budgeting decisions. Which of the following statements is most correct?

  A. The regular IRR is less than the cost of capital. Under this condition, the modified IRR will also be less than the regular IRR.

  B. The project should be accepted because the modified IRR is greater than the cost of capital.

  C. If the regular IRR is less than the cost of capital, then the modified IRR will be greater than the regular IRR. That situation applies in this case.

  D. The project should be rejected because the modified IRR is less than the regular IRR.

  E. Given the data in the problem, the modified IRR criterion indicates that the project should be accepted. However, the NPV is negative. This demonstrates that the modified IRR criterion is not always a valid decision method for projects such as this one.

  Correct Answer: C

  PV(Outflows) = -$2,000,000 - $2,000,000/1.12 = -$3,785,714.

  TV(Inflows) = $1,000,000(FVIFA(12%,4))(1.12) + $2,000,000

  = $1,000,000(4.7793)(1.12) + $2,000,000 = $7,352,816.

  1 + MIRR = [7,352,816/3,785,714]^1/6; MIRR = 11.7%.

  Since the MIRR is less than the cost of capital, the IRR is less than the MIRR.

• Question 1300:

  An investment of $1,000 will return $60 annually forever. What is its internal rate of return?

  A. 6.00%

  B. 60.00%

  C. 16.67%

  D. cannot be determined E. 0.60%

  Correct Answer: A

  $1,000 = $60/Irr; IRR = 0.06 = 6%.