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

• Question 1301:

  Which of the following statements is most correct?

  A. We ideally would like to use historical measures of the component costs from prior financing in estimating the appropriate weighted average cost of capital.

  B. The cost of a new equity issuance could possibly be lower than the cost of retained earnings if the market risk premium and risk-free rate decline by a substantial amount.

  C. None of these statements.

  D. In the weighted average cost of capital calculation, we must adjust the cost of preferred stock for the tax exclusion of 70% of dividend income.

  E. All of these statements.

  Correct Answer: C

  Unlike interest expense on debt, preferred dividends are not deductible, hence there are no tax savings associated with the use of preferred stock. The component costs of WACC should reflect the costs of new financing not historical measures. The cost of issuing new equity is always greater than the cost of retained earnings because of the existence of flotation costs.

• Question 1302:

  Stock dividends

  A. must be accompanied by cash dividends.

  B. are similar to stock splits in that they do not change the fundamental position of current shareholders.

  C. have the same effects on financial statements as cash dividends.

  D. are viewed unfavorably by investors and thus should not be used.

  E. have no effect on a firm's balance sheet.

  Correct Answer: B

  Stock dividends are dividends paid in the form of additional shares of stock rather than in cash. The total number of shares is increased, so earnings, dividends, and price per share all decline. Stock dividends that are used on a regular basis will keep the stock price more or less constrained, that is, within a desired trading range.

• Question 1303:

  Given the following net cash flows, determine the IRR of the project: TimeNet cash flow 0$1,520 1-1,000 2-1,500

  A. 36%

  B. 28%

  C. 32%

  D. 24%

  E. 20%

  Correct Answer: D

  Time line:

  0123 Periods

  1,520-1,000-1,500500

  Financial calculator solution: Using cash flows,

  Inputs: CF(0) = 1,520; CF(1) = -1,000; CF(2) = -1,500; CF(3) = 500.

  Output: IRR% = 23.98%.

• Question 1304:

  As the director of capital budgeting for Denver Corporation, you are evaluating two mutually exclusive projects with the following net cash flows: YearProject XProject Z 0-$100,000-$100,000 150,000 10,000 240,000 30,000 330,000 40,000 410,000 60,000 If Denver's cost of capital is 15 percent, which project would you choose?

  A. Project Z, since it has the higher NPV.

  B. Project X, since it has the higher NPV.

  C. Neither project.

  D. Project X, since it has the higher IRR.

  E. Project Z, since it has the higher IRR.

  Correct Answer: C

  (In thousands)

  NPV(X) = -100 + 50(PVIF(15%,1)) + 40(PVIF(15%,2)) + 30(PVIF(15%,3)) + 10(PVIF(15%,4)) = -100 + 50

  (0.8696) + 40(0.7561) + 30(0.6575) + 10(0.5718) = -0.833 = -$833. NPVZ = -100 + 10(PVIF(15%,1)) + 30

  (PVIF(15%,2)) + 40(PVIF(15%,3)) + 60(PVIF(15%,4)) = -100 + 10(0.8696) + 30(0.7561) + 40(0.6575) + 60

  (0.5718) = -8.013 = -$8,013.

  At a cost of capital of 15%, both projects have negative NPVs and, thus, both would be rejected.

• Question 1305:

  Which of the following statements is most correct?

  A. Suppose a firm is losing money and thus, is not paying taxes, and that this situation is expected to persist for a few years whether or not the firm uses debt financing. Thus the firm's after-tax cost of debt will equal its before-tax cost of debt.

  B. The bond-yield-plus-risk-premium approach to estimating a firm's cost of common equity involves adding a subjectively determined risk-premium to the market risk-free bond rate.

  C. The reason that a cost of capital is assigned to retained earnings is because these funds are already earning a return in the business, the reason does not involve the opportunity cost principle.

  D. The component cost of preferred stock is expressed as k(ps)(1 - T), because preferred stock dividends are treated as fixed charges, similar to the treatment of debt interest.

  E. All of these statements are false.

  Correct Answer: A

  Obviously if the firm is paying no taxes, its after-tax cost of debt will equal its before-tax cost of debt.

• Question 1306:

  Firms with higher operating leverage tend to have _______ financial leverage.

  A. lower

  B. same

  C. higher or lower (since the two are not related).

  D. higher

  Correct Answer: A

  Firms with higher operating leverage have a higher fraction of costs in the form of fixed costs and hence, have a higher business risk. This makes them more averse to debt. Consequently, firms with higher operating leverage tend to have lower D/E ratios i.e. lower financial leverage.

• Question 1307:

  The percentage mix of debt, preferred stock and common equity that maximizes a firm's stock price is known as:

  A. Composite Cost of Capital (CCC)

  B. Security Market Line

  C. Weighted Average Cost of Capital (WACC)

  D. Target (Optimal) Capital Structure

  E. Least Cost Structure

  F. Efficient Frontier

  Correct Answer: D

  The Target (Optimal) Capital Structure is defined as the percentages of debt, preferred stock, and common equity that will maximize the firm's stock price.

• Question 1308:

  Flood Motors is an all-equity firm with 200,000 shares outstanding. The company's EBIT is $2,000,000 and is expected to remain constant over time. The company pays out all of its earnings each year, so its earnings per share equals its dividends per share. The company's tax rate is 40 percent. The company is considering issuing $2 million worth of bonds (at par) and using the proceeds for a stock repurchase. If issued, the bonds would have an estimated yield to maturity of 10 percent. The risk-free rate in the economy is 6.6 percent, and the market risk premium is 6 percent. The company's beta is currently 0.9, but its investment banker's estimate that the company's beta would rise to 1.1 if they proceed with the recapitalization. Assume that the shares are repurchased at a price equal to the stock market price prior to the recapitalization. What would be the company's stock price following the recapitalization?

  A. $53.85

  B. $51.14

  C. $76.03

  D. $56.02

  E. $68.97

  Correct Answer: B

  First, find the company's current cost of capital, dividends per share, and stock price: k = 0.066 + (0.06)0.9 = 12%. To find the stock price, you still need the dividends per share or DPS = ($2,000,000 (1 0.4))/200,000 = $6.00. Thus, the stock price is Po = $6.00/0.12 = $50.00. Thus, by issuing $2,000,000 in new debt the company can repurchase $2,000,000/$50.00 = 40,000 shares. Now after recapitalization, the new cost of capital, DPS, and stock price can be found: k = 0.066 + (0.06)1.1 = 13.20%. DPS for the remaining (200,000 - 40,000) = 160,000 shares are thus [($2,000,000 - ($2,000,000 x 0.10))(1 0.4)]/160,000 = $6.75. And, finally, Po = $6.75/0.132 = $51.14.

• Question 1309:

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

  I. If investors are not indifferent between dividends and capital gains, regular repurchase programs could drive them away.

  II. The IRS could tax the firm for improper accumulation of capital gains if it felt regular repurchase programs had taken the place of dividends.

  III.

  The firm might end up paying a higher than fair price if it commits to a repurchase program.

  A.

  II and III

  B.

  I and III

  C.

  III only

  D.

  II only

  E.

  I only

  F.

  I, II and III

  Correct Answer: F

  If shareholders are not indifferent between dividends and capital gains, the stock price might increase more with dividends. This is because cash dividends are generally made very regularly, while stock repurchases are irregularly made. Although this has been rarely done for public corporations, the IRS can impose a tax if it believes regular repurchases are being made to avoid paying dividends. If a company's shares are thinly traded, and the firm wishes to repurchase a large number of shares, it could bid up the stock price above the equilibrium price and overpay for the shares.

• Question 1310:

  All else equal, which of the following is/are true about break-even point?

  I. An increase in the sale price per unit increases the break-even quantity.

  II. An increase in the variable cost per unit increases the break-even quantity.

  III.

  An increase in the fixed costs increases the break-even quantity.

  A.

  III only

  B.

  I and II

  C.

  I only

  D.

  II and III

  E.

  I, II and III

  F.

  II only

  G.

  I and III

  Correct Answer: D

  The break-even quantity is the number of units that must be sold to just cover the fixed and variable costs. An increase in revenues per unit will decrease the break-even quantity while an increase in costs per unit will increase the break-even quantity.