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

• Question 1311:

  As the debt level rises, the cost of equity increases because:

  A. the probability of default increases.

  B. all of these answers.

  C. the variability of EPS increases.

  D. the financial risk increases.

  Correct Answer: B

  All of the above are reasons why the cost of equity increases as the debt level rises.

• Question 1312:

  Maxvill Motors has annual sales of $15,000. Its variable costs equal 60 percent of its sales, and its fixed costs equal $1,000. If the company's sales increase 10 percent, what will be the percentage increase in the company's earnings before interest and taxes (EBIT)?

  A. 18%

  B. 20%

  C. 16%

  D. 12%

  E. 14%

  Correct Answer: D

  First, find EBIT before sales increase:

  EBIT = Sales - (Sales x VC%) - FC

  = $15,000 - ($15,000 x 0.60) - $1,000

  = $5,000.

  Now, assuming sales increase by 10% or to $15,000 x 1.10 = $16,500, calculate the new EBIT. EBIT =

  $16,500 - ($16,500 x 0.60) - $1,000 = $5,600.

  So, the percentage increase is [($5,600 - $5,000)/$5,000] x 100 = 12%.

• Question 1313:

  Louisiana Enterprises, an all-equity firm, is considering a new capital investment. Analysis has indicated that the proposed investment has a beta of 0.5 and will generate an expected return of 7 percent. The firm currently has a required return of 10.75 percent and a beta of 1.25. The investment, if undertaken, will double the firm's total assets. If k(RF) = 7 percent and the market return is 10 percent, should the firm undertake the investment?

  A. No; the expected return of the asset (7%) is less than the required return (8.5%).

  B. Yes; the expected return of the asset (7%) exceeds the required return (6.5%).

  C. Yes; the beta of the asset will reduce the risk of the firm.

  D. No; the risk of the asset (beta) will increase the firm's beta.

  E. No; the expected return of the asset is less than the firm's required return, which is 10.75%.

  Correct Answer: A

  Calculate the required return and compare to the expected return.

  k(s) = k(RF) + (k(M) - k(RF))b = 0.07 + (0.10 - 0.07)0.5 = 0.085 = 8.5%.

  The expected return of the asset (7%) is less than the required return (8.5%) so the investment should not

  be made.

• Question 1314:

  The process of planning expenditures on assets whose cash flows are expected to extend beyond one year is known as ________.

  A. Net Present Valuing

  B. Capital Budgeting

  C. Optimal Capital Structure

  D. Payback Period

  E. Weighted Average Cost of Capital (WACC)

  Correct Answer: B

  Capital Budgeting is defined as the process of planning expenditures on assets whose cash flows are expected to extend beyond one year.

• Question 1315:

  A portfolio manager with Mally, Feasance, and Company is examining shares of Melton Industries, a large

  industrial firm. Assume the following information:

  Annual Dividend: $0.70

  EPS: $1.65

  Tax Rate: 35%

  Discount Rate: 13.15%

  ROE: 16%

  Using this information, what is the expected growth rate of this firm? Assume that the discount rate, tax

  rate, and ROE are expected to remain stable.

  A. 11.59%

  B. 9.21%

  C. None of these answers

  D. 6.79%

  E. 6.00%

  F. 10.00%

  Correct Answer: B

  To calculate the dividend growth rate, assuming a stable ROE figure, use the following equation: {g = ROE (1 - Dividend Payout Ratio)}. While the ROE figure has been provided, the Dividend Payout Ratio must be calculated manually. To find the Dividend Payout Ratio, divide the annual dividend by the EPS figure, giving the following: {Dividend Payout Ratio = ($0.70/$1.65)}. From this equation, we determine that the Dividend Payout Ratio for this firm is 42.42%. Imputing this figure into the Dividend Growth Rate Equation will yield a growth rate of 9.21% for this firm. As you can see, neither tax rates nor discount rates are incorporated into the calculation.

• Question 1316:

  Clay Industries, a large industrial firm, has just released a new process system allowing mining companies to automate much of their copper extraction procedures. While the sales of this process system are expected to be hugely successful, analysts predict that sales of Clay Industries existing products will decline as a result, as customers substitute the new process system for much of the Clay Industries' older drilling components and non-automated process systems. Which of the following terms most correctly describes the problem faced by Clay Industries?

  A. Externality problem

  B. Diminishing returns problem

  C. Cannibalization

  D. Opportunity cost problem

  E. Incremental sales deterioration

  Correct Answer: C

  When a new product or service takes sales away from existing products or services, this is often referred to as cannibalization (or erosion). While firms naturally do not wish to cannibalize existing products, often if they do not, other firms will begin to erode their market share. The cannibalization problem is frequently considered in the analysis of new releases of products and services.

• Question 1317:

  If the IRS lowers the tax rate applicable to firms in a particular category, the optimal debt ratio for that category will ________.

  A. not be affected

  B. increase

  C. decrease

  D. insufficient information

  Correct Answer: C

  If the tax rate is lower, the tax-deductibility of the interest payments on debt becomes less attractive. The after-tax cost of debt rises, lowering the optimal debt ratio.

• Question 1318:

  A company has an EBIT of $4 million, and its degree of total leverage is 2.4. The firm's debt consists of $20 million in bonds with a 10 percent yield to maturity. The company is considering a new production process that will require an increase in fixed costs but a decrease in variable costs. If adopted, the new process will result in a degree of operating leverage of 1.4. The president wants to keep the degree of total leverage at 2.4. If EBIT remains at $4 million, what amount of bonds must be outstanding to accomplish this (assuming the yield to maturity remains at 10 percent)?

  A. $16.7 million

  B. $18.5 million

  C. $20.1 million

  D. $19.2 million

  E. $19.8 million

  Correct Answer: A

  First, find the new DFL: DTL = (DOL)(DFL)

  2.4 = (1.4)(DFL)

  DFL = 1.7143.

  Then, find the new interest payments in a year:

  DFL = (EBIT)/(EBIT - I)

  1.7143 = ($4,000,000)/($4,000,000 - I)

  I = $1,666,686.11.

  Finally, solve for the new debt level, knowing that the yield to maturity remains at 10%. Debt Value(YTM) =

  Interest Payment

  Debt(0.10) = $1,666,686.11

  Debt = $16,666,861.11 = $16.7 million.

• Question 1319:

  If the expected return on the market portfolio increases, the price of a firm's share ______, all else equal.

  A. can be all of these answers.

  B. is not affected

  C. decreases

  D. increases

  Correct Answer: C

  In the usual notation, Po = D1/(k-g). Therefore, if the expected return on the stock, k, increases and all else remains constant, the price will fall. The expected return on the stock, k, increases if the market's expected rate of return increases.

• Question 1320:

  Lugar Industries is considering an investment in a proposed project which requires an initial expenditure of

  $100,000 at t = 0. This expenditure can be depreciated at the following annual rates:

  tDepreciation Rate

  120%

  232%

  319%

  412%

  511%

  66%

  The project has an economic life of six years. The project's revenues are forecasted to be $90,000 a year.

  The project's operating costs (not including depreciation) are forecasted to be $50,000 a year. After six

  years, the project's estimated pre-tax salvage value is $10,000. The company's WACC is 10 percent, and

  its corporate tax rate is 40 percent. What is the project's net present value (NPV)?

  A. $31,684

  B. $34,667

  C. $45,453

  D. $33,843

  E. $38,840

  Correct Answer: E

  The cash flows for each of the years are as follows: 0-100,000 1 [90,000 - 50,000 -(100,000)(0.20)](1-0.4)+(100,000)(0.20)= 32,000 2 [90,000 - 50,000 -(100,000)(0.32)](1-0.4)+(100,000)(0.32)= 36,800 3 [90,000 - 50,000 -(100,000)(0.19)](1-0.4)+(100,000)(0.19)= 31,600 4 [90,000 - 50,000 -(100,000)(0.12)](1-0.4)+(100,000)(0.12)= 28,800 5 [90,000 - 50,000 -(100,000)(0.11)](1-0.4)+(100,000)(0.11)= 28,400 6 [90,000 - 50,000 -(100,000)(0.06)](1-0.4)+(100,000)(0.06) + (10,000)(1 - 0.4) = 32,400 Enter the cash flows and solve for the NPV = $38,839.56.