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

• Question 1331:

  Clay Industries, a large industrial firm, is evaluating the sales of its existing line of coiled machine tubing. In their analysis, the operating managers of Clay Industries have identified the following information related to the coiled machine tubing division and its product: Annual fixed operating expenses of $925,000 Average variable cost of $90 Break-even quantity of 20,109 units Which of the following best describes the average variable cost for this product?

  A. $44

  B. None of these answers is correct.

  C. $46

  D. $41.70

  E. $38

  F. The average selling price of this product cannot be determined from the information provided.

  Correct Answer: A

  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 selling price of this product, we must rearrange the standard equation using algebra, in a manner such that the resulting equation resembles the following: {[$925,000/20,109] + X = $90}. This equation is further rearranged into the following: {$46 + X = $90}. Finally, the ending equation becomes: {X = $90 - $46}. Solving for X yields an average variable cost per unit of $44.

• Question 1332:

  Stromburg Corporation makes surveillance equipment for intelligence organizations. Its sales are $75,000,000. Fixed costs, including research and development, are $40,000,000, while variable costs amount to 30 percent of sales. Stromburg plans an expansion which will generate additional fixed costs of $15,000,000, decrease variable costs to 25 percent of sales, and also permit sales to increase to $100,000,000. What is Stromburg's degree of operating leverage at the new projected sales level?

  A. 3.50

  B. 3.33

  C. 4.67

  D. 4.20

  E. 3.75

  Correct Answer: E

  Calculate DOL using new sales, new variable cost percentage, and new fixed costs: (In millions) DOL(S) = S-VC/S-VC-FC = $100-$25/($100-$25-$55) = 3.75.

• Question 1333:

  A stock has a beta of 0.44 and the market risk premium is 7.9%. Its dividend growth rate is 4.25% and its P/E ratio is 8.7. If the firm has a dividend payout ratio of 70%, the risk-free rate equals ________.

  A. 6.81%

  B. 7.12%

  C. 8.82%

  D. 4.56%

  Correct Answer: C

  Po/E1 = dividend payout/(k - g) Therefore, 8.7 = 0.7/(k - 0.0425), giving expected return = k = 12.3%. Now, the CAPM expected return on the stock is given by k = Rf + beta*(Rm - Rf). Therefore, 12.3% = Rf + 0.44*7.9%, giving risk-free rate = 8.82%.

• Question 1334:

  Which of the following may be used as mechanisms to motivate managers to act in the best interest of the stockholders?

  I. Managerial compensation

  II. Direct stockholder intervention

  III. Threat of firing

  IV.

  Threat of takeover

  A.

  IV only

  B.

  I only

  C.

  I, II, III and IV

  D.

  III only

  E.

  I, II and III

  F.

  II only

  Correct Answer: C

  Managerial compensation may be designed to not only attract and retain the best managerial talent for a firm, but also to align the management's action with the interest of the shareholders. Direct intervention is another mechanism that may be used to motivate management into acting in the owner's best interest. This in practice is executed with a wide degree of success. The threat of firing may also be used as well as the threat of hostile takeovers. The threat of a hostile takeover is strongest when a company is under performing and/or its stock is undervalued.

• Question 1335:

  Martin Corporation's common stock is currently selling for $50 per share. The current dividend is $2.00 per share. If dividends are expected to grow at 6 percent per year and if flotation costs are 10 percent, then what is the firm's cost of retained earnings and what is its cost of new common stock?

  A. 10.71%; 10.24%

  B. 10.24%; 10.71%

  C. 11.38%; 10.71%

  D. 10.24%; 11.38%

  E. 9.31%; 9.86%

  Correct Answer: B

  Cost of retained earnings: k(s) = $2.12/$50 + 0.06 = 10.24%. Cost of new common equity: k(e) = $2.12/($50(1-.10)) + 0.06 = 10.71%.

• Question 1336:

  Which of the following types of risk can be reduced through diversification? Choose the best answer.

  I. Stand-alone risk

  II. Unsystematic risk

  III. Systematic risk

  IV.

  Market risk

  V.

  Beta risk

  VI.

  Diversifiable risk

  A.

  I, III, VI

  B.

  I, VI

  C.

  II, III, V

  D.

  I, II, VI

  E.

  II, III, V, VI

  Correct Answer: D

  Of the risks listed, only unsystematic and stand-alone risk are diversifiable. Unsystematic risk is also referred to as "diversifiable risk," therefore answer VI is correct. Stand-alone risk is defined as the variability of an asset's expected returns if it were the only asset of a firm and the stock of that firm is the only security in an investor's portfolio. This type of risk is definitively reduced through diversification, and is commonly referred to as "unsystematic risk." Systematic risk measures that part of an assets risk that is inherent regardless of the level of diversification, and is measured by the Beta coefficient. Systematic risk is also referred to as "market risk" and "beta risk." Corporate risk is defined as the variability of an asset's expected returns without taking into consideration the effects of shareholder diversification. This is one step away from Stand-alone Risk, which measures the risk of an asset not only without taking into consideration the effect of shareholder diversification, but of company diversification as well. Stand-alone risk assumes that the asset in question is the only asset of the firm and that the securities of the firm are the only asset in investors' portfolios. Corporate risk takes into consideration that firms will diversify their asset bases.

• Question 1337:

  The Mike and Laurie Consulting Group Inc. is trying to decide which computer system to purchase. They can purchase state-of-the-art equipment for $20,000, which they expect to generate cash flows of $6,000 at the end of each of the next 6 years. Alternatively, they can spend $12,000 for equipment that can be used for 3 years and generates cash flows of $6,000 at the end of each year. If the company'scost of capital is 10 percent and both "projects" can be repeated indefinitely, then what is the equivalent annual annuity (EAA) of the more profitable strategy?

  A. $2,423.74

  B. $1,407.85

  C. $1,666.67

  D. $6,131.56

  E. $1,174.62

  Correct Answer: B

  First, compute the NPV of each project over its initial life. The relevant cash flows for the state-of-the- art

  equipment are CF(0) = -$20,000 and CF(1-6) = $6,000. Discounting at 10 percent yields NPV = $6,131.56.

  The relevant CFs for the less advanced equipment are CF(0) = -$12,000 and CF(1-3) = $6,000.

  Discounting again at 10 percent yields NPV = $2,921.11. Next, find the EAA of each project as follows:

  EAA for the state-of-the-art equipment: N = 6; I/YR = 10; PV = -6,131.56, FV = 0; solve for PMT = EAA =

  $1,407.85. EAA less advanced: N = 3; I/YR = 10; PV = $2,921.11; FV = 0; solve for PMT = EAA =

  $1,174.62.

  Thus, the state-of-the-art project is more profitable.

• Question 1338:

  The "degree of leverage" concept is designed to show how changes in sales will affect EBIT and EPS. If a 10 percent increase in sales causes EPS to increase from $1.00 to $1.50, and if the firm uses no debt, then what is its degree of operating leverage?

  A. 4.2

  B. 3.6

  C. 4.7

  D. 5.0

  E. 5.5

  Correct Answer: D

  These two equations could be used:

  DTL = (DOL)(DFL).

  EPS(1) = EPS(0)[1 + (DTL)(%Change Sales)].

  Note that EPS rises by 50 percent, from $1.00 to $1.50, on a 10 percent increase in sales, so

  1.50 = 1.00[1 + (DTL)(0.1)]

  1.50 = 1 + 0.1 DTL

  0.1 DTL = 0.50

  DTL = 5.00.

  Now DTL = 5 = (DOL)(DFL)

  But if Debt = 0, then DFL = 1, so DOL = DTL = 5.0.

• Question 1339:

  Clay Industries, a large industrial firm, is considering the development of an underwater drilling system which will greatly increase the productivity of deep-sea petroleum extraction. However, the development of the system involves substantial setup and implementation costs. If Clay Industries chooses to begin developing the new system, the firm will be forced to decline several other promising projects, due to a lack of available investment capital. Which of the following terms most correctly describes the problem faced by Clay Industries?

  A. Diminishing returns problem

  B. Marginal cost problem

  C. Principal/agent problem

  D. Opportunity cost problem E. Externality problem

  Correct Answer: D

  In this example, Clay Industries is faced with several mutually-exclusive projects. If the firm begins to develop the underwater drilling system, it will be forced to decline the acceptance of other projects. This is an opportunity cost problem.

• Question 1340:

  Which of the following statements is most correct?

  A. When comparing two projects, the project with the higher IRR will also have the higher MIRR.

  B. Both IRR and MIRR can produce multiple rates of return.

  C. The modified internal rate of return (MIRR) of a project increases as the cost of capital increases.

  D. All of these statements are correct.

  E. The internal rate of return (IRR) of a project increases as the cost of capital increases.

  Correct Answer: C

  The MIRR is dependent on the cost of capital. As the cost of capital increases, so does the terminal value. Because the MIRR is the rate, which equates the PV with the terminal value, the MIRR increases as the terminal value increases.