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

• Question 1341:

  Copybold Corporation is a start-up firm considering two alternative capital structures--one is conservative and the other aggressive. The conservative capital structure calls for a D/A ratio = 0.25, while the aggressive strategy call for D/A = 0.75. Once the firm selects its target capital structure it envisions two possible scenarios for its operations: Feast or Famine. The Feast scenario has a 60 percent probability of occurring and forecast EBIT in this state is $60,000. The Famine state has a 40 percent chance of occurring and the EBIT is expected to be $20,000. Further, if the firm selects the conservative capital structure its cost of debt will be 10 percent, while with the aggressive capital structure its debt cost will be 12 percent. The firm will have $400,000 in total assets, it will face a 40 percent marginal tax rate, and the book value of equity per share under either scenario is $10.00 per share. What is the difference between the EPS forecasts for Feast and Famine under the aggressive capital structure?

  A. $0

  B. $2.20

  C. $2.40

  D. $1.00

  E. $1.80

  Correct Answer: C

  Debt = 75% = $300,000; Equity = 25% = $100,000; Total assets = $400,000. FeastFamine Probability0.60.4 EBIT$60,000$20,000 Less: Interest36,00036,000 EBT$24,000-$16,000 Less: Taxes9,600-6,400 NI$14,400-$9,600 # shares10,00010,000 EPS$1.44-$0.96 Difference in EPS for conservative capital structure: EPS(Feast) - EPS(Famine) = $1.44 - (-$0.96) = $2.40

• Question 1342:

  Which of the following statements is most correct?

  A. None of the statements are correct.

  B. When choosing between mutually exclusive projects, managers should accept all projects with IRRs greater than the weighted average cost of capital.

  C. Multiple IRRs can occur in cases when project cash flows are normal, but they are more common in cases where project cash flows are nonnormal.

  D. All of the statements are correct.

  E. One of the disadvantages of choosing between mutually exclusive projects on the basis of the discounted payback method is that you might choose the project with the faster payback period but with the lower total return.

  Correct Answer: E

  The payback and discounted payback methods both ignore cash flows that are paid or received after the payback period. Concerning the other statements: Multiple IRRs can occur only for projects with nonnormal cash flows. Mutually exclusive projects implies that only one project should be chosen. The project with the highest NPV should be chosen.

• Question 1343:

  Which of the following equations correctly illustrates the calculation of the cost of equity using the BondYield-plus-Risk-Premium approach?

  A. Required rate of return on outstanding debt + subjective risk premium

  B. Before-tax yield on outstanding debt + subjective risk premium

  C. None of these answers

  D. After-tax cost of debt + subjective risk premium

  E. Annual dividend/current stock price + subjective risk premium

  F. Yield to maturity on outstanding long-term debt + subjective risk premium

  Correct Answer: F

  The Bond-Yield-plus-Risk-Premium approach is a rather ad hoc method used by financial managers to determine the cost of common equity. Under this approach, a subjective risk premium is added to the yield to maturity of the firm's outstanding long-term debt. Typically, senior debt is used when possible, however, due to the ad hoc nature of this approach, there is abounding room for flexibility. This large degree of flexibility both adds to and detracts from the attractiveness of Bond-Yield-plus-Risk-Premium approach.

• Question 1344:

  Ace Consulting, a multinational corporate finance consulting firm, is examining the data storage division of Intelligent Semiconductor Company. In order to evaluate the proposed expansion of this division, Ace Consulting is trying to determine its beta. In their analysis, Ace Consulting regresses the monthly return on assets for the data storage division against the average return on assets for the data storage index, a division of the SandP 100. Which of the following techniques most correctly describes this method of identifying individual project betas?

  A. Regression analysis

  B. Scenario analysis

  C. Pure-play method

  D. Situation analysis

  E. Monte Carlo simulation

  F. Accounting Beta method

  Correct Answer: F

  In this example, Ace Consulting is employing the Accounting Beta method to determine the beta of the data storage division of Intelligent Semiconductor. This technique is often used when "pure play" firms cannot be found, or when a more empirical, "firm-specific" analysis is desired. "Monte Carlo simulation, situation analysis," and "scenario analysis" are all techniques for measuring stand-alone risk. While "regression analysis" is an attractive choice, it does not represent the best possible answer.

• Question 1345:

  A company has determined that its optimal capital structure consists of 40 percent debt and 60 percent

  equity. Given the following information, calculate the marginal weighted average cost of capital when the

  capital budget is $40,000.

  k(d) (interest rate on the firm's new date) = 10%

  Net income = $40,000

  Payout ratio = 50%

  Tax rate = 40%

  P(0) = $25

  Growth = 0%

  Shares outstanding = 10,000 Flotation cost on additional equity = 15%

  A. 13.69%

  B. 11.81%

  C. 8.05%

  D. 14.28%

  E. 7.20%

  Correct Answer: C

  First, find the amount of equity and debt needed for a $40,000 budget:

  Debt = 0.4 x $40,000 = $16,000; Equity = 0.6 x $40,000 = $24,000.

  We can find the amount of retained earnings = Net Income(1 - Payout ratio), or RE = $40,000 x 0.5 =

  $20,000.

  We will need to find the cost of new common equity, because we have only $20,000 of equity on hand, and

  we need $4,000 more!

  Find the dividend, Do = [(0.5) $40,000]/# of Shares = $20,000/10,000 = $2.00.

  Then, find the cost of new equity: k(e) = D1/[P0(1 - F)] + g = $2.00/[$25(1 - 0.15)] + 0% = 0.0941 = 9.41%.

  Finally, calculate WACC, using k(e) = 0.0941, and k(d) = 0.10, so

  WACC = (D/A)(1 - Tax rate)k(d) + (E/A)k(e)

  WACC = 0.4(1 - 0.4)(0.10) + 0.6(0.0941) = 0.0805, or 8.05%.

• Question 1346:

  Which of the following statements is correct?

  A. Only if one attempts to calculate MIRRs does one have to worry about multiple IRRs.

  B. The discounted payback is generally shorter than the regular payback.

  C. The NPV and IRR methods can lead to conflicting accept/reject decisions only if (1) mutually exclusive projects are being evaluated and (2) if the projects' NPV profiles cross at a rate less than the firm's cost of capital.

  D. The NPV and IRR methods can lead to conflicting accept/reject decisions only if (1) mutually exclusive projects are being evaluated and (2) if the projects' NPV profiles cross at a rate greater than the firm's cost of capital.

  E. Any type of project might have multiple rates of return if the IRR is sufficiently high.

  Correct Answer: C

  The two conditions which can cause NPV profiles to cross, and thus conflicts to arise between NPV and IRR: 1) when project size differences exists, or 2) when timing differences exist.

• Question 1347:

  Assume that a firm has a degree of financial leverage of 1.25. If sales increase by 20 percent, the firm will experience a 60 percent increase in EPS, and it will have an EBIT of $100,000. What will be the EBIT for this firm if sales do not increase?

  A. $42,115

  B. $84,375

  C. $67,568

  D. $100,000

  E. $113,412

  Correct Answer: C

  DTL = % change EPS/% change Sales = 60%/20% = 3.0.

  DOL = DTL/DFL = 3.0/1.25 = 2.40.

  Old EBIT = $100,000/[1 + (0.20)(2.40)] = $100,000/1.48 = $67,568.

  Alternate solution:

  Use DFL expression to calculate change in EBIT and previous EBIT:

  DFL = 1.25 = %change EPS/%change EBIT

  = 0.60/[change EBIT/($100,000 - change EBIT)]

  = [0.60($100,000) - 0.60(change EBIT)]/change EBIT

  1.25 change EBIT = $60,000 - 0.60(change EBIT)

  1.85 change EBIT = $60,000

  change EBIT = $32,432.

  Old EBIT = $100,000 - $32,432 = $67,568.

• Question 1348:

  Returns on the market and Takeda Company's stock during the last 3 years are shown below: YearMarketTakeda 1995-12%-14% 19962331 19971610 The risk-free rate is 7 percent, and the required return on the market is 12 percent. Takeda is considering a project whose market beta was found by adding 0.2 to the company's overall corporate beta. Takeda finances only with equity, all of which comes from retained earnings. The project has a cost of $100 million, and it is expected to provide cash flows of $20 million per year at the end of Years 1 through 5 and then $30 million per year at the end of Years 6 through 10. What is the project's NPV (in millions of dollars)?

  A. $23.11

  B. $22.55

  C. $28.12

  D. $20.89

  E. $25.76

  Correct Answer: A

  1.

  Run a regression to find the corporate beta. It is 1.1633.

  2.

  Find the project's estimated beta by adding 0.2 to the corporate beta. The project beta is thus 1.3633.

  3.

  Find the company's cost of equity, which is its WACC because it uses no debt: k(s) = WACC = 7% + (12% - 7%)1.3633 = 13.8165%.

  4.

  Now find NPV (in millions): CF(0) = -100 CF(1-5) = 20 CF(6-10) = 30 I = 13.82 Solve for NPV = $23.11 million.

• Question 1349:

  Which of the following statements is correct?

  A. Market risk is important but does not have a direct effect on stock price because it only affects beta.

  B. Well diversified stockholders do not consider corporate risk when determining required rates of return.

  C. Undiversified stockholders, including the owners of small businesses, are more concerned about corporate risk than market risk.

  D. Empirical studies of the determinants of required rates of return (k) have found that only market risk affects stock prices.

  Correct Answer: C

  Corporate risk is the project's risk to the corporation giving consideration to the fact that the project represents only one of the firm's portfolio of assets, hence that some of its risk effects on the firm's profits will be diversified away.

• Question 1350:

  Calculate the cost of debt for the following firm:

  Borrowing Rate 9.5%

  Marginal Tax Rate 34%

  Credit Rating BB+

  Owner's Equity 15%

  A. 1.5%

  B. 8.075%

  C. 1.43%

  D. 9.5%

  E. 6.27%

  Correct Answer: E

  The cost of debt is simply the rate of borrowing less the tax savings. Due to the fact that interest expense is tax deductible, the cost of debt in this case is 9.5%(1 - .34) = 9.5%(.66) = 6.27%.