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

• Question 1351:

  A firm's preferred equity has a face value of 100 and a 5.5% coupon. The equity is trading at $87.29 per share. The firm is in the 40% tax bracket. Its cost of preferred stock equals ________.

  A. 2.52%

  B. 3.30%

  C. 6.30%

  D. 3.78%

  Correct Answer: C

  Preferred dividends are not tax-deductible. Hence, no tax adjustment is made while calculating the cost of preferred equity. The price of a perpetuity that pays C per year, at a discount rate of R, equals C/R. Hence,

  87.29 = 5.5/R, giving R = 6.3%.

• Question 1352:

  The common stock of Anthony Steel has a beta of 1.20. The risk-free rate is 5 percent, and the market risk premium is 6 percent. This year's addition to retained earnings is $3,000,000. The company's capital budget is $4,000,000 and its target capital structure is 50 percent debt and 50 percent equity. What is the company's cost of equity financing?

  A. 12.4%

  B. 7.0%

  C. 11.0%

  D. 12.2%

  E. 7.2%

  Correct Answer: D

  Anthony Steel will use retained earnings to fund the equity portion of its capital budget. We can see this

  because the retained earnings break point is $3,000,000/0.5 = $6,000,000, which is greater than the

  capital budget.

  The cost of equity from the CAPM (Capital Asset Pricing Model) is:

  k(s) = krf) + (k(m) - k(rf))b(i) = 5% + (6%)1.2 = 12.2%.

• Question 1353:

  True or false. Firms with higher proportions of fixed costs will have an EBIT figure that is more sensitive to changes in sales, all else equal. Additionally, companies that have low Degree of Financial Leverage figures will have more aggressive depreciation and amortization schedules.

  A. False, true

  B. The answer cannot completely be determined from the information provided.

  C. True, false

  D. True, true

  E. False, false

  Correct Answer: B

  A somewhat tricky question as the answer cannot be fully determined from the information provided. While it is true that firms whose cost structure is weighted heavily toward fixed costs, i.e. have high relative DOL figures, will be more sensitive to changes in sales, the second question cannot be answered from the information provided. The Degree of Financial Leverage is defined as the percentage change in EPS that results from a given percentage change in EBIT. For purposes of general discussion, and the Level 1 CFA exam, the DFL calculation does not have an explicit bearing on the depreciation and amortization schedules used by companies. Had the second question asked "...companies that have low Degree of Financial Leverage figures will have EPS figures which are LESS sensitive to changes in EBIT," then both answers would be true.

• Question 1354:

  Which of the following statements is most correct?

  A. All of these answers.

  B. All else equal, an increase in a company's stock price will increase the marginal cost of issuing new common equity.

  C. None of these answers.

  D. If a company's tax rate increases but the yield to maturity of its noncallable bonds remains the same, the company's marginal cost of debt capital used to calculate its weighted average cost of capital will fall.

  E. All else equal, an increase in a company's stock price will increase the marginal cost of retained earnings.

  Correct Answer: D

  The debt cost used to calculate a firm's WACC is k(d)(1 - T). If k(d) (interest rate on the firm's new debt) remains constant but T increases, then the term (1 - T) decreases and the value of the entire equation, k(d) (1 - T), decreases.

• Question 1355:

  Braun Industries is considering an investment project, which has the following cash flows: tProject Cash Flows 0-$1,000 1 400 2 300 3 500 4 400 The company's WACC is 10 percent. What is the project's payback, internal rate of return and net present value?

  A. I, II, IV, VIII

  B. II, IV, VII

  C. I, II, IV, VIII

  D. III, V, VII

  E. I, II, IV

  F. I, II, IV, VI

  Correct Answer: E

  The Degree of Operating Leverage (DOL) measures the percentage change in EBIT that results from a given percentage change in sales. Degree of Operating Leverage can be calculated using several methods, including equations based upon unit sales and dollar sales. The DOL equation based on dollar sales is illustrated as follows: {DOL = [(sales in dollars - total variable costs) / (sales in dollars - total variable costs - total fixed operating costs)]. Of the answers provided, only I, II, and IV are incorporated into this equation.

• Question 1356:

  Taylor Technologies has a target capital structure, which is 40 percent debt and 60 percent equity. The equity will be financed with retained earnings. The company's bonds have a yield to maturity of 10 percent. The company's stock has a beta = 1.1. The risk-free rate is 6 percent, the market risk premium is 5 percent, and the tax rate is 30 percent. The company is considering a project with the following cash flows: TimeCash flow ($) 0-50,000 135,000 243,000 360,000 4-40,000 What is the project's modified internal rate of return (MIRR)?

  A. 6.76%

  B. 16.14%

  C. 20.52%

  D. 10.78%

  E. 9.26%

  Correct Answer: C

  First, find the company's weighted average cost of capital:

  We're given the before-tax cost of debt, k(d) = 10%. We can find the cost of equity as follows:

  K(s) = 0.06 + 0.05(1.1) = 0.115 or 11.5%.

  Thus, the WACC is:

  k = 0.4(0.10)(1 - 0.3) + 0.6(0.115) = 0.097 or 9.7%.

  Second, the PV of all cash outflows can be calculated as follows:

  PV of CF(4): N = 4, I = 9.7, PMT = 0, FV = 40,000 and solve for PV. Total PV(Costs) = -$50,000 $27,620.62 = -$77,620.62.

  Third, find the terminal value of the project at t = 4:

  FV of CF(1) at t = 4 is calculated as follows: N = 3, I = 9.7, PV = -35,000, PMT = 0, and solve for FV =

  $46,204,89. Similarly, the FVs of CF(2) and CF(3) are found to be $51,746.59 and $65,820, respectively.

  Summing these FVs gives a terminal value of $46,204.89 + $51,746.59 + $65,820.00 = $163,771.48.

  Finally, the MIRR can be calculated as N = 4, PV = -77,620.62, PMT = 0, FV = 163,771.48, and solve for I

  = MIRR = 20.52%.

• Question 1357:

  A stock's P/E ratio is 10.4, with an expected return on equity of 14% and a dividend growth rate of 5.7%. The firm's dividend payout ratio equals ________.

  A. 24.19%

  B. 56.17%

  C. 86.32%

  D. 13.68%

  Correct Answer: C

  Po/E1 = dividend payout/(k - g)

  Therefore, 10.4 = dividend payout /(0.14 - 0.057), giving dividend payout = 86.32%.

• Question 1358:

  Kulwicki Corporation wants to determine the effect of an expansion of its sales on its operating income (EBIT). The firm's current degree of operating leverage is 2.5. It projects new unit sales to be 170,000, an increase of 45,000 over last year's level of 125,000 units. Last year's EBIT was $60,000. Based on a degree of operating leverage of 2.5, what is this year's expected EBIT with the increase in sales?

  A. $175,000

  B. $60,000

  C. $114,000

  D. $90,000

  E. $100,000

  Correct Answer: C

  Set up the DOL equation, letting x be the unknown new EBIT:

  Let x = New EBIT.

  DOL(Q) = % change EBIT/ % change Sales

  % change in sales = 45000/125000 = 36%

  2.5 = (x - $60,000/$60,000) / .36

  2.5 (0.36) = ((x - $60,000)/$60,000)

  0.90 = (x - $60,000/$60,000)

  $54,000 = x - $60,000

  x = $114,000.

  New EBIT = $114,000.

• Question 1359:

  Which of the following companies has the highest degree of financial leverage? Choose the best answer. Firm A EBIT: $10,000,000 Interest Paid: $750,000 Total Operating Expenses: $25,000,000 Fixed Operating Expenses: $19,750,000 Firm B EBIT: $8,970,000 Interest Paid: $88,000 Total Operating Expenses: $20,050,000 Fixed Operating Expenses: $17,000,000 Firm C EBIT: $10,500,000 Interest Paid: $1,050,000 Total Operating Expenses: $50,000,000 Fixed Operating Expenses: $35,000,000 Firm D EBIT: $10,000,000 Interest Paid: $750,000 Total Operating Expenses: $50,000,000 Fixed Operating Expenses: $41,000,000 Firm E EBIT: $5,195,000 Interest Paid: $400,000 Total Operating Expenses: $35,000,000 Fixed Operating Expenses: $9,875,000

  A. Firm A

  B. Firm E

  C. Firm B

  D. Firm C

  E. Firm D

  F. Firm A and D have identical DFL's

  Correct Answer: D

  The Degree of Financial Leverage (DFL) measures the percentage change in EPS that results from a given percentage change in EBIT. Financial Leverage is the second component of total leverage, along with Operating Leverage. The equation used to calculate the Degree of Financial Leverage is as follows: {DFL = [EBIT/(EBIT - Interest Paid)]}.

  In this example, Firm C has the highest DFL, with a figure of 1.11. While Firm A and D do have identical Degree of Financial Leverage calculations, the question asks which firm has the highest DFL, which is firm

  C. When calculating the DFL figure, remember that the answer can never be less than one, and can never be negative. In a situation where the company under examination has zero interest expense, the DFL would be equal to one; i.e. the EBIT is equal to the EBIT minus the interest expense. Another important note to remember is that in calculating the Degree of Financial Leverage, dividend payments to preferred stockholders should be included in the interest expense figure. Operating expenses are not factored into the DFL calculation, rather are used in the determination of Operating Leverage.

• Question 1360:

  The Target Copy Company is contemplating the replacement of its old printing machine with a new model costing $60,000. The old machine, which originally cost $40,000, has 6 years of expected life remaining and a current book value of $30,000 versus a current market value of $24,000. Target's corporate tax rate is 40 percent. If Target sells the old machine at market value, what is the initial after tax outlay for the new printing machine?

  A. -$22,180

  B. -$36,000

  C. -$30,000

  D. -$33,600

  E. -$40,000

  Correct Answer: D

  Initial outlay Cost of new machine-$60,000 Salvage value (old)+ 24,000 Tax effect of sale = $6,000(0.4) = + 2,400 After-tax outlay =-$33,600