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

• Question 1381:

  When Modigliani and Miller relaxed their assumption of zero taxes, they concluded which of the following?

  A. Firm's will wish to issue preferred stock.

  B. A firm's value is maximized only when it uses no debt.

  C. Business risk will become the main determinant of a firm's value.

  D. Dividend policy will dominate the investment decision.

  E. A firm's capital structure is irrelevant.

  F. A firm's value is maximized only when it uses 100% debt.

  Correct Answer: F

  When MandM relaxed their "no-taxes" assumption, they concluded that a firm's value was maximized only when its capital structure is composed of 100% debt. This is due to the tax-deductibility of debt. Due to these tax-shelter benefits, companies who are financed by 100% debt pass the maximum amount of their operating income to investors, and this should increase the attractiveness of the firm as an investment. MandM would be criticized on this finding, particularly because the risk of bankruptcy was completely ignored. This criticism would give birth to the "Trade-off Theory of Leverage," which states that companies will balance the tax-shelter benefits of debt with the increased interest rates and risk of bankruptcy that are associated with increased debt levels..

• Question 1382:

  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 selling price of $90 Average variable cost of $44 Which of the following best describes the break-even quantity for this product?

  A. 20,109 units

  B. The break-even quantity cannot be determined from the information provided.

  C. None of these answers is correct.

  D. 20,468 units

  E. 10,278 units

  F. 21,023 units

  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]}. The determination of the break-even quantity for this product is relatively straightforward, and does not involve any algebraic manipulation of the original equation. Incorporating the given information into the equation yields the following: {$925,000/[$90 - $44]} = 20,109 units.

• Question 1383:

  Which of the following statements is most correct?

  A. If Congress cuts the capital gains rate, but leaves the personal tax rate unchanged, then this would provide an incentive for companies to increase their dividend payouts.

  B. If a firm follows a residual dividend policy, then a sudden increase in the number of profitable projects is likely to reduce the firm's dividend payout.

  C. None of these answers are correct.

  D. Despite its drawbacks, a residual dividend policy is an effective way to stabilize dividend payouts, which makes it easier for firms to attract a clientele which prefers high dividends.

  E. All of these answers are correct.

  Correct Answer: B

  The residual dividend model is a model in which the dividend paid is set equal to the actual earnings minus the amount of retained earnings necessary to finance the firm's optimal capital budget. Ther esidual dividend policy minimizes the costs to the company of raising outside funds, but it does not provide a stable cash flow to the investors and most investors prefer stable dividends.

• Question 1384:

  Which of the following statements is most correct?

  A. If a company undertakes a 3-for-1 stock split, then the number of shares outstanding should fall, and the stock price should rise.

  B. All of these answers are correct.

  C. None of these answers are correct.

  D. If a company wants to issue new shares of common stock and also wants to implement a dividend reinvestment plan, then it should implement a new-stock dividend reinvestment plan, rather than an open-market purchase plan.

  E. If a company wants to reduce its debt ratio, then it should repurchase some of its common stock.

  Correct Answer: D

  The new stock type of dividend reinvestment plan invests the dividends in newly issued stock, hence these plans raise new capital for the firm.

• Question 1385:

  McCarver Inc. is considering the following mutually exclusive projects: Project A Project B TimeCash FlowCash Flow 0-$5,000-$5,000 1200 3,000 2800 3,000 33,000 800 45,000 200 At what cost of capital will the net present value of the two projects be the same?

  A. 16.15%

  B. 17.72%

  C. 17.80%

  D. 15.68%

  E. 16.25%

  Correct Answer: A

  Find the differences between the two projects' respective cash flows as follows:

  (Project A CF - Project B CF).

  CF(0) = -5,000 - (-5,000) = 0.

  CF(1) = 200 - 3,000 = -2,800.

  CF(2) = -2,200.

  CF(3) = 2,200.

  CF(4) = 4,800.

  Enter these CFs and find the IRR = 16.15% which is the crossover rate.

• Question 1386:

  The Global Advertising Company had net income after interest but before taxes of $40,000 this year. The marginal tax rate is 40 percent, and the dividend payout ratio is 30 percent. The company can raise debt at a 12 percent interest rate. The last dividend paid by Global was $0.90. Global's common stock is selling for $8.59 per share, and its expected growth rate in earnings and dividends is 5 percent. If Global issues new common stock, the flotation cost incurred will be 10 percent. Global plans to finance all capital expenditures with 30 percent debt and 70 percent equity. What is the cost of common equity raised by selling new stock?

  A. 10.33%

  B. 12.22%

  C. 16.00%

  D. 17.22%

  E. 9.66%

  Correct Answer: D

  k(e) (component cost of external equity) = $.945/$8.59 (1-.10) + 0.05 = 0.1722 = 17.22%.

• Question 1387:

  Which of the following statements is correct?

  A. The bond-yield-plus-risk-premium approach to estimating the cost of equity is not always accurate but its advantages are that it is a standardized and objective model.

  B. Although some methods of estimating the cost of capital encounter severe difficulties, the CAPM (Capital Asset Pricing Model) is a simple and reliable model that provides great accuracy and consistency in estimating the cost of capital.

  C. Depreciation-generated funds are an additional source of capital and, in fact, represent the largest single source of funds for some firms.

  D. The DCF (Discounted Cash Flow) model is preferred over other models to estimate the cost of equity because of the ease with which a firm's growth rate is obtained.

  Correct Answer: C

  Since depreciation is a significant non-cash expense, it is added back to net income when calculating cash flow.

• Question 1388:

  Which of the following factors directly influence capital structure decisions?

  I. Business risk

  II. Availability of various sources of capital under attractive terms

  III. Expropriation risk

  IV.

  The firm's tax position

  V.

  Management's subjective attitudes toward risk

  VI.

  Country risk

  A.

  II, III, IV, V

  B.

  I, II, III, IV, V, VI

  C.

  I, III, IV

  D.

  I, II, IV, V

  E.

  I, II, II, IV, VI

  Correct Answer: D

  There are four primary factors which influence capital structure decisions: business risk, financial flexibility, the firm's tax position, and management's subjective attitudes toward risk. Business risk is defined as the riskiness of a firm if it uses no debt. Financial flexibility refers to the ability of a company to easily raise various sources of capital under favorable terms. "Expropriation risk," and "country risk," while legitimate forms of risk, are not directly applicable to the capital structure decision. Expropriation risk is defined as the risk that a firm's existing assets and facilities will be seized, or "expropriated" by a governmental, social, or military entity. This risk is frequently incorporated into discussions of international operations.

• Question 1389:

  Shelby Inc. is considering two projects which have the following cash flows: Project 1Project 2 Time Cash Flows Cash Flows 0-$2,000-$1,900 1500 1,100 2700 900 3800 800 41,000 600 51,100 400 At what cost of capital would the two projects have the same net present value?

  A. 5.98%

  B. 5.85%

  C. 6.40%

  D. 6.70%

  E. 4.73%

  Correct Answer: B

  Subtract Project 2 cash flows from Project 1 cash flows: CF(0) = -100 CF(1) = -600 CF(2) = -200 CF(3) = 0 CF(4) = 400 CF(5) = 700 Put these in the cash flow register and solve for the IRR = 5.85%.

• Question 1390:

  Which of the following projects is likely to have multiple Modified Internal Rates of Return. Assume a 14.5% cost of capital.

  Project A Initial investment outlay: ($1,000,000) t1: $0.00 t2: $0.00 t3: $0.00 t4: $0.00 t5: $0.00 t6: $10,000,000 Project B Initial investment outlay: ($1,000,000) t1: $500,000 t2: $500,000 t3: $500,000 t4: $0.01 Project C Initial investment outlay: ($1,000,000) t1: $800,000 t2: ($100,000) t3: $550,000 Project D Initial investment outlay: ($500,000) t1: $400,000 t2: ($1,000) t3: $230,000 t4: ($50,000)

  A. Project D

  B. More than one of these answers are correct

  C. None of these answers is correct

  D. Project A

  E. Project B

  F. Project C

  Correct Answer: C

  Remember that the Modified Internal Rate of Return method will not produce multiple answers for nonnormal projects. The fact that MIRR will not produce multiple answers for non-normal projects is one of the reasons that this method should be considered as superior to the traditional Internal Rate of Return method.