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

• Question 1391:

  Which of the following statements is correct?

  A. If you are choosing between two projects which have the same life, and if their NPV profiles cross, then the smaller project will probably be the one with the steeper NPV profile.

  B. If the cost of capital is relatively high, this will favor larger, longer-term projects over smaller, shorter term alternatives because it is good to earn high rates on larger amounts over longer periods.

  C. If the cost of capital is less than the crossover rate for two mutually exclusive projects' NPV profiles, a NPV/IRR conflict will not occur.

  D. Because discounted payback takes account of the cost of capital, a project's discounted payback is normally shorter than its regular payback.

  E. The NPV and IRR methods use the same basic equation, but in the NPV method the discount rate is specified and the equation is solved for NPV, while in the IRR method the NPV is set equal to zero and the discount rate is found.

  Correct Answer: E

  This statement reflects exactly the difference between the NPV and IRR methods.

• Question 1392:

  When a mature firm raises the dividend, signaling theory implies that its stock price ________. When a growth firm cuts the dividend, signaling theory implies that its stock price ________.

  A. will fall; may rise or fall

  B. will rise; will fall

  C. will fall; will rise

  D. will rise; may rise or fall

  Correct Answer: D

  The signaling theory is properly applicable only to mature firms which have had stable dividend policies. In its pure form, the theory regards dividend changes as signals of management's forecasts of future earnings. Such an assumption is not fully justifiable for young, growth firms, which may cut dividends simply to supply retained earnings capital for expansion projects, without any signaling about the firm's future earnings prospects. Indeed, many growth firms pay no dividends at all for quite some time without an adverse effect on their stock prices. Hence, the increase in the dividend of a mature firm is taken as a signal by investors - under the signaling hypothesis - that the management's forecasts of future earnings are quite favorable, leading to a rise in the stock price. On the other hand, for a growth firm, such a signaling conclusion does not necessarily hold.

• Question 1393:

  Normal projects C and D are mutually exclusive. Project C has a higher net present value if the WACC is less than 12 percent, whereas Project D has a higher net present value if the WACC exceeds 12 percent. Which of the following statements is most correct?

  A. None of the answers are correct.

  B. Project C probably has a faster payback.

  C. Project D is probably larger in scale than Project C.

  D. Project D has a higher internal rate of return.

  E. All of the statements are correct.

  Correct Answer: D

  In this situation, D has a flatter NPV profile and a higher IRR. Project acceptance depends on what is the correct discount rate. If the discount rate is less than 12%, accept C. If it is greater than 12%, accept D. Projects that return their cash flows early (faster payback) and have lower initial investments tend to have higher IRRs.

• Question 1394:

  Texas Products Inc. has a division, which makes burlap bags for the citrus industry. The unit has fixed costs of $10,000 per month, and it expects to sell 42,000 bags per month. If the variable cost per bag is $2.00, what price must the division charge in order to break even?

  A. $2.47

  B. $3.15

  C. $2.24

  D. $2.00

  E. $2.82

  Correct Answer: C

  Total costs = $10,000 + $2(42,000) = $94,000. Price = $94,000/42,000 = $2.24.

• Question 1395:

  Market risk in a revenue-producing project can best be adjusted for by

  A. Ignoring it.

  B. Adjusting the discount rate downward for increasing risk.

  C. Picking a risk factor equal to the average discount rate.

  D. Adjusting the discount rate upward for increasing risk.

  E. Reducing the NPV by 10 percent for risky projects.

  Correct Answer: D

  An increase in a project's beta will cause its stock price to decrease unless the increased beta were offset by a higher expected rate of return. Therefore, high-risk investments require higher rates of return, whereas low-risk investments require lower rates of return.

• Question 1396:

  Driver Corporation faces an IOS schedule calling for a capital budget of $60 million. Its optimal capital structure is 60 percent equity and 40 percent debt. Its earnings before interest and taxes (EBIT) were $98 million for the year. The firm has $200 million in assets, pays an average of 10 percent on all its debt, and faces a marginal tax rate of 35 percent. If the firm maintains a residual dividend policy and will keep its optimal capital structure intact, what will be the amount of the dividends it pays out after financing its capital budget?

  A. $30.0 million

  B. $59.4 million

  C. $22.5 million

  D. $60.0 million

  E. $0

  Correct Answer: C

  Calculate interest cost:

  Total assets = $200M; 40% debt x $200M = $80 million in debt.

  Interest cost = $80M x 0.10 = $8.0 million.

  Calculate net income (in millions):

  EBIT$98.0

  less: Interest- 8.0

  EBT$90.0

  less: Taxes (35%) 31.5

  Net income$58.5

  Calculate portion of projects financed with retained earnings:

  IOS contains $60 million in positive NPV projects.

  Retained earnings portion:$60M x 0.60 = $36.0 million

  Debt portion:$60M x 0.40 = $24.0 million

  Calculate residual available for dividends:

  $58.5M - $36.0M = $22.5 million in dividends.

• Question 1397:

  A firm is considering the purchase of an asset whose risk is greater than the current risk of the firm, based on any method for assessing risk. In evaluating this asset, the decision-maker should

  A. Increase the NPV of the asset to reflect the greater risk.

  B. Ignore the risk differential if the asset to be accepted would comprise only a small fraction of the total assets of the firm.

  C. Reject the asset, since its acceptance would increase the risk of the firm.

  D. Increase the IRR of the asset to reflect the greater risk.

  E. Increase the cost of capital used to evaluate the project to reflect the higher risk of the project.

  Correct Answer: E

  An increase in a project's beta will cause its stock price to decrease unless the increased beta were offset by a higher expected rate of return. Therefore, high-risk investments require higher rates of return, whereas low-risk investments require lower rates of return.

• Question 1398:

  Lascheid Enterprises is an all-equity firm with 175,000 shares outstanding. The company's stock price is currently $80 a share. The company's EBIT is $2,000,000 and is expected to remain constant over time. The company pays out all of its earning each year--so its earnings per share equals its dividends per share. The firm's tax rate is 30 percent. The company is considering issuing $800,000 worth of bonds and using the proceeds for a stock repurchase. If issued the bonds would have an estimated yield to maturity of 8 percent. The risk-free rate is 5 percent and the market risk premium is also 5 percent. The company's beta is currently 1.0, but its investment banker's estimate that the company's beta would rise to 1.2 if they proceeded with the recapitalization. What would be the company's stock price following the repurchase transaction.

  A. $102.63

  B. $106.67

  C. $77.14

  D. $74.67

  E. $70.40

  Correct Answer: D

  The bonds used in the repurchase will create a new interest expense for the company. This will change net

  income. Dividends per share will change because net income changes and the number of shares

  outstanding changes.

  New interest expense: $800,000 x 8% = $64,000.

  New net income: ($2,000,000 - $64,000)(1 - 0.3) = $1,355,200.

  Shares repurchased: $800,000/80 = 10,000 shares.

  New shares outstanding: 175,000 - 10,000 = 165,000 shares.

  New dividends per share: $1,355,200/165,000 = $8.21.

  We must also calculate a new cost of equity: 5% + (5%)1.2 = 11%.

  New stock price: $8.21/11% = $74.67.

• Question 1399:

  Which of the following is not expressly incorporated into the Degree of Total Leverage (DTL) calculation?

  A. None of these answers

  B. Discount rate

  C. Interest expense

  D. Fixed costs

  E. Sales

  F. Variable costs

  Correct Answer: B

  The Degree of Total Leverage (DTL) calculation measures the percentage change in EPS from a given percentage change in sales. The equation used to produce DTL is as follows: {DTL = [(Sales - Variable Costs) / (Sales - Variable Costs - Fixed Costs - Interest Expense)]. As you can see, the DTL calculation does not involve the use of an explicit discount rate.

• Question 1400:

  Company D has a 50 percent debt ratio, whereas Company E has no debt financing. The two companies have the same level of sales, and the same degree of operating leverage. Which of the following statements is most correct?

  A. None of these answers are correct.

  B. If sales increase 10 percent for both companies, then Company D will have a larger percentage increase in its operating income (EBIT).

  C. All of these answers are correct.

  D. If EBIT increases 10 percent for both companies, then Company D's net income will rise by more than 10 percent, while Company E's net income will rise by less than 10 percent.

  E. If sales increase 10 percent for both companies, then Company D will have a larger percentage increase in its net income.

  Correct Answer: E

  After the sales increase, the percentage increase in EBIT will be the same for both companies. Company E's net income will rise by exactly 10%.