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

• Question 1401:

  Which of the following statements is most correct?

  A. The optimal capital structure is the one that maximizes EBIT, and this always calls for a debt ratio, which is lower than the one that maximizes expected EPS.

  B. When financial leverage is used, the graphical probability distribution of net income would tend to be more peaked than a distribution where no leverage is present, other things held constant.

  C. From an operational standpoint the goal of maintaining financial flexibility translates into maintaining adequate reserve borrowing capacity.

  D. While business risk varies from one industry to another and can change over time, it affects all firms equally within a particular industry.

  E. All of these statements are false.

  Correct Answer: C

  Even in normal times, a firm should maintain a reserve borrowing capacity, which is the ability to borrow money at a reasonable cost when good investment opportunities arise.

• Question 1402:

  The management of Clay Industries have adhered to the following capital structure: 50% debt, 35%

  common equity, and 15% perpetual preferred equity. The following information applies to the firm:

  Before-tax cost of debt, i.e. yield to maturity of the outstanding senior long-term debt = 9.5%

  Combined State/Federal tax rate = 35%

  Cost of common equity = 14.45%

  Annual preferred dividend = $2.75

  Preferred stock net offering price = $28.50

  Given this information, what is the Weighted Average Cost of Capital for Clay Industries?

  A. 9.60%

  B. 10.45%

  C. The WACC for Clay Industries cannot be calculated from the information given.

  D. 11.27%

  E. 6.52%

  F. 8.67%

  Correct Answer: A

  The calculation of the Weighted Average Cost of Capital is as follows: {fraction of debt * [yield to maturity of outstanding long-term debt][1-combined state/federal income tax rate]} + {fraction of preferred stock * [annual dividend/net offering price]} + {fraction of common stock * cost of equity}. The cost of common equity can be calculated using three methods, the Capital Asset Pricing Model (CAPM), the DividendYield-plus-Growth-Rate (or Discounted Cash Flow) approach, and the Bond- Yield-plus-Risk-Premium approach. In this example, the cost of equity is given, so none of the three approaches is necessary. However, the cost of debt and preferred stock must be calculated. The cost of debt is found by multiplying the before tax cost of debt (9.5%) by (1-tax rate). Incorporating the given figures into this equation will yield a cost of debt at 6.175%. Determining the cost of perpetual preferred stock is relatively straightforward, simply divide the annual preferred dividend ($2.75) by the net price of preferred stock ($28.50), which yields a cost of preferred stock of 9.65%. These figures can now be incorporated into the WACC equation, which is provided below: {[50% debt * 9.5% * (1- 35%)] + [15% * ($2.75/$28.50)] + [35% * 14.45%]} = 9.60%

• Question 1403:

  Rollins Corporation is constructing its MCC schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock, which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm, which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plusrisk- premium method to find k(s). The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent. What is Rollins' retained earnings break point?

  A. $800,000

  B. $1,000,000

  C. $1,200,000

  D. $1,400,000

  E. $600,000

  Correct Answer: B

  Retained earnings = 0.6($1,000,000) = $600,000. BP(RE) = $600,000/0.6 = $1,000,000.

• Question 1404:

  A firm's dividend growth rate is 3.2% when the dividend payout ratio equals 37%. It is expected to pay a dividend of $2.2 next year. If the cost of external equity for the firm equals 19.2% and the firm's stock is currently priced at $14.1, the flotation cost of equity equals ________.

  A. 1.78%

  B. 0.89%

  C. 2.50%

  D. 1.91%

  Correct Answer: C

  IF F is the percentage flotation cost and P is the amount of new equity raised per new share, then Ke = D1/ [P(1-F)] + g, where Ke is the cost of external equity. Here, g = 3.2%, D1 = $2.2, P = $14.1 and Ke = 19.2%. Therefore, 19.2% = 2.2/ (14.1*(1-F)) + 3.2%. Solving for F gives F = 2.5%.

• Question 1405:

  Ace Consulting, a multinational corporate finance consulting firm, is analyzing the profitability of a new line of superconductors designed by Clay Industries, a large industrial firm. In their analysis, Ace Consulting has developed a detailed statistical model that generates random values for key variables, and these random numbers are incorporated into the analysis. Using this proprietary statistical software, Ace Consulting is allowed to formulate a computer-based model of the superconductor's expected cash flows and NPV, given any randomly selected value for seven essential variables. Which of the following choices best describes this technique for measuring stand-alone risk?

  A. Relational computation analysis

  B. Monte Carlo simulation

  C. Sensitivity analysis

  D. Scenario analysis

  E. Regression analysis

  F. Marco Polo simulation

  Correct Answer: B

  In this example, Ace Consulting has developed a statistical model which generates random values for seven key variables. Using this information, Ace can provide Clay Industries with an expected range of NPV and IRR for any assumed variable values. This process is referred to as Monte Carlo simulation, and is so named because the first Monte Carlo models were incorporated into the mathematical analysis of Casino gambling.

• Question 1406:

  Cepeda Corporation requires a computer system for the next ten years, and is in the process of choosing among two mutually exclusive alternatives. System A costs $50,000 today, and will produce positive net cash flows of $12,000 a year for the next ten years (t = 1 through t = 10). System B costs $30,000 today and will produce positive net cash flows of $11,000 a year for the next five years. After five years, System B can be replaced under the same terms. The company's cost of capital is 10 percent. What is the equivalent annual annuity (EAA) of the best system?

  A. $6,261.18

  B. $3,862.73

  C. $5,002.39

  D. $3,086.07

  E. $2,373.48

  Correct Answer: B

  First find the NPV's of each system over its initial life.

  System A: CF(0) = -50,000; CF(1-10)= 12,000; I = 10; solve for NPV = $23,734.81. System B: CF(0) = 30,000; CF(1-5)= 11,000; I = 10, solve for NPV = $11,698.65. Second, find the value of the EAA of each

  system. System A: N = 10; I = 10; PV = -23,734.81; FV = 0; solve for PMT = EAA = $3,862.73. System B:

  N = 5; I = 10; PV = -11,698.65; FV = 0; solve for PMT = EAA = $3,086.07. Given System A has a higher

  EAA, it is the better of the two systems.

• Question 1407:

  Quick Launch Rocket Company, a satellite launching firm, expects its sales to increase by 50 percent in the coming year as a result of NASA's recent problems with the space shuttle. The firm's current EPS is $3.25. Its degree of operating leverage is 1.6, while its degree of financial leverage is 2.1. What is the firm's projected EPS for the coming year using the DTL approach?

  A. $3.25

  B. $5.46

  C. $19.63

  D. $10.92

  E. $8.71

  Correct Answer: E

  EPS(1) = EPS(0) + EPS(0) [DTL x (percent change in sales)]

  = $3.25 [1 + (1.6)(2.1)(0.5)] = $3.25 [2.68]

  EPS(1) = $8.71.

• Question 1408:

  Calculate the cost of debt for the following firm:

  Borrowing Rate 10%

  Marginal Tax Rate 40%

  Project IRR 12.5%

  Owner's Equity 15%

  A. 1.5%

  B. 6%

  C. 60%

  D. 27.5%

  E. 10%

  Correct Answer: B

  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 10%(1 - .4) = 10%(.6) = 6%.

• Question 1409:

  Firms A and B have the same fixed costs in producing widgets. However, firm A charges 15% more than firm B for a widget while its variable costs per widget are 12% lower than those of B. If firm A sells a widget for 35% above its variable costs, the break-even point for B is ________ times higher than that for A.

  A. 2.0

  B. 9.2

  C. 3.3

  D. 2.5

  Correct Answer: B

  The break-even quantity, Q, is given by Q = FC/(P - V), where FC = total fixed costs, P = average sale price per unit and V = average variable cost per unit. You're given that FCA = FCB, PA = 1.35VA, PA = 1.15PB and VA = 0.88VB. Therefore, PB = (1.35/1.15)VA = 1.174VA and VB = (1/0.88)VA = 1.136V A. This gives QA/QB = FC(PA-VA)/FC(PB-VB) = (PB - VB)/(PA - VA) = (1.174 - 1.136)/(1.35 - 1) = 0.109. Thus, the break-even point for B is (1/0.109) = 9.21 times that for A.

• Question 1410:

  Assume you are the director of capital budgeting for an all-equity firm. The firm's current cost of equity is 16 percent; the risk-free rate is 10 percent; and the market risk premium is 5 percent. You are considering a new project that has 50 percent more beta risk than your firm's assets currently have, i.e., its beta is 50 percent larger than the firm's existing beta. The expected return (IRR) on the new project is 18 percent. Should the project be accepted if beta risk is the appropriate risk measure?

  A. Yes; its IRR is greater than the firm's cost of capital.

  B. No; a 50 percent increase in beta risk gives a risk-adjusted required return of 24 percent.

  C. No; the project's risk-adjusted required return is 1 percentage point above its IRR.

  D. Yes; the project's risk-adjusted required return is less than its IRR.

  E. No; the project's risk-adjusted required return is 2 percentage points above its IRR.

  Correct Answer: C

  Calculate the beta of the firm, and use to calculate project beta:

  k(s) = 0.16 = 0.10 + (0.05)b. b = 1.2.

  b(Project) = b(Firm)1.5 b(Project) is 50% greater than current b(Firm)

  b(Project) = (1.2)1.5 = 1.8.

  Calculate required return on project, k(Project), and compare to IRR.

  Project: k(Project) = 0.10 + (0.05)1.8 = 0.19 = 19%. IRR = 0.18 = 18%.

  Since the required return is one percentage point greater than the expected IRR, the firm should not

  accept the new project.