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

• Question 1411:

  Which of the following is most correct?

  A. Conflicts between NPV and IRR rules arise in choosing between two mutually exclusive projects (that each have normal cash flows) when the cost of capital exceeds the crossover point (that is, the point at which the NPV profiles cross).

  B. None of the statements are correct.

  C. The discounted payback method overcomes the problems that the payback method has with cash flows occurring after the payback period.

  D. The NPV and IRR rules will always lead to the same decision in choosing between mutually exclusive projects, unless one or both of the projects are "non-normal" in the sense of having only one change of sign in the cash flow stream.

  E. The Modified Internal Rate of Return (MIRR) compounds cash outflows at the cost of capital.

  Correct Answer: B

  IRR can lead to conflicting decisions with NPV even with normal cash flows if the projects are mutually exclusive. Cash outflows are discounted at the cost of capital with the MIRR method, while cash inflows are compounded at the cost of capital. Conflicts between NPV and IRR arise when the cost of capital is below the crossover point. The discounted payback method does correct the problem of ignoring the time value of money, but it still does not account for cash flows beyond the payback period.

• Question 1412:

  Suppose the firm's WACC is stated in nominal terms, but the project's expected cash flows are expressed in real dollars. In this situation, other things held constant, the calculated NPV would

  A. possibly have a bias, but it could be upward or downward.

  B. more information is needed; otherwise, we can make no reasonable statement.

  C. be biased upward.

  D. be biased downward.

  E. be correct.

  Correct Answer: D

  Given the fact that there is inflation, a cost of capital stated in nominal terms would understate the calculated NPV. If inflation is expected, but this expectation is not built into the forecasted cash flows, then the calculated NPV will be downward biased.

• Question 1413:

  Which of the following types of dividends, are never paid out in the form of cash?

  A. All of these are paid in the form of cash.

  B. Stock dividends.

  C. Regular dividends.

  D. Extra dividends.

  E. Liquidating dividends.

  Correct Answer: B

  Stock dividends are dividends paid in the form of additional shares of stock rather than in cash. The total number of shares is increased, so earnings, dividends, and price per share all decline. Stock dividends that are used on a regular basis will keep the stock price more or less constrained, that is, within the optimal trading range.

• Question 1414:

  The post-audit is used to

  A. eliminate potentially profitable but risky projects.

  B. all of these answers are correct.

  C. review cash flow forecasts.

  D. stimulate management to improve operations and bring results into line with forecasts.

  E. none of these answers are correct.

  Correct Answer: D

  The two main purposes of the post-audit are to improve forecasts and improve operations. Management is putting their reputations on the line when forecasting an investment, and they will strive to improve operations to bring results into line with forecasts.

• Question 1415:

  The management of Clay Industries have adhered to the following capital structure: 50% debt, 45%

  common equity, and 5% perpetual preferred equity. The following information applies to the firm:

  Before-tax cost of debt = 7.5%

  Combined state/federal tax rate = 35%

  Expected return on the market = 14.5%

  Annual risk-free rate of return = 5.25%

  Historical Beta coefficient of Clay Industries Common Stock = 1.15

  Annual preferred dividend = $1.35

  Preferred stock net offering price = $17.70

  Expected annual common dividend = $0.45

  Common stock price = $30.90

  Expected growth rate = 11.75%

  Subjective risk premium = 3.3%

  Given this information, and using the Bond-Yield-plus-Risk-Premium approach to calculate the component

  cost of common equity, what is the Weighted Average Cost of Capital for Clay Industries?

  A. 15.03%

  B. 9.97%

  C. 8.762%

  D. 7.70%

  E. 7.30%

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

  Correct Answer: D

  The calculation of the Weighted Average Cost of Capital is as follows: {fraction of debt * [yield to maturity on 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, you are asked to calculate the cost of common equity using the Bond-Yieldplus-Risk-Premium approach. To calculate the cost of equity using this approach, take the yield to maturity on the firm's outstanding debt (7.5%) and add a subjective risk premium (3.3%), which gives a cost of common equity of 10.8%. The after-tax cost of debt can be found by multiplying the yield to maturity on the firm's outstanding long- term debt (7.5%) by (1-tax rate). Using this method, the after-tax cost of debt is found as 4.875%. The calculation of the cost of perpetual preferred stock is relatively straightforward, simply divide the annual preferred dividend by the net offering price. Using this method, the cost of preferred stock is found as 7.627%. Incorporating these figures into the WACC equation gives the answer of 7.679%.

• Question 1416:

  Which of the following statements is most correct?

  A. All of these statements are false.

  B. A break point is based on the dollar value used of a specific type of capital, and occurs at the point where the cost of that capital type increases. Thus, if a firm has $100,000 in earnings, and stockholders want $50,000 of those earnings paid as dividends, then retained earnings will have two break points.

  C. A firm facing a steep demand curve (that is, high flotation costs) for new equity would likely also face, at some point, a steeply upward sloping WACC curve.

  D. All of these statements are correct.

  E. One purpose of calculating the WACC (Weighted Average Cost of Capital) is to have a singular cost of capital measure that can be applied to evaluate all of the firm's projects, including those of greater than and lesser than average risks.

  Correct Answer: C

  Because of high flotation costs, dollars raised by selling new stock must work harder than dollars raised by retaining earnings. Steep demand would result in a steeply upward sloping WACC curve. Note, however, that for most firms, new equity issues are rare.

• Question 1417:

  Scott Corporation's new project calls for an investment of $10,000. It has an estimated life of 10 years. The IRR has been calculated to be 15 percent. If cash flows are evenly distributed and the tax rate is 40 percent, what is the annual before-tax cash flow each year? (Assume depreciation is a negligible amount.)

  A. $1,500

  B. $3,321

  C. $5,019

  D. $1,993

  E. $4,983

  Correct Answer: B

  X = after-tax cash flow.

  Y = before-tax cash flow.

  X = Y(1 - T).

  $10,000 = X(PVIFA(15%,10))

  $10,000 = X(5.0188)

  X = $1,992.51.

  $1,992.51 = Y(1 - 0.40)

  Y = $3,320.85 = $3,321.

• Question 1418:

  Returns on the market and Company Y's stock during the last 3 years are shown below: Year Market Company Y 1995 -24% -22% 1996 10 13 1997 22 36 The risk-free rate is 5 percent, and the required return on the market is 11 percent. You are considering a low-risk project whose market beta is 0.5 less than the company's overall corporate beta. You finance only with equity, all of which comes from retained earnings. The project has a cost of $500 million, and it is expected to provide cash flows of $100 million per year at the end of Years 1 through 5 and then $50 million per year at the end of Years 6 through 10. What is the project's NPV (in millions of dollars)?

  A. $7.10

  B. $12.10

  C. $9.26

  D. $15.75

  E. $10.42

  Correct Answer: E

  Step 1 Run a regression to find the corporate beta. Market returns are the X-input values, while Y's returns

  are the Y-input values. Beta is 1.2102. Step 2 Find the project's estimated beta by subtracting 0.5 from the

  corporate beta. The project beta is thus 1.2102 - 0.5 = 0.7102. Step 3 Find the company's cost of equity,

  which is its WACC because it uses no debt: k(s) = WACC = 5% + (11% - 5%)0.7102 = 9.26%.

  Step 4 Now find the project's NPV (inputs are in millions):

  CF(0) = -500

  CF(1-5) = 100

  CF(6-10) = 50

  I = 9.26%

  Solve for NPV = $10.42 million.

• Question 1419:

  The additional risk associated with a firm's earnings when it uses debt capital is known as

  A. business risk.

  B. systematic risk.

  C. capital market risk.

  D. financial risk.

  Correct Answer: D

  Financial risk is the additional risk associated with a firm's earnings when it uses debt capital.

• Question 1420:

  Which of the following statements is most incorrect?

  A. All of these answers are correct.

  B. If the after-tax cost of equity financing exceeds the after-tax cost of debt financing, firms are always able to reduce their WACC by increasing the amount of debt in their capital structure.

  C. The optimal capital structure minimizes the WACC.

  D. None of these answers are correct.

  E. Increasing the amount of debt in a firm's capital structure is likely to increase the cost of both debt and equity financing.

  Correct Answer: B

  This statement is not always true.