CFA Institute CFA-LEVEL-1 Online Practice Questions and Exam Preparation

CFA Institute CFA-LEVEL-1 Online Questions & Answers

• Question 1421:

  TCH Corporation is considering two alternative capital structures with the following characteristics.

  AB

  Debt/Assets ratio0.30.7

  kd10%14%

  The firm will have total assets of $500,000, a tax rate of 40 percent, and book value per share of $10, regardless of capital structure. EBIT is expected to be $200,000 for the coming year. What is the difference in earnings per share (EPS)

  between the two alternatives?

  A. $4. 78
  B. $2. 87
  C. $7. 62
  D. $1.19
  E. $3. 03
  B. $2. 87

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  Explanation

  Capital structure A: The firm will have debt of $500,000(0.3) = $150,000 and equity of $350,000. We're told the shares have a book value of $10 so the number of shares outstanding is $350,000/$10 = 35,000. Interest expense will be $150,000(10%) = $15,000. We can compute EBT as EBIT - I or $200,000 - $15,000 = $185,000. Also, we can compute NI as EBT(1 - T) or $185,000(1 - 0.4) = $111,000. Finally, EPS = $111,000/35,000 = $3. 17. Capital structure B: The firm will have debt of $500,000(0.7) = $350,000 and equity of $150,000. The number of shares outstanding is $150,000/$10 = 15,000. Interest expense will be $350,000(14%) = $49,000. We can compute EBT as $200,000 - $49,000 = $151,000. Also, we can compute NI as $151,000 (1 - 0.4) = $90,600. Finally, EPS = $90,600/15,000 = $6. 04. The difference in EPS between capital structure A and capital structure B is $6. 04 - $3. 17 = $2. 87.

• Question 1422:

  According to the Signaling Theory of capital structure, an increase in bankruptcy costs:

  A. increases the debt ratio of a firm.
  B. none of these answers.
  C. may or may not affect the debt ratio of a firm.
  D. decreases the debt ratio of a firm.
  C. may or may not affect the debt ratio of a firm.

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  Explanation

  The Signaling Theory of capital structure considers the decisions of a firm's manager to raise debt or equity capital as a function of the relative profitability prospects of the firm's projects. It does not use bankruptcy costs as an explanation of the debt ratios prevalent in various industries. Bankruptcy costs are used by the Trade-off Theory of capital structure.

• Question 1423:

  The direct capitalization approach equals:

  Market Value = ________ / Market Capitalization Rate

  A. Monthly Gross Operating Income
  B. Annual NOI
  C. Annual Gross Operating Income
  D. Monthly NOI
  B. Annual NOI

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  Explanation

  The direct capitalization approach =

  Market Value = Annual NOI / Market Capitalization Rate

• Question 1424:

  If the economy is producing less than the full-employment output level, which of the following would most likely direct the economy back to long-run equilibrium?

  A. a decrease in resource prices
  B. an increase in the real rate of interest
  C. an increase in resource prices
  D. an increase in technology
  A. a decrease in resource prices

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  Explanation

  To understand this question, note that the price of resources is simply a function of supply and demand. This question is implying that demand for resources (i.e. labor) is weak. Holding supply constant, if demand for a good falls, prices must fall as well. Eventually some equilibrium will be reached.

• Question 1425:

  Parts of the standards that are ________ must be observed.

  A. restraining
  B. mandatory
  C. recommended
  D. suggested
  E. inhibiting
  B. mandatory

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  Explanation

  Some aspects of the Performance Presentation Standards are mandatory and must be observed, while other aspects are recommended.

• Question 1426:

  Termite Terminators has a debt-to-equity ratio of 50%. The equity consists of 80,000 common stock, valued at the year-end at 65. The preferred equity consists of 30,000 shares of par value 25 and coupon of 6%. The debt carries a coupon rate of 8%. During the year, Termite earned 1.2 million and had an average stock price of 75. It also has 40,000 warrants attached to the debt, each exercisable at 68. Termite's reported Diluted EPS should be:

  A. 14. 64
  B. 13. 79
  C. 15. 08
  D. 15. 00
  B. 13. 79

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  Explanation

  For Diluted EPS, the average price is used in the treasury stock method. Since the average price of 75 is more than the strike price of 68 of the warrants, the warrants are dilutive for DEPS calculations. The preferred dividend is 30,000*25*6% = 45,000. The additional shares using the treasury stock method equal 40,000 - 40,000*68/75 = 3,733. The DEPS then equals (1,200,000-45,000)/(80,000+3,733) = 13. 79.

• Question 1427:

  During an economic boom, the AD-AS model indicates that

  A. both the real interest rate and real wage rates will decline.
  B. real interest rate will decline and real wage rates will rise.
  C. real interest rate will rise and real wage rates will decline.
  D. both the real interest rate and real wage rates will increase.
  E. real wage rates will remain constant while the real interest rate will rise.
  D. both the real interest rate and real wage rates will increase.

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  Explanation

  High demand for resources (like labor) during an economic boom will increase the price of labor (the real wage rate). Similarly high demand for loanable funds during a boom will cause the real interest rate to rise.

• Question 1428:

  Irwin Inc. has a self-insurance plan. Each year, retained earnings is appropriated for contingencies in an amount equal to insurance premiums saved minus recognized losses from lawsuits and other claims. As a result of a 1996 accident, Irwin is a defendant in a lawsuit in which it will probably have to pay damages of $190,000. What are the effects of this lawsuit's probable outcome on Irwin's 1996 financial statements?

  A. An increase in expenses and no effect on liabilities.
  B. No effect on expenses and an increase in liabilities.
  C. An increase in both expenses and liabilities.
  D. None of these answers.
  E. No effect on either expenses nor liabilities.
  C. An increase in both expenses and liabilities.

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  Explanation

  Since the outcome of the lawsuit is probable and estimable, the amount of $190,000 will be recorded in the financial statements as a contingent liability and an expense.

• Question 1429:

  A stock has an expected dividend growth rate of 4. 4%. The firm has just announced a dividend of $1.9 per share, with an ex dividend date 3 days from now. Investors expect a rate of return of 9% from the stock and the stock is trading at $31.84. Ignoring stock price uncertainty between now and the ex dividend date and expecting the same growth, the stock is:

  A. fairly priced.
  B. under-priced.
  C. insufficient information.
  D. overpriced.
  B. under-priced.

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  Explanation

  Ignoring stock price uncertainty between now and the ex dividend date, the stock would have a fair price of Po on the ex dividend date, given by Po = D1/(r-g) = 1.9*1.044/(9% - 4. 4%) = $43. 12. Therefore,the current fair price of the stock is

  $43. 12 + $1.9 = $45. 02, which is much greater than the actual trading price of $31.84. Thus, the stock is under-priced.

  Note that the operative phrase in this example is "ignoring all uncertainty between now and the ex dividend date and expecting the same growth." If the market is expecting some negative information about the firm to be released some time in

  the near future (not necessarily before ex dividend date) or does not believe that the firm will continue to grow at or more than 4. 4%, the actual trading price could be a fair price. Hence, you should never blindly apply the DDM.

• Question 1430:

  Intelligent Semiconductor is considering issuing additional common stock. The firm has an after-tax cost of debt of 8.55%, and the company's combined federal/state income tax is 35%. The risk-free rate of return is 5. 6%, and the annual return on the broadest market index is expected to be 13. 5%. Shares of Intelligent Semiconductor have a historical beta of 1.6. What is the cost of equity for this proposed common stock issue using the Capital Asset Pricing Model?

  A. 18.24%
  B. 4. 09%
  C. 12. 64%
  D. 7. 04%
  E. 5. 56%
  A. 18.24%

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  Explanation

  The cost of issuing common stock can be calculated using several methods, including the Bond-Yield- Plus-Risk-Premium approach, Discounted Cash Flow method, or by using the Capital Asset Pricing Model. The latter is illustrated in this example. To calculate the cost of common equity using the CAPM, use the following formula: {cost of common equity = [risk free rate of return + beta(expected return on the market - risk free rate of return)}. Incorporating the appropriate figures into this example will yield a cost of common equity at 18.24%.