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

• Question 1421:

  Which of the following figures is not expressly incorporated into the Degree of Operating Leverage, as based on the "unit sales" calculation.

  A. Average sales price

  B. Total variable operating costs per unit

  C. Price

  D. Common shares outstanding

  E. Total fixed operating costs

  F. Sales in units

  Correct Answer: D

  The Degree of Operating Leverage (DOL) measures the percentage change in EBIT that results from a given change in sales. The DOL can be calculated using several methods, including one that is based on unit sales. This version of the DOL equation is as follows: {DOL = [(Sales in units(average sales price variable cost per unit) / (sales in units(average sales price - variable cost per unit) - total fixed operating costs]}. Of the choices listed, only the number of common shares outstanding is not incorporated into the DTL equation. In fact, the number of common shares outstanding is not factored into any of the equations used to calculate DOL.

• Question 1422:

  Consider the following information:

  30-day treasury rate (Risk Free rate) 7.2%

  Company XYZ Bond yield 10.2%

  Beta 0.8

  Risk Premium 4.0%

  Credit Rating B-

  Calculate Company XYZ's cost of retained earnings using the Bond-Yield-plus-Risk-Premium approach.

  A. 15.2%

  B. 12.2%

  C. 11.36%

  D. 17.4%

  E. 5.2%

  F. 14.2%

  Correct Answer: F

  To estimate a firm's cost of retained earnings using the Bond-Yield-plus-Risk-Premium approach, simply take the company's bond yield and add the risk premium. In this case the cost of retained earnings = 10.2% + 4.0% = 14.2%.

• Question 1423:

  J. Ross and Sons Inc. has a target capital structure that calls for 40 percent debt, 10 percent preferred stock, and 50 percent common equity. The firm's current after-tax cost of debt is 6 percent, and it can sell as much debt as it wishes at this rate. The firm's preferred stock currently sells for $90 a share and pays a dividend of $10 per share; however, the firm will net only $80 per share from the sale of new preferred stock. Ross expects to retain $15,000 in earnings over the next year. Ross' common stock currently sells for $40 per share, but the firm will net only $34 per share from the sale of new common stock. The firm recently paid a dividend of $2 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year. What is the firm's cost of newly issued common stock?

  A. 16.5%

  B. 18.0%

  C. 10.0%

  D. 12.5%

  E. 15.5%

  Correct Answer: A

  Cost of new common equity: k(e) = ($2.20/$34) + 0.10 = 0.1647 = 16.5%.

• Question 1424:

  Clay Industries, a large industrial firm, is in the process of developing a coal refining system which greatly increases the efficiency of coal as an energy source. However, the new system has been criticized as leading to a tremendous increase in emissions of CFTA, a dangerous carbon-based pollutant believed to be linked to thyroid cancer. While the firm is concerned about the possible risk to the public posed by the new system, the management of Clay Industries decides that the sales potential for the product outweighs both the risk to society and the liability exposure of the firm. Which of the following choices best describes this situation faced by Clay Industries?

  A. Opportunity cost problem

  B. Diminishing returns problem

  C. Cannibalization problem

  D. Positive externality

  E. Negative externality

  F. Principal/agent problem

  Correct Answer: E

  In this situation, a negative externality exists for Clay Industries and the development of the new coal refining system. A negative externality is some detrimental effect which is to result on stakeholders from the acceptance of a project. While often difficult to quantify, externalities are an important consideration in the accept/reject decision in capital projects. Externalities can be both positive and negative.

• Question 1425:

  A project that is intended to increase income is known as ________.

  A. Externality

  B. Replacement Project

  C. Cannibalization

  D. Opportunity Cost

  E. Expansion Project

  F. Low Cost Provider

  Correct Answer: E

  An expansion project is defined as a project that is intended to increase income.

• Question 1426:

  A mutual fund manager is examining the financial and operating condition of a Questron Media Corporation, and has discovered the following information. Sales: $3,000,000 Fixed costs: $1,000,000 Variable costs: $300,000 Interest expense: $150,000 Tax rate: 35% Weighted Average Cost of Capital: 14.75%

  Beta coefficient: 1.66 Common shares outstanding: 1,321,000 Using this information, what are the earnings per share (EPS) for Questron Media?

  A. $1.26

  B. $1.47

  C. $0.66

  D. $0.76

  E. $0.78

  F. $0.89

  Correct Answer: D

  The EPS figure is perhaps the single most popular term in the field of conventional equity investments. Any glance into financial media and business periodicals will undoubtedly uncover numerous instances in which the EPS figure is cited. While quite popular and useful, many investors and business professionals do not truly understand the mechanics behind the EPS calculation, and an investigation into the components of EPS figure is a valuable learning experience. The EPS calculation is found by the following equation: {EPS = [(Sales - Fixed Costs - Variable Costs - Interest Expense)(1 - Tax Rate)] / [# of Common Shares Outstanding]} Additionally, the EPS figure can be found by: {EPS = [(EBIT - Interest Expense)(1 - Tax Rate) / # of Common Shares Outstanding]} Incorporating the given information into the first EPS equation will yield the following: {EPS = [($3,000,000 - $1,000,000 $300,000 - $150,000)(1 - 0.35)] / 1,321,000} = $0.7627

• Question 1427:

  Dick Boe Enterprises, an all-equity firm, has a corporate beta coefficient of 1.5. The financial manager is evaluating a project with an IRR of 21 percent, before any risk adjustment. The risk-free rate is 10 percent, and the required rate of return on the market is 16 percent. The project being evaluated is riskier than Boe's average project, in terms of both beta risk and total risk. Which of the following statements is most correct?

  A. Riskier-than-average projects should have their IRRs increased to reflect their added riskiness. Clearly, this would make the project acceptable regardless of the amount of the adjustment.

  B. The accept/reject decision depends on the risk-adjustment policy of the firm. If the firm's policy were to reduce a riskier-than-average project's IRR by 1 percentage point, then the project should be accepted.

  C. The project should be accepted since its IRR (before risk adjustment) is greater than its required return.

  D. The project should be rejected since its IRR (before risk adjustment) is less than it's required return.

  E. Projects should be evaluated on the basis of their total risk alone. Thus, there is insufficient information in the problem to make an accept/reject decision.

  Correct Answer: B

  k(s) = 10% + (16% - 10%)1.5 = 10% + 9% = 19%. Original IRR = 21%. 21% - Risk adjustment 1% = 20%. Risk adjusted IRR = 20% > k(s) = 19%.

• Question 1428:

  Suppose changes in corporate law make it more difficult for debt holders to force companies into bankruptcies. This will cause firms to:

  A. raise more equity capital through retained earnings.

  B. either increase or decrease their debt levels.

  C. increase their debt-to-equity ratios.

  D. decrease their debt-to-equity ratios.

  Correct Answer: B

  It is tempting to assume that lower probability of bankruptcy will entice firms into borrowing more. However, remember that debt holders are not entirely stupid! They will factor in this change in the law and demand a higher yield and stricter covenants on corporate debt to compensate for the lower recourse they have against the firms. Depending on whether they actually underestimate or overestimate the effect and also depending on whether the firms perceive that the debt holders have under- or overestimated the effect, companies could increase or decrease their debt levels.

• Question 1429:

  As the capital budgeting director for Chapel Hill Coffins Company, you are evaluating construction of a new plant. The plant has a net cost of $5 million in Year 0 (today), and it will provide net cash inflows of $1 million at the end of Year 1, $1.5 million at the end of Year 2, and $2 million at the end of Years 3 through

  5. Within what range is the plant's IRR?

  A. 17 - 18%

  B. 15 - 16%

  C. 18 - 19%

  D. 14 - 15%

  E. 16 - 17%

  Correct Answer: C

  Time line: (In millions)

  012345 Years

  -511222

  Financial calculator solution: (In millions)

  Inputs: CF(0) = -5; CF(1) = 1.0; CF(2) = 1.5; CF(3) = 2.0; N(j) = 3.

  Output: IRR% = 18.37%.

• Question 1430:

  Gulf Electric Company (GEC) uses only debt and equity in its capital structure. It can borrow unlimited amounts at an interest rate of 10 percent so long as it finances at its target capital structure, which calls for 55 percent debt and 45 percent common equity. Its last dividend was $2.20; its expected constant growth rate is 6 percent; its stock sells on the NYSE at a price of $35; and new stock would net the company $30 per share after flotation costs. GEC's tax rate is 40 percent, and it expects to have $100 million of retained earnings this year. GEC has two projects available: Project A has a cost of $200 million and a rate of return of 13 percent, while Project B has a cost of $125 million and a rate of return of 10 percent. All of the company's potential projects are equally risky. What is GEC's cost of equity from newly issued stock?

  A. 13.77%

  B. 13.33%

  C. 10.00%

  D. 12.66%

  E. 12.29%

  Correct Answer: A

  k(d) (interest rate on the firm's new debt) = 10%

  k(d)(1 - T) (after-tax-component cost of the debt) = 10%(0.6) = 6%.

  D/A = 55%; D0 = $2.20; g = 6%; P0 = $35; PN = $35; T = 40%.

  Retained earnings = $100M; BP(RE) = $100M/ .45 = $222.22M.

  k(s) (component cost of retained earnings) = $2.33/$35 + 6% = 12.66%.

  k(e) (component cost of external equity) = $2.33/$30 + 6% = 13.77%.