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

• Question 1431:

  Your company has decided that its capital budget during the coming year will be $20 million. Its optimal capital structure is 60 percent equity and 40 percent debt. Its earnings before interest and taxes (EBIT) are projected to be $34.667 million for the year. The company has $200 million of assets; its average interest rate on outstanding debt is 10 percent; and its tax rate is 40 percent. If the company follows the residual dividend policy and maintains the same capital structure, what will its dividend payout ratio be?

  A. 35%

  B. 30%

  C. 15%

  D. 20%

  E. 25%

  Correct Answer: E

  Capital budget = $20 million.

  Optimal capital structure: 60% equity, 40% debt.

  EBIT = $34.667 million.

  Assets = $200 million.

  k(d) = 10%; T = 40%. Dividend Payout = ?

  Debt = 0.40($200 million) = $80 million.

  Interest = 0.10($80 million) = $8 million.

  EBIT$34.667

  -INT8.000

  EBT$26.667

  Taxes (40%)10.667

  NI$16.000

  Equity needed = 0.60($20 million) = $12 million.

  Net Income$16

  -Equity needed12

  Amount left for dividend$4

  Dividend Payout = $4/$16 = 25%.

• Question 1432:

  Modigliani and Miller (MM) argued that dividend policy is irrelevant. On the other hand, Gordon and Lintner (GL) argued that dividend policy does matter. GL's argument rests on the contention that

  A. most investors will reinvest rather than spend dividends, so it would save investors money (taxes) if corporations simply reinvested earnings rather than paid them out as dividends.

  B. k(s) = D1/P0 + g is constant for any dividend policy.

  C. none of the answers are correct.

  D. investors, because of tax differentials, value a dollar of expected capital gains more highly than a dollar of dividends.

  E. because of perceived differences in risk, investors value a dollar of dividends more highly than a dollar of expected capital gains.

  Correct Answer: E

  The main conclusion of MM's irrelevance theory is that dividend policy does not affect the required rate of return on equity. Gordon-Lintner disagreed stating that k(s) decreases as the dividend payout is increased because investors are less certain of receiving the capital gains which should result from retaining earnings than they are of receiving dividends. They said that investors value expected dividends more highly than expected capital gains because the dividend yield is less risky than the growth component in the total expected return equation, k(s) = D1/Po + g. MM disagreed and theorized that k(s) is independent of dividend policy, implying that investors are indifferent between dividends and capital gains.

• Question 1433:

  The net cash flow attributable to an investment project is known as which of the following terms?

  A. Sunk Cost

  B. Opportunity Cost

  C. Incremental Cash Flow

  D. Cannibalization

  E. Externality

  Correct Answer: C

  Incremental cash flow is defined as the net cash flow attributable to an investment project.

• Question 1434:

  Following an internal investigation into her professional business activities, a financial analyst with Smith,

  Kleen and Beetchnutty admits that in her NPV and IRR calculations, she has failed to index all cash flows for

  the effects of anticipated inflation. However, the analyst claims that the discount rate she has used in her

  calculations does take into effect anticipated inflation.

  Which of the following correctly describes the effects this will have on the NPV and IRR calculations?

  A. NPV will be biased downward, IRR will be biased upward

  B. NPV will be biased upward, IRR will be biased downward

  C. Both NPV and IRR will be biased downward

  D. Both NPV and IRR will remain unaffected

  E. NPV will be biased downward, IRR will be unaffected

  F. Both NPV and IRR will be biased upward

  Correct Answer: C

  By failing to index the cash flows of projects in her NPV analysis, while at the same time including an adjustment for inflation into the discount rate, this analyst has biased the NPV calculation downward. This is because the cash inflows are being understated by the inflation-adjusted discounting. This phenomenon will skew the NPV figure downward. Remember that while the Internal Rate of Return calculation does not specify an explicit discount rate, rather calculates the discount rate that equates the cash inflows of a project with its cash outflows, the fact remains that the cash flows in the calculation have not been indexed for the effects of positive inflation. What has happened here is that cash flows have been understated, and this will bias the IRR calculation downward.

• Question 1435:

  A financial analyst with Smith, Kleen, and Beetchnutty is examining shares of Claypool Manufacturing for possible investment. Assume the following information:

  Sales: $50,000,000 Fixed costs: $33,000,000 Variable costs: $8,500,000 Interest expense: $900,000 Tax rate: 35% Weighted Average Cost of Capital: 11.50% Beta coefficient: 0.96 Common shares outstanding: 4,000,000 Using this information, what are the earnings per share (EPS) for Claypool Manufacturing?

  A. $1.34

  B. $1.40

  C. The answer cannot be determined from the information provided.

  D. $1.70

  E. $1.24

  F. $1.11

  Correct Answer: E

  The EPS figure is perhaps the single most popular term in the field of conventional equity investments, along with the Price-to-Earnings Ratio (P/E). Any glance into financial media and business periodicals will undoubtedly uncover numerous instances in which the EPS figure is cited or discussed. While quite popular and useful, most investors, and many business professionals, undoubtedly do not understand the mechanics behind the EPS calculation, and an investigation into the components of EPS 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 = [($50,000,000 - $33,000,000 $8,500,000 - $900,000)(1 - 0.35)] / 4,000,000} = $1.24.

• Question 1436:

  Which of the following statements is most correct?

  A. The CAPM approach is typically used to estimate a firm's flotation cost adjustment factor, and this factor is added to the DCF cost estimate.

  B. These statements are all incorrect.

  C. In practice (as opposed to in theory), the DCF method and the CAPM method usually produce exactly the same estimate for k(s).

  D. The risk premium used in the bond-yield-plus-risk-premium method is the same as the one used in the CAPM method.

  E. Under normal conditions, the CAPM (Capital Asset Pricing Model) approach to estimating a firm's cost of retained earnings gives a higher estimate than the DCF (Discounted Cash Flow) approach.

  Correct Answer: B

  All are incorrect. Under the CAPM approach, it is at best difficult to obtain correct estimates of the inputs require to make it operational. The same could be said about the growth rate input under the DCF approach. The risk premium under the bond-yield-plus-risk premium approach is purely judgmental and results in a ballpark estimate.

• Question 1437:

  Which of the following statements is most correct?

  A. If a company does a 2-for-1 stock split, its stock price will roughly double.

  B. An open-market dividend reinvestment plan is likely to be attractive to companies that are looking to issue additional shares of common stock.

  C. All of these answers are correct.

  D. None of the answers are correct.

  E. Stock repurchases have the effect of reducing financial leverage.

  Correct Answer: D

  A new stock type of DRIP would result in raising new capital for the firm. Stock repurchases increase financial leverage. In a 2-for-1 stock split, the stock price will be halved.

• Question 1438:

  The initial investment outlay consists of which of the following?

  I. Up-front costs of the project's fixed assets.

  II. Flotation costs associated with raising the necessary capital.

  III. Increases in net working capital.

  IV.

  Present value of all interest expenses associated with the project capital.

  A.

  II only

  B.

  I, II and IV

  C.

  I, II and III

  D.

  I, II, III and IV

  E.

  I and III

  F.

  III only

  G.

  I only

  H.

  IV only

  Correct Answer: E

  The initial investment outlay consists of up-front costs of the project's fixed assets and any increases in net working capital. Costs involved in raising the finances are not part of the initial outlay.

• Question 1439:

  An investment project has an initial cost, and then generates inflows of $50 a year for the next five years. The project has a payback period of 3.6 years. What is the project's internal rate of return (IRR)?

  A. 12.05%

  B. 13.47%

  C. 15.89%

  D. 14.66%

  E. 11.18%

  Correct Answer: A

  Investment cost = $180.

  CF(0) = -180

  CF(1-5) = 50

  Solve for IRR = 12.05%.

• Question 1440:

  According to the signaling theory, if a firm issues debt capital to finance a project, the firm's management must consider the project to be ________.

  A. none of these answers

  B. likely to raise the probability of bankruptcy

  C. very desirable

  D. not very profitable

  Correct Answer: C

  According to the signaling theory of capital structure, a firm will try to raise debt capital when the project's returns are deemed very favorable and vice versa. The firm is signaling that the project has sufficient cash flows to pay back the debt.