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

• Question 1441:

  The return on the best alternative use of an asset, or the highest return that will not be earned if funds are invested in a particular project is known as which of the following terms?

  A. Sunk Cost

  B. Cannibalization

  C. Opportunity Cost

  D. Externality

  E. Incremental Cash Flow

  Correct Answer: C

  Opportunity cost is defined as the return on the best alternative use of an asset, or the highest return that will not be earned if funds are invested in a particular project

• Question 1442:

  Suppose Congress votes to raise the personal tax rate on interest and dividend income. However, it does not change the capital gains tax or the corporate tax rates. This will have the effect of:

  A. increasing the reliance on debt financing.

  B. increasing the reliance on retained earnings as capital.

  C. decreasing the reliance on equity capital.

  D. decreasing the sizes of seasoned equity offerings.

  Correct Answer: B

  As personal tax rates increase, firms have to modify their reliance on different capital markets so as to minimize the costs imposed on debt and equity investors. An increase in interest and dividend income makes debt and dividend payouts costlier. On the other hand, since capital gains are not affected, firms will tend to decrease their dividend pay-out ratios and bank on retained earnings to finance their capital requirements.

• Question 1443:

  Alyeska Salmon Inc., a large salmon canning firm operating out of Valdez, Alaska, has a new automated production line project it is considering. The project has a cost of $275,000 and is expected to provide after-tax annual cash flows of $73,306 for eight years. The firm's management is uncomfortable with the IRR reinvestment assumption and prefers the modified IRR approach. You have calculated a cost of capital for the firm of 12 percent. What is the project's MIRR?

  A. 17.0%

  B. 15.0%

  C. 12.0%

  D. 14.0%

  E. 16.0%

  Correct Answer: E

  TV = $73,306(FVIFA(12%,8)) = $73,306(12.300) = $901,663.80.

  $275,000 = $901,663.80 / (1 + MIRR)^8

  (1 + MIRR)^8 = (FVIF(Irr,8)) = 3.27869.

  Look in table: Periods = 8, I = 16%. MIRR = 16%.

  Alternate method

  3.27869^1/8 = 1 + MIRR

  MIRR = 16%.

• Question 1444:

  Consider the following argument: "The cost of common stock should decrease as the dividend payout is increased because investors are more certain of receiving these dividends than the capital gains which are supposed to be derived from retained earnings." This statement applies best to which of the following financial theories? Choose the best answer.

  A. Tax Preference Theory

  B. Dividend Irrelevance Theory

  C. Tax Irrelevance Theory

  D. Dividend Relevance Theory

  E. Bird-in-hand Theory

  Correct Answer: E

  The Bird-in-the-Hand Theory came about as a refutation of Modigliani and Miller's Dividend Irrelevance Theory. The founders of the Bird-in-the-Hand Theory, Myron Gordon and John Lintner, stated that investors are more confident in the fact that they will receive dividends versus capital gains. So said, the cost of common stock should decrease as the payout ratio is increased. The Tax Preference Theory states that investors prefer capital gains to dividends, and this is due to the structure of tax rates. Specifically, dividends are typically taxed at a higher rate than capital gains, and are in this respect less attractive.

• Question 1445:

  The Clientele Effect theory implies that investors in the low tax brackets will prefer:

  A. none of these answers.

  B. high capital gains.

  C. high dividend payouts.

  D. low dividend payouts.

  Correct Answer: C

  The Clientele Effect is based on the presumption that different groups of investors will prefer different dividend policies based on their tax status and their need for current versus future income requirements. Hence, investors who face high taxes on current income will tend to avoid stocks with high pay-out ratios. This lowering of demand for such stocks will tend to depress their prices and to take advantage of this; investors in low tax brackets would gravitate toward them. To this, add the fact that usually, investors in low tax brackets with sufficient capital to invest tend to be either people who are old and retired or institutions like pension funds. Both these groups have a higher need for current income but are sensitive to liquidation of capital. They therefore prefer their income from stocks to be in the form of dividends rather than from the sale of their stock holdings.

• Question 1446:

  Which of the following is not considered a capital component?

  A. All of these are considered capital components

  B. Preferred stock

  C. Common stock

  D. Long-term debt

  E. Retained earnings

  Correct Answer: A

  The four major capital components are debt, preferred stock, retained earnings, and new issues of common stock.

• Question 1447:

  Sun State Mining Inc., an all-equity firm, is considering the formation of a new division, which will increase the assets of the firm by 50 percent. Sun State currently has a required rate of return of 18 percent, U.S. Treasury bonds yield 7 percent, and the market risk premium is 5 percent. If Sun State wants to reduce its required rate of return to 16 percent, what is the maximum beta coefficient the new division could have?

  A. 2.0

  B. 1.0

  C. 2.2

  D. 1.6

  E. 1.8

  Correct Answer: B

  Old assets = 1.0.New assets = 0.5.Total assets = 1.5.

  Old required rate:New required rate:

  18% = 7% + (5%)b16% = 7% + (5%)b

  beta = 2.2.beta = 1.8.

  New b must not be greater than 1.8, therefore

  0.3333(b) = 0.3333

  b = 1.0.

  Therefore, beta of the new division cannot exceed 1.0.

• Question 1448:

  Which of the following is not considered a relevant concern in determining incremental cash flows for a new product?

  A. The cost of a product analysis completed in the previous tax year and specific to the new product.

  B. All of these are relevant.

  C. The use of factory floor space which is currently unused but available for production of any product.

  D. Shipping and installation costs associated with preparing the machine to be used to produce the new product.

  E. Revenues from the existing product that would be lost as a result of some customers switching to the new product.

  Correct Answer: A

  The product analysis cost is considered a sunk cost and is not relevant.

• Question 1449:

  Which of the following statements is correct?

  A. The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a relatively powerful computer, coupled with an efficient financial planning software package, whereas simulation analysis can be done using a PC with a spreadsheet program or even a calculator.

  B. All of these answers are correct.

  C. Sensitivity analysis is incomplete because it fails to consider the range of likely values of key variables as reflected in their probability distributions.

  D. In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less risky, because a small error in estimating a variable, such as unit sales, would produce only a small error in the project's NPV.

  E. Sensitivity analysis is a risk analysis technique that considers both the sensitivity of NPV to changes in key variables and the likely range of variable values.

  Correct Answer: C

  A project's stand-alone risk depends on (1) the sensitivity of NPV to changes in key variables and (2) the range of likely values of these variables as reflected in their probability distribution. Sensitivity analysis considers only the first factor.

• Question 1450:

  A stock has an expected dividend growth rate of 4.9%. The firm has just paid a dividend of $2.5 per share. With a required rate of return of 10%, the stock is trading at $42.8. The stock is:

  A. overpriced.

  B. insufficient information.

  C. fairly priced.

  D. under-priced.

  Correct Answer: D

  The fair price of the stock with a required rate of return, r and a dividend growth rate, g, is given by P = D1/ (r-g), where D1 = Do*(1-g) = dividend to be paid next year. In this case, the fair price of the stock equals 2.5*1.049/(10% - 4.9%) = $51.42. Thus, the stock is under-priced by $(51.42 - 42.8) = $8.62.