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

• Question 1531:

  Given the following information about a manufacturing firm, determine the optimal capital structure. The optimal capital structure for this firm is:

  A. 10% Debt, 90% Equity.

  B. 25% Debt, 40% Equity.

  C. 40% Debt, 60% Equity.

  D. 50% Debt, 50% Equity.

  Correct Answer: C

  After calculating the missing data points in the table, we can determine that the capital structure of 40%

  debt and 60% equity minimizes the WACC and maximizes the stock price (see calculations below), and is

  thus considered optimal.

  To calculate WACC for the missing data points, we will use the formula:

  WACC = (wd)(kd) + (we)(ke), where wd, weare the weights used for debt and common equity.

  To calculate the Stock Price for the missing data points, we will use the formula:P0= D1/ ke

  Here, we need to calculate D1using the EPS and payout information; g is given as 0.0%.

• Question 1532:

  Using the following assumptions, calculate the stock price at which investors Helen Alba, who shorts the stock on margin, and Kobin Lubis, who purchases the stock on margin, will receive a margin call. Which of the following choices is closest to the correct answer? Alba will receive a margin call at a stock price of:

  A. $33.00 and Lubis will receive a margin call at a stock price of $37.66.

  B. $33.00 and Lubis will receive a margin call at a stock price of $53.45.

  C. $46.85 and Lubis will receive a margin call at a stock price of $33.00.

  D. $37.66 and Lubis will receive a margin call at a stock price of $53.45.

  Correct Answer: C

  Calculations are as follows:

  Since Alba is short(sold the stock), the formula for the margin call price is:

  Margin Call = (original price) * (1 + initial margin) / (1 + maintenance margin)

  = $42 * (1 + 0.45) / (1 + 0.30) =$46.85

  Since Lubis is long(purchased the stock), the formula for the margin call price is:

  Margin Call = (original price) * (1 ?initial margin) / (1 ?maintenance margin)

  = $42 * (1 ?0.45) / (1 ?0.30) =$33.00

• Question 1533:

  Which of the following statements about dividend policy and capital structure is TRUE?

  A. A person who believes in the clientele effect and a proponent of the "bird-in-hand" theory would have similar views on dividend payout policy.

  B. Investors view a stock repurchase as a positive signal and a stock issue as a negative signal.

  C. A diversified shareholder is most concerned with stand-alone risk.

  D. Monte Carlo simulation is used to estimate market risks; scenario analysis measures stand-alone risk.

  Correct Answer: B

  Investors view a stock repurchase as a positive signal and a stock issue as a negative signal. A repurchase may mean that management believes the stock is undervalued. To understand why a stock issue is viewed negatively, consider the following circumstances: A biotech company has a new blockbuster drug that will increase its profitability, but to produce and market the drug, the company needs to raise capital. If the company sells new stock, then as sales (and thus profits) occur, the price of the stock will rise. The current shareholders will do well but not as well as they would have had the company not sold more stock before the share price increased. Thus, it is assumed that management will prefer to finance growth with non-stock sources. The other statements are false. A person who believes in the clientele effect and a proponent of the "birdin-hand" theory would not have similar views on dividend policy. The clientele effect suggests that different groups of investors want different dividend levels (often based on tax status), and through the law of supply and demand, investors will select companies that meet their needs. Thus, dividend payout policy does not matter. According to the "bird-in-hand" theory, investors prefer dividends to capital appreciation because they view the former (D1/ P0) as less risky than the latter (g, or growth rate). Stand-alone risk is the company's individual, or unique, risk. An undiversified shareholder is concerned with stand-alone risk. A diversified shareholder is most concerned about undiversifiable, or systematic, risk. Both Monte Carlo simulation and scenario analysis are used to estimate stand-alone risk.

• Question 1534:

  KGraphix, a small, privately owned publishing company, plans to upgrade its printing process by

  purchasing either a high-speed color laser printer or a webpress (a high speed color printing machine).

  Incremental cash flow information for each piece of equipment is as follows:

  Assuming that the company's weighted average cost of capital (WACC) is 13 percent, which of the

  following statements is most correct? KGraphix should purchase the:

  A. webpress because its net present value (NPV) of $9,939 is greater than the color laser printer's NPV of $7,223.

  B. color laser printer because its Internal rate of return (IRR) is higher than that of the webpress.

  C. color laser printer because it has the highest equivalent annual annuity.

  D. webpress because it has the longest life and the highest net present value (NPV).

  Correct Answer: C

  Here, we have two projects with unequal lives, so we have to adjust the cash flow. We can either adjust the cash flows of the shorter-term project to match the life of the longer-term project (adjusted NPV), or we can use the equivalent annual annuity (EAA) approach. The answer given is most correct because the project with the highest EAA will have the highest adjusted NPV, and the color laser printer has the highest EAA (and adjusted NPV). (See table below.) The statement, "KGraphix should purchase the webpress because its NPV of $9,939 is greater than the color laser printer's NPV of $7,223," calculates NPV only using the given lives (or unadjusted NPV). Unadjusted NPV is not the best criterion to use for deciding between mutually exclusive projects with unequal lives. Although the color laser printer has an IRR higher than that of the webpress, IRR is also not the best criterion to use for mutually exclusive projects with unequal lives Quantitatively: (all amounts are in $ unless indicated otherwise): Notes:1Repeats color laser project beginning in year 3; year 3 cash flow equals the net initial investment cost of $40,000 and $20,000 inflow from the last year of the "first" printer. Following are examples of how to use financial calculator to solve this problem. (Note, the example is for the unadjusted NPV, IRR, and EAA of the color laser printer. Use a similar methodology to determine the NPV, IRR, and EVA for the other cash flows streams.

  

  

  

  Note:1Negative sign is for calculator functionality, not to signify a negative amount

• Question 1535:

  Norine Benson is studying for the Level 1 CFA examination and is having difficulty with the broader concepts of capital budgeting. Her study partner, Henri Manz, tests her understanding by asking her to identify which of the following statements is TRUE?

  A. For mutually exclusive projects, the decision rule is to pick the project that has the highest net present value (NPV).

  B. If the change in current liabilities is greater than the change in current assets, it means that additional financing was needed and there is a cash outflow.

  C. An analyst can ignore inflation since price level expectations are built into the weighted average cost of capital (WACC).

  D. Replacement decisions involve mutually exclusive projects.

  Correct Answer: D

  Because replacement decisions involve either keeping the old asset or replacing the old asset, the projects are mutually exclusive. The decision rule for NPV is to pick the project with the highest positive NPV. Only projects with positive NPV add to the company's value. If a neither project has a positive NPV, neither project should be chosen. The statement about net working capital (NWC) is stated in the reverse of how we usually think of it: in NWC = Current Assets ?Current Liabilities. Here, the change in current liabilities exceeds the change in current assets and the result is negative, meaning the project frees up cash, creating a cash inflow. Because the WACC is adjusted for inflation, the analyst must adjust project cash flows upward to reflect inflation. If the cash flows are not adjusted for inflation, the NPV will be biased downward. (Reverse the preceding logic for deflation.)

• Question 1536:

  Which of the following statements about the cost of capital is TRUE?

  A. New common equity used to finance projects is usually dilutive.

  B. The component cost of retained earnings equals the required rate of return on new stock.

  C. Using the marginal cost of capital (MCC) is superior to the weighted average cost of capital (WACC) because the MCC assumes different risks across projects.

  D. A firm can shift its retained earnings breakpoint by changing the dividend policy.

  Correct Answer: D

  The firm can shift the break point of the MCC schedule by changing its payout ratio through the dividend policy. Remember that the dividend payout ratio is in the numerator of the calculation that dictates the breakpoint between lower cost internally generated equity (retained earnings) and higher cost externally generated equity (common stock). The other choices are false. New common equity is not by definition dilutive. However, if the firm does not earn the cost of new common equity on the portion of the investment that is financed with the new issue, the firm's earnings per share will fall. The MCC is the cost of the last dollar raised by the company and assumes constant risk across projects. The component cost of retained earnings equals the required rate of return on existing stock.

• Question 1537:

  Calculate the weighted average cost of capital (WACC) for a company with the following capital component

  information:

  The firm can issue new common stock with a price of $40.00, floatation costs of 3.0%, and a dividend in

  year 0 of D0= $3.00.

  Which of the following is closest to the correct answer? The WACC equals:

  A. 9.82%.

  B. 9.49%.

  C. 9.05%.

  D. 10.05%.

  Correct Answer: B

  Step 1: Determine the after-tax cost of debt:

  Theafter-tax cost of debt[kd(1 – t)]is used to compute the weighted average cost of capital. It is the interest

  rate on new debt (kd) less the tax savings due to the deductibility of interest (kdt).

  Here, we are given the inputs needed to calculate kd: n = 15*2 = 30, PMT = (1000*0.07)/2 = 35, FV =

  1000, PV = -1047.46, compute I = 3.25, multiply by 2 = 6.50%.

  Thus, kd(1 – t) = 6.50% * (1 – 0.35) =4.22%

  Step 2: Determine the cost of preferred stock:

  Preferred stock is a perpetuity that pays a fixed dividend (Dps) forever. Thecost of preferred stock (kps)=

  Dps/ Pnet where Dps = preferred dividends.

  Pnet = net issuingprice after deducting flotation costs.

  Here, Dps= 0.08 * $35.00 = $2.80, so kps= Dps/ Pnet =$2.80 / $33.60 = 0.0833, or8.33%. Step 3: Determine the cost of retained earnings:Given as 10.5%. Step 4: Determine the cost of common equity: Thecost of new common equityis given by:

  ke= [D1/ (P0(1 – F))] + g where F = the percentage flotation cost incurred in selling new stock, or

  (current stock price – funds going to company) / current stock price

  D1= Dividend in next year

  P0= Current stock price

  g = Dividend growth rate

  Here, D1= D0* (1 + g) = $3.00 * ( 1 + 0.06) = $3.18. F is given.

  ke= [ 3.18 / (40 * (1 – 0.03))] + 0.06 = 0.1420 or 14.20%.

  Step 5: Calculate WACC:

  WACC = (wd)(kd) + (wps)(kps) + (ws)(ks)+ (we)(ke)

  where wd, wps, wsandweare the weights used for debt, preferred stock, retained earnings, and common

  equity.

  Here, WACC = (0.30 * 4.22%) + (0.20 * 8.33%) + (0.15 * 10.5%) + (0.35 * 14.2%) =9.49%.

  Note:Your calculation may differ slightly, depending on whether you carry all calculations in your calculator,

  or round to two decimals and then calculate.

• Question 1538:

  Which of the following statements about agency theory is TRUE?

  A. A company that pays fixed salaries with no variable compensation schemes likely has little agency conflict.

  B. An agency relationship is created when the board of directors appoints a new Chief Financial Officer.

  C. Restrictive debt covenants reduce the conflict between stockholders and managers.

  D. Encouraging managers to take on high-risk projects aligns their goals with that of bondholders.

  Correct Answer: B

  An agency relationship is created when decision-making authority is delegated to an agent without the agent being 100% responsible for the consequences of her decisions. Here, unless the Chief Financial Officer owns 100% of the firm, she has an agency relationship with the company. Stockholders and managers both benefit from risky projects that increase profitability and firm value. However, bondholders bear the risk of bankruptcy. Thus, encouraging managers to take on high-risk projects does not help to align their goals with that of creditors. A company that pays fixed salaries with no variable compensation schemes is not set up to reduce agency conflict. Without managerial compensation plans that motivate managers to act to increase stock price, stockholders and managers may have disparate goals.

• Question 1539:

  Kep Polznik is a financial consultant to an entrepreneur who owns a chain of check-cashing establishments (individuals who meet certain criteria can cash post-dated checks and then repay the money at a later date). The company's Treasurer is considering using plain vanilla swaps. Which of the following statements should Polznik NOT use to sell the Treasurer on the use of interest rate swaps?

  A. The Treasurer can use swaps to exploit market inefficiencies.

  B. The swap market's operational efficiency results in reduced transaction costs.

  C. Swap agreements allow companies a more flexible way to package cash flows.

  D. By using swaps, the Treasurer can maintain the confidentiality of business strategy.

  Correct Answer: A

  Exploiting market inefficiencies is no longer considered a motivation for entering into swap agreements. Historically, there were two basic motivations for swaps, to exploit market inefficiencies and to attempt to obtain cheaper financing. Both were based on the belief that financial markets are inefficient. Today, the swap markets have matured and there are few arbitrage opportunities. The swap markets are considered operationally efficient and flexible. Thus, the main reasons to enter into swap agreements include: to reduce transaction costs, to avoid costly regulations, and to maintain privacy.

• Question 1540:

  Joel Franklin, CFA, has just been promoted to junior portfolio manager for a large equity portfolio at Davidson-Sherman (DS), a large multinational investment banking firm. He is specifically responsible for the development of a new investment strategy that DS wants all equity portfolios to implement. DS has decided to begin overlaying option strategies on all equity portfolios. The reason for this decision is the relatively poor performance of many of their equity portfolios. They look at the option strategies as an opportunity to add value or reduce risk. Franklin recognizes that the behavior of an options value is dependent on many variables and decides to spend information shown in Exhibit's 1 and 2 for European style options.

  

  

  Joel recognizes that his software only includes the valuation information for European style options. He wants to know how the premium of an American style option compares with its European counterpart. Which of the following is TRUE? The premium of the American option:

  A. the same or lower.

  B. strictly higher.

  C. the same or higher.

  D. strictly lower.

  Correct Answer: C

  The owner of a European option may exercise it only at expiration whereas an American option can be exercised at any time before or at expiration. Therefore, an American option cannot be worth less than a European option.