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

CFA Institute CFA-LEVEL-1 Online Questions & Answers

• Question 1591:

  Flood Motors is an all-equity firm with 200,000 shares outstanding. The company's EBIT is $2,000,000 and is expected to remain constant over time. The company pays out all of its earnings each year, so its earnings per share equals its dividends per share. The company's tax rate is 40 percent. The company is considering issuing $2 million worth of bonds (at par) and using the proceeds for a stock repurchase. If issued, the bonds would have an estimated yield to maturity of 10 percent. The risk-free rate in the economy is 6. 6 percent, and the market risk premium is 6 percent. The company's beta is currently 0.9, but its investment banker's estimate that the company's beta would rise to 1.1 if they proceed with the recapitalization. Assume that the shares are repurchased at a price equal to the stock market price prior to the recapitalization. What would be the company's stock price following the recapitalization?

  A. $53. 85
  B. $51.14
  C. $76. 03
  D. $56. 02
  E. $68.97
  B. $51.14

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  Explanation

  First, find the company's current cost of capital, dividends per share, and stock price: k = 0.066 + (0.06)0.9 = 12%. To find the stock price, you still need the dividends per share or DPS = ($2,000,000 (1 - 0.4))/200,000 = $6. 00. Thus, the stock price is Po = $6. 00/0.12 = $50.00. Thus, by issuing $2,000,000 in new debt the company can repurchase $2,000,000/$50.00 = 40,000 shares. Now after recapitalization, the new cost of capital, DPS, and stock price can be found: k = 0.066 + (0.06)1.1 = 13. 20%. DPS for the remaining (200,000 - 40,000) = 160,000 shares are thus [($2,000,000 - ($2,000,000 x 0.10))(1 - 0.4)]/160,000 = $6. 75. And, finally, Po = $6. 75/0.132 = $51.14.

• Question 1592:

  Which of the following methods of measuring a project's stand-alone risk is characterized by using a computer to analyze a project's NPV across a wide range of values for numerous input variables? (Hint: This style of analysis evolved from methods used to examine probabilities in casino gambling.)

  A. Sensitivity Analysis
  B. Monte Carlo Simulation
  C. Scenario Analysis
  D. Probability Analysis
  E. None of these answers
  B. Monte Carlo Simulation

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  Explanation

  When measuring stand-alone risk using Monte Carlo Simulation, the use of a computer and a rather complex software package is necessary. In Monte Carlo Simulation, the expected ranges of inputvariables are specified, and random numbers are incorporated into the analysis function, producing a NPV value across a wide range of possible situations. Monte Carlo Simulation is so named because the technique evolved largely from methods used to analyze probabilities in casino gambling. Scenario analysis involves the establishment of a "best case" and "worst case" scenario, which is compared to a predetermined "base case." Sensitivity Analysis seeks to determine the sensitivity of a project's NPV to changes in specific input variables, and "Probability Analysis" can be conducted using simple statistical formulas. None of these three methods absolutely require the use of a computer or complex statistical software package.

• Question 1593:

  The management of Olively.com, an online research network, are considering becoming a public company. At a lengthy meeting with the board of directors, the CEO of Olively.com details his idea as to methods in which the firm should raise capital. In his discussion, the CEO states that "45% of new capital should come from debt, leaving 55% to come from the issuance of common equity. We will disregard issuing preferred stock at this point." In the simplistic sense, the CEO of Olively.com is detailing which of the following?

  A. Optimal capital structure
  B. Target capital structure
  C. Target asset base
  D. Capital asset base
  E. Optimal asset base
  B. Target capital structure

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  Explanation

  In this example, the CEO of Olively.com is detailing his idea of the company's target capital structure. The target capital structure can best be thought of as the proportion of debt, common stock, and preferred stock that the firm plans to issue in its effort to raise capital. The "optimal capital structure" is defined as the capital structure that balances risk and return, thereby maximizing the firm's stock price.

• Question 1594:

  A portfolio manager with Smith, Kleen and Beetchnutty is examining shares of Microscam for possible investment. In her research, this portfolio manager has assimilated the following information about Microscam from the Company's most recent fiscal year:

  Adjusted operating profit before tax: $30,040,000 Cash operating taxes: $10,500,000 Cost of capital: 18.25% per year Total capital employed: $98,750,000

  Using this information, what is the Economic Value Added for Microscam? Further, should the management of Microscam be considered to have created value for shareholders?

  A. $1,743,071; management has created economic value
  B. None of these answers is correct.
  C. ($1,150,000); management has not created economic value
  D. ($1,518,125); management has created economic value
  E. $1,518,125; management has created economic value
  F. $1,518,125; management has not created economic value
  E. $1,518,125; management has created economic value

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  Explanation

  Economic Value Added, a value-based measure of economic profit, is a registered trademark of Stern, Stewart and Company. The equation used to calculate EVA is as follows:

  EVA = {Net Operating Profits Less Adjusted Taxes - [Total Capital Employed * (Cost of Capital)]}.

  In this case, the NOPLAT figure must be calculated manually by subtracting the Cash Operating Taxes from the Adjusted Operating Profit before Tax (AOPBT) figure. Doing so will produce an answer of $19,540,000 for the Net Operating Profit Less Adjusted Taxes figure. Now that the necessary information has been determined, the calculation of EVA is as follows:

  EVA = {$19,540,000 - ($98,750,000 * 0.1825)} = $1,518,125

  A positive EVA calculation indicates that management has provided economic profits to shareholders, as evidenced by the fact that the opportunity cost of capital employed is less than the AOPAT figure. In this example, the management of

  Intelligent Semiconductor should be considered as having succeeded to provide shareholder value.

  The calculation of Adjusted Operating Profit Before Taxes (AOPBT), and Cash Operating Taxes are important. The calculation of AOPBT is as follows:

  Operating profit (after depreciation and amortization) + Implied interest on operating leases + any increase in the LIFO reserve + goodwill amortization = Adjusted Operating Profit Before Taxes.

  Cash Operating Taxes, another important component of EVA, is calculated as follows:

  Cash Operating Taxes = Income Tax Expense + tax benefit from interest expenses + tax benefit from interest on leases + taxes on non-operating income Adjusted Operating Profit Before Taxes minus Cash Operating Taxes = Net Operating

  Profit Less

  Adjusted Taxes (NOPLAT). Subtracting the dollar cost of capital from the NOPLAT figure will yield the EVA.

• Question 1595:

  Which of the following is/are true about Treasury stock?

  I. They represent registered shares that have been reacquired from shareholders.

  II. Ownership of treasury stock represents part of a firm's assets.

  III.

  Purchase of treasury stock reduces both assets and equity.

  A. I and II
  B. I, II and III
  C. I only
  D. I and III
  D. I and III

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  Explanation

  Treasury stock represents the equity that has been repurchased by the company. It should be remembered that treasury stock is not an asset; rather it is a contra equity account, serving to reduce the outstanding equity. A compensating reduction in assets also occurs when the firm has to pay cash to buy-back the shares.

• Question 1596:

  What would the bid-ask spread be for pound sterling quoted at $14419-28?

  A. 6. 4%
  B. 0.64%
  C. 6. 2%
  D. 0.62%
  E. 0.63%
  D. 0.62%

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  Explanation

  Percent spread = [(1.4428 - 1.4419)/1.4428] x 100 = 0.062%

• Question 1597:

  Which measure of dispersion disregards the algebraic signs (plus and minus) of each difference between X and the mean?

  A. Standard deviation
  B. Variance
  C. Mean deviation
  D. Mean
  E. None of these answers
  C. Mean deviation

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  Explanation

  The mean deviation is the mean of the absolute values of the deviations from the mean.

• Question 1598:

  According to Say's law, there cannot be overproduction of goods and services because

  A. overproduction will lead to higher unemployment, which will reduce production.
  B. demand creates its own supply.
  C. less fortunate countries will always buy the excess output.
  D. producing goods generates enough income to buy the total output.
  D. producing goods generates enough income to buy the total output.

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  Explanation

  Say's Law is the view that production creates its own demand. Demand will always be sufficient to purchase the goods produced because the income payments to the resource suppliers will equal the value of the goods produced.

• Question 1599:

  Jeret Behr is a member of a Level 1 CFA Study Group. Last week, he was assigned the reading on asset pricing models and is to prepare a "tough" question on the capital market line (CML). He constructs the following graphical representation of the CML and drafts the following four statements about the graph. The letters W, X Y, and Z represent risky portfolios. Portfolio M is the market portfolio. The linesRfXandRfYrepresent the combination of the risk-free asset and the risky portfolio.

  Which of the following statements about the above graph did Behr make TRUE?

  A. Investors are not compensated for the risk represented by the area to the left of point S.
  B. The correct label for the x-axis is beta risk.
  C. Portfolio Z was created by borrowing at the risk free rate.
  D. Portfolio Y is inefficient.
  D. Portfolio Y is inefficient.

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  Explanation

  This selection is true (or not false). By definition, all portfolios below the CML are inefficient in that they do not give enough return for their risk. Investors could do better by combining the risk-free asset with the portfolio. The area to the left of point S represents systematic or undiversifiable risk. Investors are compensated for this risk. The correct label for the x-axis is total risk, or standard deviation. The CML plots total risk (systematic plus unsystematic risk) versus expected return; the security market line (SML) plots beta (or systematic risk) versus expected return. Portfolio Z is created by lending at the risk-free rate and holding less than 100% of Portfolio M. Investors in portfolios to the left of the market portfolio, M, are invested in less than 100% of M.

• Question 1600:

  The "dollar-weighted" rate of return measure incorporates which of the following in its return calculation?

  A. None of these answers is correct.
  B. Modified Internal Rate of Return
  C. Net Present Value
  D. More than one of these answers is correct.
  E. Discounted Payback Period
  F. Internal Rate of Return
  F. Internal Rate of Return

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  Explanation

  Performance measurement is an important consideration for the CFA candidate, and can be a particularly difficult task in situations where the portfolio under consideration is subject to additions and withdrawals. Two performance measurement tools discussed in the Level I readings are the "dollar-weighted rate of return" and the "time-weighted rate of return." In fact, the dollar-weighted rate of return is simply another name for the IRR equation. In investment management applications, the IRR equation is commonly referred to as the "dollar-weighted rate of return" because it accounts for the timing and scope of all cash flows.