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

CFA Institute CFA-LEVEL-1 Online Questions & Answers

• Question 3521:

  The management of Allcycles.com, a motorcycle supply chain, is examining several capital projects. The firm is financed according to the following schedule based on market values:

  60% debt

  35% common stock

  5% perpetual preferred stock

  Additionally, consider the following information:

  Yield on outstanding debt: 10.12%

  Tax rate: 35%

  Annual preferred dividend: $0.64

  Preferred stock price: $7. 36

  Return on equity: 18%

  Dividend payout ratio: 25%

  Cost of common stock: 16. 33%

  Using this information, what is the Weighted Average Cost of Capital for Allcycles.com?

  A. 10.55%
  B. The answer cannot be completely calculated from the given information.
  C. 9.98%
  D. 10.04%
  E. None of these answers.
  F. 10.10%
  F. 10.10%

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  Explanation

  In order to calculate the WACC, it is necessary to first calculate the component after-tax cost of debt, common equity, and preferred equity. Once the cost of these components is determined, they are imputed into the WACC equation, which is

  as follows:

  {WACC = [(% weight of debt securities * cost of debt) + (% weight of common stock * cost of common stock) + (% weight of preferred stock * cost of preferred stock)]} To calculate the component after-tax cost of debt, use the following

  equation:

  {Cost of debt = [yield on outstanding debt securities * (1 - tax rate)}

  Factoring in the given information into this equation would yield the following:

  {After-tax cost of debt = [10.12% * (1 - 0.35%)]} = 6. 578%

  To calculate the component cost of outstanding preferred stock, the following equation must be used:

  {Cost of preferred stock = [annual dividend / preferred stock price]}

  {Cost of preferred stock - = [$0.64 / $7. 36]} = 8.70%.

  The final component of the WACC calculation, the cost of common equity, has been provided as 16. 33%.

  Now that the after-tax cost of debt, preferred stock, and common stock have been determined, the WACC calculation can be found. The calculation of the WACC is as follows:

  {[0.60 * 0.06578] + [0.35 * 0.1633] + [0.05 * 0.0870]} = 10.10%.

• Question 3522:

  An investor is examining shares of Intelligent Semiconductor to determine if they are trading at an appropriate multiple. Assume the following information:

  k = 14. 25% per year g = 13. 4% per year D0 = $2. 15 P0 = $110.80

  Using the information provided, what is the appropriate P/E ratio for Intelligent Semiconductor?

  A. 25. 89
  B. The answer cannot be determined from the information provided.
  C. 51.53
  D. 2. 59
  E. 45. 11
  F. None of these answers is correct.
  B. The answer cannot be determined from the information provided.

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  Explanation

  In this example, not all of the necessary information has been provided. Specifically, the EPS figure must be known in order for the P/E ratio to be determined.

  If the EPS figure is known, however, the infinite period dividend discount equation can be manipulated to solve for the P/E multiple. Specifically, by dividing each side of the infinite period dividend discount equation by the EPS figure, it is possible to determine the P/E ratio. This is illustrated as follows:

  P0/EPS = (D1 / EPS)/(k-g)

  Where: P0 = the price of the common stock at t0, D1 = the dividend at t1, EPS = the earnings per share calculation for t1, k = the required rate of return, and g = the expected growth rate.

  Manipulating the infinite period dividend discount model to solve for the PE is a rather intuitive process.

  Consider the fact that an investment's value is truly nothing more than the present value of all future returns. So said, dividing both sides of the infinite period dividend discount model equation by the EPS figure should yield the appropriate multiple, or "earnings multiplier." This is the price-to-earnings ratio.

• Question 3523:

  Cash outflows for payment of cash dividends is an example of:

  A. cash flows from operating activities
  B. cash flows from financing activities
  C. cash flows from noncash investing and financing activities
  D. cash flows from investing activities
  C. cash flows from noncash investing and financing activities

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  Explanation

  Providing stockholders with a return on their investment in the form of a cash dividend is a financing activity.

• Question 3524:

  Clay Industries, a large industrial firm, has begun the development of an underwater drilling system which will greatly increase the efficiency of deep-sea petroleum extraction. In their analysis of the project's cash-flow potential, the corporate finance division of Clay Industries does not factor in the initial RandD costs for the quarter, rather examines only the initial cash outlay and expected cash inflows specific to the underwater drilling system. The RandD costs involved for this quarter could best be described as which of the following?

  A. Externality
  B. None of these answers
  C. Opportunity cost
  D. Implicit cost
  E. Sunk cost
  F. Incremental cost
  E. Sunk cost

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  Explanation

  In this example, the RandD expenditures are an example of a sunk cost. In an analysis of any project, sunk costs are not included. This is because sunk costs represent outlays which have already occurred or have already been committed. These costs are not incremental, and hence are not affected by the decision under consideration.

• Question 3525:

  In the 1980s, the government cut back on the tax rates in an effort to spur the economy. This led to a significant decrease in real tax revenues. A breakdown of this decrease indicated that most of the decrease came from the lower tax brackets. Tax revenues from top tax bracket actually increased despite the cut. There was a modest growth in the GDP during this period, though amongst all the industrialized nations, only Japan matched this rate. This empirical evidence indicates that:

  A. The supply side effects are not as potent as hypothesized by economists.
  B. The supply-side response of tax payers can have a strong effect on a nation's growth.
  C. The Rational Expectations model is a fair description of how people respond to fiscal policy.
  D. The tax avoidance behavior governing the demand side has a significant impact on the economy.
  B. The supply-side response of tax payers can have a strong effect on a nation's growth.

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  Explanation

  The important part in this empirical observation is the effect of a change in marginal tax revenues. Marginal tax rates are central to the effects postulated by Supply-side economists. According to this theory, a reduction in marginal tax rates increases the incentive to work and save more by increasing the disposable income. This causes people to shift away from leisure and toward more productive work, enlarging the effective resource base and improving the efficiency with which it is utilized. The empirical evidence in the study indicate that supply-side effects can be quite important in directing the growth of an economy.

• Question 3526:

  Mrs. Davis was in the habit of keeping $500 in currency in her jewelry chest in case she ever needed cash and the bank was closed. However, she recently got a combination debit/ATM card that gives her access to her checking account 24

  hours a day. She deposits her $500 in cash into her checking account.

  How does this immediately impact the monetary base and the effective amount money available for transactions?

  A. decrease, increase
  B. increase, decrease
  C. no change, decrease
  D. both increase
  E. no change for either
  F. decrease, no change
  G. both decrease
  F. decrease, no change

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  Explanation

  Effectively, there is no difference in how Mrs. Davis is using money, simply a different vehicle for spending it. Therefore the effective level of money in circulation has not changed. However, where the monetary base previously had including her $500 in currency, it would now only include the percentage of this money held in reserve by her bank. The monetary base equals currency plus bank reserves. Therefore the monetary base would decrease. Innovations like debit cards have decreased the need to hold currency. Therefore certain measures of the money supply may decrease despite no real change in the money level in circulation.

• Question 3527:

  The share price of a closed-end investment company is

  A. generally lower than its NAV.
  B. generally higher than its NAV.
  C. typically equal to its NAV.
  D. always equal to its NAV.
  A. generally lower than its NAV.

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  Explanation

  The share price of a closed-end investment company is determined by the market supply and demand for its stock. Over the long run, shares of closed-end investment companies have traded 5 to 20 percent below their NAVs. The reason for this disparity is still open to question.

• Question 3528:

  A portfolio manager with Churn Brothers Brokerage is examining the health care industry from the perspective of relative valuation. In her analysis, the portfolio manager examines the relationship between the historical earnings multiple of the health care industry and the historical earnings multiple of the entire market using a time series forecast. Which of the following best characterizes this method of estimating an earnings multiplier? Choose the best answer.

  A. Microanalysis
  B. Macroanalysis
  C. Linear regression
  D. Forbes method
  E. Simulation analysis
  B. Macroanalysis

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  Explanation

  The method profiled in this example is "macroanalysis," which is one of two methods for estimating the earnings multiplier of an industry. Macroanalysis involves examining the historical relationship between the earnings multiplier of an

  industry with that of the overall market. Macroanalysis forecasts often use a time series.

  The macroanalysis method is contrasted by microanalysis, which involves examining the variables underlying the earnings multiplier - the required rate of return, the growth forecast, and the dividend payout ratio. In microanalysis, these

  variables are examined for the industry and then compare them with the values of these variables for the entire market.

  "Simulation analysis" is a method of examining stand-alone risk, and the "Forbes method" is a fictitious term. "Linear regression" does not represent the best choice.

• Question 3529:

  Which is a true statement concerning the empirical evidence of mutual fund performance?

  A. more aggressive funds did not outperform more conservative funds
  B. over 50 percent of the funds outperform the DJIA
  C. risk measures increase as fund objectives become more aggressive
  D. successful market forecasting was accomplished overall by fund managers
  E. none of these answers
  F. good performance is associated with high expense ratios
  C. risk measures increase as fund objectives become more aggressive

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  Explanation

  There is a positive relationship between stated objectives and measure of risk, with risk measures increasing as objectives become more aggressive.

• Question 3530:

  Simon Steel Inc. had the following unusual financial events occur this year: Bonds payable were retired 5 years before their scheduled maturity, resulting in a $260,000 gain, Simon has frequently retired bonds early when interest rates declined significantly. A steel forming segment suffered $255,000 in losses from hurricane damage. This was the fourth similar loss sustained in a 5-year period at that location. A segment of Simon's operations, steel transportation, was sold at a net loss of $350,000. This was Simon's first divestiture of one of its operating segments. Before income taxes, what amount should be disclosed as the gain (loss) from extraordinary times for this year?

  A. $260,000
  B. $(345,000)
  C. $5,000
  D. $(90,000)
  E. $(350,000)
  A. $260,000

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  Explanation

  Accounting rules require that any gain or loss from early retirement of debt must be recognized as an extraordinary item. For all other transactions to be classified as extraordinary items, they must be both unusual and infrequent. In this case, none of the other gains or losses qualify.