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

• Question 911:

  Which of the following is a key benefit of using the degree of leverage concept in financial analysis?

  A. It shows how a given change in leverage will affect sales.

  B. None of these statements are correct.

  C. It establishes the optimal capital structure for the firm.

  D. It allows decision-makers a relatively clear assessment of the consequences of alternative actions.

  E. All of these statements are correct.

  Correct Answer: D

  The degree of leverage concept is useful primarily for the insights it provides regarding the joint effects of operating and financial leverage on EPS. DOL concepts provide alternatives to decision-makers, giving a better idea of the ramifications of alternative actions.

• Question 912:

  Which of the following actions will enable a company to raise additional equity capital (that is, which of the following will raise the total book value of equity)?

  A. A stock repurchase.

  B. The establishment of a new-stock dividend reinvestment plan.

  C. A stock split.

  D. All of these answers are correct.

  E. The establishment of an open-market purchase dividend reinvestment plan.

  Correct Answer: B

  The new stock type of dividend reinvestment plan invests the dividends in newly issued stock, hence these plans raise new capital for the firm.

• Question 913:

  Externalities:

  I. are spill-over effects of a project.

  II. are not necessarily harmful and can actually be beneficial.

  III.

  should be ignored in project evaluation, just as sunk costs are.

  A.

  I, II and III

  B.

  II and III

  C.

  I and II

  D.

  I and III

  E.

  I only

  F.

  III only

  G.

  II only

  Correct Answer: C

  You should remember three things about externalities:

  1.

  They are spill-over effects from the project under consideration and affect the rest of the firm.

  2.

  They are not necessarily harmful. Many of them can be beneficial ("positive externalities").

  3.

  Unlike sunk costs, which have no future cash flow effects, externalities cannot be ignored in project evaluation since their effects on the cash flows are incremental cash flows themselves.

• Question 914:

  Which of the following is/are true?

  I. A project's sunk costs are irrelevant to the decision of accepting or rejecting it.

  II. A project's incremental cash flows are not affected by interest expenses.

  III.

  Project rankings using incremental net income and incremental net cash flows can be different.

  A.

  II only

  B.

  I and II

  C.

  II and III

  D.

  I, II and III

  E.

  I and III

  F.

  I only

  G.

  III only

  Correct Answer: D

  Incremental cash flows of a project are the cash flows that occur if and only if the project is undertaken. Since the effects of debt financing are taken into account through the discount rate used to discount the project cash flows, interest payments are ignored while estimating the project's cash flows. Therefore, a project's incremental cash flows are not affected by interest expense. Sunk costs represent expenses that have already been incurred or committed to. Therefore, they should not be allowed to affect future decisions. Finally, since income includes non-cash items, the discounting of income numbers can distort the project rankings based on cash flows. In capital budgeting, annual cash flows, not accounting income, are used to evaluate a project.

• Question 915:

  Van Slyke Inc. has $5,000,000 in assets, and currently has no debt--it is financed entirely with 200,000 shares of common stock, each of which trades at $25 per share. The firm's EBIT is expected to be $1,250,000 at year-end (i.e., at t=1). The corporate tax rate is 40 percent. Van Slyke expects to pay out a dividend at year-end which is 50 percent of its net income. The company estimates that its earnings and dividends grow at a constant rate of 3 percent a year. The company is considering a recapitalization where they would issue $1,000,000 of debt at a before- tax cost of 10 percent. The proceeds from thedebt issued would be used to repurchase shares of the company's stock at $25 per share. The company's investment bankers estimate that the cost of equity capital would be 16 percent after the recapitalization. What would you expect the company's stock price to be immediately following the recapitalization? Assume that the dividend has not yet been paid.

  A. $27.25

  B. $33.17

  C. $12.15

  D. $16.59

  E. $20.98

  Correct Answer: D

  Step 1 Find EPS:

  EBIT$1,250,000

  Interest expense100,000 = 0.10($1,000,000)

  Earnings before taxes$1,150,000

  Taxes (40%)460,000

  Net income$690,000

  Shares purchased = $1,000,000/$25 = 40,000.

  Shares remaining = 200,000 - 40,000 = 160,000.

  EPS = $690,000/160,000 = $4.3125.

  Step 2 Find D1:

  EPS(1)P/o = D1 $4.3125 (0.50) = $2.1563. Step 3 Find Po: ks = D1/Po + g

  0.16 = $2.1563/Po + 0.03 Po = $16.59.

• Question 916:

  The Target (optimal) Capital Structure will be the mix of debt, preferred stock, and common equity that will accomplish which of the following items?

  A. Ensures that all debt and preferred dividend payments are met

  B. Maximize the firm's profits

  C. Provides funding for any project that a firm wishes to undertake

  D. Provide the lowest debt cost

  E. Maximize the firm's stock price F. Provide the smallest chance of bankruptcy

  Correct Answer: E

  The Target (Optimal) Capital Structure is defined as the percentages of debt, preferred stock, and common equity that will maximize the firm's stock price.

• Question 917:

  Which of the following constitutes an example of a cost which is not incremental, and therefore not relevant in an accept/reject decision?

  A. A firm has a parcel of land that can be used for a new plant site or, alternatively, can be used to grow watermelons.

  B. All of these are examples of incremental cash flows, and therefore, relevant cash flows.

  C. A firm orders and receives a piece of new equipment, which is shipped across the country and requires $25,000 in installation and set-up costs.

  D. A firm can produce a new cleaning product that will generate new sales, but some of the new sales will be from customers who switch from another product the company currently produces.

  E. All of these are not examples of incremental cash flows.

  Correct Answer: B

  These are examples of opportunity costs, externalities or installation costs and are all incremental cash flows.

• Question 918:

  Genuine Products Inc. requires a new machine. Two companies have submitted bids, and you have been assigned the task of choosing one of the machines. Cash flow analysis indicates the following: Year Machine AMachine B 0-$2,000-$2,000 1 0 832 2 0 832 3 0 832 4 3,877 832 What is the internal rate of return for each machine?

  A. IRR(A) = 16%; IRR(B) = 20%

  B. IRR(A) = 24%; IRR(B) = 20%

  C. IRR(A) = 18%; IRR(B) = 24%

  D. IRR(A) = 18%; IRR(B) = 16%

  E. IRR(A) = 24%; IRR(B) = 26%

  Correct Answer: C

  Solve for numerical PVIF and PVIFA then obtain corresponding interest rate from table Machine A $2,000

  = $3,877(PVIF(IrrA,4))

  0.51586 = PVIFA(IrrA,4)

  IRR(A) = 18%.

  Machine B $2,000 = $832(PVIFA(IrrB,4))

  2.40385 = PVIFA(IrrB,4)

  IRR(B) = 24%.

• Question 919:

  Project A has an IRR of 10% and project B has an IRR of 12%. The crossover rate for these projects is 7.4%. You use the NPV rule for making project selections. If both the projects have a cost of capital of 6.9%, and are mutually exclusive with normal cash flows, you should:

  A. insufficient information.

  B. select project A.

  C. select neither A nor B.

  D. select project B.

  Correct Answer: B

  The crossover rate is the discount rate at which the graphs of NPV versus discount rate for the two projects cross. Since the projects have normal cash flows, they will have a single crossover rate. Further, the project with the higher IRR has a "flatter" NPV profile. Therefore, if the cost of capital is smaller than the crossover rate, the project with the flatter profile will have a smaller NPV. Therefore, project A has a higher NPV at the cost of capital of 6.9% and should be selected over project B.

• Question 920:

  Projects A and B both have normal (conventional) cash flows. A's IRR is 7% and B's IRR is 8%. If projects A and B are mutually exclusive, you should select:

  A. Project B.

  B. Neither A not B.

  C. Insufficient information.

  D. Project A.

  Correct Answer: C

  If you were to use the IRR rule, you would select project B if the project's cost of capital were greater than 8%. However, you should always use the NPV criterion for selecting projects. Even though B has a higher IRR, it could have a lower NPV at the project's cost of capital. Since this information is missing, you cannot say for sure whether project A is preferable or project B. Indeed, you don't even know if either of the projects has a positive NPV!