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

• Question 921:

  The following information applies to Lott Enterprises: Operating Income (EBIT) $300,000 Debt $100,000 Interest Expense $10,000 Tax Rate 40% Shares Outstanding 120,000 EPS $1.45 Stock Price $17.40 The company is considering a recapitalization where it would issue $348,000 worth of new debt and use the proceeds to buyback $348,000 worth of common stock. The buyback will be undertaken at the prerecapitalization share price ($17.40). The recapitalization is not expected to have an effect on operating income or the tax rate. After the recapitalization, the company's interest expense will be $50,000. Assume that the recapitalization has no effect on the company's price earnings ratio. What is the expected price of the company's stock following the recapitalization?

  A. $15.30

  B. $19.03

  C. $20.48

  D. $18.00

  E. $17.75

  Correct Answer: D

  We can do this problem by using the P/E before and after the recap. Recall that P/E = Price/EPS.

  Before the recap After recap EBIT$300,000 $300,000 Interest-10,000-50,000 EBT$290,000 $250,000 Tax116,000 100,000 NI$174,000 $150,000 Shares120,000 100,000* EPS$174,000/120,000$150,000/100,000 = $1.45= $1.50 P/E$17.40/1.45 = 12x *120,000 - ($348,000/$17.40) As P/E = 12 after the recapitalization (recall the question states that it does not change), we know 12 = Price/$1.50 Price = 12 x $1.50 = $18.00.

• Question 922:

  A company estimates that its weighted average cost of capital (WACC) is 10 percent. Which of the following independent projects should the company accept?

  A. Project C requires an up-front expenditure of $1,000,000 and generates a positive internal rate of return of 9.7 percent.

  B. Project D has an internal rate of return of 9.5 percent.

  C. None of the projects should be accepted.

  D. Project B has a modified internal rate of return of 9.5 percent.

  E. Project A requires an up-front expenditure of $1,000,000 and generates a net present value of $3,200.

  Correct Answer: E

  This is the only project with either a positive NPV or an IRR which exceeds the cost of capital.

• Question 923:

  Normal projects C and D are mutually exclusive. Project C has a higher net present value if the WACC is less than 12 percent, whereas Project D has a higher net present value if the WACC exceeds 12 percent. Which of the following statements is most correct?

  A. All of the statements are incorrect.

  B. Project D has a higher internal rate of return.

  C. All of the statements are correct.

  D. Project D is probably larger in scale than Project C.

  E. Project C probably has a faster payback.

  Correct Answer: B

  From the information given, D has the higher IRR. The project's scale cannot be determined from the

  information given. As C's NPV declines more rapidly with an increase in rates, this implies that more of the

  cash flows are coming later on.

  So C would have a slower payback than D.

• Question 924:

  The use of financial leverage by the firm has a potential impact on which of the following?

  1.

  The risk associated with the firm.

  2.

  The return experienced by the shareholder.

  3.

  The variability of net income.

  4.

  The degree of operating leverage.

  5.

  The degree of financial leverage.

  A. 1, 3, 5

  B. 1, 2, 5

  C. 2, 3, 5

  D. 2, 3, 4, 5

  E. 1, 2, 3, 5

  Correct Answer: E

  Since financial leverage is the extent to which fixed-income securities are used in a firm's capital structure all of these would impact except the degree of operating leverage, which is the percentage change in EBIT that results from a given percentage change in sales.

• Question 925:

  A firm has fixed costs of $13,000, variable costs of $15 and sale price per unit of $22. The firm has an interest expense of $800. The degree of financial leverage of the firm at an output level of 2,000 units is:

  A. 4.2

  B. 2.3

  C. 4.0

  D. 5.0

  Correct Answer: D

  DFL = EBIT/(EBIT - I). Also, EBIT = Q(P-V) - FC. Therefore, EBIT = 2000*(22-15) - 13,000 = 1,000 and DFL = 1000/(1000 - 800) = 5.

• Question 926:

  A project with normal (or conventional) cash flows has a single IRR of 10%. If a project's hurdle rate is 8%, the project NPV:

  A. is positive.

  B. could be all of these answers.

  C. equals zero.

  D. is negative.

  Correct Answer: A

  "Normal cash flows" implies that there is an up front cost when the project is set up but all cash flows after that are cash inflows. For normal cash flows, the NPV is positive for discount rates lower than the IRR and negative for discount rates higher than the IRR. Since the project's hurdle rate is less than the IRR, the project's NPV is positive. Note: if there are cash outflows after the project is put into operation, one can get multiple IRRs.

• Question 927:

  The date on which a company actually distributes a dividend is known as the:

  A. Ex-Dividend Date

  B. Holder-of-Record Date

  C. Declaration Date

  D. Expiration Date

  E. Payment Date

  Correct Answer: E

  The "Payment Date" is the date that a company actually mails the dividend checks.

• Question 928:

  Phoenix Products Inc. requires a new machine to produce a part for a solar air conditioner. 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 A Machine B 0-$1,000-$1,000 10 417 20 417 30 417 41,938 417 If the cost of capital for Phoenix Products is 5 percent, which of the following is the most valid statement?

  A. The IRR(A) > IRR(B), therefore accept Machine A.

  B. The NPV(A) < NPV(B), therefore accept Machine B.

  C. Take neither A nor B since the cost of capital is greater than the internal rate of return.

  D. The NPV(A) > NPV(B), therefore accept Machine A.

  E. The IRR(A) < IRR(B), therefore accept Machine B.

  Correct Answer: D

  NPV(A) = $1,938(PVIF(5%,4)) - $1,000

  = $1,938(0.8227) - $1,000 = $1,594.39 - $1,000 = $594.39.

  NPV(B0 = $417(PVIFA(5%,4)) - $1,000

  = $417(3.5460) - $1,000 = $1,478.68 - $1,000 = $478.68.

  Therefore, accept Machine A since NPV(A) > NPV(B).

• Question 929:

  Given the following choices, what is the optimal capital structure for Chip Co.? (Assume that the company's growth rate is 2 percent.)

  Debt Ratio Dividends Per Share ($) Cost of Equity 0%5.5011.5% 256.0012.0 406.5013.0 507.0014.0 757.5015.0

  A. 50% debt; 50% equity

  B. 40% debt; 60% equity

  C. 25% debt; 75% equity

  D. 75% debt; 25% equity

  E. 0% debt; 100% equity

  Correct Answer: C

  First, calculate the stock price for each debt level using the dividend growth model, Po = D1/(ks - g).

  Debt Div/share ksPo

  0%$5.5011.5% $5.50/(0.115 - 0.02) = $57.89.

  25%6.0012%$6.00/(0.12 - 0.02) = $60.00.

  40%6.5013%$6.50/(0.13 - 0.02) = $59.09.

  50%7.0014%$7.00/(0.14 - 0.02) = $58.33.

  75%7.5015%$7.50/(0.15 - 0.02) = $57.69.

  Clearly, $60.00 is the highest price, so 25% debt and 75% equity is the optimal capital structure.

• Question 930:

  The Bird-in-the-Hand theory implies that as the dividend pay-out ratio is increased, the stock price:

  A. remains unaffected.

  B. decreases.

  C. increases.

  D. increases or decreases.

  Correct Answer: C

  The Bird-in-the-Hand theory implies that as the dividend pay-out ratio is increased, the stock price increases.