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

• Question 931:

  A fundamental analyst for Smith, Kleen, and Beetchnutty is examining the financial information of Ludicrous Bubble Semiconductor to determine whether it is an appropriate investment for a hedge fund. In his analysis, the fundamental analyst has identified the following financial information: Sales $5,900,000 Total fixed cost $2,300,000 Total variable cost $1,665,000 Interest expense $75,750 EBIT $1,885,000 Amortization expense $47,550 Given this information, what is the Degree of Total Leverage for Ludicrous Bubble Semiconductor?

  A. 2.338

  B. 3.544

  C. 2.311

  D. 2.278

  E. 2.565

  Correct Answer: D

  The Degree of Total Leverage (DTL) demonstrates how a given change in sales will impact a firm's EPS. The equation used for calculating the DTL is as follows: {[Sales - variable costs] / [sales - variable costs fixed costs - interest expense]}. Incorporating the given values for these components into the DTL equation yields the following: {[Sales $5,900,000 - variable costs $1,665,000] / [sales $5,900,000 - variable costs $1,665,000 - fixed costs $2,300,000 - interest expense $75,750]}=2.278. "EBIT" and "amortization expense" are not explicitly incorporated into the DTL equation.

• Question 932:

  Assume that a firm currently has EBIT of $2,000,000, a degree of total leverage of 7.5, and a degree of financial leverage of 1.875. If sales decline by 20 percent next year, then what will be the firm's expected EBIT in one year?

  A. $1,600,000

  B. $3,600,000

  C. $1,350,000

  D. $400,000

  E. $2,400,000

  Correct Answer: D

  DOL = DTL/DFL = 7.5/1.875 = 4.0.

  Change EBIT = (-0.20)(4.0)($2,000,000) = -$1,600,000. EBIT = $2,000,000 - $1,600,000 = $400,000.

• Question 933:

  Coats Corp. generates $10,000,000 in sales. Its variable costs equal 85 percent of sales and its fixed costs are $500,000. Therefore, the company's operating income (EBIT) equals $1,000,000. The company estimates that if its sales were to increase 10 percent, its net income and EPS would increase 17.5 percent. What is the company's interest expense? (Assume that the change in sales would have no effect on the company's tax rate.)

  A. $142,857

  B. $100,000

  C. $857,142

  D. $105,874

  E. $111,584

  Correct Answer: A

  Recall that DTL = % change in NI/% change in sales = 0.175/0.10 = 1.75. DTL = (S - VC)/(S - VC - FC - I)

  1.75 = ($10,000,000 - $8,500,000)/($10,000,000 - $8,500,000 - $500,000 - I)

  1.75 = $1,500,000/($1,000,000 - I) $1,500,000 = $1,750,000 - 1.75I I = $142,857.14.

• Question 934:

  Consider the following information:

  30 day T-Bill rate (Risk free rate) 8.0%

  Common stock Beta 1.2

  Expected rate of return for the market 12.0%

  Asset turnover ratio 3.4x

  Calculate this firm's cost of retained earnings using the CAPM approach.

  A. 43.52%

  B. 12.8%

  C. 9.6%

  D. 8.0%

  E. 27.2%

  F. 12.0%

  Correct Answer: B

  To calculate the cost of retained earnings for a firm using CAPM, one may use the following formula: Cost of retained earnings = risk free rate + [(expected rate of return on the market - risk free rate) x Beta]. In this case, the cost of retained earnings = 8.0% + [(12.0% - 8.0%) x 1.2] = 12.8%.

• Question 935:

  Musgrave Corporation has fixed costs of $46,000 and variable costs that are 30 percent of the current sales price of $2.15. At a price of $2.15, Musgrave sells 40,000 units. Musgrave can increase sales by 10,000 units by cutting its unit price from $2.15 to $1.95, but variable cost per unit won't change. Should it cut its price?

  A. No, EBIT decreases by $250.

  B. No, EBIT decreases by $6,000.

  C. Yes, EBIT increases by $8,050.

  D. Yes, EBIT increases by $11,500.

  E. Yes, EBIT increases by $5,050.

  Correct Answer: C

  Calculate EBIT(1) at 40,000 units using the current sales price:

  EBIT(1) = S - VC - FC = 40,000($2.15) - 0.30(40,000)($2.15) - $46,000 = $86,000 - $25,800 - $46,000 =

  $14,200.

  Calculate EBIT(2) at 50,000 units using the lower price of $1.95:

  EBIT(2) = 50,000($1.95) - 0.30(50,000)($1.95) - $46,000 = $97,500 - $29,250 - $46,000 = $22,250.

  The change in EBIT = $22,250 - $14,200 = +$8,050.

  Yes, Musgrave should cut its price, EBIT increases by $8,050.

• Question 936:

  Which of the following terms describes what happens when the introduction of a new product causes the sales of existing products to decrease?

  A. Opportunity Cost

  B. Sunk Cost

  C. Externality

  D. Incremental Cash Flow

  E. Cannibalization

  Correct Answer: E

  When the introduction of a new product causes the sales of existing products to decrease, it is called cannibalization.

• Question 937:

  Which of the following statements is most correct?

  A. If a company's stock price increases, this increases its cost of equity capital.

  B. The before-tax cost of preferred stock may be lower than the before-tax cost of debt, even though preferred stock is riskier than debt.

  C. None of these statements are correct.

  D. If the cost of equity capital is low enough, it may be cheaper to issue common stock than it is to finance projects with retained earnings.

  E. All of these statements are correct.

  Correct Answer: B

  Corporations, which receive a 70 percent exclusion of dividend income from their taxable income, own most preferred stock. Consequently, the before-tax coupons on preferred stock may be lower than the before-tax coupons on debt, despite the fact that preferred stock is riskier than debt. All the other statements are false.

• Question 938:

  Which of the following is/are true?

  I. The IRR method assumes that future cash flows are reinvested at the project's cost of capital.

  II. The NPV method assumes that future cash flows are reinvested at the project's cost of capital.

  III. The MIRR method assumes that future cash flows are reinvested at the project's cost of capital.

  IV.

  MIRR and NPV methods always lead to the same decisions for projects of similar sizes.

  A.

  II, III and IV

  B.

  I only

  C.

  II and III

  D.

  II only

  E.

  I, II, III and IV

  F.

  III only

  G.

  II and IV

  H.

  IV only

  Correct Answer: A

  The IRR method assumes that future cash flows are reinvested at the internal rate of return of the project, not the project's cost of capital. Statements (II), (III) and (IV) are true.

• Question 939:

  Which of the following are substantive purposes for conducting post-audit procedures in capital budgeting situations? Choose the best answer.

  I. Improving forecasts

  II. Shifts in the Security Market Line

  III. Improving operations

  IV.

  Controlling management

  V.

  Adhering to Bond Covenants

  VII.

  Ensuring adherence to governmental guidelines for performance presentation

  A.

  I, III, IV

  B.

  I, II, III, IV, VII, VIII

  C.

  I, III, IV, VIII

  D.

  I, III

  E.

  II, IV, VIII

  F.

  I, V, VII, VIII

  Correct Answer: D

  An important aspect of the capital budgeting process is the post-audit, which involves comparing actual results with those forecasted and determining why any discrepancies exist. The post-audit process has two main purposes. First, the post-audit process is used to improve the forecasting capacity of the firm. Second, this process is used to improve the operations of the firm. "Shifts in the Security Market Line" has little to do with the post-audit process. Additionally, remember that aside from AIMR PPS and other suggested performance presentation guidelines, there are no real "guidelines for research and performance presentation." There are certainly no "governmental guidelines" for performance presentation; therefore, answer VII is incorrect.

• Question 940:

  A project requires an initial outlay of 650. It also needs capital spending of 700 at the end of year 1 and 900 at the end of year 2. It has no revenues for the first 2 years but receives 1,200 in year 3, 1,600 in year 4 and 2,300 in year 5. The project's payback period equals ________.

  A. 4.54 years

  B. 2.26 years

  C. 3.66 years

  D. 4.91 years

  Correct Answer: D

  The cash flows of the project starting at the end of year 1 are: -700, -900, +1,200, +1,600, +2,300 The payback period is defined as the expected number of years that would be required to recover the original investment. In particular, Payback period = Years before full recovery + (unrecovered cost at the start of payback year)/(net cash flow in the payback year) The net account balance goes positive in the 4th year. At the beginning of the 4th year, the outstanding balance equals 650+700+900-1,200 = $1,050. Therefore, payback period = 3 + 1,050/1,600 = 3.66 years.