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

• Question 971:

  Makeover Inc. believes that at its current stock price of $16.00 the firm is undervalued in the market. Makeover plans to repurchase 2.4 million of its 20 million shares outstanding. The firm's managers expect that they can repurchase the entire 2.4 million shares at the expected equilibrium price after repurchase. The firm's current earnings are $44 million. If management's assumptions hold, what is the expected market price after repurchase?

  A. $16.00

  B. $17.26

  C. $20.00

  D. $18.18

  E. $24.40

  Correct Answer: D

  Step 1: Current EPS = $44 million/20 million = $2.20 per share.

  Step 2: P/E ratio = $16.00/$2.20 = 7.27x.

  Step 3: EPS after repurchase = $44 million/17.6 million = $2.50.

  Step 4:Expected market price after repurchase: 7.27 x $2.50 = $18.18 per share.

• Question 972:

  The following information applies to a company's preferred stock: Current price $48.00 per share Par value $50.00 per share Annual dividend $3.50 per share The company issued the preferred stock at par and incurred a 10% floatation cost. If the company's marginal corporate tax rate is 34%, what is the after-tax cost of preferred stock at the time of issue?

  A. 4.6%

  B. 5.1%

  C. 7%

  D. 7.8%

  E. 7.3%

  F. 3.5%

  Correct Answer: D

  The cost of preferred stock is calculated as the preferred stock dividend divided by the net issuing price. The dividend for this preferred stock is $3.50, and the net issuing price was $45.00. Thus the cost of preferred stock is 3.5 divided by 45 or 7.8%. There are no tax savings associated with the use of preferred stock, therefore no tax adjustments are made when calculating the cost.

• Question 973:

  Which of the following statements is likely to encourage a firm to increase its debt ratio?

  A. Management believes that the firm's stock is overvalued.

  B. Its corporate tax rate declines.

  C. Its sales become less stable over time.

  D. None of these answers are correct.

  E. All of these answers are correct.

  Correct Answer: D

  None of these would promote an increase in the debt ratio of a firm. Less stable sales would lead a firm to lower its debt ratio. A lower corporate tax rate reduces the tax advantage of the deductibility of interest expense. This reduction in the tax shield provided by debt would encourage less use of debt. If management believes the firm's stock is overvalued, then it would want to issue equity, rather than debt.

• Question 974:

  Shannon Industries is considering a project, which has the following cash flows: Time Cash Flow 0? 1$2,000 23,000 33,000 41,500 The project has a payback of 2.5 years. The firm's cost of capital is 12 percent. What is the project's net present value NPV?

  A. $3,765.91

  B. $765.91

  C. $577.68

  D. $1,049.80

  E. $2,761.32

  Correct Answer: B

  First, find the missing t = 0 cash flow. If payback = 2.5 years, this implies t = 0 cash flow must be - $2,000 $3,000 + (0.5) $3,000 = -$6,500. Enter the cash flows and the firm's cost of capital of 12%, then NPV = $765.91.

• Question 975:

  Which of the following statements is most correct? The modified IRR (MIRR) method:

  A. All of these answers are correct.

  B. Calculates a return that is always less than the regular IRR.

  C. Overcomes the problem of multiple rates of return.

  D. Always leads to the same ranking decision as NPV for independent projects.

  Correct Answer: C

  MIRR assumes that cash flows from all projects are reinvested at the cost of capital, while the regular IRR assumes that the cash flows from each project are reinvested at the project's own IRR. The MIRR is a better indicator of profitability because reinvestment at the cost of capital is generally more correct.

• Question 976:

  Copybold Corporation is a start-up firm considering two alternative capital structures--one is conservative and the other aggressive. The conservative capital structure calls for a D/A ratio = 0.25, while the aggressive strategy call for D/A = 0.75. Once the firm selects its target capital structure it envisions two possible scenarios for its operations: Feast or Famine. The Feast scenario has a 60 percent probability of occurring and forecast EBIT in this state is $60,000. The Famine state has a 40 percent chance of occurring and the EBIT is expected to be $20,000. Further, if the firm selects the conservative capital structure its cost of debt will be 10 percent, while with the aggressive capital structure its debtcost will be 12 percent. The firm will have $400,000 in total assets, it will face a 40 percent marginal tax rate, and the book value of equity per share under either scenario is $10.00 per share. What is the difference between the EPS forecasts for Feast and Famine under the conservative capital structure?

  A. $2.20

  B. $0.80

  C. $0

  D. $0.44

  E. $1.00

  Correct Answer: B

  Debt = 25% = $100,000; Equity = 75% = $300,000; Total assets = $400,000. Feast Famine Probability0.60.4 EBIT$60,000$20,000 Less: Interest10,00010,000 EBT$50,000$10,000 Less: Taxes20,0004,000 NI$30,000$6,000 # shares30,00030,000 EPS$1.00$0.20 Difference in EPS for conservative capital structure: EPS(Feast) - EPS(Famine) = $1.00 - $0.20 = $0.80.

• Question 977:

  Rollins Corporation is constructing its MCC (marginal cost of capital) schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock, which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm, which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find k(s) (component cost of retained earnings). The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent. What is Rollins' cost of retained earnings using the CAPM (Capital Asset Pricing Model) approach?

  A. 16.0%

  B. 14.1%

  C. 16.9%

  D. 16.6%

  E. 13.6%

  Correct Answer: A

  Cost of retained earnings (CAPM approach): k(s) (component cost of retained earnings) = 10% + 1.2(5%) = 16.0%.

• Question 978:

  Doherty Industries wants to invest in a new computer system. The company only wants to invest in one system, and has narrowed the choice down to System A and System B. System A requires an up-front cost of $100,000 and then generates positive after-tax cash flows of $60,000 at the end of each of the next two years. The system can be replaced every two years with the cash inflows and outflows remaining the same. System B also requires an up-front cost of $100,000 and then generates positive after-tax cash flows of $48,000 at the end of each of the next three years. System B can be replaced every three years, but each time the system is replaced, both the cash inflows and outflows increase by 10 percent. The company needs a computer system for the six years, after which time the current owners plan on retiring and liquidating the firm. The company's cost of capital is 11 percent. What is the NPV (on a six-year extended basis) of the system, which creates the most value to the company?

  A. $31,211.52

  B. $103,065.82

  C. $17,298.30

  D. $38,523.43

  E. $22,634.77

  Correct Answer: A

  To find the NPV of the system we must use the replacement chain approach. Time System ASystem B 0-100,000-100,000 160,00048,000 260,000 - 100,000 = -40,00048,000 360,00048,000-110,000 =-62,000 460,000 - 100,000 = -40,00052,800 560,00052,800 660,00052,800 Use the CF key to enter the cash flows for each period. I/YR = 11. This should give the following NPVs: NPV(A) = $6,796.93. NPV(B) = $31,211.52. Computer system B creates the most value for the firm.

• Question 979:

  Michigan Mattress Company is considering the purchase of land and the construction of a new plant. The land, which would be bought immediately (at t = 0), has a cost of $100,000 and the building, which would be erected at the end of the first year (t = 1), would cost $500,000. It is estimated that the firm's after-tax cash flow will be increased by $100,000 starting at the end of the second year, and that this incremental flow would increase at a 10 percent rate annually over the next 10 years. What is the approximate payback period?

  A. 4 years

  B. 6 years

  C. 2 years

  D. 10 years

  E. 8 years

  Correct Answer: B

  Payback = 5 + 135.9/146.41 = 5.928 years = 6 years.

• Question 980:

  Which of the following methods for examining a project's stand-alone risk cannot be effectively conducted without the use of a random number generator? Choose the best answer.

  A. Probability Analysis

  B. More than one of these answers is correct

  C. Monte Carlo Regression

  D. Monte Carlo Simulation

  E. Scenario Analysis

  F. Sensitivity Analysis

  Correct Answer: D

  Monte Carlo Simulation seeks to examine the NPV of a project throughout a large series of possible values for input variables. When measuring stand-alone risk using Monte Carlo Simulation, the use of a computer and rather complex software package is necessary. In Monte Carlo Simulation, the expected ranges of input variables 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 require the use of a random number generator.