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CFA CFA I Exam
CFA Level I Chartered Financial Analyst (Page 12 )

Updated On: 26-Jan-2026
Page 12 of 793
PDF with 3960 Questions

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 debt cost 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 aggressive capital structure?

  1. $0
  2. $2.20
  3. $2.40
  4. $1.00
  5. $1.80

Answer(s): C

Explanation:

Debt = 75% = $300,000; Equity = 25% = $100,000; Total assets = $400,000.
FeastFamine
Probability0.60.4
EBIT$60,000$20,000
Less: Interest36,00036,000
EBT$24,000-$16,000
Less: Taxes9,600-6,400
NI$14,400-$9,600
# shares10,00010,000
EPS$1.44-$0.96
Difference in EPS for conservative capital structure:
EPS(Feast) - EPS(Famine) = $1.44 - (-$0.96) = $2.40



The Mike & Laurie Consulting Group Inc. is trying to decide which computer system to purchase. They can purchase state-of-the-art equipment for $20,000, which they expect to generate cash flows of $6,000 at the end of each of the next 6 years. Alternatively, they can spend $12,000 for equipment that can be used for 3 years and generates cash flows of $6,000 at the end of each year. If the company'scost of capital is 10 percent and both "projects" can be repeated indefinitely, then what is the equivalent annual annuity (EAA) of the more profitable strategy?

  1. $2,423.74
  2. $1,407.85
  3. $1,666.67
  4. $6,131.56
  5. $1,174.62

Answer(s): B

Explanation:

First, compute the NPV of each project over its initial life. The relevant cash flows for the state-of-the- art equipment are CF(0) = -$20,000 and CF(1-6) = $6,000. Discounting at 10 percent yields NPV = $6,131.56.
The relevant CFs for the less advanced equipment are CF(0) = -$12,000 and CF(1-3) = $6,000. Discounting again at 10 percent yields NPV = $2,921.11. Next, find the EAA of each project as follows: EAA for the state-of- the-art equipment: N = 6; I/YR = 10; PV = -6,131.56, FV = 0; solve for PMT = EAA = $1,407.85. EAA less advanced: N = 3; I/YR = 10; PV = $2,921.11; FV = 0; solve for PMT = EAA = $1,174.62.
Thus, the state-of-the-art project is more profitable.



The "degree of leverage" concept is designed to show how changes in sales will affect EBIT and EPS. If a 10 percent increase in sales causes EPS to increase from $1.00 to $1.50, and if the firm uses no debt, then what is its degree of operating leverage?

  1. 4.2
  2. 3.6
  3. 4.7
  4. 5.0
  5. 5.5

Answer(s): D

Explanation:

These two equations could be used:
DTL = (DOL)(DFL).
EPS(1) = EPS(0)[1 + (DTL)(%Change Sales)].
Note that EPS rises by 50 percent, from $1.00 to $1.50, on a 10 percent increase in sales, so 1.50 = 1.00[1 + (DTL)(0.1)]
1.50 = 1 + 0.1 DTL
0.1 DTL = 0.50
DTL = 5.00.
Now DTL = 5 = (DOL)(DFL)
But if Debt = 0, then DFL = 1, so DOL = DTL = 5.0.



Clay Industries, a large industrial firm, is considering the development of an underwater drilling system which will greatly increase the productivity of deep-sea petroleum extraction. However, the development of the system involves substantial setup and implementation costs. If Clay Industries chooses to begin developing the new system, the firm will be forced to decline several other promising projects, due to a lack of available investment capital. Which of the following terms most correctly describes the problem faced by Clay Industries?

  1. Diminishing returns problem
  2. Marginal cost problem
  3. Principal/agent problem
  4. Opportunity cost problem
  5. Externality problem

Answer(s): D

Explanation:

In this example, Clay Industries is faced with several mutually-exclusive projects. If the firm begins to develop the underwater drilling system, it will be forced to decline the acceptance of other projects. This is an opportunity cost problem.



Which of the following types of risk can be reduced through diversification? Choose the best answer.

  1. Stand-alone risk
    II. Unsystematic risk
    III. Systematic risk
    IV. Market risk
  2. Beta risk
    VI. Diversifiable risk
  3. I, III, VI
  4. I, VI
  5. II, III, V
  6. I, II, VI
  7. II, III, V, VI

Answer(s): D

Explanation:

Of the risks listed, only unsystematic and stand-alone risk are diversifiable. Unsystematic risk is also referred to as "diversifiable risk," therefore answer VI is correct. Stand-alone risk is defined as the variability of an asset's expected returns if it were the only asset of a firm and the stock of that firm is the only security in an investor's portfolio. This type of risk is definitively reduced through diversification, and is commonly referred to as "unsystematic risk." Systematic risk measures that part of an assets risk that is inherent regardless of the level of diversification, and is measured by the Beta coefficient. Systematic risk is also referred to as "market risk" and "beta risk." Corporate risk is defined as the variability of an asset's expected returns without taking into consideration the effects of shareholder diversification. This is one step away from Stand-alone Risk, which measures the risk of an asset not only without taking into consideration the effect of shareholder diversification, but of company diversification as well. Stand-alone risk assumes that the asset in question is the only asset of the firm and that the securities of the firm are the only asset in investors' portfolios. Corporate risk takes into consideration that firms will diversify their asset bases.



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