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CFA CFA I Exam
CFA Level I Chartered Financial Analyst (Page 62 )

Updated On: 26-Jan-2026
Page 62 of 793
PDF with 3960 Questions

In his determination of a project's NPV and IRR, a financial analyst with Smith, Kleen, & Beetchnutty indexes the project's anticipated cash flows for the expected effects of inflation. However, the discount rate applied to these cash flows does not factor an adjustment for inflation. Assuming a positive inflation figure for the every period in the project's lifespan, which of the following correctly describes the effects of the omission on the NPV and IRR calculations?

  1. NPV and IRR will be biased upward
  2. NPV and IRR will be biased downward
  3. NPV will be biased downward, IRR will be biased upward
  4. NPV will be biased upward, IRR will be unaffected
  5. NPV will remain unaffected, IRR will be biased downward
  6. NPV will be biased downward, IRR will be unaffected

Answer(s): D

Explanation:

By failing to include an the effects of anticipated inflation in the discount rate applied to the project's cash inflows, this analyst is creating a situation in which the NPV calculations will be biased upward. This is due to the fact that the project's inflows have been adjusted for the anticipated effects of POSITIVE inflation, i.e. these cash flows have been indexed upward, while at the same time the rate at which these cash flows are being discounted has not increased. In effect, the cash inflows of the project are being overstated, and this will lead to an upward bias in the NPV calculation. Remember that the Internal Rate of Return calculation does not specify an explicit discount rate, rather calculates the discount rate that equates the cash inflows of a project with its cash outflows. The fact that this analyst has not incorporated the effects of inflation into the discount rate has no bearing on IRR, because the IRR equation does not call for a discount rate.



Brock Brothers wants to maintain its capital structure, which is 30 percent debt, and 70 percent equity. The company forecasts that its net income this year will be $1,000,000. The company follows a residual dividend policy, and anticipates a dividend payout ratio of 40 percent. What is the size of the company's capital budget?

  1. $857,143
  2. $1,428,571
  3. $1,000,000
  4. $600,000
  5. $2,000,000

Answer(s): A

Explanation:

Since the company expects to pay out 40% of net income or $400,000, it must expect to have $600,000 of retained earnings available for capital investment. Given that the firm will finance new investment with 70% equity and 30% debt, $600,000 must represent 70% of the firm's capital budget, that is, $600,000 = (0.7)CB or CB = $857,143.



Which of the following statements is most correct?

  1. Investors can interpret a stock repurchase by a firm as a signal that the firm's managers believe the stock is underpriced.
  2. None of these statements are correct.
  3. After a 3-for-1 stock split, a company's price per share will fall and it's number of shares outstanding will rise.
  4. Stock repurchases can be used by firms to defend against hostile takeovers since they increase the proportion of debt in a firm's capital structure.
  5. All of these statements are correct.

Answer(s): E

Explanation:

These are all correct.



Stargell Industries follows a strict residual dividend policy. The company has a capital budget of $3,000,000. It has a target capital structure, which consists of 30 percent debt and 70 percent equity. The company forecasts that its net income will be $3,500,000. What will be the company's expected dividend payout ratio this year?

  1. 40%
  2. 45%
  3. 30%
  4. 25%
  5. 35%

Answer(s): A

Explanation:

Step 1 Find equity required to maintain capital budget:
Capital budget$3,000,000
% of budget financed with equityx 0.70
$2,100,000
Step 2 Calculate dividend:
Earnings$3,500,000
Less equity retained(2,100,000)
Dividend$1,400,000
Step 3 Find payout ratio:
Dividend/Earnings = $1,400,000/$3,500,000 = 0.4000 = 40%.



Projects whose cash flows are not affected by the acceptance or rejection of other projects are known as ________.

  1. independent projects
  2. project net worth optimization
  3. optimal capital budgeting
  4. equity enhancement
  5. mutually exclusive projects

Answer(s): A

Explanation:

Independent Projects are defined as projects whose cash flows are not affected by the acceptance or rejection of other projects.



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