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Free Test Prep CFA-Level-I Exam Questions (page: 5)

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Firms with higher operating leverage tend to have _______ financial leverage.

  1. lower
  2. same
  3. higher or lower (since the two are not related).
  4. higher

Answer(s): A

Explanation:

Firms with higher operating leverage have a higher fraction of costs in the form of fixed costs and hence, have a higher business risk. This makes them more averse to debt. Consequently, firms with higher operating leverage tend to have lower D/E ratios i.e. lower financial leverage.



The percentage mix of debt, preferred stock and common equity that maximizes a firm's stock price is known
as:

  1. Composite Cost of Capital (CCC)
  2. Security Market Line
  3. Weighted Average Cost of Capital (WACC)
  4. Target (Optimal) Capital Structure
  5. Least Cost Structure
  6. Efficient Frontier

Answer(s): D

Explanation:

The Target (Optimal) Capital Structure is defined as the percentages of debt, preferred stock, and common equity that will maximize the firm's stock price.



Stock dividends

  1. must be accompanied by cash dividends.
  2. are similar to stock splits in that they do not change the fundamental position of current shareholders.
  3. have the same effects on financial statements as cash dividends.
  4. are viewed unfavorably by investors and thus should not be used.
  5. have no effect on a firm's balance sheet.

Answer(s): B

Explanation:

Stock dividends are dividends paid in the form of additional shares of stock rather than in cash. The total number of shares is increased, so earnings, dividends, and price per share all decline. Stock dividends that are used on a regular basis will keep the stock price more or less constrained, that is, within a desired trading range.



As the debt level rises, the cost of equity increases because:

  1. the probability of default increases.
  2. all of these answers.
  3. the variability of EPS increases.
  4. the financial risk increases.

Answer(s): B

Explanation:

All of the above are reasons why the cost of equity increases as the debt level rises.



Stromburg Corporation makes surveillance equipment for intelligence organizations. Its sales are $75,000,000. Fixed costs, including research and development, are $40,000,000, while variable costs amount to 30 percent of sales. Stromburg plans an expansion which will generate additional fixed costs of $15,000,000, decrease variable costs to 25 percent of sales, and also permit sales to increase to $100,000,000. What is Stromburg's degree of operating leverage at the new projected sales level?

  1. 3.50
  2. 3.33
  3. 4.67
  4. 4.20
  5. 3.75

Answer(s): E

Explanation:

Calculate DOL using new sales, new variable cost percentage, and new fixed costs: (In millions) DOL(S) = S- VC/S-VC-FC = $100-$25/($100-$25-$55) = 3.75.



Clay Industries, a large industrial firm, is evaluating the sales of its existing line of coiled machine tubing. In their analysis, the operating managers of Clay Industries have identified the following information related to the

coiled machine tubing division and its product: Annual fixed operating expenses of $925,000 Average variable cost of $90 Break-even quantity of 20,109 units Which of the following best describes the average variable cost for this product?

  1. $44
  2. None of these answers is correct.
  3. $46
  4. $41.70
  5. $38
  6. The average selling price of this product cannot be determined from the information provided.

Answer(s): A

Explanation:

To calculate the break-even quantity for a product, use the following equation: {Fixed operating costs/[avg.
sales price per unit - variable cost per unit]}. To determine the average selling price of this product, we must rearrange the standard equation using algebra, in a manner such that the resulting equation resembles the following: {[$925,000/20,109] + X = $90}. This equation is further rearranged into the following: {$46 + X = $90}.
Finally, the ending equation becomes: {X = $90 - $46}. Solving for X yields an average variable cost per unit of $44.



The following facts apply to your company:
Target capital structure: 50% debt; 50% equity.
EBIT:$200 million
Assets:$500 million
Tax rate:40%
Cost of new and old debt:8%
Based on the residual dividend policy, the payout ratio is 60 percent. How large (in millions of dollars) will the capital budget be?

  1. $43.2
  2. $50.0
  3. $108.0
  4. $86.4
  5. $64.8

Answer(s): D

Explanation:

Debt = 0.5(Assets) = 0.5($500) = $250 million.
Interest = 0.08($250) = $20 million.
EBT = EBIT - I = $200 - $20 = $180.
NI = $180 - Taxes = $180 - $180(0.4) = 0.6($180) = $108 million.
Dividends = $108(0.6) = $64.80 million.
Retained earnings = NI - D = $108.00 - $64.80 = $43.20 million.
Half of the capital budget will be debt, half will be common equity from retained earnings, so the capital budget will = $86.40 million.



Which of the following companies has the highest degree of financial leverage? Choose the best answer.

Firm A
EBIT: $10,000,000
Interest Paid: $750,000
Total Operating Expenses: $25,000,000
Fixed Operating Expenses: $19,750,000
Firm B
EBIT: $8,970,000
Interest Paid: $88,000
Total Operating Expenses: $20,050,000
Fixed Operating Expenses: $17,000,000
Firm C
EBIT: $10,500,000
Interest Paid: $1,050,000
Total Operating Expenses: $50,000,000
Fixed Operating Expenses: $35,000,000
Firm D
EBIT: $10,000,000
Interest Paid: $750,000
Total Operating Expenses: $50,000,000
Fixed Operating Expenses: $41,000,000
Firm E
EBIT: $5,195,000
Interest Paid: $400,000
Total Operating Expenses: $35,000,000
Fixed Operating Expenses: $9,875,000

  1. Firm A
  2. Firm E
  3. Firm B
  4. Firm C
  5. Firm D
  6. Firm A and D have identical DFL's

Answer(s): D

Explanation:

The Degree of Financial Leverage (DFL) measures the percentage change in EPS that results from a given percentage change in EBIT. Financial Leverage is the second component of total leverage, along with Operating Leverage. The equation used to calculate the Degree of Financial Leverage is as follows: {DFL = [EBIT/(EBIT - Interest Paid)]}.
In this example, Firm C has the highest DFL, with a figure of 1.11. While Firm A and D do have identical Degree of Financial Leverage calculations, the question asks which firm has the highest DFL, which is firm C.
When calculating the DFL figure, remember that the answer can never be less than one, and can never be negative. In a situation where the company under examination has zero interest expense, the DFL would be equal to one; i.e. the EBIT is equal to the EBIT minus the interest expense. Another important note to remember is that in calculating the Degree of Financial Leverage, dividend payments to preferred stockholders should be included in the interest expense figure. Operating expenses are not factored into the DFL calculation, rather are used in the determination of Operating Leverage.



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