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Free Test Prep CFA-Level-I Exam Questions (page: 6)

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A stock's P/E ratio is 10.4, with an expected return on equity of 14% and a dividend growth rate of 5.7%. The firm's dividend payout ratio equals ________.

  1. 24.19%
  2. 56.17%
  3. 86.32%
  4. 13.68%

Answer(s): C

Explanation:

Po/E1 = dividend payout/(k - g)
Therefore, 10.4 = dividend payout /(0.14 - 0.057), giving dividend payout = 86.32%.



Kulwicki Corporation wants to determine the effect of an expansion of its sales on its operating income (EBIT). The firm's current degree of operating leverage is 2.5. It projects new unit sales to be 170,000, an increase of 45,000 over last year's level of 125,000 units. Last year's EBIT was $60,000. Based on a degree of operating leverage of 2.5, what is this year's expected EBIT with the increase in sales?

  1. $175,000
  2. $60,000
  3. $114,000
  4. $90,000
  5. $100,000

Answer(s): C

Explanation:

Set up the DOL equation, letting x be the unknown new EBIT:
Let x = New EBIT.
DOL(Q) = % change EBIT/ % change Sales
% change in sales = 45000/125000 = 36%
2.5 = (x - $60,000/$60,000) / .36
2.5 (0.36) = ((x - $60,000)/$60,000)
0.90 = (x - $60,000/$60,000)
$54,000 = x - $60,000
x = $114,000.
New EBIT = $114,000.



Which of the following statements is most correct?

  1. All of these answers.
  2. All else equal, an increase in a company's stock price will increase the marginal cost of issuing new common equity.
  3. None of these answers.
  4. If a company's tax rate increases but the yield to maturity of its noncallable bonds remains the same, the company's marginal cost of debt capital used to calculate its weighted average cost of capital will fall.
  5. All else equal, an increase in a company's stock price will increase the marginal cost of retained earnings.

Answer(s): D

Explanation:

The debt cost used to calculate a firm's WACC is k(d)(1 - T). If k(d) (interest rate on the firm's new debt) remains constant but T increases, then the term (1 - T) decreases and the value of the entire equation, k(d)(1 - T), decreases.



Which of the following figures are incorporated into the Degree of Operating Leverage equation as based on total dollar sales?

  1. Sales in dollars
    II. Total variable costs
    III. Average sales price
    IV. Total fixed operating costs
  2. Average variable cost per unit
    VI. Number of common shares outstanding
    VII. Sales in units
    VIII. Discount rate
  3. I, II, IV, VIII
  4. II, IV, VII
  5. I, II, IV, VIII
  6. III, V, VII
  7. I, II, IV
  8. I, II, IV, VI

Answer(s): E

Explanation:

The Degree of Operating Leverage (DOL) measures the percentage change in EBIT that results from a given percentage change in sales. Degree of Operating Leverage can be calculated using several methods, including equations based upon unit sales and dollar sales. The DOL equation based on dollar sales is illustrated as follows:
{DOL = [(sales in dollars - total variable costs) / (sales in dollars - total variable costs - total fixed operating costs)]. Of the answers provided, only I, II, and IV are incorporated into this equation.



Taylor Technologies has a target capital structure, which is 40 percent debt and 60 percent equity. The equity will be financed with retained earnings. The company's bonds have a yield to maturity of 10 percent. The company's stock has a beta = 1.1. The risk-free rate is 6 percent, the market risk premium is 5 percent, and the tax rate is 30 percent. The company is considering a project with the following cash flows:
TimeCash flow ($)
0-50,000
135,000
243,000
360,000
4-40,000
What is the project's modified internal rate of return (MIRR)?

  1. 6.76%
  2. 16.14%
  3. 20.52%
  4. 10.78%
  5. 9.26%

Answer(s): C

Explanation:

First, find the company's weighted average cost of capital:
We're given the before-tax cost of debt, k(d) = 10%. We can find the cost of equity as follows:
K(s) = 0.06 + 0.05(1.1) = 0.115 or 11.5%.
Thus, the WACC is:
k = 0.4(0.10)(1 - 0.3) + 0.6(0.115) = 0.097 or 9.7%.
Second, the PV of all cash outflows can be calculated as follows:
PV of CF(4): N = 4, I = 9.7, PMT = 0, FV = 40,000 and solve for PV. Total PV(Costs) = -$50,000 - $27,620.62 = -$77,620.62.
Third, find the terminal value of the project at t = 4:
FV of CF(1) at t = 4 is calculated as follows: N = 3, I = 9.7, PV = -35,000, PMT = 0, and solve for FV = $46,204,89. Similarly, the FVs of CF(2) and CF(3) are found to be $51,746.59 and $65,820, respectively.
Summing these FVs gives a terminal value of $46,204.89 + $51,746.59 + $65,820.00 = $163,771.48.
Finally, the MIRR can be calculated as N = 4, PV = -77,620.62, PMT = 0, FV = 163,771.48, and solve for I = MIRR = 20.52%.



True or false. Firms with higher proportions of fixed costs will have an EBIT figure that is more sensitive to changes in sales, all else equal. Additionally, companies that have low Degree of Financial Leverage figures will have more aggressive depreciation and amortization schedules.

  1. False, true
  2. The answer cannot completely be determined from the information provided.
  3. True, false
  4. True, true
  5. False, false

Answer(s): B

Explanation:

A somewhat tricky question as the answer cannot be fully determined from the information provided. While it is true that firms whose cost structure is weighted heavily toward fixed costs, i.e. have high relative DOL figures, will be more sensitive to changes in sales, the second question cannot be answered from the information provided. The Degree of Financial Leverage is defined as the percentage change in EPS that results from a given percentage change in EBIT. For purposes of general discussion, and the Level 1 CFA exam, the DFL calculation does not have an explicit bearing on the depreciation and amortization schedules used by companies. Had the second question asked "...companies that have low Degree of Financial Leverage figures will have EPS figures which are LESS sensitive to changes in EBIT," then both answers would be true.



Which of the following statements is correct?

  1. Market risk is important but does not have a direct effect on stock price because it only affects beta.
  2. Well diversified stockholders do not consider corporate risk when determining required rates of return.
  3. Undiversified stockholders, including the owners of small businesses, are more concerned about corporate risk than market risk.
  4. Empirical studies of the determinants of required rates of return (k) have found that only market risk affects stock prices.

Answer(s): C

Explanation:

Corporate risk is the project's risk to the corporation giving consideration to the fact that the project represents only one of the firm's portfolio of assets, hence that some of its risk effects on the firm's profits will be diversified away.



Calculate the cost of debt for the following firm:
Borrowing Rate 9.5%
Marginal Tax Rate 34%
Credit Rating BB+
Owner's Equity 15%

  1. 1.5%
  2. 8.075%
  3. 1.43%
  4. 9.5%
  5. 6.27%

Answer(s): E

Explanation:

The cost of debt is simply the rate of borrowing less the tax savings. Due to the fact that interest expense is tax deductible, the cost of debt in this case is 9.5%(1 - .34) = 9.5%(.66) = 6.27%.



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