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Free Test Prep CFA-Level-I Exam Questions (page: 11)

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Which of the following statements is most correct?

  1. None of the statements are correct.
  2. The discounted payback method solves all the problems associated with the payback method.
  3. The NPV method is appealing to some managers because it produces a dollar amount upon which to base decisions rather than a IRR method.
  4. All of the statements are correct.
  5. For independent projects, the decision to accept or reject will always be the same using either the IRR method or the NPV method.

Answer(s): E

Explanation:

For mutually exclusive projects, a conflict can exist if the cost of capital is less than the crossover rate.



Adams Audio is considering whether to make an investment in a new type of technology. Which of the following factors should the company consider when it decides whether to undertake the investment?

  1. None of these factors should be considered.
  2. The installation costs for the new equipment for the new technology are very high.
  3. The new technology will affect the cash flows produced by its other operations.
  4. If the investment is not made, then the company will be able to sell one of its laboratories for $2 million.
  5. All of these factors should be considered.

Answer(s): E

Explanation:

These are all incremental cash flows which change the firm's total cash flow that occurs as a direct result of accepting the project, and should all be considered



Which of the following statements about capital structure theory is most correct?

  1. In general, an increase in the corporate tax rate would cause firms to use less debt in their capital structures.
  2. Signaling theory suggests firms should in normal times maintain reserve-borrowing capacity which can be used if an especially good investment opportunity comes along.
  3. All of the statements are correct.
  4. None of the statements are correct.
  5. According to the "trade-off theory," a decrease in the costs of debt would lead firms to increase equity financing in their capital structures.

Answer(s): B

Explanation:

An increase in the corporate tax rate reduces the after-tax cost of debt making it more attractive relative to equity. Thus, firms might be expected to use more debt. The trade-off theory of leverage states a firm trades off the benefits of debt financing (favorable corporate tax treatment) against the higher interest rates and bankruptcy costs.



Moynihan Motors has a cost of capital of 10.25 percent. The firm has two normal projects of equal risk. Project A has an internal rate of return of 14 percent, while Project B has an internal rate of return of 12.25 percent.
Which of the following statements is most correct?

  1. If the crossover rate (i.e., the rate at which the Project's NPV profiles intersect) is 8 percent, Project A will have a lower net present value than Project B.
  2. All of these answers are correct.
  3. If the projects are mutually exclusive, the firm should always select Project A.
  4. None of these answers are correct.
  5. Both projects have a positive net present value.

Answer(s): E

Explanation:

If the projects were independent, both should be accepted. They both have an IRR greater than the cost of capital, so they have positive NPVs. If the cost of capital were above 14%, both projects should be rejected.
Project B will have a higher NPV at discount rates below 8% and Project A will have a higher NPV at discount rates above 8%.



Empirical testing has confirmed the validity of which of the following dividend theories?

  1. Tax differential theory.
  2. Empirical testing has not produced any definitive results.
  3. Empirical testing has produced some evidence in support of each of these theories.
  4. Dividend irrelevance, or Modigliani-Miller, theory.
  5. Bird-in-the-hand theory.

Answer(s): C

Explanation:

These 3 theories have produced unclear empirical tests because of two reasons: 1. For a valid statistical test, things other than dividend policy must be held constant, and 2. We must be able to measure with a high degree of accuracy each sample firm's cost of equity. Neither of these two conditions holds.



A firm's earnings break point equals $98 million. Its net income is $58 million and it is committed to a dividend payout ratio of 30%. It's after-tax cost of debt equals 9% and its shareholders demand an expected rate of return of 15%. The firm's WACC equals ________.

  1. 12.2%
  2. 9.8%
  3. 11.5
  4. 10.3%

Answer(s): C

Explanation:

The retained earnings of the firm = $58*0.7 = $40.6 million. If the earnings breakpoint is $98 million then the firm must issue $(98-40.6) = $57.4 million in debt to maintain constant D/E ratio. This implies that the firm's D/E ratio equals 57.4/40.6 = 1.41. Debt comprises 57.4/98 = 58.57% of the capital structure. Therefore, WACC = 0.5857*0.09 + 0.4143*15% = 11.49%.



Assume a project has normal cash flows (that is, the initial cash flow is negative, and all other cash flows are positive). Which of the following statements is most correct?

  1. All else equal, a project's IRR increases as the cost of capital declines.
  2. All else equal, a project's NPV decreases as the cost of capital declines.
  3. All else equal, a project's NPV increases as the cost of capital declines.
  4. All else equal, a project's MIRR is unaffected by changes in the cost of capital.
  5. None of the answers are correct.

Answer(s): C

Explanation:

Since the cost of capital is in the denominator of the NPV formula, the lower the cost of capital the higher the NPV. The more positive the NPV, the more cash the project is generating to service its debt and to provide the required return to shareholders.



Conrad Corp. has an investment project with the following cash flows:
TimeProject Cash Flows
0-$1,000
2-300
4-700
The company's WACC is 12 percent. What is the project's modified internal rate of return (MIRR)?

  1. 5.68%
  2. 3.95%
  3. 6.83%
  4. 3.20%
  5. 2.63%

Answer(s): B

Explanation:

Find the present value of the outflows:
t = 0: -1,000
t = 2: N = 2, I = 12, PMT = 0, FV = 300, and solve for PV = -$239.1582.
t = 4: N = 4, I = 12, PMT = 0, FV = 700, and solve for PV = -$444.8627.
Total PV(Costs) = -$1,000 - $239.1582 - $444.8627 = -$1,684.0209.
Find the future value of the inflows:
t = 1: N = 4, I = 12, PV = -200, PMT = 0, and solve for FV = $314.7039.
t = 3: N = 2, I = 12, PV = -900, PMT = 0, and solve for FV = $1,128.96.
t = 5: N = 0, I = 12, PV = -600, PMT = 0, and solve for FV = $600.
Total FV(Inflows) = $314.7039 + $1,128.96 + $600 = $2,043.6639.
Then find the MIRR:
N = 5
PV = -1,684.0209
PMT = 0
FV = 2,043.6639
Solve for MIRR = I = 3.9471%.



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