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Free Test Prep CFA-Level-I Exam Questions (page: 12)

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The management of Olively.com, an online research network, are considering becoming a public company. At a lengthy meeting with the board of directors, the CEO of Olively.com details his idea as to methods in which the firm should raise capital. In his discussion, the CEO states that "45% of new capital should come from debt, leaving 55% to come from the issuance of common equity. We will disregard issuing preferred stock at this point." In the simplistic sense, the CEO of Olively.com is detailing which of the following?

  1. Optimal capital structure
  2. Target capital structure
  3. Target asset base
  4. Capital asset base
  5. Optimal asset base

Answer(s): B

Explanation:

In this example, the CEO of Olively.com is detailing his idea of the company's target capital structure. The target capital structure can best be thought of as the proportion of debt, common stock, and preferred stock that the firm plans to issue in its effort to raise capital. The "optimal capital structure" is defined as the capital structure that balances risk and return, thereby maximizing the firm's stock price.



The corporate finance division of Intelligent Semiconductor is examining the firm's recent sales in an attempt to forecast future operating performance. In their investigation, the management of the firm's corporate finance division have identified the following sales and EBIT information for the previous two years:
Sales in year 1 $1,200,000
Sales in year 2 $1,500,000
EBIT in year 1 $400,000
EBIT in year 2 $550,000
Given this information, what is the degree of operating leverage for Intelligent Semiconductor for this period?

  1. .350
  2. 1.25
  3. .3667
  4. .3333
  5. 1.50

Answer(s): E

Explanation:

To calculate the degree of operating leverage (DOL), use the following equation: {% change in EBIT/% change in sales}. Incorporating the given information into this equation yields the following: {[(year 2 EBIT $550,000 - year 1 EBIT $400,000)/year 1 EBIT $400,000]/[(year 2 sales $1,500,000- year 1 sales $1,200,000)/year 1 sales $1,200,000] = 1.50



Which of the following is/are true?

  1. Discounted payback period and simple payback period can produce conflicting project rankings.
    II. Independent projects are mutually exclusive.
    III. The payback period rule ignores cash flows beyond the payback period.
  2. I, II & III
  3. II only
  4. I & III
  5. I & II
  6. I only
  7. II & III
  8. III only

Answer(s): C

Explanation:

Independent projects are ones whose cash flows are not dependent on each other while mutually exclusive projects are those which cannot be undertaken simultaneously. It is not necessary for independent projects to be mutually exclusive or vice versa.



Which of the following types of risk measures the variability of an asset's expected returns, assuming that the asset is not the only asset of the company in question while at the same time not taking into consideration the effects of shareholder diversification? Choose the best answer

  1. Beta coefficient
  2. Unsystematic risk
  3. Market risk
  4. More than one of these answers is correct
  5. Corporate risk
  6. Alpha risk

Answer(s): E

Explanation:

Corporate risk is defined as the variability of an assets 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 assets in investors' portfolios. Corporate risk takes into consideration that firms will diversify their asset bases.



Which of the following factors affect(s) a firm's optimal pay-out ratio?

  1. The availability and cost of external capital.
    II. The investment opportunities available.
    III. The firm's target debt-to-equity ratio.
    IV. Investors' preference for dividends versus capital gains.
  2. II only
  3. I only
  4. I, II, III & IV
  5. IV only
  6. I, II & III
  7. I & III
  8. III only
  9. III & IV

Answer(s): C

Explanation:

A firm must consider all of these factors while determining what fraction of the earnings it should pay out. It should be noted that another factor that must be considered is the capability of keeping the dividends stable over time.



A company is considering a project with the following cash flows:
TimeCash flow
0-$100,000
150,000
250,000
350,000
4-10,000
The project's cost of capital is estimated to be 10 percent. What is the modified internal rate of return (MIRR)?

  1. 11.25%
  2. 20.34%
  3. 14.25%
  4. 11.56%
  5. 13.28%

Answer(s): C

Explanation:

First, calculate the present value of costs:
N = 4, I/YR = 10, PMT = 0, FV = -10,000, and solve for PV = -$6,830.13.
Add -$100,000 + -6,830.13 = -$106,830.13.
Then, find the terminal value of inflows:
Shift to BEGIN MODE, N = 3, I/YR = 10, PV = 0, PMT = -50,000, and solve for FV = $182,050.
Finally, shift back to END mode, and solve for MIRR, where N = 4, PV = $-106,830, PMT = 0, FV = 182,050, and solve for I/YR = 14.25%.



An entrepreneur has invested $2.2 million in project A with an NPV of $245,000 and an estimated beta of 0.59. She has invested another $3.7 million in project B with an NPV of $320,000 and an estimated beta of 1.23. The firm's estimated beta equals ________.

  1. 1.11
  2. 0.72
  3. 1.23
  4. 0.99

Answer(s): D

Explanation:

The market value of project A equals $2.2 million + $245,000 = $2.445 million.
The market value of project B equals $3.7 million + $320,000 = $4.02 million.
The firm can be considered a portfolio of 2 projects. The beta of a portfolio equals the weighted average of the betas of the individual components. The weight of a component equals the fraction of the market value it comprises. Therefore, the firm's market value equals 2.445 + 4.02 = $6.465 million and its beta equals 2.445/6.465*0.59 + 4.02/6.465*1.23 = 0.99.



Consider the following information:
Borrowing Rate 10%
Marginal Tax Rate 40%
Preferred Stock Par Price $100
Preferred Dividend $10
Preferred Stock floatation cost 2.5%
Cost of common equity 12.0%
Preferred Stock issued at Par
The Optimal Capital Structure is 40% debt, 50% common equity, and 10% preferred stock. Credit Rating BB+ What is the firm's Weighted Average Cost of Capital (WACC)?

  1. 12.62%
  2. 7.42%
  3. 9.0%
  4. 8.0%
  5. 2.5%
  6. 9.42%

Answer(s): F

Explanation:

The firm's Weighted Average Cost of Capital (WACC) is a weighted average of the component cost of capital.
In this case 10%(borrowing rate) x (1-.4)Tax savings = 6% is the component cost of debt. $10 (preferred dividend) / 97.5(Par minus floatation cost) = 10.25% is the component cost of preferred stock. Thus the WACC = .4(6%) + .5(12%) + .1(10.25%) = 9.42%



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