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Free Test Prep CFA-Level-I Exam Questions (page: 14)

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Intelligent Semiconductor, a diversified technology company, is considering two mutually-exclusive projects.
Assume the following information:
Project A
Initial cash outlay: ($500,000)
t1: $125,000
t2: $125,000
t3: $155,000
t4: $285,000
Cost of capital 11.35%
Project B
Initial cash outlay ($395,000)
t1: $170,000
t2: $160,000
t3: $175,000
Cost of capital 11.35%
Assuming no taxes, a $0.00 salvage value at the end of each projects' life, and the ability for each project to be replicated identically, identify the superior project according to the Replacement Chain approach. Additionally, what is the NPV and IRR of the superior project over the common life?

  1. Project B, NPV $25,577.90, IRR 13.30%
  2. Project A, NPV $18,954.46, IRR 10.33%
  3. Project B, NPV $35, 417.16, IRR 15.67%
  4. Project B, NPV $35,417.16, IRR 13.30%
  5. The Replacement Chain approach cannot be applied to these projects.
  6. Project A, NPV $22,256.14, IRR 12.22%

Answer(s): D

Explanation:

The Replacement Chain, or "Common Life" approach, is a useful analysis method which allows two or more projects with unequal lives to be examined. In the Replacement Chain approach, the lifespans of each project being examined are multiplied in such a way that the resulting projects share a "common life." In this example, Project A has a lifespan of 4 periods, whereas Project B has a lifespan of 3. The common multiple of both is 12, and to transform each project into one which has a twelve period lifespan, multiply project A by 3 and Project B by 4. Doing so will result in the following series of cash flows for Project A:
Project A
t0 ($500,000)
t1: $125,000
t2: $125,000
t3: $155,000
t4: [$285,000 + ($500,000)]=($215,000)
t5: $125,000
t6: $125,000
t7: $155,000
t8: [$285,000 + ($500,000)]=($215,000)
t9: $125,000
t10 $125,000
t11: $155,000
t12: $285,000
Multiplying project B by 4 will result in the following cash flows: t0 ($395,000)
t1: $170,000
t2: $160,000
t3: [$175,000 + ($395,000)]=($220,000)
t4: $170,000
t5: $160,000
t6: [$175,000 + ($395,000)]=($220,000)
t7: $170,000
t8: $160,000
t9: [$175,000 + ($395,000)]=($220,000)
t10: $170,000
t11: $160,000
t12 $175,000
Solving for NPV and IRR will determine that Project B is superior on both figures, with an NPV of $35,417.16, and an IRR of 13.301%. Project A has a NPV of $22,256.14 and an IRR of 12.22%.



Suppose capital gains are taxed at 32% and realized income is taxed at 38%. The tax preference theory implies that as the dividend pay-out ratio is increased, the cost of equity:

  1. increases or decreases.
  2. increases.
  3. remains unaffected.
  4. decreases.

Answer(s): B

Explanation:

Since the capital gains tax rate is lower than the realized income tax rate, investors would prefer to defer the realization of this income through the capital gains component. Hence, increasing the payout ratio will make the stock less attractive and depress the price, raising the cost of equity.



Clay Industries, a large industrial firm, is examining the capital structure of one of its Lebanese subsidiaries. The management of Clay Industries has identified the following information:
EBIT $1,000,000
EPS $1.88
Interest paid $121,590
Sales $1,940,000
Cost of debt 6.60%
Given this information, what is the Degree of Financial Leverage for this operating division?

  1. 1.940
  2. 1.138
  3. 1.551
  4. The Degree of Financial Leverage cannot be calculated from the information provided.
  5. 1.197
  6. 1.063

Answer(s): B

Explanation:

To calculate the DFL, the financial analyst needs to determine the EBIT and interest paid for a predetermined time period. To calculate the Degree of Financial Leverage, the following equation is used: {EBIT/[EBIT - interest paid]}. Incorporating the given information into this equation yields the following: {EBIT $1,000,000 / [EBIT $1,000,000 - interest paid $121,590]}= 1.138.
The Degree of Financial Leverage measures the percentage change in EPS which results from a given percentage change in EBIT. Remember that any preferred stock dividends must be incorporated into the DFL calculation, and that the DFL can never be less than one.



Which of the following factors in the discounted cash flow approach to estimating the cost of common equity is the least difficult to estimate?

  1. All of these answers are equally difficult to estimate.
  2. Expected rate of return.
  3. Required return.
  4. Dividend yield.
  5. Expected growth rate.

Answer(s): D

Explanation:

It is easy to determine the dividend yield since the dividend and the price of the stock are known. It is more difficult to establish a proper growth rate or beta as required in the other factors.



A firm has to pay 1.5% fee to underwriters when it issues new equity. The firm has a dividend payout ratio of 37% and a return on equity of 13.9%. The firm has just announced earnings of $3.27 per share. If the stock's cost of external equity is 14.9%, how much capital would the firm raise by issuing 6 million shares?

  1. $111.12 million
  2. none of these answers
  3. $98.33 million
  4. $130.55 million

Answer(s): D

Explanation:

IF F is the percentage flotation cost and P is the amount of new equity raised per new share, then P = D1/[(Ke - g)(1-F)], where Ke is the cost of external equity and D1 is next year's expected dividend.
Also, g = ROE*retention ratio = ROE*(1-payout ratio) = 13.9%*(1-37%) = 8.76%. D1 = 3.27*0.37*(1+8.76%) = $1.316. Therefore, P = 1.316/[(1-1.5%)*(14.9% - 8.76%) = $21.76. By issuing 6 million shares, the firm will therefore raise 6*21.74 = $130.55 million.



Which of the following statements is most correct?

  1. None of the answers are correct.
  2. The modified internal rate of return (MIRR) can never exceed the IRR.
  3. All of the answers are correct.
  4. If the IRR of Project A exceeds the IRR of Project B, then Project A must also have a higher NPV.
  5. If a project with normal cash flows has an IRR which exceeds the cost of capital, then the project must have a positive NPV.

Answer(s): E

Explanation:

The IRR is the discount rate at which a project's NPV is zero. If a project's IRR exceeds the firm's cost of capital, then its NPV must be positive, since NPV is calculated using the firm's cost of capital to discount project cash flows.



Ace Consulting, a multinational corporate finance consulting firm, is performing an analysis of the East Asian distribution network of Smith, Kleen, and Beetchnutty. Specifically, Ace Consulting is trying to identify the effect of changes in specific variables on the overall efficiency of SKB's distribution process. In their analysis, Ace Consulting identified a "base case" situation using the expected values for each input. Then, Ace modified each variable a few points above and below the base case, holding other variables constant. This was done in an effort to determine the effect of each variable on the overall efficiency of SKB's distribution process. Which of the following choices correctly describes this stand-alone risk measurement technique?

  1. Monte Carlo simulation
  2. Scenario analysis
  3. Case study analysis
  4. Regression analysis
  5. Sensitivity analysis
  6. Relational analysis

Answer(s): E

Explanation:

In this example, Ace consulting has been conducting a sensitivity analysis. This analysis begins with the identification of a "base case" situation using expected values for each input. Then, a variable is manipulated holding the other variables constant, in an effort to determine the sensitivity of the output to manipulations in each variable. Sensitivity analysis is the most widely used technique for measuring stand-alone risk, and can be performed relatively easily using a commercially available spreadsheet package such as Microsoft Excel.



The Seattle Corporation has been presented with an investment opportunity which will yield cash flows of $30,000 per year in Years 1 through 4, $35,000 per year in Years 5 through 9, and $40,000 in Year 10. This investment will cost the firm $150,000 today, and the firm's cost of capital is 10 percent. Assume cash flows occur evenly during the year, 1/365th each day. What is the payback period for this investment?

  1. 4.35 years
  2. 4.00 years
  3. 5.23 years
  4. 4.86 years
  5. 6.12 years

Answer(s): D

Explanation:

Using the even cash flow distribution assumption, the project will completely recover initial investment after 30/35 = 0.86 of Year 5:
Payback = 4 + 30/35 = 4.86 years.



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