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Free Test Prep CFA-Level-I Exam Questions (page: 18)

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Sun State Mining Inc., an all-equity firm, is considering the formation of a new division, which will increase the assets of the firm by 50 percent. Sun State currently has a required rate of return of 18 percent, U.S. Treasury bonds yield 7 percent, and the market risk premium is 5 percent. If Sun State wants to reduce its required rate of return to 16 percent, what is the maximum beta coefficient the new division could have?

  1. 2.0
  2. 1.0
  3. 2.2
  4. 1.6
  5. 1.8

Answer(s): B

Explanation:

Old assets = 1.0.New assets = 0.5.Total assets = 1.5.
Old required rate:New required rate:
18% = 7% + (5%)b16% = 7% + (5%)b
beta = 2.2.beta = 1.8.
New b must not be greater than 1.8, therefore
0.3333(b) = 0.3333
b = 1.0.
Therefore, beta of the new division cannot exceed 1.0.



Which of the following is not considered a relevant concern in determining incremental cash flows for a new product?

  1. The cost of a product analysis completed in the previous tax year and specific to the new product.
  2. All of these are relevant.
  3. The use of factory floor space which is currently unused but available for production of any product.
  4. Shipping and installation costs associated with preparing the machine to be used to produce the new product.
  5. Revenues from the existing product that would be lost as a result of some customers switching to the new product.

Answer(s): A

Explanation:

The product analysis cost is considered a sunk cost and is not relevant.



Which of the following statements is correct?

  1. The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a relatively powerful computer, coupled with an efficient financial planning software package, whereas simulation analysis can be done using a PC with a spreadsheet program or even a calculator.
  2. All of these answers are correct.
  3. Sensitivity analysis is incomplete because it fails to consider the range of likely values of key variables as reflected in their probability distributions.
  4. In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less risky, because a small error in estimating a variable, such as unit sales, would produce only a small error in the project's NPV.
  5. Sensitivity analysis is a risk analysis technique that considers both the sensitivity of NPV to changes in key variables and the likely range of variable values.

Answer(s): C

Explanation:

A project's stand-alone risk depends on (1) the sensitivity of NPV to changes in key variables and (2) the range of likely values of these variables as reflected in their probability distribution. Sensitivity analysis considers only the first factor.



The Clientele Effect theory implies that investors in the low tax brackets will prefer:

  1. none of these answers.
  2. high capital gains.
  3. high dividend payouts.
  4. low dividend payouts.

Answer(s): C

Explanation:

The Clientele Effect is based on the presumption that different groups of investors will prefer different dividend policies based on their tax status and their need for current versus future income requirements. Hence, investors who face high taxes on current income will tend to avoid stocks with high pay-out ratios. This lowering of demand for such stocks will tend to depress their prices and to take advantage of this; investors in low tax brackets would gravitate toward them. To this, add the fact that usually, investors in low tax brackets with sufficient capital to invest tend to be either people who are old and retired or institutions like pension funds.
Both these groups have a higher need for current income but are sensitive to liquidation of capital. They therefore prefer their income from stocks to be in the form of dividends rather than from the sale of their stock holdings.



Alyeska Salmon Inc., a large salmon canning firm operating out of Valdez, Alaska, has a new automated production line project it is considering. The project has a cost of $275,000 and is expected to provide after-tax annual cash flows of $73,306 for eight years. The firm's management is uncomfortable with the IRR reinvestment assumption and prefers the modified IRR approach. You have calculated a cost of capital for the firm of 12 percent. What is the project's MIRR?

  1. 17.0%
  2. 15.0%
  3. 12.0%
  4. 14.0%
  5. 16.0%

Answer(s): E

Explanation:

TV = $73,306(FVIFA(12%,8)) = $73,306(12.300) = $901,663.80.
$275,000 = $901,663.80 / (1 + MIRR)^8
(1 + MIRR)^8 = (FVIF(Irr,8)) = 3.27869.
Look in table: Periods = 8, I = 16%. MIRR = 16%.
Alternate method
3.27869^1/8 = 1 + MIRR
MIRR = 16%.



Consider the following argument: "The cost of common stock should decrease as the dividend payout is increased because investors are more certain of receiving these dividends than the capital gains which are supposed to be derived from retained earnings." This statement applies best to which of the following financial theories? Choose the best answer.

  1. Tax Preference Theory
  2. Dividend Irrelevance Theory
  3. Tax Irrelevance Theory
  4. Dividend Relevance Theory
  5. Bird-in-hand Theory

Answer(s): E

Explanation:

The Bird-in-the-Hand Theory came about as a refutation of Modigliani and Miller's Dividend Irrelevance Theory.
The founders of the Bird-in-the-Hand Theory, Myron Gordon and John Lintner, stated that investors are more confident in the fact that they will receive dividends versus capital gains. So said, the cost of common stock should decrease as the payout ratio is increased.
The Tax Preference Theory states that investors prefer capital gains to dividends, and this is due to the structure of tax rates. Specifically, dividends are typically taxed at a higher rate than capital gains, and are in this respect less attractive.



An investment project has an initial cost, and then generates inflows of $50 a year for the next five years. The project has a payback period of 3.6 years. What is the project's internal rate of return (IRR)?

  1. 12.05%
  2. 13.47%
  3. 15.89%
  4. 14.66%
  5. 11.18%

Answer(s): A

Explanation:

Investment cost = $180.
CF(0) = -180
CF(1-5) = 50
Solve for IRR = 12.05%.



According to the signaling theory, if a firm issues debt capital to finance a project, the firm's management must consider the project to be ________.

  1. none of these answers
  2. likely to raise the probability of bankruptcy
  3. very desirable
  4. not very profitable

Answer(s): C

Explanation:

According to the signaling theory of capital structure, a firm will try to raise debt capital when the project's returns are deemed very favorable and vice versa. The firm is signaling that the project has sufficient cash flows to pay back the debt.



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