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Free Test Prep CFA-Level-I Exam Questions (page: 19)

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The return on the best alternative use of an asset, or the highest return that will not be earned if funds are invested in a particular project is known as which of the following terms?

  1. Sunk Cost
  2. Cannibalization
  3. Opportunity Cost
  4. Externality
  5. Incremental Cash Flow

Answer(s): C

Explanation:

Opportunity cost is defined as the return on the best alternative use of an asset, or the highest return that will not be earned if funds are invested in a particular project



Suppose Congress votes to raise the personal tax rate on interest and dividend income. However, it does not change the capital gains tax or the corporate tax rates. This will have the effect of:

  1. increasing the reliance on debt financing.
  2. increasing the reliance on retained earnings as capital.
  3. decreasing the reliance on equity capital.
  4. decreasing the sizes of seasoned equity offerings.

Answer(s): B

Explanation:

As personal tax rates increase, firms have to modify their reliance on different capital markets so as to minimize the costs imposed on debt and equity investors. An increase in interest and dividend income makes debt and dividend payouts costlier. On the other hand, since capital gains are not affected, firms will tend to decrease their dividend pay-out ratios and bank on retained earnings to finance their capital requirements.



The initial investment outlay consists of which of the following?

  1. Up-front costs of the project's fixed assets.
    II. Flotation costs associated with raising the necessary capital.
    III. Increases in net working capital.
    IV. Present value of all interest expenses associated with the project capital.
  2. II only
  3. I, II & IV
  4. I, II & III
  5. I, II, III & IV
  6. I & III
  7. III only
  8. I only
  9. IV only

Answer(s): E

Explanation:

The initial investment outlay consists of up-front costs of the project's fixed assets and any increases in net working capital. Costs involved in raising the finances are not part of the initial outlay.



Which of the following statements is most correct?

  1. The CAPM approach is typically used to estimate a firm's flotation cost adjustment factor, and this factor is added to the DCF cost estimate.
  2. These statements are all incorrect.
  3. In practice (as opposed to in theory), the DCF method and the CAPM method usually produce exactly the same estimate for k(s).
  4. The risk premium used in the bond-yield-plus-risk-premium method is the same as the one used in the CAPM method.
  5. Under normal conditions, the CAPM (Capital Asset Pricing Model) approach to estimating a firm's cost of retained earnings gives a higher estimate than the DCF (Discounted Cash Flow) approach.

Answer(s): B

Explanation:

All are incorrect. Under the CAPM approach, it is at best difficult to obtain correct estimates of the inputs require to make it operational. The same could be said about the growth rate input under the DCF approach.
The risk premium under the bond-yield-plus-risk premium approach is purely judgmental and results in a ballpark estimate.



Which of the following statements is most correct?

  1. If a company does a 2-for-1 stock split, its stock price will roughly double.
  2. An open-market dividend reinvestment plan is likely to be attractive to companies that are looking to issue additional shares of common stock.
  3. All of these answers are correct.
  4. None of the answers are correct.
  5. Stock repurchases have the effect of reducing financial leverage.

Answer(s): D

Explanation:

A new stock type of DRIP would result in raising new capital for the firm. Stock repurchases increase financial leverage. In a 2-for-1 stock split, the stock price will be halved.



A financial analyst with Smith, Kleen, & Beetchnutty is examining shares of Claypool Manufacturing for possible investment. Assume the following information:

Sales: $50,000,000
Fixed costs: $33,000,000
Variable costs: $8,500,000
Interest expense: $900,000
Tax rate: 35%
Weighted Average Cost of Capital: 11.50%
Beta coefficient: 0.96

Common shares outstanding: 4,000,000
Using this information, what are the earnings per share (EPS) for Claypool Manufacturing?

  1. $1.34
  2. $1.40
  3. The answer cannot be determined from the information provided.
  4. $1.70
  5. $1.24
  6. $1.11

Answer(s): E

Explanation:

The EPS figure is perhaps the single most popular term in the field of conventional equity investments, along with the Price-to-Earnings Ratio (P/E). Any glance into financial media and business periodicals will undoubtedly uncover numerous instances in which the EPS figure is cited or discussed. While quite popular and useful, most investors, and many business professionals, undoubtedly do not understand the mechanics behind the EPS calculation, and an investigation into the components of EPS is a valuable learning experience.
The EPS calculation is found by the following equation:
{EPS = [(Sales - Fixed Costs - Variable Costs - Interest Expense)(1 - Tax Rate)] / [# of Common Shares Outstanding]}
Additionally, the EPS figure can be found by:
{EPS = [(EBIT - Interest Expense)(1 - Tax Rate) / # of Common Shares Outstanding]} Incorporating the given information into the first EPS equation will yield the following: {EPS = [($50,000,000 - $33,000,000 - $8,500,000
- $900,000)(1 - 0.35)] / 4,000,000} = $1.24.



The net cash flow attributable to an investment project is known as which of the following terms?

  1. Sunk Cost
  2. Opportunity Cost
  3. Incremental Cash Flow
  4. Cannibalization
  5. Externality

Answer(s): C

Explanation:

Incremental cash flow is defined as the net cash flow attributable to an investment project.



Following an internal investigation into her professional business activities, a financial analyst with Smith, Kleen & Beetchnutty admits that in her NPV and IRR calculations, she has failed to index all cash flows for the effects of anticipated inflation. However, the analyst claims that the discount rate she has used in her calculations does take into effect anticipated inflation.
Which of the following correctly describes the effects this will have on the NPV and IRR calculations?

  1. NPV will be biased downward, IRR will be biased upward
  2. NPV will be biased upward, IRR will be biased downward
  3. Both NPV and IRR will be biased downward
  4. Both NPV and IRR will remain unaffected
  5. NPV will be biased downward, IRR will be unaffected
  6. Both NPV and IRR will be biased upward

Answer(s): C

Explanation:

By failing to index the cash flows of projects in her NPV analysis, while at the same time including an adjustment for inflation into the discount rate, this analyst has biased the NPV calculation downward. This is because the cash inflows are being understated by the inflation-adjusted discounting. This phenomenon will skew the NPV figure downward. Remember that while the Internal Rate of Return calculation does not specify an explicit discount rate, rather calculates the discount rate that equates the cash inflows of a project with its cash outflows, the fact remains that the cash flows in the calculation have not been indexed for the effects of positive inflation. What has happened here is that cash flows have been understated, and this will bias the IRR calculation downward.



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