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Free Test Prep CFA-Level-I Exam Questions (page: 21)

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Dick Boe Enterprises, an all-equity firm, has a corporate beta coefficient of 1.5. The financial manager is evaluating a project with an IRR of 21 percent, before any risk adjustment. The risk-free rate is 10 percent, and the required rate of return on the market is 16 percent. The project being evaluated is riskier than Boe's average project, in terms of both beta risk and total risk. Which of the following statements is most correct?

  1. Riskier-than-average projects should have their IRRs increased to reflect their added riskiness. Clearly, this would make the project acceptable regardless of the amount of the adjustment.
  2. The accept/reject decision depends on the risk-adjustment policy of the firm. If the firm's policy were to reduce a riskier-than-average project's IRR by 1 percentage point, then the project should be accepted.
  3. The project should be accepted since its IRR (before risk adjustment) is greater than its required return.
  4. The project should be rejected since its IRR (before risk adjustment) is less than it's required return.
  5. Projects should be evaluated on the basis of their total risk alone. Thus, there is insufficient information in the problem to make an accept/reject decision.

Answer(s): B

Explanation:

k(s) = 10% + (16% - 10%)1.5 = 10% + 9% = 19%.
Original IRR = 21%. 21% - Risk adjustment 1% = 20%.
Risk adjusted IRR = 20% > k(s) = 19%.



Despite relative congruence in their ranking methods, NPV and MIRR will sometimes produce conflicting answers. Which of the following correctly illustrates an example in which the two methods would likely produce conflicting rankings?

  1. When examining projects with non-normal cash flows
    II. When examining projects that differ substantially in scale III. When examining independent projects
    IV. When examining projects that differ substantially in their lifespan
  2. I and III
  3. I and II
  4. II and IV
  5. II and IV

Answer(s): C

Explanation:

While the MIRR method is designed to tackle many of the problems associated with the traditional IRR calculation, there exist situations in which the MIRR will produce rankings which conflict with those produced by the NPV method. Specifically, when mutually-exclusive projects whose lifespans or scale differ substantially are being examined. In these situations, the NPV calculation should be relied on, as this method is considered to produce the correct results.



A mutual fund has a load of 4 percent and a net asset value (NAV) of $20 per share. What must an investor pay to purchase 250 shares?

  1. $5,200.
  2. $4,800.
  3. $5,013.
  4. $5,208.

Answer(s): D

Explanation:



Jacobi Lefebre, CFA, recently accepted a position in the Real Estate Strategy group of a large retail company. The Director of the group walks by Lefebre's cubicle, hands him a report with the following information, and asks Lefebre to determine how large a project the firm can undertake without increasing the marginal cost of capital.
The firm can undertake a project costing up to approximately:

  1. $54 million.
  2. $81 million.
  3. $83 million.
  4. $29 million.

Answer(s): A

Explanation:

This question is asking you to calculate the retained earnings break even point BPRE(in relation to the marginal cost of capital). Once the breakeven point is reached, the firm will have to use external equity to fund projects, thus increasing the weighted average cost of capital (WACC).
The break point on the marginal cost curve is given by:
BPRE= (Retained Earnings) / (Equity Fraction, we)
Here, RE = earnings * (1 ­ Payout) = $50 million * (1 ­ 0.35) = $ 32.5 million, And BPRE= $32.5 million / 0.60 = $54.17 million, or approximately $54 million.



Helmut Humm, manager at a large U.S. firm, has just been assigned to the capital budgeting area to replace a person who left suddenly. One of Humm's first tasks is to calculate the company's weighted average cost of capital (WACC) ­ and fast! The CEO is scheduled to present to the board in half an hour and needs the WACC ­ now! Luckily, Humm finds clear notes on the Target capital component weights in the current workpapers. Unfortunately, all he can find for the cost of capital components is some handwritten notes. He can make out the numbers, but not the corresponding capital component. As time runs out, he has to guess.
Here is what Humm deciphered:
If Humm guesses correctly, the WACC is:

  1. 10.1%.
  2. 10.4%.
  3. 9.7%.
  4. 11.0%.

Answer(s): B

Explanation:

If Humm remembers to order the capital components from cheapest to most expensive, he can calculate WACC. The order from cheapest to most expensive is: debt, preferred stock (which acts like a hybrid of debt and equity), retained earnings, and common stock. (Remember that internal equity ­ retained earnings is cheaper than external equity ­common equity due to floatation costs.) Then, using the formula for WACC = (wd)(kd) + (wps)(kps) + (ws)(ks)+ (we)(ke) where wd, wps, wsandweare the weights used for debt, preferred stock, retained earnings, and common equity.
WACC = (0.30 * 6.0%) + (0.20 * 8.5%) + (0.15 * 11.00%) + (0.35 * 15.0%) =10.4%.



Dana Leone, Level 2 candidate in the CFA Program, is a manager in the capital planning division of a large consumer products company. Today, she must decide whether to recommend Project Forrest or Project Trieste to the Division Director. Leone's assistant has determined the following information about the projects (which are of approximately the same size and life):



Note:NPV = Net Present Value
MIRR = Modified Internal Rate of Return
PBP = Pay Back Period
WACC = Weighted Average Cost of Capital
Based on the information in the above table, which of the following statements is FALSE? If company management is most concerned with:

  1. increasing the value of the firm, Leone should recommend Project Forrest.
  2. liquidity, Leone should recommend Project Trieste.
  3. return safety margin, Leone should recommend Project Forrest.
  4. shareholder interests, Leone should recommend Project Trieste.

Answer(s): A

Explanation:

Since Leone can recommend either Forrest or Trieste, this question should be answered using the decision rules for mutually exclusive projects. For a company most interested in shareholder wealth and increasing the value of the firm (which are the same concept), Project Trieste is best because it has the higher NPV. NPV is the measure that indicates the direct impact on shareholder wealth. The other statements are true. The PBP measures liquidity, i.e., the shorter the PBP, the higher the liquidity.The IRR method does provide a measure of safety margin (and Project Forrest does have the highest IRR).



Annah Korotkin is the sole proprietor of CoverMeUp, a business that designs and sews outdoor clothing for dogs. Each year, she rents a booth at the regional Pet Expo and sells only blankets. Korotkin views the Expo as primarily a marketing tool and is happy to break even (that is, cover her booth rental). For the last 3 years, she has sold exactly enough blankets to cover the $750 booth rental fee. This year, she decided to make all blankets for the Expo out of high-tech waterproof/breathable material that is more expensive to produce, but that she believes she can sell for a higher profit margin. Information on the two types of blankets is as follows:



Assuming that Korotkin remains most interested in covering the booth cost (which has increased to $840), how many more or fewer blankets (new style) does she need to sell to cover the booth cost? To cover this year's booth costs, Korotkin needs to sell:

  1. 42 more blankets than last year.
  2. 42 fewer blankets than last year.
  3. 30 fewer blankets than last year.
  4. the same amount of blankets as last year.

Answer(s): C

Explanation:

To obtain this result, we need to calculate Last Year's Breakeven Quantity, This Year's Breakeven Quantity, and calculate the difference.
Step 1: Determine Last Year's (Basic Blanket) breakeven quantity:
QBE= (Fixed Costs) / (Sales Price per unit ­ Variable Cost per unit) = 750 / (25 ­ 20) = 150 Step 2: Determine This Year's (New Blanket) breakeven quantity:
QBE= (Fixed Costs) / (Sales Price per unit ­ Variable Cost per unit) = 840 / (40 ­ 33) = 120 Step 3: Determine Change in Units:
Q = QThis Year­ QLast Year= 120 ­ 150 = -30. Korotkin needs to sell 30fewerblankets.



Using the following assumptions, calculate the rate of return on a margin transaction and the stock price at which the investor who purchases the stock will receive a margin call. What of the following choices is closest to the correct answer? The margin transaction return is:

  1. 83.33%, and the investor will receive a margin call at a stock price of $15.43.
  2. 33.33%, and the investor will receive a margin call at a stock price of $15.43.
  3. 111.11%, and the investor will receive a margin call at a stock price of $21.00.
  4. 111.11%, and the investor will receive a margin call at a stock price of $15.43.

Answer(s): A

Explanation:

To obtain the result:
Part 1: Calculate Margin Return:
Margin Return % = [((Ending Value - Loan Payoff) / Beginning Equity Position) ­ 1] * 100 = = [(([$24 * 1,000] ­ [$18 * 1,000 * 0.60]) / ($18 * 0.40 * 1,000)) ­ 1] * 100 = = 83.33%
Alternative (Check): Calculate the all cash return and multiply by the margin leverage factor.
= [(24,000 ­ 18,000)/18,000] * [1 / 0.40] = 33.33% * 2.5 = 83.33% Part 2: Calculate Margin Call Price:
Since the investor is long (purchased the stock), the formula for the margin call price is:
Margin Call = (original price) * (1 ­ initial margin) / (1 ­ maintenance margin) = $18 * (1 ­ 0.40) / (1 ­ 0.30) = $15.43



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