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Free Test Prep CFA-Level-I Exam Questions (page: 3)

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Ace Consulting, a corporate finance consulting firm, is examining the operating performance of Microscam Incorporated. In their analysis, Ace Consulting has identified the following information:
Year 1 interest paid $28,000
Year 2 interest paid $35,000
Year 1 sales $1,675,000
Year 2 sales $1,895,000
Year 1 EBIT $750,000
Year 2 EBIT $987,500
Cost of debt 7.70%
Given this information, what is the Degree of Operating Leverage for this firm during the time period in question?

  1. 1.531
  2. 2.431
  3. The Degree of Operating Leverage cannot be calculated due to the fact that an appropriate discount rate has not been provided.
  4. 2.412
  5. 2.618
  6. 0.415

Answer(s): D

Explanation:

To calculate the degree of operating leverage, use the following equation: {% change in EBIT/% change in sales}. In this example, neither the percentage change in sales, neither the percentage change in EBIT are provided, and must be calculated manually. To calculate the percentage change in sales, use the following equation: {[sales in year 2 - sales in year 1]/sales in year 1}. Incorporating the given information into this calculation yields a % change in sales of 13.13%. To calculate the percentage change in EBIT, use the same equation as follows: {[EBIT in year 2 - EBIT in year 1]/EBIT in year 1}. Incorporating the given information into this calculation yields a percentage change in the EBIT of 31.67%. Finally, to calculate the Degree of Operating Leverage, divide the percentage change in EBIT by the percentage change in sales, which derives a DOL of 2.412. The "interest paid" information is irrelevant in the calculation of the DOL, rather is incorporated into a determination of the Degree of Financial Leverage. This information has been provided to trick you.
Additionally, the Degree of Operating Leverage can be calculated regardless of whether an appropriate discount rate has been provided or not.



If the expected return on the market portfolio increases, the price of a firm's share ______, all else equal.

  1. can be all of these answers.
  2. is not affected
  3. decreases
  4. increases

Answer(s): C

Explanation:

In the usual notation, Po = D1/(k-g). Therefore, if the expected return on the stock, k, increases and all else remains constant, the price will fall. The expected return on the stock, k, increases if the market's expected rate of return increases.



Lugar Industries is considering an investment in a proposed project which requires an initial expenditure of $100,000 at t = 0. This expenditure can be depreciated at the following annual rates:
tDepreciation Rate
120%
232%
319%
412%
511%
66%
The project has an economic life of six years. The project's revenues are forecasted to be $90,000 a year. The project's operating costs (not including depreciation) are forecasted to be $50,000 a year. After six years, the project's estimated pre-tax salvage value is $10,000. The company's WACC is 10 percent, and its corporate tax rate is 40 percent. What is the project's net present value (NPV)?

  1. $31,684
  2. $34,667
  3. $45,453
  4. $33,843
  5. $38,840

Answer(s): E

Explanation:

The cash flows for each of the years are as follows:
0-100,000
1 [90,000 - 50,000 -(100,000)(0.20)](1-0.4)+(100,000)(0.20)= 32,000 2 [90,000 - 50,000 -(100,000)(0.32)](1-0.4)+(100,000)(0.32)= 36,800 3 [90,000 - 50,000 -(100,000)(0.19)](1-0.4)+(100,000)(0.19)= 31,600 4 [90,000 - 50,000 -(100,000)(0.12)](1-0.4)+(100,000)(0.12)= 28,800 5 [90,000 - 50,000 -(100,000)(0.11)](1-0.4)+(100,000)(0.11)= 28,400 6 [90,000 - 50,000 -(100,000)(0.06)](1-0.4)+(100,000)(0.06) + (10,000)(1 - 0.4) = 32,400 Enter the cash flows and solve for the NPV = $38,839.56.



If the IRS lowers the tax rate applicable to firms in a particular category, the optimal debt ratio for that category will ________.

  1. not be affected
  2. increase
  3. decrease
  4. insufficient information

Answer(s): C

Explanation:

If the tax rate is lower, the tax-deductibility of the interest payments on debt becomes less attractive. The after- tax cost of debt rises, lowering the optimal debt ratio.



A company has an EBIT of $4 million, and its degree of total leverage is 2.4. The firm's debt consists of $20 million in bonds with a 10 percent yield to maturity. The company is considering a new production process that will require an increase in fixed costs but a decrease in variable costs. If adopted, the new process will result in a degree of operating leverage of 1.4. The president wants to keep the degree of total leverage at 2.4. If EBIT remains at $4 million, what amount of bonds must be outstanding to accomplish this (assuming the yield to maturity remains at 10 percent)?

  1. $16.7 million
  2. $18.5 million
  3. $20.1 million
  4. $19.2 million
  5. $19.8 million

Answer(s): A

Explanation:

First, find the new DFL:
DTL = (DOL)(DFL)
2.4 = (1.4)(DFL)
DFL = 1.7143.
Then, find the new interest payments in a year:
DFL = (EBIT)/(EBIT - I)
1.7143 = ($4,000,000)/($4,000,000 - I)
I = $1,666,686.11.
Finally, solve for the new debt level, knowing that the yield to maturity remains at 10%. Debt Value(YTM) = Interest Payment
Debt(0.10) = $1,666,686.11
Debt = $16,666,861.11 = $16.7 million.



Which of the following is not expressly incorporated into the Degree of Total Leverage (DTL) calculation?

  1. Sales
  2. Fixed costs
  3. Variable costs
  4. Interest expense
  5. None of these answers
  6. Common shares outstanding

Answer(s): F

Explanation:

The Degree of Total Leverage (DTL) calculation measures the percentage change in EPS from a given percentage change in sales. The equation used to produce DTL is as follows:
{DTL = [(Sales - Variable Costs) / (Sales - Variable Costs - Fixed Costs - Interest Expense)]. Of all the choices listed, "only the number of common shares outstanding" is not expressly incorporated into the DTL calculation.



Clay Industries, a large industrial firm, has just released a new process system allowing mining companies to automate much of their copper extraction procedures. While the sales of this process system are expected to be hugely successful, analysts predict that sales of Clay Industries existing products will decline as a result, as customers substitute the new process system for much of the Clay Industries' older drilling components and non-automated process systems. Which of the following terms most correctly describes the problem faced by Clay Industries?

  1. Externality problem
  2. Diminishing returns problem
  3. Cannibalization
  4. Opportunity cost problem
  5. Incremental sales deterioration

Answer(s): C

Explanation:

When a new product or service takes sales away from existing products or services, this is often referred to as cannibalization (or erosion). While firms naturally do not wish to cannibalize existing products, often if they do not, other firms will begin to erode their market share. The cannibalization problem is frequently considered in the analysis of new releases of products and services.



Maxvill Motors has annual sales of $15,000. Its variable costs equal 60 percent of its sales, and its fixed costs equal $1,000. If the company's sales increase 10 percent, what will be the percentage increase in the company's earnings before interest and taxes (EBIT)?

  1. 18%
  2. 20%
  3. 16%
  4. 12%
  5. 14%

Answer(s): D

Explanation:

First, find EBIT before sales increase:
EBIT = Sales - (Sales x VC%) - FC
= $15,000 - ($15,000 x 0.60) - $1,000
= $5,000.
Now, assuming sales increase by 10% or to $15,000 x 1.10 = $16,500, calculate the new EBIT. EBIT = $16,500
- ($16,500 x 0.60) - $1,000 = $5,600.
So, the percentage increase is [($5,600 - $5,000)/$5,000] x 100 = 12%.



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