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Free Test Prep CFA-Level-I Exam Questions (page: 30)

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Suppose the firm's WACC is stated in nominal terms, but the project's expected cash flows are expressed in real dollars. In this situation, other things held constant, the calculated NPV would

  1. possibly have a bias, but it could be upward or downward.
  2. more information is needed; otherwise, we can make no reasonable statement.
  3. be biased upward.
  4. be biased downward.
  5. be correct.

Answer(s): D

Explanation:

Given the fact that there is inflation, a cost of capital stated in nominal terms would understate the calculated NPV. If inflation is expected, but this expectation is not built into the forecasted cash flows, then the calculated NPV will be downward biased.



Which of the following types of dividends, are never paid out in the form of cash?

  1. All of these are paid in the form of cash.
  2. Stock dividends.
  3. Regular dividends.
  4. Extra dividends.
  5. Liquidating dividends.

Answer(s): B

Explanation:

Stock dividends are dividends paid in the form of additional shares of stock rather than in cash. The total number of shares is increased, so earnings, dividends, and price per share all decline. Stock dividends that are used on a regular basis will keep the stock price more or less constrained, that is, within the optimal trading range.



The post-audit is used to

  1. eliminate potentially profitable but risky projects.
  2. all of these answers are correct.
  3. review cash flow forecasts.
  4. stimulate management to improve operations and bring results into line with forecasts.
  5. none of these answers are correct.

Answer(s): D

Explanation:

The two main purposes of the post-audit are to improve forecasts and improve operations. Management is putting their reputations on the line when forecasting an investment, and they will strive to improve operations to bring results into line with forecasts.



Which of the following is most correct?

  1. Conflicts between NPV and IRR rules arise in choosing between two mutually exclusive projects (that each have normal cash flows) when the cost of capital exceeds the crossover point (that is, the point at which the NPV profiles cross).
  2. None of the statements are correct.
  3. The discounted payback method overcomes the problems that the payback method has with cash flows occurring after the payback period.
  4. The NPV and IRR rules will always lead to the same decision in choosing between mutually exclusive projects, unless one or both of the projects are "non-normal" in the sense of having only one change of sign in the cash flow stream.
  5. The Modified Internal Rate of Return (MIRR) compounds cash outflows at the cost of capital.

Answer(s): B

Explanation:

IRR can lead to conflicting decisions with NPV even with normal cash flows if the projects are mutually exclusive. Cash outflows are discounted at the cost of capital with the MIRR method, while cash inflows are compounded at the cost of capital. Conflicts between NPV and IRR arise when the cost of capital is below the crossover point. The discounted payback method does correct the problem of ignoring the time value of money, but it still does not account for cash flows beyond the payback period.



Quick Launch Rocket Company, a satellite launching firm, expects its sales to increase by 50 percent in the coming year as a result of NASA's recent problems with the space shuttle. The firm's current EPS is $3.25. Its degree of operating leverage is 1.6, while its degree of financial leverage is 2.1. What is the firm's projected EPS for the coming year using the DTL approach?

  1. $3.25
  2. $5.46
  3. $19.63
  4. $10.92
  5. $8.71

Answer(s): E

Explanation:

EPS(1) = EPS(0) + EPS(0) [DTL x (percent change in sales)]
= $3.25 [1 + (1.6)(2.1)(0.5)] = $3.25 [2.68]
EPS(1) = $8.71.



Calculate the cost of debt for the following firm:
Borrowing Rate 10%
Marginal Tax Rate 40%
Project IRR 12.5%
Owner's Equity 15%

  1. 1.5%
  2. 6%
  3. 60%
  4. 27.5%
  5. 10%

Answer(s): B

Explanation:

The cost of debt is simply the rate of borrowing less the tax savings. Due to the fact that interest expense is tax deductible, the cost of debt in this case is 10%(1 - .4) = 10%(.6) = 6%.



Firms A and B have the same fixed costs in producing widgets. However, firm A charges 15% more than firm B for a widget while its variable costs per widget are 12% lower than those of B. If firm A sells a widget for 35% above its variable costs, the break-even point for B is ________ times higher than that for A.

  1. 2.0
  2. 9.2
  3. 3.3
  4. 2.5

Answer(s): B

Explanation:

The break-even quantity, Q, is given by Q = FC/(P - V), where FC = total fixed costs, P = average sale price per unit and V = average variable cost per unit.
You're given that FCA = FCB, PA = 1.35VA, PA = 1.15PB and VA = 0.88VB. Therefore, PB = (1.35/1.15)VA = 1.174VA and VB = (1/0.88)VA = 1.136V
E. This gives QA/QB = FC(PA-VA)/FC(PB-VB) = (PB - VB)/(PA - VA) = (1.174 - 1.136)/(1.35 - 1) = 0.109.
Thus, the break-even point for B is (1/0.109) = 9.21 times that for A.



Assume you are the director of capital budgeting for an all-equity firm. The firm's current cost of equity is 16 percent; the risk-free rate is 10 percent; and the market risk premium is 5 percent. You are considering a new project that has 50 percent more beta risk than your firm's assets currently have, i.e., its beta is 50 percent larger than the firm's existing beta. The expected return (IRR) on the new project is 18 percent. Should the project be accepted if beta risk is the appropriate risk measure?

  1. Yes; its IRR is greater than the firm's cost of capital.
  2. No; a 50 percent increase in beta risk gives a risk-adjusted required return of 24 percent.
  3. No; the project's risk-adjusted required return is 1 percentage point above its IRR.
  4. Yes; the project's risk-adjusted required return is less than its IRR.
  5. No; the project's risk-adjusted required return is 2 percentage points above its IRR.

Answer(s): C

Explanation:

Calculate the beta of the firm, and use to calculate project beta:
k(s) = 0.16 = 0.10 + (0.05)b. b = 1.2.
b(Project) = b(Firm)1.5 b(Project) is 50% greater than current b(Firm) b(Project) = (1.2)1.5 = 1.8.
Calculate required return on project, k(Project), and compare to IRR.
Project: k(Project) = 0.10 + (0.05)1.8 = 0.19 = 19%. IRR = 0.18 = 18%.
Since the required return is one percentage point greater than the expected IRR, the firm should not accept the new project.



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