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Free Test Prep CFA-Level-I Exam Questions (page: 34)

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Which of the following are practical difficulties associated with capital structure and degree of leverage analyses?

  1. All of these statements are correct.
  2. None of the statements represent a serious impediment to the practical application of leverage analysis in capital structure determination.
  3. Managers' attitudes toward risk differ and some managers may set a target capital structure other than the one that would maximize stock price.
  4. Managers often have a responsibility to provide continuous service; they must preserve the long-run viability of the enterprise. Thus, the goal of employing leverage to maximize short-run stock price and minimize capital cost may conflict with long-run viability.
  5. It is nearly impossible to determine exactly how P/E ratios or equity capitalization rates are affected by different degrees of financial leverage.

Answer(s): A

Explanation:

Two projects being considered are mutually exclusive and have the following projected cash flows:
Year Project AProject B
0-$50,000-$50,000
115,6250
215,6250
315,6250
415,6250
515,62599,500



If the required rate of return on these projects is 10 percent, which would be chosen and why?

  1. Project B because it has the higher IRR.
  2. Neither, because both have IRRs less than the cost of capital.
  3. Project B because it has the higher NPV.
  4. Project A because it has the higher IRR.
  5. Project A because it has the higher NPV.

Answer(s): C

Explanation:

NPV(A) = $15,625(PVIFA(10%,5)) - $50,000 = $15,625(3.7908) - $50,000 = $59,231.25 - $50,000 = $9,231.25.
NPVB = $99,500(PVIF(10%,5)) - $50,000 = $99,500(0.6209) - $50,000 = $61,779.55 - $50,000 = $11,779.55.
NPV(B) > NPV(A); $11,779.55 > $9,231.25; Choose Project B.



A financial analyst with Smith, Kleen, and Beetchnutty is examining shares of Clever Industries, for possible investment. Clever Industries is involved in textile manufacturing, and the firm has been growing at a steady rate for much of the last nine decades. The analyst is trying to determine the appropriate current price range for Clever shares, and has ascertained the following information:
Expected annual dividend = $0.35
Expected sustainable annual growth rate = 15%
Investors required rate of return = 18.6%
Given this information, what is the appropriate current price for Clever Industries common stock?

  1. $10.28
  2. The current price of Clever Industries cannot be determined from the given information.
  3. $1.88
  4. $2.33
  5. $9.72

Answer(s): E

Explanation:

To calculate the appropriate stock price for Clever using the given information, the appropriate equation is as follows: {expected annual dividend/[investor's required rate of return - expected growth rate]}. Incorporating the given information into this equation yields a stock price of $9.722. Remember that this model to stock valuations is most appropriate for firms who are in the constant growth stage. Another important note to remember is that this model will yield realistic results only in those instances in which the investor's required rate of return exceeds the expected growth rate.



A set of projects where only one can be accepted is known as ________.

  1. Project Net Worth Optimization
  2. Equity Enhancement
  3. Independent Projects
  4. Optimal Capital Budgeting
  5. Mutually Exclusive Projects

Answer(s): E

Explanation:

Mutually Exclusive Projects are defined as a set of projects where only one can be accepted.



Which of the following statements is most correct?

  1. None of these answers are correct.
  2. An increase in fixed costs, (holding sales and variable costs constant) will reduce the company's degree of operating leverage.
  3. If the company has no debt outstanding, then its degree of total leverage equals its degree of operating leverage.
  4. All of these answers are correct.
  5. An increase in interest expense will reduce the company's degree of financial leverage.

Answer(s): C

Explanation:

The degree of financial leverage is the percentage change in EPS that results form a given percentage change in earnings before interest and taxes. If a firm has no debt outstanding the degree of financial leverage would be 1.0.



Which of the following firm's earnings per share (EPS) figure would be least sensitive to a percentage change in Earnings Before Interest and Taxes (EBIT)?
Firm A
EBIT: $6,800,000
Interest Paid: $505,000
Total Operating Expenses: $80,000,000
Fixed Operating Expenses: $50,250,000
Firm B
EBIT: $20,000,000
Interest Paid: $600,000

Total Operating Expenses: $40,000,000
Fixed Operating Expenses: $30,250,000
Firm C
EBIT: $50,500,000
Interest Paid: $3,500,000
Total Operating Expenses: $66,000,000
Fixed Operating Expenses: $30,750,000
Firm D
EBIT: $49,700,000
Interest Paid: $7,750,000
Total Operating Expenses: $90,000,000
Fixed Operating Expenses: $75,000,000
Firm E
EBIT: $43,000,000
Interest Paid: $7,000,000
Total Operating Expenses: $85,000,000
Fixed Operating Expenses: $60,500,000

  1. The answer cannot be determined from the information provided.
  2. Firm B
  3. Firm A
  4. Firm D
  5. Firm C
  6. Firm E

Answer(s): B

Explanation:

This question is asking you to calculate the Degree of Financial Leverage for each company. The Degree of Financial Leverage (DFL) measures the percentage change in EPS that results from a given percentage change in EBIT. Financial Leverage is the second component of total leverage, along with Operating Leverage.
The equation used to calculate the Degree of Financial Leverage is as follows: {DFL = [EBIT/(EBIT - Interest Paid)]}. As companies incorporate more debt in their capital structure, their EPS figure will become more sensitive to fluctuations occurring from interest payments, and this is evidenced by an increase in the Degree of Financial Leverage. In this example, Firm B has the lowest DFL with a figure of 1.031. In light of this information, it can be concluded that firm B has an EPS figure which is the least sensitive to a given change in EBIT. When calculating the DFL figure, remember that the answer can never be less than one, and can never be negative. In a situation where the company under examination has zero debt, and no preferred stock dividends (and therefore no interest expense for purposes of the DFL equation), the DFL would be equal to one. It is important note to remember is that in calculating the Degree of Financial Leverage, dividend payments to preferred stockholders should be included in the interest expense figure. Operating expenses are not factored into the DFL calculation, rather are used in the determination of Operating Leverage.



The length of time required for an investment's net revenues to cover its cost is known as ________.

  1. Optimal Capital Structure
  2. Net Present Valuing
  3. Capital Budgeting
  4. Payback Period
  5. Weighted Average Cost of Capital (WACC)

Answer(s): D

Explanation:

Payback Period is defined as the length of time required for an investment's net revenues to cover its cost.



Which of the following is/are true about project risk analysis?

  1. Stand-alone risk is measured by the variability of the projects expected returns.
    II. Corporate risk measures the impact of the project's risk on the company's stock price variability.
    III. Market risk measures the impact of the project on the stock's unsystematic risk.
  2. I & II
  3. II & III
  4. III only
  5. I, II & III
  6. II only
  7. I only

Answer(s): F

Explanation:

Standalone risk evaluates the risk of a project ignoring all portfolio aspects by looking at the variability of the project's projected returns. The corporate risk of a project is measured by the project's impact on the uncertainty about the firm's future earnings. The market risk of a project is measured by the project's impact on the systematic risk of the firm's stock.



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