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Free Test Prep CFA-Level-I Exam Questions (page: 37)

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Which of the following conditions are necessary for the IRR and NPV calculations to produce similar ranking decisions.
Choose the best possible answer.

  1. Projects must have equal lifespans, projects must be of equal scale
  2. Projects must be independent, have equal lifespans, and must be equal in scale
  3. Projects must be of equal size and have equal life, and must have normal cash flows
  4. Projects must have equal lifespans, projects must have normal cash flows
  5. Projects must be mutually exclusive, have equal lifespans, and must be of equal scale

Answer(s): C

Explanation:

When examining mutually-exclusive projects with equal lifespans and of equal size, the IRR and NPV calculations will produce similar ranking results as long as the projects under examination have "normal" cash flows. It is when the projects under examination have "non-normal" cash flows that IRR calculations can experience difficulty. Non-normal cash flows are defined as cash flows in which negative flows are juxtaposed within a series of positive cash inflows, creating a situation in which the sign will change more than once. When examining these "non-normal" projects, the Internal Rate of Return method will often produce multiple answers which leads to an incorrect accept/reject decision.



Which of the following statements about the cost of capital is incorrect?

  1. The cost of retained earnings is equal to the return stockholders could earn on alternative investments of equal risk.
  2. WACC calculations should be based on after-tax costs of capital.
  3. Flotation costs can increase the WAC
  4. If a company's tax rate increases, then, all else equal, its weighted average cost of capital will increase.
  5. A company's target capital structure affects its WACC (Weighted Average Cost of Capital).

Answer(s): D

Explanation:

A tax rate increase would lead to a decrease in the after-tax cost of debt and, consequently, the firm's WACC would decrease.



Which of the following statements best describes the theories of investors' preferences for dividends?

  1. The tax preference theory suggests that a company can increase its stock price by increasing its dividend payout ratio.
  2. One key advantage of a residual dividend policy is that it enables a company to follow a stable dividend policy.
  3. The clientele effect suggests that companies should follow a stable dividend policy.
  4. Modigliani and Miller argue that investors prefer dividends to capital gains.
  5. The bird-in-hand theory suggests that a company can reduce its cost of equity capital by reducing its dividend payout ratio.

Answer(s): C

Explanation:

Different groups, or clientele, of stockholders prefer different dividend payout policies. Stockholders in a low or tax-free tax bracket generally prefer cash income, so a payout would be their preference. On the other hand, stockholders in a high tax bracket might prefer reinvestment of earnings because they have little need for current investment income. To the extent that stockholders can switch firms, a firm can change from one dividend payout policy to another to let stockholder who do not like the new policy sell to other investors who do.
Yet this would be costly because of brokerage costs, the capital gains taxes that would have to be paid by the selling stockholders, and the chance that there will be a net loss of investors who like the firm's new dividend policy. Management should therefore, probably not change its policy. Several studies show that there is a clientele effect, which is the tendency of a firm to attract a set of investors who like its dividend policy. The existence of the clientele effect does not necessarily imply that one dividend policy is better than another.



Two mutually exclusive projects each have a cost of $10,000. The total, undiscounted cash flows from Project L are $15,000, while the undiscounted cash flows from Project S total $13,000. Their NPV profiles cross at a discount rate of 10 percent. Which of the following statements best describes this situation?

  1. To determine if a ranking conflict will occur between the two projects the cost of capital is needed as well as an additional piece of information.
  2. Project L should be selected at any cost of capital, because it has a higher IRR.
  3. The NPV and IRR methods will select the same project if the cost of capital is greater than 10 percent; for example, 18 percent.
  4. The NPV and IRR methods will select the same project if the cost of capital is less than 10 percent; for example, 8 percent.
  5. Project S should be selected at any cost of capital, because it has a higher IRR.

Answer(s): C

Explanation:

The crossover rate is the discount rate at which the NPV profiles of the two projects cross and, thus, at which the projects' NPVs are equal. As long as the discount rate is greater than the crossover rate, both the NPV and IRR methods will lead to the same conclusion.



Bricks, Inc. has just installed a factory for producing titanium-strengthened bricks. The fixed costs equal $1.25 million. The bricks can be sold at $2.25 per unit and cost $1.9 per unit in variable expenses. How many bricks must be sold by Bricks, Inc. for it to break even?

  1. 1.34 million
  2. 3.57 million
  3. 4.19 million
  4. 2.19 million

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. In this case, Q = 1.25/(2.25 - 1.9) million = 3.57 million bricks.



The management of Clay Industries have adhered to the following capital structure: 40% debt, 45% common equity, and 15% perpetual preferred equity. The following information applies to the firm:
Yield to maturity of outstanding long-term debt = 9.5%
Expected return on the market = 14.5%
Annual risk-free rate of return = 6.25%
Historical Beta coefficient of Clay Industries Common Stock = 1.24 Annual preferred dividend = $1.75 Preferred stock net offering price = $28.50
Combined state/federal corporate tax rate = 35%
Given this information, and using the Capital Asset Pricing Model to calculate the component cost of common equity, what is the Weighted Average Cost of Capital for Clay Industries?

  1. The WACC for Clay Industries cannot be determined from the information provided.
  2. 14.45%
  3. 10.00%
  4. 12.14%
  5. 8.54%
  6. 10.81%

Answer(s): F

Explanation:

The calculation of the Weighted Average Cost of Capital is as follows: {fraction of debt * [yield to maturity on outstanding long-term debt][1-combined state/federal income tax rate]} + {fraction of preferred stock * [annual dividend/net offering price]} + {fraction of common stock * cost of equity}. The cost of common equity can be calculated using three methods, the Capital Asset Pricing Model (CAPM), the Dividend-Yield-plus-Growth-Rate (or Discounted Cash Flow) approach, and the Bond- Yield-plus-Risk-Premium approach. In this example, you are required to calculate the cost of equity using the Capital Asset Pricing Model (CAPM), which is illustrated as follows: {risk-free rate + beta(expected return on the market - risk-free rate)}. Using this model, the cost of common equity can be found as 16.48%. The cost of perpetual preferred stock can be found by dividing the annual dividend by the net offering price, which is illustrated in this case as follows: {$1.75/28.50) = 6.14%. The after-tax cost of debt can be found by taking the yield to maturity on the firm's outstanding long- term debt (9.5%), and multiplying this figure by (1 - annual tax rate 35%) = 6.175%. Incorporating all of these figures into the WACC equation gives a Weighted Average Cost of Capital of 10.807%



Which of the following statements is correct?

  1. If you are choosing between two projects which have the same cost, and if their NPV profiles cross, then the project with the higher IRR probably has more of its cash flows coming in the later years.
  2. The NPV and IRR methods both assume that cash flows are reinvested at the cost of capital. However, the MIRR method assumes reinvestment at the MIRR itself.
  3. There can never be a conflict between NPV and IRR decisions if the decision is related to a normal, independent project, i.e., NPV will never indicate acceptance if IRR indicates rejection.
  4. A change in the cost of capital would normally change both a project's NPV and its IRR.
  5. To find the MIRR, we first compound CFs at the regular IRR to find the TV, and then we discount the TV at the cost of capital to find the PV.

Answer(s): C

Explanation:

To see this, sketch out a NPV profile for a normal, independent project, which means that only one NPV profile will appear on the graph. If WACC < IRR, then IRR says accept. But in that case, NPV > 0, so NPV will also say accept.



Ace Consulting, a corporate finance consulting firm, is examining the operations of Intelligent Semiconductor and has determined the following information:
Sales $1,000,000
Total variable costs $270,000
Total fixed costs $400,000
Interest expense $75,000
EBIT $325,000
Given this information, what is the degree of total leverage for Intelligent Semiconductor?

  1. 1.342
  2. 2.863
  3. 1.4925
  4. 3.077
  5. 2.292

Answer(s): B

Explanation:

The Degree of Total Leverage (DTL) demonstrates how a given change in sales will impact a firm's EPS. The equation used for calculating the DTL is as follows: {[Sales - variable costs] / [sales - variable costs - fixed costs
- interest expense]}. Incorporating the given values for these components into the DTL equation yields the following: {[Sales $1,000,000 - variable costs $270,000] / [sales $1,000,000 - variable costs $270,000 - fixed costs $400,000 - interest expense $75,000]}=2.863. The EBIT figure is not explicitly incorporated into the DTL equation.



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