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Free Test Prep CFA-Level-I Exam Questions (page: 4)

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Louisiana Enterprises, an all-equity firm, is considering a new capital investment. Analysis has indicated that the proposed investment has a beta of 0.5 and will generate an expected return of 7 percent. The firm currently has a required return of 10.75 percent and a beta of 1.25. The investment, if undertaken, will double the firm's

total assets. If k(RF) = 7 percent and the market return is 10 percent, should the firm undertake the investment?

  1. No; the expected return of the asset (7%) is less than the required return (8.5%).
  2. Yes; the expected return of the asset (7%) exceeds the required return (6.5%).
  3. Yes; the beta of the asset will reduce the risk of the firm.
  4. No; the risk of the asset (beta) will increase the firm's beta.
  5. No; the expected return of the asset is less than the firm's required return, which is 10.75%.

Answer(s): A

Explanation:

Calculate the required return and compare to the expected return.
k(s) = k(RF) + (k(M) - k(RF))b = 0.07 + (0.10 - 0.07)0.5 = 0.085 = 8.5%.
The expected return of the asset (7%) is less than the required return (8.5%) so the investment should not be made.



The process of planning expenditures on assets whose cash flows are expected to extend beyond one year is known as ________.

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

Answer(s): B

Explanation:

Capital Budgeting is defined as the process of planning expenditures on assets whose cash flows are expected to extend beyond one year.



A portfolio manager with Mally, Feasance, & Company is examining shares of Melton Industries, a large industrial firm. Assume the following information:
Annual Dividend: $0.70
EPS: $1.65
Tax Rate: 35%
Discount Rate: 13.15%
ROE: 16%
Using this information, what is the expected growth rate of this firm? Assume that the discount rate, tax rate, and ROE are expected to remain stable.

  1. 11.59%
  2. 9.21%
  3. None of these answers
  4. 6.79%
  5. 6.00%
  6. 10.00%

Answer(s): B

Explanation:

To calculate the dividend growth rate, assuming a stable ROE figure, use the following equation: {g = ROE(1 - Dividend Payout Ratio)}. While the ROE figure has been provided, the Dividend Payout Ratio must be calculated manually. To find the Dividend Payout Ratio, divide the annual dividend by the EPS figure, giving the following: {Dividend Payout Ratio = ($0.70/$1.65)}. From this equation, we determine that the Dividend Payout Ratio for this firm is 42.42%. Imputing this figure into the Dividend Growth Rate Equation will yield a growth rate of 9.21% for this firm. As you can see, neither tax rates nor discount rates are incorporated into the calculation.



All else equal, which of the following is/are true about break-even point?

  1. An increase in the sale price per unit increases the break-even quantity.
    II. An increase in the variable cost per unit increases the break-even quantity.
    III. An increase in the fixed costs increases the break-even quantity.
  2. III only
  3. I & II
  4. I only
  5. II & III
  6. I, II & III
  7. II only
  8. I & III

Answer(s): D

Explanation:

The break-even quantity is the number of units that must be sold to just cover the fixed and variable costs. An increase in revenues per unit will decrease the break-even quantity while an increase in costs per unit will increase the break-even quantity.



Flood Motors is an all-equity firm with 200,000 shares outstanding. The company's EBIT is $2,000,000 and is expected to remain constant over time. The company pays out all of its earnings each year, so its earnings per share equals its dividends per share. The company's tax rate is 40 percent. The company is considering issuing $2 million worth of bonds (at par) and using the proceeds for a stock repurchase. If issued, the bonds would have an estimated yield to maturity of 10 percent. The risk-free rate in the economy is 6.6 percent, and the market risk premium is 6 percent. The company's beta is currently 0.9, but its investment banker's estimate that the company's beta would rise to 1.1 if they proceed with the recapitalization. Assume that the shares are repurchased at a price equal to the stock market price prior to the recapitalization. What would be the company's stock price following the recapitalization?

  1. $53.85
  2. $51.14
  3. $76.03
  4. $56.02
  5. $68.97

Answer(s): B

Explanation:

First, find the company's current cost of capital, dividends per share, and stock price: k = 0.066 + (0.06)0.9 = 12%. To find the stock price, you still need the dividends per share or DPS = ($2,000,000 (1 - 0.4))/200,000 = $6.00. Thus, the stock price is Po = $6.00/0.12 = $50.00. Thus, by issuing $2,000,000 in new debt the company can repurchase $2,000,000/$50.00 = 40,000 shares.
Now after recapitalization, the new cost of capital, DPS, and stock price can be found: k = 0.066 + (0.06)1.1 = 13.20%. DPS for the remaining (200,000 - 40,000) = 160,000 shares are thus [($2,000,000 - ($2,000,000 x 0.10))(1 - 0.4)]/160,000 = $6.75. And, finally, Po = $6.75/0.132 = $51.14.



Which of the following is/are disadvantages of stock repurchases?

  1. If investors are not indifferent between dividends and capital gains, regular repurchase programs could drive them away.
    II. The IRS could tax the firm for improper accumulation of capital gains if it felt regular repurchase programs had taken the place of dividends.
    III. The firm might end up paying a higher than fair price if it commits to a repurchase program.
  2. II & III
  3. I & III
  4. III only
  5. II only
  6. I only
  7. I, II & III

Answer(s): F

Explanation:

If shareholders are not indifferent between dividends and capital gains, the stock price might increase more with dividends. This is because cash dividends are generally made very regularly, while stock repurchases are irregularly made. Although this has been rarely done for public corporations, the IRS can impose a tax if it believes regular repurchases are being made to avoid paying dividends. If a company's shares are thinly traded, and the firm wishes to repurchase a large number of shares, it could bid up the stock price above the equilibrium price and overpay for the shares.



As the director of capital budgeting for Denver Corporation, you are evaluating two mutually exclusive projects with the following net cash flows:
YearProject XProject Z
0-$100,000-$100,000
150,000 10,000
240,000 30,000
330,000 40,000
410,000 60,000
If Denver's cost of capital is 15 percent, which project would you choose?

  1. Project Z, since it has the higher NPV.
  2. Project X, since it has the higher NPV.
  3. Neither project.
  4. Project X, since it has the higher IRR.
  5. Project Z, since it has the higher IRR.

Answer(s): C

Explanation:

(In thousands)
NPV(X) = -100 + 50(PVIF(15%,1)) + 40(PVIF(15%,2)) + 30(PVIF(15%,3)) + 10(PVIF(15%,4)) = -100 + 50 (0.8696) + 40(0.7561) + 30(0.6575) + 10(0.5718) = -0.833 = -$833.
NPVZ = -100 + 10(PVIF(15%,1)) + 30(PVIF(15%,2)) + 40(PVIF(15%,3)) + 60(PVIF(15%,4)) = -100 + 10 (0.8696) + 30(0.7561) + 40(0.6575) + 60(0.5718) = -8.013 = -$8,013.
At a cost of capital of 15%, both projects have negative NPVs and, thus, both would be rejected.



Which of the following statements is most correct?

  1. Suppose a firm is losing money and thus, is not paying taxes, and that this situation is expected to persist for a few years whether or not the firm uses debt financing. Thus the firm's after-tax cost of debt will equal its before-tax cost of debt.
  2. The bond-yield-plus-risk-premium approach to estimating a firm's cost of common equity involves adding a subjectively determined risk-premium to the market risk-free bond rate.
  3. The reason that a cost of capital is assigned to retained earnings is because these funds are already earning a return in the business, the reason does not involve the opportunity cost principle.
  4. The component cost of preferred stock is expressed as k(ps)(1 - T), because preferred stock dividends are treated as fixed charges, similar to the treatment of debt interest.
  5. All of these statements are false.

Answer(s): A

Explanation:

Obviously if the firm is paying no taxes, its after-tax cost of debt will equal its before-tax cost of debt.



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