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Free Test Prep CFA-Level-I Exam Questions (page: 51)

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Dumb & Dumber Development Company has two mutually exclusive investment projects to evaluate. Assume both projects can be repeated indefinitely. The following cash flows are associated with each project:
Time Project A Project B
0-$100,000-$70,000
1 30,000 30,000
2 50,000 30,000
3 70,000 30,000
4-30,000
5-10,000
The project types are equally risky and the firm's cost of capital is 12 percent. What is the EAA of the higher valued project? (Round your final answer to the nearest whole dollar.)

  1. $16,470
  2. $7,433
  3. $11,325
  4. $6,857
  5. None of the answers

Answer(s): B

Explanation:

Step 1 Calculate the NPV for both projects:
A:CF(0) = -100,000; CF(1) = 30,000; CF(2) = 50,000; CF(3) = 70,000; I/YR = 12; solve for NPV = $16,470.
B:CF(0) = -70,000; CF(1) = 30,000; CF(2) = 30,000; CF(3) = 30,000;CF(4) = 30,000; CF(5) = 10,000; I/YR = 12; NPV = $26,795.
Step 2 Calculate the EAA for both projects:
A: N = 3; I/YR = 12; PV = -16,470; FV = 0; solve for PMT = $6,857.
B: N = 5; I/YR = 12; PV = -26,795; FV = 0; solve for PMT = $7,433.
The PMT is the EAA for each project. Since Project B has the larger EAA $7,433 is the correct answer.



Consider the following information for a company.
Common Stock Price $53.25
Preferred Stock Par Price $50
Preferred Dividend $3.5
Debt Rating BB+
Owners Equity 25%
Preferred Stock Flotation Cost 2.0%
The Preferred Stock is issued at Par
Calculate the component cost of this newly issued preferred stock. (Note that for existing preferred stock, flotation costs may be ignored.)

  1. 18.78%
  2. 7.14%
  3. 6.57%
  4. 7.0%
  5. 10%
  6. 3.5%
  7. 12.5%

Answer(s): B

Explanation:

The component cost of preferred stock is the dividend divided by issue price minus floatation cost. In this case the component cost of preferred stock = $3.50 / (50 - 1) = 7.14%.



A project has the following cash flows over the next 5 years: $1,000, $600, $300, $1,200 and $1,400. Assume all cash flows occur at the end of a year. The project requires an initial cash outlay of $2,900. The project's cost of capital is 8%. The NPV of the project equals ________.

  1. $1,194
  2. $1,735
  3. $3,513
  4. $613

Answer(s): D

Explanation:

The discounted cash flow at the end of year N is obtained by dividing that year's cash flow by 1.08N, since the project's cost of capital is 8%. Using this, the discounted cash flows are:
$926, $514, $238, $882 and $953.
The present value of all the future cash flows = $(926 + 514 + 238 + 882 + 953) = $3,513. The NPV is then equal to $(3,513 - 2,900) = $613.



Which of the following statements is most correct?

  1. An increase in the flotation cost incurred in selling new stock will reduce the retained earnings break point, as long as the dollar level of retained earnings and the fraction of capital which is equity financed remains constant.
  2. None of these answers are correct.
  3. All of these answers are correct.
  4. An increase in a firm's corporate tax rate, will increase the firm s cost of debt capital, as long as the yield to maturity on the company's bonds remains constant or falls.
  5. An increase in the flotation cost incurred in selling new stock will increase the cost of retained earnings.

Answer(s): B

Explanation:

An increase in the flotation cost has no effect on the cost of retained earnings or the retained earnings break point. An increase in the firm's corporate tax rate reduces the after-tax component cost of debt.



Ranking conflicts occur between the NPV and IRR methods because I NPV profiles have differing slopes. II IRR assumes reinvestment of intermediate cash flows at the IRR rate. III IRR doesn't take into account cash flows occurring far in the future. IV NPV incorrectly uses the same discount rate for all cash flows.

  1. I, II and III only
  2. II only
  3. I only
  4. II, III and IV only
  5. All of these are correct
  6. I and II only

Answer(s): F

Explanation:

Project with differing initial investments and cash flow patterns may have NPV profiles with differing slopes. The point at which the NPV profiles cross represents the discount rate at which the NPV of both projects is the same. There will be ranking conflicts between NPV and IRR at discount rates below this point. The NPV method implicitly assumes that the rate at which cash flows can be reinvested is the cost of capital, whereas the IRR method assumes that the firm can reinvest at the IRR. IRR does take all cash flows into account, even those far in the future. It is correct to use the same discount rate for all project cash flows, unless you know project risk will change in the future.



Which of the following statements is/are true about observed capital structures?

  1. Firms with higher stability in sales tend to use higher debt ratios.
    II. Firms with a higher ratio of general-purpose assets to special-purpose assets tend to have higher debt ratios.
    III. Young firms with higher growth rates tend to have higher debt ratios.
  2. II only
  3. I & II
  4. I only
  5. I, II & III
  6. I & III
  7. III only

Answer(s): B

Explanation:

Stability of sales implies a stability in profitability. This allows firms to service higher levels of debt without worrying about bankruptcy. Similarly, since general-purpose assets are more valuable as collateral than firm- specific assets, firms with a higher ratio of general-purpose assets to special- purpose assets tend to have higher debt ratios. However, young firms which face higher uncertainty in their project payoffs tend to favor equity financing.



Clay Industries, a large industrial firm, is examining the operating leverage of its tooling division during the last year. Consider the following information:
% change in EBIT during the last year 28%
Sales for period 1$435,000
Sales for period 2$578,000
Cost of debt 7.75%
Expected return on the market 15%
Risk-free rate 4.55%
Beta 1.05
Given this information, what is the operating leverage of this division during the time period in question?

  1. 0.8518
  2. 1.1741
  3. 0.9178
  4. The degree of operating leverage for this firm cannot be calculated from the information provided.
  5. 0.1322
  6. 0.98402

Answer(s): A

Explanation:

To calculate the degree of operating leverage, use the following equation: {% change in EBIT/% change in sales}. In this example, the percentage change in EBIT is provided. However, the percentage change in sales must be calculated, and can be found by the following: {[sales in period 2 - sales in period 1]/sales in period 1}.
Incorporating the given information into this equation yields a percentage change in sales of 32.87%. From this point on, the calculation of the DOL is straightforward, and can be found as follows: {% change in EBIT 28%/% change in sales 32.87%}= 0.8518. In attempt to trick you, the cost of debt, along with the components of the Capital Asset Pricing Model have been provided. None of these figures are relevant in the calculation of the Degree of Operating Leverage.



Assume that all the assumptions of Modigliani and Miller hold. In particular, there are no taxes and transaction costs. A firm has a policy of paying out 5% of the stock price as dividends. However, an investor would like to receive a 7% dividend. For this, he should:

  1. liquidate 7% of his stock holding after receiving the dividend.
  2. liquidate 2% of his stock holding after receiving the dividend.
  3. use the dividend to buy 2% of the stock after receiving the dividend.
  4. none of these answers.

Answer(s): D

Explanation:

Suppose the investor is holding stocks worth $100. The company then pays $5 as dividends. When the dividend is paid out, the stock price falls to $95 (in the absence of tax effects, as assumed). To increase his income to $7, the investor must sell off stocks worth $2. This corresponds to 2/95 = 2.105% of the post dividend stock holding.



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