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Free Test Prep CFA-Level-I Exam Questions (page: 55)

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When a firm uses no debt,

  1. its financial risk equals its business risk.
  2. its business risk equals the market risk.
  3. all of these answers.
  4. its ROA equals its ROE.

Answer(s): D

Explanation:

With no debt, total capital equals total equity, giving ROA = ROE. Note that without debt, financial risk is zero since financial risk is defined as the additional risk caused due to debt in the capital structure. Market risk is the systematic risk arising from the correlation of the firm's stock price with the market and is different from business risk.



It has been observed in the market that most of the increases in dividends are followed by an increase in the stock price and vice-versa. This implies that:

  1. at least one of the M&M assumptions must be false.
    II. there must be signaling effects involved.
    III. investors are behaving irrationally.
  2. II only
  3. III only
  4. I, II & III
  5. II & III
  6. I & II
  7. I only

Answer(s): F

Explanation:

If all of the M&M assumptions held, a change in dividend policy would not cause the stock price to change; dividend policy would be irrelevant. However, one does not necessarily need signaling effects to account for market behavior. Other theories like the Bird-in-the-Hand theories can also explain the phenomenon in the presence of transaction costs. In itself, then, the phenomenon does not imply that the market is behaving irrationally.



Your assistant has just completed an analysis of two mutually exclusive projects. You must now take her report to a board of directors meeting and present the alternatives for the board's consideration. To help you with your presentation, your assistant also constructed a graph with NPV profiles for the two projects. However, she forgot to label the profiles, so you do not know which line applies to which project. Of the following statements regarding the profiles, which one is most reasonable?

  1. If one of the projects has a NPV profile which crosses the X-axis twice, hence the project appears to have two IRRs, your assistant must have made a mistake.
  2. If the two projects' NPV profiles cross once, in the upper left quadrant, at a discount rate of minus 10 percent, then there will probably not be a NPV versus IRR conflict, irrespective of the relative sizes of the two projects, in any meaningful, practical sense (that is, a conflict which will affect the actual investment decision).
  3. If the two projects both have a single outlay at t = 0, followed by a series of positive cash inflows, and if their NPV profiles cross in the lower left quadrant, then one of the projects should be accepted. Both would be accepted if they were not mutually exclusive.
  4. Whenever a conflict between NPV and IRR exist, then, if the two projects have the same initial cost, the one with the steeper NPV profile probably has less rapid cash flows. However, if they have identical cash flow patterns, then the one with the steeper profile probably has the lower initial cost.
  5. If the two projects have the same investment cost, and if their NPV profiles cross once in the upper right quadrant, at a discount rate of 40 percent, this suggests that a NPV versus IRR conflict is not likely to exist.

Answer(s): B

Explanation:

A conflict will exist if the cost of capital is less than the crossover rate. In this case the cost of capital must be greater than minus 10 percent and, therefore, there will probably not be a NPV versus IRR conflict.



Consider the following information for Company ABC:
Current Price of Stock $25.5
Expected dividend in 1 Year $1.00
Growth rate 8.0%
Beta 1.2
Risk Free Rate 4.5%
Calculate this company's cost of retained earnings using the Discounted Cash Flow (DCF) method.

  1. 13.30%
  2. 8.0%
  3. 12.0%
  4. 11.92%
  5. 12.2%

Answer(s): D

Explanation:

The DCF method for estimating the cost of retained earnings states: Cost of Retained Earnings = (Dividend for period 1 / Current Price) + Growth Rate. In this case the estimated Cost of Retained Earnings = (1 / 25.5) + 8.0% = 3.92 + 8.00 = 11.92%



If you know that your firm is facing relatively poor prospects but needs new capital, and you know that investors do not have this information, signaling theory would predict that you would

  1. postpone going into capital markets until your firm's prospects improve.
  2. be indifferent between issuing debt and equity.
  3. issue debt to maintain the returns of equity holders.
  4. issue equity to share the burden of decreased equity returns between old and new shareholders.
  5. convey your inside information to investors using the media to eliminate the information asymmetry.

Answer(s): D

Explanation:

The announcement of a stock offering is generally taken as a signal that the firm's prospects as seen by its management are not bright.



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

  1. Stock repurchases increase the price per share by reducing the number of shares.
    II. Stock repurchases are often viewed as a positive signal by investors, raising the intrinsic value of each share and increasing shareholder value.
    III. Stock repurchases allow firms to distribute funds to shareholders without raising "sticky" dividends.
  2. II only
  3. II & III
  4. I only
  5. I & III
  6. I, II & III
  7. III only
  8. I & II

Answer(s): B

Explanation:

The value of a stock repurchase does not come from a simple reduction in the number of shares outstanding.
Remember that for this reduction, the firm must pay out part of its assets in the buy-back process. If such a buyback takes place at a fair price, the shareholder value is completely unaffected, for all you have done is exchanged cash for an equivalent value of common stock. The real wealth increase through a repurchase program arises from real and tangible effects like the interpretation of the program as a positive signal about future prospects. Further, if the management thinks that excess cash reserves are only temporary, then they would be reluctant to raise dividends and add instability to dividend policy. Repurchase programs allow them to distribute excess funds without paying them as dividends.



Which of the following statements is incorrect?

  1. NPV can be negative if the IRR is positive.
  2. Assuming a project has normal cash flows, the NPV will be positive if the IRR is less than the cost of capital.
  3. If IRR = k (the cost of capital), then NPV = 0.
  4. If the multiple IRR problem does not exist, any independent project acceptable by the NPV method will also be acceptable by the IRR method.
  5. The NPV method is not affected by the multiple IRR problem.

Answer(s): B

Explanation:

NPV is positive if IRR is greater than the cost of capital.



Alabama Pulp Company (APC) can control its environmental pollution using either "Project Old Tech" or "Project New Tech." Both will do the job, but the actual costs involved with Project New Tech, which uses unproved, new state-of-the-art technology, could be much higher than the expected cost levels. The cash outflows associated with Project Old Tech, which uses standard proven technology, are less risky--they are about as uncertain as the cash flows associated with an average project. APC's cost of capital for average risk projects is normally set at 12 percent, and the company adds 3 percent for high risk projects but subtracts 3 percent for low risk projects. The two projects in question meet the criteriafor high and average risk, but the financial manager is concerned about applying the normal rule to such cost-only projects. You must decide which project to recommend, and you should recommend the one with the lower PV of costs. What is the PV of costs of the better project?
Cash Outflows
Years:01234
Project New Tech1,500315315315315
Project Old Tech600600600600600

  1. 2,399
  2. 2,521
  3. 2,457
  4. 2,422
  5. 2,543

Answer(s): D

Explanation:

Recognize that (1) risky outflows must be discounted at lower rates, and (2) since Project New Tech is risky, it must be discounted at a rate of 12% - 3% = 9%. Project Old Tech must be discounted at 12%.
Tabular solution:
PV(New Tech) = -$1,500 - $315(PVIFA9%,4) = -$1,500 - $315(3.2397) = -$2,520.51. PV(Old Tech) = -$600 - $600(PVIFA12%,4) = -$600 - $600(3.0373) = -$2,422.38. PV(Old Tech) is a smaller outflow than NPV(New Tech), thus, Project Old Tech is the better project.



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