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Free Test Prep CFA-Level-I Exam Questions (page: 96)

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Leveraged buyout financing is used by management to:

  1. take a private firm public.
  2. buy additional product lines.
  3. develop new lines to revitalize the firm.
  4. take a public firm private.

Answer(s): D



Tony Nguyen works in the investor relations department of a medium sized technology firm. He recently received the following e-mail: "I am an investor concerned with agency problems between managers and stockholders. What assurance do I have that the company works to align the interests of these two groups?" Which of the following actions that the firm has taken does NOT address the e-mail's concerns?

  1. Every employee receives performance shares and cash bonuses, based on his or her position and company earnings per share results.
  2. The company recently expanded its executive stock-option program to include middle-level managers.
  3. The company recently adopted a shareholder rights plan that allows existing shareholders favorable terms over outside parties. The plan is triggered if a person or group acquires beneficial ownership of 10 percent or more of the company's common stock.
  4. The board has a reputation for aggressively monitoring current management and is quick to remove poor- performing managers.

Answer(s): C

Explanation:

The shareholder rights agreement is an example of a poison pill, a device used to discourage hostile takeovers.
The threat of takeover is a mechanism designed to reduce conflicts between managers and shareholders, so anything that weakens the threat would not align the interests of managers and shareholders.
Performance shares, cash bonuses, and stock option plans are examples of managerial compensation mechanisms designed to align the interests of stockholders and managers. The aggressive board is an example of the threat of firing mechanism. The other mechanism noted in the reading is direct intervention by shareholders. The goal of these mechanisms is to motivate managers to achieve a higher stock price, which improves shareholder wealth.



Thomas Otto is an associate in the strategic consulting group for a medium-sized manufacturing company. Historically, the firm has financed projects using internal equity funds. The company is approaching the retained earnings break-even point, and the group's Executive Vice President asks Otto to determine the change in the weighted average cost of capital (WACC) if the firm uses external equity funds instead of internal funds. An analyst in the group provides the following information:
And, the firm's investment bank provides the following projections for a new common stock issue:
Which of the following choices best completes the following sentence? Using this information, Otto reports that the WACC will:

  1. increase by 1.82%.
  2. increase by 1.66%.
  3. decrease by 1.66%.
  4. remain the same.

Answer(s): A

Explanation:

Step 1: Calculate WACC using internal equity:
WACC = (wd)(kd) + (ws)(ks), where wd, wsare the weights used for debt and retained earnings.
WACC = (0.40 * 6.0%) + (0.60 * 13.0%) =10.20%.
Step 2: Calculate WACC using external equity (new common stock):
First, we need to determine the cost of new common equity.
Thecost of new common equityis given by:
ke= [D1/ (P0(1 ­ F))] + g
where
F = the percentage flotation cost incurred in selling new stock, or (current stock price ­ funds going to company) / current stock price D1= Dividend in next year
P0= Current stock price
g = Dividend growth rate
Here, D1and F are given, and ke= [ 2.33 / (30 * (1 ­ 0.035))] + 0.08 = 0.1604 or 16.04% Then, calculate WACC as before:
WACC = (wd)(kd) + (we)(ke), where wd, weare the weights used for debt and common equity.
WACC = (0.40 * 6.0%) + (0.60 * 16.04%) =12.02%.
Step 3: Calculate the difference:
The change in WACC = 12.02% - 10.20% = 1.82%, or an increase of 1.82%.



While studying for the Level 1 CFA examination, Leonard Hart draws the following graph of a firm's capital structure. Using his graph and the assumptions below, determine which of the following statements A through D below is FALSE.


  1. The value for X is $90 million.
  2. The weighted average cost of capital (WACC) of 10.00% uses retained earnings, the WACC of 12.25% uses common stock.
  3. The firm should use this graph to adjust projects for risk.
  4. As the firm needs to raise more and more capital, the weighted average cost of capital (WACC) will remain lower than the marginal cost of capital.

Answer(s): A

Explanation:

This graph represents the marginal cost of capital (MCC).
BPRE= (Retained Earnings) / (Equity Fraction, we)
Here, RE = earnings * (1 ­ Payout) = $100 million (1 ­ 0.45) = $ 55.0 million, And BPRE= $55.0 million / 0.50 = $110 million.
The other statements are true.
WACC using internal equity (retained earnings):
WACC = (wd)(kd) + (ws)(ks), where wd, wsare the weights used for debt and retained earnings.
WACC = (0.50 * 7.0%) + (0.50 * 13.0%) =10.00%.
WACC using external equity (common stock):
WACC = (wd)(kd) + (we)(ke), where wd, weare the weights used for debt and common equity.
WACC = (0.50 * 7.0%) + (0.50 * 17.5%) =12.25%.
Note:To save time on the exam, remember that internal equity cost is less than external equity cost (or ks< ke) due to floatation costs.



All of the following comments about the capital budget post auditing process are correct EXCEPT:

  1. After the initial capital budgeting decision is made, the company should follow up and compare the actual results to the projected results.
  2. The project managers should explain large variances (projection versus actual).
  3. The function of the post audit includes improving forecasting and operations.
  4. One of the purposes of the post-audit process is to limit risky projects.

Answer(s): D

Explanation:

The role of the post-audit process is to follow-up on capital budgeting decisions and to track results. The process is not meant to limit the capital projects; the company will still want to accept projects based on the decision rules for net present value (NPV), internal rate of return (IRR), and other valuation methods (using internal and external benchmarks).



Erwin DeLavall, the Plant Manager of Patch Grove Cabinets, is trying to decide whether or not to replace the old manual lathe machine with a new computerized lathe. He thinks the new machine will add value, but is not sure how to quantify his opinion. He asks his colleague, Terri Wharten, for advice. Wharten`s son just happens to be a Level 2 CFA candidate. DeLavall and Wharten provide the following information to Wharten's son:
Company Assumptions:
New Machine Assumptions:
Which of the following choices is most correct? Patch Grove Cabinets should:

  1. not replace the old lathe with the new lathe because the new one will decrease the firm's value by $5,370.
  2. replace the old lathe with the new lathe because the new one will add $10,316 to the firm's value.
  3. not replace the old lathe with the new lathe because the new one will decrease the firm's value by $3,132.
  4. replace the old lathe with the new lathe because the new one will add $3,760 to the firm's value.

Answer(s): D

Explanation:

The valuation method that shows the project's impact on the value of the firm is net present value (NPV). To calculate NPV, we need to determine the initial investment outlay, the operating cash flows, and the terminal year cash flows. Then, we discount the cash flows at the WACC. The calculations are as follows:
Step 1: Initial Investment Outlay:
= cost of new machine + proceeds/loss from old machine + change in net working capital (NWC) = -$90,000 + $30,000 - $6,800 + $5,000 =-$61,800(cash outflow) Details of calculation:
o Sales price = $30,000inflow
o Tax/tax credit: $6,800outflow
o NWC =current assets -current liabilities = 20,000 ­ 25,000 = -5,000 (a decrease in working capital is a source of funds)
Step 2: Operating Cash Flows (years 1-4):Given as$16,800inflow Step 3: Terminal Value:
=year 5 cash flow + return/use of NWC + proceeds/loss from disposal of new machine + tax/tax credit =$16,800 - $5,000 + $15,000 + $1,920 =$28,720inflow
Details of calculation:
o Sales price = $15,000inflow
o Tax/tax credit: $1,920inflow
Step 4:Calculate NPV:
NPV = -$61,800 + ($16,800 / 1.131) + ($16,800 / 1.132) +($16,800 / 1.133) +($16,800 / 1.134) +($28,720 / 1.135) =$3,759.
Since the NPV is positive, Patch Grove should replace the old lathe with the new one, because the new lathe will increase the firm's value by the amount of the NPV, or $3,759.
You may also solve this problem quickly by using the cash flow (CF) key on your calculator.





The management of Strings & All, Inc., a small, highly leveraged, electric guitar manufacturer, wants to reduce the company's degree of total leverage (DTL) to 2.0. Currently, the company's expected operating performance is as follows:
To obtain a DTL of 2.0, management must (all else constant):

  1. increase variable expenses by 30%.
  2. reduce variable expenses by 38.5%.
  3. reduce variable expenses by 30%.
  4. increase variable expenses by 38.5%.

Answer(s): C

Explanation:

To obtain this result, we need to calculate the current variable costs, determine the variable costs that will result in a DTL ratio of 2.00, and calculate the percentage change.
Step 1: Calculate current variable costs (VC): VC = 0.6 * 500,000 = 300,000 Step 2: Calculate Variable costs needed to decrease the DTL to 2.0:
Rearranging the formula for DTL:
= (Sales ­ Variable Costs) / (Sales ­ Variable Costs ­ Fixed Costs ­ Interest Expense) results in: Variable Costs (VC) = Sales ­ (2 * Fixed Costs) ­ (2 * Interest Expense) = 500,000 ­ (2*120,000) ­ (2*25,000) = 210,000
Step 3: Calculate percentage change:
VC = (300,000 ­ 210,000) / 300,000 = 0.30, or 30%.



Which of the following statements about dividend policy and capital structure is FALSE?

  1. A company's growth rate equals the retention ratio multiplied by return on equity.
  2. Companies should use the residual dividend model to set the long-run target dividend payout ratio, but should not use it to set the dividend payment in any one year.
  3. If the board of directors decreases the target payout ratio, the stock price may increase or decrease.
  4. Assuming a world of taxes and bankruptcy, there is an optimal capital structure that maximizes earnings per share (EPS) and minimizes the cost of debt.

Answer(s): D

Explanation:

The optimal capital structure is the one that maximizes the stock price and minimizes the cost of capital.
The other statements are true. "A company's growth rate equals the retention ratio multiplied by return on equity," is simply the word version of the equation g = (1 - Payout Ratio) * ROE. Know this equation for the exam! A company that uses the residual dividend model to set the dividend payment in any one year will not have a stable payout ratio, and investors will likely demand a higher required return to offset this uncertainty.
The higher required return will result in a lower stock price. If the board of directors decreases the target payout ratio, the stock price may increase or decrease because there will be two opposing effects. For example, this may result in a decrease in stock price (due to lower dividend payout, D1), and an increase in the stock price due to increased funds available for reinvestment. Remember: g = (1 ­ Payout) * ROE. The net effect partially depends on investor's preference for dividends over capital gains or vice versa.



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