CFA Practice Exam: Part 2
1. Question 1:
The Clientele Effect theory implies that investors in the low tax brackets will prefer:
* none of these answers.
* high capital gains.
* high dividend payouts.
* low dividend payouts.
Correct answer:
high dividend payouts.
The Clientele Effect is based on the presumption that different groups of investors will prefer different dividend policies based on their tax status and their need for current versus future income requirements.
Hence, investors who face high taxes on current income will tend to avoid stocks with high pay-out ratios.
This lowering of demand for such stocks will tend to depress their prices and to take advantage of this; investors in low tax brackets would gravitate toward them. To this, add the fact that usually, investors in low tax brackets with sufficient capital to invest tend to be either people who are old and retired or institutions like pension funds. Both these groups have a higher need for current income but are sensitive to liquidation of capital. They therefore prefer their income from stocks to be in the form of dividends rather than from the sale of their stock holdings.
2. Question 2:
Alyeska Salmon Inc., a large salmon canning firm operating out of Valdez, Alaska, has a new automated production line project it is considering. The project has a cost of $275,000 and is expected to provide after-tax annual cash flows of $73,306 for eight years.
The firm's management is uncomfortable with the IRR reinvestment assumption and prefers the modified IRR approach. You have calculated a cost of capital for the firm of 12 percent.
What is the project's MIRR?
* 17.0%
* 15.0%
* 12.0%
* 14.0%
* 16.0%
Correct answer:
16.0%
TV = $73,306(FVIFA(12%,8)) = $73,306(12.300) = $901,663.80.
$275,000 = $901,663.80 / (1 + MIRR)^8
(1 + MIRR)^8 = (FVIF(Irr,8)) = 3.27869.
Look in table: Periods = 8, I = 16%. MIRR = 16%.
Alternate method
3.27869^1/8 = 1 + MIRR
MIRR = 16%
3. Question 3:
Consider the following argument: "The cost of common stock should decrease as the dividend payout is increased because investors are more certain of receiving these dividends than the capital gains which are supposed to be derived from retained earnings."
This statement applies best to which of the following financial theories? Choose the best answer.
* Tax Preference Theory
* Dividend Irrelevance Theory
* Tax Irrelevance Theory
* Dividend Relevance Theory
* Bird-in-hand Theory
Correct answer:Bird-in-hand Theory
The Bird-in-the-Hand Theory came about as a refutation of Modigliani and Miller's Dividend Irrelevance Theory. The founders of the Bird-in-the-Hand Theory, Myron Gordon and John Lintner, stated that investors are more confident in the fact that they will receive dividends versus capital gains. So said, the cost of common stock should decrease as the payout ratio is increased.
The Tax Preference Theory states that investors prefer capital gains to dividends, and this is due to the structure of tax rates. Specifically, dividends are typically taxed at a higher rate than capital gains, and are in this respect less attractive.
4. Question 4:
An investment project has an initial cost, and then generates inflows of $50 a year for the next five years.
The project has a payback period of 3.6 years. What is the project's internal rate of return (IRR)?
* 12.05%
* 13.47%
* 15.89%
* 14.66%
* 11.18%
Correct answer: Investment cost = $180.
CF(0) = -180
CF(1-5) = 50
Solve for IRR = 12.05%.
5. Question 5:
According to the signaling theory, if a firm issues debt capital to finance a project, the firm's management must consider the project to be ________.
* none of these answers
* likely to raise the probability of bankruptcy
* very desirable
* not very profitable
Correct answer:very desirable
According to the signaling theory of capital structure, a firm will try to raise debt capital when the project's returns are deemed very favorable and vice versa. The firm is signaling that the project has sufficient cash flows to pay back the debt.
6. Question 6:
The return on the best alternative use of an asset, or the highest return that will not be earned if funds are invested in a particular project is known as which of the following terms?
* Sunk Cost
* Cannibalization
* Opportunity Cost
* Externality
* Incremental Cash Flow
Correct answer:
Opportunity Cost
Opportunity cost is defined as the return on the best alternative use of an asset, or the highest return that will not be earned if funds are invested in a particular project
7. Question 7:
Suppose Congress votes to raise the personal tax rate on interest and dividend income.
However, it does not change the capital gains tax or the corporate tax rates.
This will have the effect of:
* increasing the reliance on debt financing.
* increasing the reliance on retained earnings as capital.
* decreasing the reliance on equity capital.
* decreasing the sizes of seasoned equity offerings.
Correct answer:
increasing the reliance on retained earnings as capital.
As personal tax rates increase, firms have to modify their reliance on different capital markets so as to
minimize the costs imposed on debt and equity investors. An increase in interest and dividend income
makes debt and dividend payouts costlier.
On the other hand, since capital gains are not affected, firms will tend to decrease their dividend pay-out ratios and bank on retained earnings to finance their capital requirements.
8. Question 8:
Which of the following is correct?
* The drug industry has a high debt to common equity ratio because their earnings are very stable and
thus, can support the large interest costs associated with higher debt levels.
* Since most stocks sell at or around their book values, using accounting values provides an accurate
picture of a firm's capital structure.
* Wide variations in capital structures exist between industries and also between individual firms within industries and are influenced by unique firm factors including managerial attitudes.
* Utilities generally have very high common equity ratios due to their need for vast amounts of equity
supported capital.
* Generally, debt to total assets ratios do not vary much among different industries although they do vary for firms within a particular industry.
Correct answer:
Wide variations in capital structures exist between industries and also between individual firms within industries and are influenced by unique firm factors including managerial attitudes.
Wide variations in the use of financial leverage exist across industries and among individual firms in each industry.
Computer and pharmaceutical firms do not use much debt because the uncertainties in these
industries that are cyclical, research-oriented, or subject to huge product liability suits, which would make the high use of debt unwise.
The airline and utility firms use relatively more debt, with the utilities using large amounts of long-term debt.
9. Question 9:
The initial investment outlay consists of which of the following?
I. Up-front costs of the project's fixed assets.
II. Flotation costs associated with raising the necessary capital.
III. Increases in net working capital.
IV. Present value of all interest expenses associated with the project capital.
* II only
* I, II & IV
* I, II & III
* I, II, III & IV
* I & III
* III only
* I only
* IV only
Correct answer:
I & III
The initial investment outlay consists of up-front costs of the project's fixed assets and any increases in net working capital.
Costs involved in raising the finances are not part of the initial outlay.
10. Question 10:
Which of the following statements is most correct?
* The CAPM approach is typically used to estimate a firm's flotation cost adjustment factor, and this factor is added to the DCF cost estimate.
* These statements are all incorrect.
* In practice (as opposed to in theory), the DCF method and the CAPM method usually produce exactly the same estimate for k(s).
* The risk premium used in the bond-yield-plus-risk-premium method is the same as the one used in the CAPM method.
* Under normal conditions, the CAPM (Capital Asset Pricing Model) approach to estimating a firm's cost of retained earnings gives a higher estimate than the DCF (Discounted Cash Flow) approach.
Correct answer:
These statements are all incorrect
All are incorrect. Under the CAPM approach, it is at best difficult to obtain correct estimates of the inputs require to make it operational.
The same could be said about the growth rate input under the DCF approach.
The risk premium under the bond-yield-plus-risk premium approach is purely judgmental and
results in a ballpark estimate.
The Clientele Effect theory implies that investors in the low tax brackets will prefer:
* none of these answers.
* high capital gains.
* high dividend payouts.
* low dividend payouts.
Correct answer:
high dividend payouts.
The Clientele Effect is based on the presumption that different groups of investors will prefer different dividend policies based on their tax status and their need for current versus future income requirements.
Hence, investors who face high taxes on current income will tend to avoid stocks with high pay-out ratios.
This lowering of demand for such stocks will tend to depress their prices and to take advantage of this; investors in low tax brackets would gravitate toward them. To this, add the fact that usually, investors in low tax brackets with sufficient capital to invest tend to be either people who are old and retired or institutions like pension funds. Both these groups have a higher need for current income but are sensitive to liquidation of capital. They therefore prefer their income from stocks to be in the form of dividends rather than from the sale of their stock holdings.
2. Question 2:
Alyeska Salmon Inc., a large salmon canning firm operating out of Valdez, Alaska, has a new automated production line project it is considering. The project has a cost of $275,000 and is expected to provide after-tax annual cash flows of $73,306 for eight years.
The firm's management is uncomfortable with the IRR reinvestment assumption and prefers the modified IRR approach. You have calculated a cost of capital for the firm of 12 percent.
What is the project's MIRR?
* 17.0%
* 15.0%
* 12.0%
* 14.0%
* 16.0%
Correct answer:
16.0%
TV = $73,306(FVIFA(12%,8)) = $73,306(12.300) = $901,663.80.
$275,000 = $901,663.80 / (1 + MIRR)^8
(1 + MIRR)^8 = (FVIF(Irr,8)) = 3.27869.
Look in table: Periods = 8, I = 16%. MIRR = 16%.
Alternate method
3.27869^1/8 = 1 + MIRR
MIRR = 16%
3. Question 3:
Consider the following argument: "The cost of common stock should decrease as the dividend payout is increased because investors are more certain of receiving these dividends than the capital gains which are supposed to be derived from retained earnings."
This statement applies best to which of the following financial theories? Choose the best answer.
* Tax Preference Theory
* Dividend Irrelevance Theory
* Tax Irrelevance Theory
* Dividend Relevance Theory
* Bird-in-hand Theory
Correct answer:Bird-in-hand Theory
The Bird-in-the-Hand Theory came about as a refutation of Modigliani and Miller's Dividend Irrelevance Theory. The founders of the Bird-in-the-Hand Theory, Myron Gordon and John Lintner, stated that investors are more confident in the fact that they will receive dividends versus capital gains. So said, the cost of common stock should decrease as the payout ratio is increased.
The Tax Preference Theory states that investors prefer capital gains to dividends, and this is due to the structure of tax rates. Specifically, dividends are typically taxed at a higher rate than capital gains, and are in this respect less attractive.
4. Question 4:
An investment project has an initial cost, and then generates inflows of $50 a year for the next five years.
The project has a payback period of 3.6 years. What is the project's internal rate of return (IRR)?
* 12.05%
* 13.47%
* 15.89%
* 14.66%
* 11.18%
Correct answer: Investment cost = $180.
CF(0) = -180
CF(1-5) = 50
Solve for IRR = 12.05%.
5. Question 5:
According to the signaling theory, if a firm issues debt capital to finance a project, the firm's management must consider the project to be ________.
* none of these answers
* likely to raise the probability of bankruptcy
* very desirable
* not very profitable
Correct answer:very desirable
According to the signaling theory of capital structure, a firm will try to raise debt capital when the project's returns are deemed very favorable and vice versa. The firm is signaling that the project has sufficient cash flows to pay back the debt.
6. Question 6:
The return on the best alternative use of an asset, or the highest return that will not be earned if funds are invested in a particular project is known as which of the following terms?
* Sunk Cost
* Cannibalization
* Opportunity Cost
* Externality
* Incremental Cash Flow
Correct answer:
Opportunity Cost
Opportunity cost is defined as the return on the best alternative use of an asset, or the highest return that will not be earned if funds are invested in a particular project
7. Question 7:
Suppose Congress votes to raise the personal tax rate on interest and dividend income.
However, it does not change the capital gains tax or the corporate tax rates.
This will have the effect of:
* increasing the reliance on debt financing.
* increasing the reliance on retained earnings as capital.
* decreasing the reliance on equity capital.
* decreasing the sizes of seasoned equity offerings.
Correct answer:
increasing the reliance on retained earnings as capital.
As personal tax rates increase, firms have to modify their reliance on different capital markets so as to
minimize the costs imposed on debt and equity investors. An increase in interest and dividend income
makes debt and dividend payouts costlier.
On the other hand, since capital gains are not affected, firms will tend to decrease their dividend pay-out ratios and bank on retained earnings to finance their capital requirements.
8. Question 8:
Which of the following is correct?
* The drug industry has a high debt to common equity ratio because their earnings are very stable and
thus, can support the large interest costs associated with higher debt levels.
* Since most stocks sell at or around their book values, using accounting values provides an accurate
picture of a firm's capital structure.
* Wide variations in capital structures exist between industries and also between individual firms within industries and are influenced by unique firm factors including managerial attitudes.
* Utilities generally have very high common equity ratios due to their need for vast amounts of equity
supported capital.
* Generally, debt to total assets ratios do not vary much among different industries although they do vary for firms within a particular industry.
Correct answer:
Wide variations in capital structures exist between industries and also between individual firms within industries and are influenced by unique firm factors including managerial attitudes.
Wide variations in the use of financial leverage exist across industries and among individual firms in each industry.
Computer and pharmaceutical firms do not use much debt because the uncertainties in these
industries that are cyclical, research-oriented, or subject to huge product liability suits, which would make the high use of debt unwise.
The airline and utility firms use relatively more debt, with the utilities using large amounts of long-term debt.
9. Question 9:
The initial investment outlay consists of which of the following?
I. Up-front costs of the project's fixed assets.
II. Flotation costs associated with raising the necessary capital.
III. Increases in net working capital.
IV. Present value of all interest expenses associated with the project capital.
* II only
* I, II & IV
* I, II & III
* I, II, III & IV
* I & III
* III only
* I only
* IV only
Correct answer:
I & III
The initial investment outlay consists of up-front costs of the project's fixed assets and any increases in net working capital.
Costs involved in raising the finances are not part of the initial outlay.
10. Question 10:
Which of the following statements is most correct?
* The CAPM approach is typically used to estimate a firm's flotation cost adjustment factor, and this factor is added to the DCF cost estimate.
* These statements are all incorrect.
* In practice (as opposed to in theory), the DCF method and the CAPM method usually produce exactly the same estimate for k(s).
* The risk premium used in the bond-yield-plus-risk-premium method is the same as the one used in the CAPM method.
* Under normal conditions, the CAPM (Capital Asset Pricing Model) approach to estimating a firm's cost of retained earnings gives a higher estimate than the DCF (Discounted Cash Flow) approach.
Correct answer:
These statements are all incorrect
All are incorrect. Under the CAPM approach, it is at best difficult to obtain correct estimates of the inputs require to make it operational.
The same could be said about the growth rate input under the DCF approach.
The risk premium under the bond-yield-plus-risk premium approach is purely judgmental and
results in a ballpark estimate.
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