CFA® Sample Questions:
Levels 1 & 2
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CFA Exam Practice Questions and Rationales
An analyst gathers the following information about a company:
Total capital | 82 billion |
Debt-to-equity ratio | 25% |
Cost of common equity | 9.0% |
Pretax cost of debt | 5.0% |
Tax rate | 20% |
If the company has only common equity and debt in its capital structure, the company’s weighted average cost of capital (WACC) is closest to:
A) 7.80% | ||
B) 8.06% | ||
C) 8.67% |
A company’s weighted average cost of capital (WACC) is its marginal cost to raise additional capital. If each source of capital has a different component cost of capital, WACC is the weighted average of these costs of capital. The costs are weighted by the proportions of capital the company currently uses to support all its business activities.
In this question, to calculate the WACC the weights of debt and equity must be derived from the company’s debt-to-equity ratio (D/E). The company’s D/E ratio of 25% means it has $0.25 of debt for every $1.00 of equity, or 25% as much debt as equity. The weights can be derived as follows:
Note: Since the proportions of debt and equity must equal 100%, the
weight of equity is
80% = 100% −
20% .
To calculate WACC, the company’s component costs of capital are multiplied by their weights. To account for the after-tax cost of debt, be sure to apply the company’s tax rate:
WACC = [( 0.20) (0.05 × (1 − 0.20))] + [( 0.80) (0.09)]
WACC = 8.00%
(Choice A) 7.75% results from incorrectly interpreting the company’s D/E ratio of 25% to mean that 25%, instead of 20%, of the company’s cost structure is debt.
(Choice C) 8.20% results from using the company’s pretax, instead of after-tax, cost of debt.
Things to remember:
A company’s weighted average cost of capital (WACC) is its marginal cost
to raise additional capital. WACC is the sum of each capital component’s
cost weighted by its proportion of the overall capital structure.
An analyst gathers the following information abouta company reporting under US GAAP:
($ millions) | Fiscal Year End 20X1 |
---|---|
Total deferred tax assets | 1,100 |
Valuation allowance | (700) |
Total deferred tax assets after valuation allowance | 400 |
Total deferred tax liabilities | (1,500) |
Net deferred tax liabilities | (1,100) |
All else being equal, an increase in the statutory tax rate from 20% to 25% would most likely increase:
A) total liabilities. | ||
B) total assets. | ||
C) taxable income. |
Deferred tax assets (DTA) and deferred tax liabilities (DTL) result from temporary differences between taxable income (based on tax reporting) and accounting profit (based on financial reporting). These differences create future tax benefits (ie, DTA) or obligations (ie, DTL).
DTA and DTL are reassessed at the end of each fiscal year, based on the tax rates that will be applied in the future when the temporary differences reverse, and DTA is recovered, or DTL is settled. If future income is taxed at higher (lower) rates:
- the company’s tax obligations increase (decrease), resulting in an increased (decreased) DTL, and
- the benefit of future deductions increases (decreases), resulting in an increased (decreased) DTA.
Deferred taxes and statutory tax rates | |||
---|---|---|---|
20% rate | 25% rate | Difference | |
Total DTA | 1,100 | 1,375 | 275 |
Total DTL | (1,500) | (1,875) | (375) |
Net effect | (900) | (500) | (100) |
An increase in the statutory tax rate increases both DTL and DTA, so in this scenario the net effect is an increase in net DTL. Therefore,total liabilities will increase and the tax rate change will not affect total assets (Choice B) .
Note: No calculation is necessary to answer this question.
(Choice C) Tax rates do not affect the amount of taxable income; instead, they are used to determine taxes payable, calculated as the tax rate multiplied by the taxable income.Things to remember:
Deferred tax assets (DTA) and deferred tax liabilities (DTL) are created by temporary differences and must be reassessed every year for any changes in the applicable tax rate. An increase in the statutory tax rate increases both DTA and DTL since both future tax benefits (ie, DTA) and obligations (ie, DTL) will increase. DTA and DTL are netted and reported as a single item on the balance sheet.
A hedge fund has the following fee structure, charged on year-end assets under management (AUM):
Annual management fee | 1.5% |
Incentive fee | 12% |
Soft hurdle rate | 5% |
High-water mark | $380 million |
The fund value is $372 million at the beginning of the year and $412 million, before fees, at the end of the year. For this year, if fees are calculated independently, the net return to the investor is closest to:
A) 50,000 | ||
B) 62,500 | ||
C) 75,000 |
Typical hedge fund fee structure | ||
---|---|---|
Fee | Basic for calculation | Specific details |
Management | End-of-period assets under management (AUM) |
|
Incentive | Annual retuns |
|
An investor’s return is calculated net of fees and as a percentage of the fund’s beginning value. Hedge funds often levy both a management fee and an incentive fee.
- The management fee is calculated as a percentage of the fund’s total ending assets under management (AUM) and is assessed regardless of profitability.
- The incentive fee is calculated as a percentage of profits either net (ie, after deducting) or gross (ie, before deducting) of management fees.
- If fees are calculated independently, calculations are on a gross basis.
An incentive fee is often contingent on profits being greater than a hurdle rate and/or AUM being higher than the high-water mark. In this scenario, the fund’s threshold to earn an incentive fee is contingent on exceeding the 5% soft hurdle rate and the high-water mark of $380 million. Due to the soft hurdle rate, the incentive fee will be applied to the entire gain above the high-water mark.
The investor’s return for the year is calculated (in $ millions) as follows:
Steps | Calculations |
---|---|
Calculate profit before fees Calculate return after management fee |
Ending AUM
412
Begining AUM
(372)
Profit before Fees
40
Management Fee(412 × 0.015)
(6.18)
Profit after Manangement fee
33.82
Return after management fee
(33.82 ÷ 372)
9.09%
|
Calculate incentive fee Incentive fee earned since 9.09% > 5% hurdle rate |
Profit before fees
40
High-water mark adj(380 – 372)
(8)
Incentive fee base
32
Incentive fee (32 × 0.12)
(3.84)
|
Calculate investor return |
Profit before fees
40
Management fee
(6.18)
Incentive fee
(3.84)
Profit after fees
29.98
Investor return (29.98 ÷ 372 )
8.06%
|
The operating breakeven point is not to be confused with the (total) breakeven point where revenue equals the firm’s total costs. Total costs include all operating and nonoperating costs (eg, fixed financial costs).
(Choice A) A 7.80% return inappropriately calculates returns using beginning AUM, instead of the high-water mark, as the incentive fee’s base.
(Choice C) An 8.67% return inappropriately calculates returns using a hard hurdle rate.
An investor’s return on a hedge fund is calculated net of fees and as a percentage of the fund’s beginning value. Hedge funds levy both a management fee and an incentive fee. The management fee is calculated as a percentage of the fund’s ending total value, gross of fees, and assessed regardless of profitability. The incentive fee is calculated as a percentage of profits, subject to hurdle rates and high-water marks.
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