CFA Institute CFA Institute Certifications CFA-LEVEL-1 Questions & Answers

• Question 961:

  As a general rule, the capital structure that

  A. Minimizes the required rate on equity also maximizes the stock price.

  B. Maximizes the price per share of common stock also minimizes the weighted average cost of capital.

  C. Maximizes expected EPS also maximize the price per share of common stock.

  D. None of these are correct.

  E. Minimizes the interest rate on debt also maximizes the expected EPS.

  Correct Answer: B

  The optimal capital structure is the one that maximizes the price of the firm's stock, and this generally calls for a debt ratio which is lower than the one that maximizes expected EPS.

• Question 962:

  Which of the following conditions must be satisfied for a stable dividend policy to result from the Residual Dividend Policy?

  I. The earnings of a firm must be stable.

  II. Investor preference for dividends must be stable.

  III. The investment opportunities available to the firm must be stable.

  IV.

  There should be no signaling effects involved.

  A.

  III and IV

  B.

  I, III and IV

  C.

  I only

  D.

  I and III

  E.

  I and II

  F.

  III only

  G.

  II only

  Correct Answer: D

  Under the Residual Dividend Policy, a firm first determines the amount of capital it requires for sufficiently profitable projects. It then uses retained earnings to supply equity capital and raises debt in the proper amount to maintain the target capital structure. If any earnings are left over after this, they are paid out as dividends. If not, the firm will not only not pay any dividends but also issues new equity for financing. Thus, for this to lead to stable dividends, one must have stability in earnings and available investment opportunities. Note that for positive dividends, earnings must exceed capital requirements under the Residual Dividend Policy.

• Question 963:

  The Price Company will produce 55,000 widgets next year. Variable costs will equal 40 percent of sales, while fixed costs will total $110,000. At what price must each widget be sold for the company to achieve an EBIT of $95,000?

  A. $5.37

  B. $5.00

  C. $4.45

  D. $2.00

  E. $6.21

  Correct Answer: E

  EBIT = PQ - VQ - FC $95,000 = P(55,000) - (0.4)P(55,000) - $110,000 $205,000 = (0.6)(55,000)P $205,000 = 33,000P P = $6.21.

• Question 964:

  Rollins Corporation is constructing its MCC schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock, which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm, which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond- yield-plusrisk- premium method to find k(s) (component cost of retained earnings). The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent. What is the firm's cost of retained earnings using the DCF approach?

  A. 14.1%

  B. 16.9%

  C. 16.0%

  D. 16.6%

  E. 13.6%

  Correct Answer: C

  Cost of retained earnings (DCF approach): k(s) = $2.16/`$27.00 + 8% = 16.0%.

• Question 965:

  A company currently sells 75,000 units annually. At this sales level, its EBIT is $4 million, and its degree of total leverage is 2.0. The firm's debt consists of $15 million in bonds with a 9.5 percent coupon. The company is considering a new production method which will entail an increase in fixed costs but adecrease in variable costs, and will result in a degree of operating leverage of 1.6. The president, who is concerned about the stand-alone risk of the firm, wants to keep the degree of total leverage at 2.0. If EBIT remains at $4 million, what amount of bonds must be retired to accomplish this?

  A. $9.19 million

  B. $8.42 million

  C. $6.58 million

  D. $4.44 million

  E. $7.63 million

  Correct Answer: C

  DTL = (DOL)(DFL)

  2.0 = 1.6(DFL)

  1.25 = DFL.

  1.25 = $4,000,000/($4,000,000-I)

  $5,000,000 - 1.25(I) = $4,000,000

  I = $800,000.

  Debt = $800,000/.095 = $8,421,053.

  Must retire = $15,000,000 - $8,421,053 = $6.58 million of debt.

• Question 966:

  A firm pays an annual preferred dividend of $1.9 per share and investors expect a rate of return of 7.8% from this equity issue. The firm is in the 35% tax bracket. The preferred stock should be trading at:

  A. $37.47

  B. $42.19

  C. $69.60

  D. $24.35

  Correct Answer: D

  Preferred dividends are not tax-deductible. Hence, no tax adjustment is made while calculating the cost of preferred equity. The price of a perpetuity that pays C per year, at a discount rate of R, equals C/R. Hence, P = 1.9/0.078 = $24.35.

• Question 967:

  "Operating leverage" refers to:

  A. the degree of reliance on debt capital.

  B. none of these answers.

  C. the extent to which changes in sales revenues affect operating profits.

  D. the extent to which operating profits are affected by variable costs.

  Correct Answer: C

  Operating leverage is the extent to which changes in sales revenues affect operating profits.

• Question 968:

  A decrease in a firm's willingness to pay dividends is likely to result from an increase in its ________.

  A. collection of accounts receivable

  B. earnings stability

  C. access to capital markets

  D. stock price

  E. profitable investment opportunities

  Correct Answer: E

  Two points must be kept in mind when deciding how much cash should be distributed to stockholders:

  1.

  The main objective is to maximize shareholder value.

  2.

  The cash flows generated by the firm belong to its shareholders.

  The optimal payout ratio is a function of 4 factors:

  1.

  Investors' preferences for dividends versus capital gains.

  2.

  The firm's investment opportunities.

  3.

  The firm's target capital structure.

  4.

  The availability and cost of external capital.

  The last 3 steps are combined in the residual dividend model, which is a model in which the dividend paid

  is set equal to the actual earnings minus the amount of retained earnings necessary to finance the firm's

  optimal capital budget.

• Question 969:

  In a recent press release, the management of Intelligent Semiconductor have announced their intention on an engaging a rather liberal debt offering, which will bring the proportion of debt within their capital structure from 35% to 50%. According to the Signaling Theory, his decision should be viewed as which of the following? Choose the best answer.

  A. The Signaling Theory would not apply to this announcement.

  B. Bullish, because it indicates superior investment prospects for the firm.

  C. Bearish, because it is indicative of a shift toward a more liberal capital structure.

  D. Bearish, because this will increase the financial risk of the firm.

  E. Bullish, because it is indicative of a shift toward a more conservative capital structure.

  F. Bearish, because it indicates poor investment prospects for the firm.

  Correct Answer: B

  According to the Signaling Theory, the management of companies send implicit signals to investors by their capital budgeting decisions. Believers of this theory feel that corporate managers have access to superior information, and are allowed to exploit this information asymmetry through their capital budgeting decisions. According to the signaling theory, when investment prospects are good, companies will prefer to raise capital first by using internally generated funds, i.e. retained earnings and marketable securities investments. If this source of capital is unavailable, then companies will prefer to issue debt rather than common or preferred equity. The reasoning behind this is the fact that by raising debt, the company will not dilute the ROE figure, which is expected to be high due to favorable investment prospects. In contrast, when investment prospects are poor, the Signaling Theory states that companies will prefer to raise funds first by issuing common equity. The reasoning behind this is the fact that by issuing additional equity when investment prospects are poor, companies will be able to "spread the losses" amongst a greater pool of investors, thereby lessening the overall negative effect of the poor investment prospects. In this example, the management of Intelligent Semiconductor has announced its intention on issuing more debt. According to the Signaling Theory, this should be viewed as an indication that the firm has superior investment prospects. While the decision to issue more debt is indicative of a shift toward a more liberal capital structure, and the issuance of this debt will increase the financial risk of the firm, both of which are somewhat bearish, neither represent the best answer.

• Question 970:

  If you were to argue that the firm's cost of equity increases as the dividend payout decreases, you would be making an argument ________ with MM's dividend irrelevance theory, and ________ with Gordon and Lintner's "bird-in-the-hand" theory.

  A. consistent; consistent

  B. consistent; inconsistent

  C. the argument does not make sense; neither theory involves the cost of equity capital

  D. inconsistent; consistent

  E. inconsistent; inconsistent

  Correct Answer: D

  The main conclusion of MM's irrelevance theory is that dividend policy does not affect the required rate of return on equity. Gordon-Lintner disagreed stating that k(s) decreases as the dividend payout is increased because investors are less certain of receiving the capital gains which should result from retaining earnings than they are of receiving dividends. They said that investors value expected dividends more highly than expected capital gains because the dividend yield is less risky than the growth component in the total expected return equation, k(s) = D1/Po + g. MM disagreed and theorized that k(s) is independent of dividend policy, implying that investors are indifferent between dividends and capital gains. MM called the Gordon-Lintner's study the bird-in-the- hand fallacy, because MM thought the riskiness of the firm's cash flows to investors in the long run is determined by the riskiness of the operating cash flows, not by dividend policy.