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CFA CFA I Exam
CFA Level I Chartered Financial Analyst (Page 29 )

Updated On: 26-Jan-2026
Page 29 of 793
PDF with 3960 Questions

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 ________.

  1. none of these answers
  2. likely to raise the probability of bankruptcy
  3. very desirable
  4. not very profitable

Answer(s): C

Explanation:

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.



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?

  1. Sunk Cost
  2. Cannibalization
  3. Opportunity Cost
  4. Externality
  5. Incremental Cash Flow

Answer(s): C

Explanation:

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



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:

  1. increasing the reliance on debt financing.
  2. increasing the reliance on retained earnings as capital.
  3. decreasing the reliance on equity capital.
  4. decreasing the sizes of seasoned equity offerings.

Answer(s): B

Explanation:

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.



The initial investment outlay consists of which of the following?

  1. 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.
  2. II only
  3. I, II & IV
  4. I, II & III
  5. I, II, III & IV
  6. I & III
  7. III only
  8. I only
  9. IV only

Answer(s): E

Explanation:

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.



Which of the following statements is most correct?

  1. 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.
  2. These statements are all incorrect.
  3. In practice (as opposed to in theory), the DCF method and the CAPM method usually produce exactly the same estimate for k(s).
  4. The risk premium used in the bond-yield-plus-risk-premium method is the same as the one used in the CAPM method.
  5. 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.

Answer(s): B

Explanation:

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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