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CFA CFA I Exam
CFA Level I Chartered Financial Analyst (Page 31 )

Updated On: 26-Jan-2026
Page 31 of 793
PDF with 3960 Questions

Modigliani and Miller (MM) argued that dividend policy is irrelevant. On the other hand, Gordon and Lintner (GL) argued that dividend policy does matter. GL's argument rests on the contention that

  1. most investors will reinvest rather than spend dividends, so it would save investors money (taxes) if corporations simply reinvested earnings rather than paid them out as dividends.
  2. k(s) = D1/P0 + g is constant for any dividend policy.
  3. none of the answers are correct.
  4. investors, because of tax differentials, value a dollar of expected capital gains more highly than a dollar of dividends.
  5. because of perceived differences in risk, investors value a dollar of dividends more highly than a dollar of expected capital gains.

Answer(s): E

Explanation:

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.



Gulf Electric Company (GEC) uses only debt and equity in its capital structure. It can borrow unlimited amounts at an interest rate of 10 percent so long as it finances at its target capital structure, which calls for 55 percent debt and 45 percent common equity. Its last dividend was $2.20; its expected constant growth rate is 6 percent; its stock sells on the NYSE at a price of $35; and new stock would net the company $30 per share after flotation costs. GEC's tax rate is 40 percent, and it expects to have $100 million of retained earnings this year. GEC has two projects available: Project A has a cost of $200 million and a rate of return of 13 percent, while Project B has a cost of $125 million and a rate of return of 10 percent. All of the company's potential projects are equally risky. What is GEC's cost of equity from newly issued stock?

  1. 13.77%
  2. 13.33%
  3. 10.00%
  4. 12.66%
  5. 12.29%

Answer(s): A

Explanation:

k(d) (interest rate on the firm's new debt) = 10%
k(d)(1 - T) (after-tax-component cost of the debt) = 10%(0.6) = 6%.
D/A = 55%; D0 = $2.20; g = 6%; P0 = $35; PN = $35; T = 40%.
Retained earnings = $100M; BP(RE) = $100M/ .45 = $222.22M.
k(s) (component cost of retained earnings) = $2.33/$35 + 6% = 12.66%.
k(e) (component cost of external equity) = $2.33/$30 + 6% = 13.77%.



Suppose changes in corporate law make it more difficult for debt holders to force companies into bankruptcies.
This will cause firms to:

  1. raise more equity capital through retained earnings.
  2. either increase or decrease their debt levels.
  3. increase their debt-to-equity ratios.
  4. decrease their debt-to-equity ratios.

Answer(s): B

Explanation:

It is tempting to assume that lower probability of bankruptcy will entice firms into borrowing more. However, remember that debt holders are not entirely stupid! They will factor in this change in the law and demand a higher yield and stricter covenants on corporate debt to compensate for the lower recourse they have against the firms. Depending on whether they actually underestimate or overestimate the effect and also depending on whether the firms perceive that the debt holders have under- or overestimated the effect, companies could increase or decrease their debt levels.



As the capital budgeting director for Chapel Hill Coffins Company, you are evaluating construction of a new plant. The plant has a net cost of $5 million in Year 0 (today), and it will provide net cash inflows of $1 million at the end of Year 1, $1.5 million at the end of Year 2, and $2 million at the end of Years 3 through 5. Within what range is the plant's IRR?

  1. 17 - 18%
  2. 15 - 16%
  3. 18 - 19%
  4. 14 - 15%
  5. 16 - 17%

Answer(s): C

Explanation:

Time line: (In millions)
012345 Years
-511222
Financial calculator solution: (In millions)
Inputs: CF(0) = -5; CF(1) = 1.0; CF(2) = 1.5; CF(3) = 2.0; N(j) = 3.
Output: IRR% = 18.37%.



A project that is intended to increase income is known as ________.

  1. Externality
  2. Replacement Project
  3. Cannibalization
  4. Opportunity Cost
  5. Expansion Project
  6. Low Cost Provider

Answer(s): E

Explanation:

An expansion project is defined as a project that is intended to increase income.



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