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CFA CFA I Exam
CFA Level I Chartered Financial Analyst (Page 41 )

Updated On: 26-Jan-2026
Page 41 of 793
PDF with 3960 Questions

From the information below, select the optimal capital structure for Minnow Entertainment Company.

  1. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.
  2. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.
  3. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.
  4. Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90.
  5. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.

Answer(s): B

Explanation:

Since the optimal capital structure is the one that maximizes the price of the firm's stock, and minimizes the firm's WACC, this would be the optimal capital structure.



Tapley Acquisition Inc. is considering the purchase of Target Company. The acquisition would require an initial investment of $190,000, but Tapley's after-tax net cash flows would increase by $30,000 per year and remain at

this new level forever. Assume a cost of capital of 15 percent. Should Tapley buy Target?

  1. Yes, because the IRR < the cost of capital.
  2. Yes, because the NPV = $10,000.
  3. No, because NPV < 0.
  4. No, because k > IRR.
  5. Yes, because the NPV = $30,000.

Answer(s): B

Explanation:

NPV = $30,000/0.15 - $190,000 = $200,000 - $190,000 = $10,000.



When Modigliani and Miller relaxed their assumption of zero taxes, they concluded which of the following?

  1. Firm's will wish to issue preferred stock.
  2. A firm's value is maximized only when it uses no debt.
  3. Business risk will become the main determinant of a firm's value.
  4. Dividend policy will dominate the investment decision.
  5. A firm's capital structure is irrelevant.
  6. A firm's value is maximized only when it uses 100% debt.

Answer(s): F

Explanation:

When M&M relaxed their "no-taxes" assumption, they concluded that a firm's value was maximized only when its capital structure is composed of 100% debt. This is due to the tax-deductibility of debt. Due to these tax- shelter benefits, companies who are financed by 100% debt pass the maximum amount of their operating income to investors, and this should increase the attractiveness of the firm as an investment. M&M would be criticized on this finding, particularly because the risk of bankruptcy was completely ignored. This criticism would give birth to the "Trade-off Theory of Leverage," which states that companies will balance the tax-shelter benefits of debt with the increased interest rates and risk of bankruptcy that are associated with increased debt levels..



Which of the following statements is most correct?

  1. All of the answers above are correct.
  2. An increase in the personal tax rate is likely to increase the debt ratio of the average corporation.
  3. A reduction in the corporate tax rate is likely to increase the debt ratio of the average corporation.
  4. None of these answers are correct.
  5. If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation.

Answer(s): D

Explanation:

A major reason for using debt is that interest is deductible, which lowers the effective cost of debt. Lowering the corporate tax rate reduces the tax advantages of debt leading firms to use less debt financing. If the personal tax rate were to increase, individuals would now find interest received on corporate debt less attractive, causing firms to utilize less debt financing. An increase in the costs of bankruptcy might lead firms to use less debt in order to reduce the probability of having to incur these higher costs.



A stock has an expected dividend growth rate of 4.4%. The firm has just announced a dividend of $1.9 per share, with an ex dividend date 3 days from now. Investors expect a rate of return of 9% from the stock and the stock is trading at $31.84. Ignoring stock price uncertainty between now and the ex dividend date and expecting the same growth, the stock is:

  1. fairly priced.
  2. under-priced.
  3. insufficient information.
  4. overpriced.

Answer(s): B

Explanation:

Ignoring stock price uncertainty between now and the ex dividend date, the stock would have a fair price of Po on the ex dividend date, given by Po = D1/(r-g) = 1.9*1.044/(9% - 4.4%) = $43.12. Therefore,the current fair price of the stock is $43.12 + $1.9 = $45.02, which is much greater than the actual trading price of $31.84.
Thus, the stock is under-priced.
Note that the operative phrase in this example is "ignoring all uncertainty between now and the ex dividend date and expecting the same growth." If the market is expecting some negative information about the firm to be released some time in the near future (not necessarily before ex dividend date) or does not believe that the firm will continue to grow at or more than 4.4%, the actual trading price could be a fair price. Hence, you should never blindly apply the DDM.



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