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CFA CFA I Exam
CFA Level I Chartered Financial Analyst (Page 49 )

Updated On: 26-Jan-2026
Page 49 of 793
PDF with 3960 Questions

A firm's dividend growth rate is 3.2% when the dividend payout ratio equals 37%. It is expected to pay a dividend of $2.2 next year. If the cost of external equity for the firm equals 19.2% and the firm's stock is currently priced at $14.1, the flotation cost of equity equals ________.

  1. 1.78%
  2. 0.89%
  3. 2.50%
  4. 1.91%

Answer(s): C

Explanation:

IF F is the percentage flotation cost and P is the amount of new equity raised per new share, then Ke = D1/[P (1-F)] + g, where Ke is the cost of external equity. Here, g = 3.2%, D1 = $2.2, P = $14.1 and Ke = 19.2%.
Therefore, 19.2% = 2.2/(14.1*(1-F)) + 3.2%. Solving for F gives F = 2.5%.



The management of Clay Industries have adhered to the following capital structure: 50% debt, 35% common equity, and 15% perpetual preferred equity. The following information applies to the firm:
Before-tax cost of debt, i.e. yield to maturity of the outstanding senior long-term debt = 9.5% Combined State/Federal tax rate = 35%
Cost of common equity = 14.45%
Annual preferred dividend = $2.75
Preferred stock net offering price = $28.50
Given this information, what is the Weighted Average Cost of Capital for Clay Industries?

  1. 9.60%
  2. 10.45%
  3. The WACC for Clay Industries cannot be calculated from the information given.
  4. 11.27%
  5. 6.52%
  6. 8.67%

Answer(s): A

Explanation:

The calculation of the Weighted Average Cost of Capital is as follows: {fraction of debt * [yield to maturity of outstanding long-term debt][1-combined state/federal income tax rate]} + {fraction of preferred stock * [annual dividend/net offering price]} + {fraction of common stock * cost of equity}. The cost of common equity can be calculated using three methods, the Capital Asset Pricing Model (CAPM), the Dividend-Yield-plus-Growth-Rate (or Discounted Cash Flow) approach, and the Bond- Yield-plus-Risk-Premium approach. In this example, the cost of equity is given, so none of the three approaches is necessary. However, the cost of debt and preferred stock must be calculated. The cost of debt is found by multiplying the before tax cost of debt (9.5%) by (1-tax rate). Incorporating the given figures into this equation will yield a cost of debt at 6.175%. Determining the cost of perpetual preferred stock is relatively straightforward, simply divide the annual preferred dividend ($2.75) by the net price of preferred stock ($28.50), which yields a cost of preferred stock of 9.65%. These figures can now be incorporated into the WACC equation, which is provided below: {[50% debt * 9.5% * (1- 35%)] + [15% * ($2.75/$28.50)] + [35% * 14.45%]} = 9.60%



Which of the following is not expressly incorporated into the Degree of Total Leverage (DTL) calculation?

  1. None of these answers
  2. Discount rate
  3. Interest expense
  4. Fixed costs
  5. Sales
  6. Variable costs

Answer(s): B

Explanation:

The Degree of Total Leverage (DTL) calculation measures the percentage change in EPS from a given percentage change in sales. The equation used to produce DTL is as follows: {DTL = [(Sales - Variable Costs) / (Sales - Variable Costs - Fixed Costs - Interest Expense)]. As you can see, the DTL calculation does not involve the use of an explicit discount rate.



Company D has a 50 percent debt ratio, whereas Company E has no debt financing. The two companies have the same level of sales, and the same degree of operating leverage. Which of the following statements is most correct?

  1. None of these answers are correct.
  2. If sales increase 10 percent for both companies, then Company D will have a larger percentage increase in its operating income (EBIT).
  3. All of these answers are correct.
  4. If EBIT increases 10 percent for both companies, then Company D's net income will rise by more than 10 percent, while Company E's net income will rise by less than 10 percent.
  5. If sales increase 10 percent for both companies, then Company D will have a larger percentage increase in its net income.

Answer(s): E

Explanation:

After the sales increase, the percentage increase in EBIT will be the same for both companies. Company E's net income will rise by exactly 10%.



Which of the following statements is most correct?

  1. The optimal capital structure is the one that maximizes EBIT, and this always calls for a debt ratio, which is lower than the one that maximizes expected EPS.
  2. When financial leverage is used, the graphical probability distribution of net income would tend to be more peaked than a distribution where no leverage is present, other things held constant.
  3. From an operational standpoint the goal of maintaining financial flexibility translates into maintaining adequate reserve borrowing capacity.
  4. While business risk varies from one industry to another and can change over time, it affects all firms equally within a particular industry.
  5. All of these statements are false.

Answer(s): C

Explanation:

Even in normal times, a firm should maintain a reserve borrowing capacity, which is the ability to borrow money at a reasonable cost when good investment opportunities arise.



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