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CFA CFA I Exam
CFA Level I Chartered Financial Analyst (Page 51 )

Updated On: 26-Jan-2026
Page 51 of 793
PDF with 3960 Questions

In applying the CAPM (Capital Asset Pricing Model) to estimate the cost of equity capital, which of the following elements is not subject to dispute or controversy?

  1. Expected rate of return on the market.
  2. All of these answers are subject to dispute.
  3. The stock's beta coefficient.
  4. Market risk premium.
  5. Risk-free rate.

Answer(s): B

Explanation:

Under the CAPM approach, it is difficult at best, to obtain correct estimates of the inputs required to make it operational:
1. there is controversy about whether to use long-term or short-term Treasury yields for the risk-free rate.
2. it is difficult to estimate the beta that investors expect to firm to have in the future, and it is difficult to estimate the market risk premium.



Flavortech Inc. expects EBIT of $2,000,000 for the coming year. The firm's capital structure consists of 40 percent debt and 60 percent equity, and its marginal tax rate is 40 percent. The cost of equity is 14 percent, and the company pays a 10 percent rate on its $5,000,000 of long-term debt. One million shares of common stock are outstanding. In its next capital budgeting cycle, the firm expects to fund one large positive NPV project costing $1,200,000, and it will fund this project in accordance with its target capital structure. If the firm follows a residual dividend policy and has no other projects, what is its expected dividend payout ratio?

  1. 0%
  2. 40%
  3. 60%
  4. 100%
  5. 20%

Answer(s): E

Explanation:

EBIT$2,000,000
- I500,000 ($5,000,000 debt x 10% coupon)
EBT1,500,000
- Taxes600,000 ($1,500,000 EBT x 40% tax rate)
NI900,000
Project funding $1,200,000 project funded:
Residual earnings 0.60 equity = $720,000
0.40 debt = $480,000
Payable as dividends: 900,000 - 720,000 = $180,000
Dividend payout ratio = $180,000/$900,000 = 20%.



Myron Gordon and John Lintner believe that the required return on equity increases as the dividend payout ratio is decreased. Their argument is based on the assumption that

  1. investors require that the dividend yield and capital gains yield equal a constant.
  2. investors are indifferent between dividends and capital gains.
  3. investors value a dollar of expected capital gains more highly than a dollar of expected dividends because of the lower tax rate on capital gains.
  4. investors view dividends as being less risky than potential future capital gains.
  5. capital gains are taxed at a higher rate than dividends.

Answer(s): D

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.



Doering Computers is considering two mutually exclusive projects. Their cash flows are shown below:
tProj. A Cash FlowsProj. B Cash Flows
0-$500-$700

1200 250
2400 475
3100 125
4----225
The company's cost of capital (WACC) is 10 percent. Each of the projects can be repeated. What is the equivalent annual annuity (EAA) of the project, which adds the most to shareholder value?

  1. $61.64
  2. $52.82
  3. $63.45
  4. $35.20
  5. $25.41

Answer(s): B

Explanation:

Find NPV of each project.
NPV(A) = $87.5282.
NPV(B) = $167.4271.
Find EAA:
For Project A:
N = 3; I = 10; PV = -87.5282; FV = 0; solve for PMT = EAA = $35.1964.
For Project B:
N = 4; I = 10; PV = -167.4271; FV = 0; solve for PMT = EAA = $52.8184.



TCH Corporation is considering two alternative capital structures with the following characteristics.
AB
Debt/Assets ratio0.30.7
kd10%14%
The firm will have total assets of $500,000, a tax rate of 40 percent, and book value per share of $10, regardless of capital structure. EBIT is expected to be $200,000 for the coming year. What is the difference in earnings per share (EPS) between the two alternatives?

  1. $4.78
  2. $2.87
  3. $7.62
  4. $1.19
  5. $3.03

Answer(s): B

Explanation:

Capital structure A: The firm will have debt of $500,000(0.3) = $150,000 and equity of $350,000. We're told the shares have a book value of $10 so the number of shares outstanding is $350,000/$10 = 35,000. Interest expense will be $150,000(10%) = $15,000. We can compute EBT as EBIT - I or $200,000 - $15,000 = $185,000. Also, we can compute NI as EBT(1 - T) or $185,000(1 - 0.4) = $111,000. Finally, EPS = $111,000/35,000 = $3.17. Capital structure B: The firm will have debt of $500,000(0.7) = $350,000 and equity of $150,000. The number of shares outstanding is $150,000/$10 = 15,000. Interest expense will be $350,000 (14%) = $49,000. We can compute EBT as $200,000 - $49,000 = $151,000. Also, we can compute NI as $151,000 (1 - 0.4) = $90,600. Finally, EPS = $90,600/15,000 = $6.04. The difference in EPS between capital structure A and capital structure B is $6.04 - $3.17 = $2.87.



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