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CFA CFA I Exam
CFA Level I Chartered Financial Analyst (Page 83 )

Updated On: 26-Jan-2026
Page 83 of 793
PDF with 3960 Questions

Which of the following statements is correct?

  1. Due to the way the MCC (Marginal Cost of Capital) is constructed, the first break point in the MCC schedule must be associated with using up all available retained earnings and having to issue common stock.
  2. Normally, the cost of external equity raised by issuing new common stock is above the cost of retained earnings. Moreover, the higher the growth rate is relative to the dividend yield, the more the cost of external equity will exceed the cost of retained earnings.
  3. The lower a company's tax rate, the greater the advantage of using debt in terms of lowering its WAC
  4. Because we often need to make comparisons among firms that are in different income tax brackets, it is best to calculate the WACC (Weighted Average Cost of Capital) on a before-tax basis.
  5. If a firm has been suffering accounting losses and is expected to continue suffering such losses, and therefore its tax rate is zero. It is possible that its after-tax component cost of preferred stock as used to calculate the WACC will be less than its after-tax component cost of debt.

Answer(s): E

Explanation:

Because corporations can exclude dividends for tax purposes, preferred stock often has a market return that is less than the issuing company's cost of debt. Then, if the issuer's tax rate is zero, its component cost of preferred would be less than its cost of debt.



A financial analyst with Smith, Kleen, & Beetchnutty is examining shares of Clay Industries for possible investment. Assume the following information:
EPS: $4.19
ROE: 11.25%
Growth rate of dividends: 6.75%
Discount rate: 11.50%
Tax Rate 35%
Using this information, what is the dividend payout ratio for Clay Industries? Further, what is the annual dividend?

  1. 35.87%, $1.50
  2. 60.00%, $2.51
  3. 60.00%, $1.68
  4. The answer cannot be determined from the information provided.
  5. 40.00%, $1.68
  6. 40.00%, $2.51

Answer(s): E

Explanation:

To determine the dividend payout ratio, the equation used to determine the growth rate of dividends must be manipulated. This equation is originally structured as follows:
{g = ROE (1 - Dividend Payout Ratio)}
In order to determine the Dividend Payout Ratio, the equation must be rearranged to the following: {(1 - Dividend Payout Ratio) = Growth Rate of Dividends / ROE}.
Imputing the given information into this equation will yield:
{(1 - Dividend Payout Ratio) = 0.0675/0.1125)} = 0.60
Finally, subtracting this answer from 1 will yield the answer of 40%. We must subtract the first answer from one because the first answer represents the retention rate, i.e. the percentage of earnings that is retained and reinvested at the firm's ROE, and not the Dividend Payout Ratio. The retention rate and the payout ratio will always combine to equal positive one. In order to determine the annual dividend, take the Dividend Payout Ratio, which was found to be 40%, and multiply this figure by the Earnings Per Share calculation, which is given as $4.19. This will yield an annual dividend of $1.676. As you can see, neither the discount rate nor the tax rate is factored into the equation



Using the Security Market Line concept in capital budgeting, which of the following is correct?

  1. If two mutually exclusive projects' expected returns are both above the SML, the project with the lower risk should be accepted.
  2. If a project's expected rate of return is greater than the expected rate of return on an average project, it should be accepted.
  3. If a project's return lies below the SML, it should be rejected if it has a beta greater than the firm's existing beta but accepted if its beta is below the firm's beta.
  4. If the expected rate of return on a given capital project lies above the SML, the project should be accepted even if its beta is above the beta of the firm's average project.

Answer(s): D

Explanation:

If the expected rate of return on a given capital project lies above the SML, the expected rate of return on the project is more than enough to compensate for its risk, and the project should be accepted. Conversely, if the project's rate of return lies below the SML, it should be rejected.



Bouchard Company's stock sells for $20 per share, its last dividend was $1.00. Its growth rate is a constant 6 percent, and the company would incur a flotation cost of 20 percent if it sold new common stock. Retained earnings for the coming year are expected to be $1,000,000, and the amount of common equity in the capital structure is 60 percent. If Bouchard has a capital budget of $2,000,000, what component cost of common equity will be built into the WACC for the last dollar of capital the company raises?

  1. 12.15%
  2. 11.80%
  3. 11.30%
  4. 11.45%
  5. 12.63%

Answer(s): E

Explanation:

BP(RE) = RE/Equity fraction = $1,000,000/0.6 = $1,666,667.
Since the capital budget will be $2 million, and since all equity in the WACC (Weighted Average Cost of Capital) beyond $1,666,667 will be external equity, the WACC of the last dollar raised will include equity at a cost of k(e) (component cost of external equity obtained by issuing new common stock as opposed to retaining earnings):
k(e) = $1(1.06)/$20(1 - 0.2) + 0.06 = 0.0663 + 0.06 = 0.1263 = 12.63%.



A company is analyzing two mutually exclusive projects, S and L, whose cash flows are shown below:
Years01234
S-1,1009003505010
L-1,1000300500850
The company's cost of capital is 12 percent, and it can get an unlimited amount of capital at that cost. What is the regular IRR (not MIRR) of the better project?

  1. 12.00%
  2. 13.09%
  3. 17.46%
  4. 12.53%
  5. 13.88%

Answer(s): B

Explanation:

Time line:
0 k = 12%1234 Years
Cash flows S -1,1009003505010
NPV(S) = ? IRR(S) = ?
Cash flows L -1,1000300500850
NPV(L) = ? IRR(L) = ?
Financial calculator solution:
Calculate the NPV and IRR of each project then select the IRR of the higher NPV project Project S; Inputs: CF (0) = -1,100; CF(1) = 900; CF(2) = 350; CF(3) = 50; CF(4) = 10; I = 12 Output: NPV(S) = 24.53; IRR(S) = 13.88%.
Project L; Inputs: CF(0) = -1,100; CF(1) = 0; CF(2) = 300; CF(3) = 500; CF(4) = 850; I = 12 Output: NPVL = 35.24; IRR(L) = 13.09%.
Project L has the higher NPV and its IRR = 13.09%.



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