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CFA CFA I Exam
CFA Level I Chartered Financial Analyst (Page 87 )

Updated On: 26-Jan-2026
Page 87 of 793
PDF with 3960 Questions

It has been observed in the market that most of the increases in dividends are followed by an increase in the stock price and vice-versa. This implies that:

  1. at least one of the M&M assumptions must be false.
    II. there must be signaling effects involved.
    III. investors are behaving irrationally.
  2. II only
  3. III only
  4. I, II & III
  5. II & III
  6. I & II
  7. I only

Answer(s): F

Explanation:

If all of the M&M assumptions held, a change in dividend policy would not cause the stock price to change; dividend policy would be irrelevant. However, one does not necessarily need signaling effects to account for market behavior. Other theories like the Bird-in-the-Hand theories can also explain the phenomenon in the presence of transaction costs. In itself, then, the phenomenon does not imply that the market is behaving irrationally.



Your assistant has just completed an analysis of two mutually exclusive projects. You must now take her report to a board of directors meeting and present the alternatives for the board's consideration. To help you with your presentation, your assistant also constructed a graph with NPV profiles for the two projects. However, she forgot to label the profiles, so you do not know which line applies to which project. Of the following statements regarding the profiles, which one is most reasonable?

  1. If one of the projects has a NPV profile which crosses the X-axis twice, hence the project appears to have two IRRs, your assistant must have made a mistake.
  2. If the two projects' NPV profiles cross once, in the upper left quadrant, at a discount rate of minus 10 percent, then there will probably not be a NPV versus IRR conflict, irrespective of the relative sizes of the two projects, in any meaningful, practical sense (that is, a conflict which will affect the actual investment decision).
  3. If the two projects both have a single outlay at t = 0, followed by a series of positive cash inflows, and if their NPV profiles cross in the lower left quadrant, then one of the projects should be accepted. Both would be accepted if they were not mutually exclusive.
  4. Whenever a conflict between NPV and IRR exist, then, if the two projects have the same initial cost, the one with the steeper NPV profile probably has less rapid cash flows. However, if they have identical cash flow patterns, then the one with the steeper profile probably has the lower initial cost.
  5. If the two projects have the same investment cost, and if their NPV profiles cross once in the upper right quadrant, at a discount rate of 40 percent, this suggests that a NPV versus IRR conflict is not likely to exist.

Answer(s): B

Explanation:

A conflict will exist if the cost of capital is less than the crossover rate. In this case the cost of capital must be greater than minus 10 percent and, therefore, there will probably not be a NPV versus IRR conflict.



Consider the following information for Company ABC:
Current Price of Stock $25.5
Expected dividend in 1 Year $1.00
Growth rate 8.0%
Beta 1.2
Risk Free Rate 4.5%
Calculate this company's cost of retained earnings using the Discounted Cash Flow (DCF) method.

  1. 13.30%
  2. 8.0%
  3. 12.0%
  4. 11.92%
  5. 12.2%

Answer(s): D

Explanation:

The DCF method for estimating the cost of retained earnings states: Cost of Retained Earnings = (Dividend for period 1 / Current Price) + Growth Rate. In this case the estimated Cost of Retained Earnings = (1 / 25.5) + 8.0% = 3.92 + 8.00 = 11.92%



If you know that your firm is facing relatively poor prospects but needs new capital, and you know that investors do not have this information, signaling theory would predict that you would

  1. postpone going into capital markets until your firm's prospects improve.
  2. be indifferent between issuing debt and equity.
  3. issue debt to maintain the returns of equity holders.
  4. issue equity to share the burden of decreased equity returns between old and new shareholders.
  5. convey your inside information to investors using the media to eliminate the information asymmetry.

Answer(s): D

Explanation:

The announcement of a stock offering is generally taken as a signal that the firm's prospects as seen by its management are not bright.



Which of the following is/are advantages of stock repurchases?

  1. Stock repurchases increase the price per share by reducing the number of shares.
    II. Stock repurchases are often viewed as a positive signal by investors, raising the intrinsic value of each share and increasing shareholder value.
    III. Stock repurchases allow firms to distribute funds to shareholders without raising "sticky" dividends.
  2. II only
  3. II & III
  4. I only
  5. I & III
  6. I, II & III
  7. III only
  8. I & II

Answer(s): B

Explanation:

The value of a stock repurchase does not come from a simple reduction in the number of shares outstanding.
Remember that for this reduction, the firm must pay out part of its assets in the buy-back process. If such a buyback takes place at a fair price, the shareholder value is completely unaffected, for all you have done is exchanged cash for an equivalent value of common stock. The real wealth increase through a repurchase program arises from real and tangible effects like the interpretation of the program as a positive signal about future prospects. Further, if the management thinks that excess cash reserves are only temporary, then they would be reluctant to raise dividends and add instability to dividend policy. Repurchase programs allow them to distribute excess funds without paying them as dividends.



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