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Test Prep CFA-Level-I Exam
CFA® Level I Chartered Financial Analyst (Page 6 )

Updated On: 12-Jan-2026
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PDF with 3963 Questions

Flood Motors is an all-equity firm with 200,000 shares outstanding. The company's EBIT is $2,000,000 and is expected to remain constant over time. The company pays out all of its earnings each year, so its earnings per share equals its dividends per share. The company's tax rate is 40 percent. The company is considering issuing $2 million worth of bonds (at par) and using the proceeds for a stock repurchase. If issued, the bonds would have an estimated yield to maturity of 10 percent. The risk-free rate in the economy is 6.6 percent, and the market risk premium is 6 percent. The company's beta is currently 0.9, but its investment banker's estimate that the company's beta would rise to 1.1 if they proceed with the recapitalization. Assume that the shares are repurchased at a price equal to the stock market price prior to the recapitalization. What would be the company's stock price following the recapitalization?

  1. $53.85
  2. $51.14
  3. $76.03
  4. $56.02
  5. $68.97

Answer(s): B

Explanation:

First, find the company's current cost of capital, dividends per share, and stock price: k = 0.066 + (0.06)0.9 = 12%. To find the stock price, you still need the dividends per share or DPS = ($2,000,000 (1 - 0.4))/200,000 = $6.00. Thus, the stock price is Po = $6.00/0.12 = $50.00. Thus, by issuing $2,000,000 in new debt the company can repurchase $2,000,000/$50.00 = 40,000 shares.
Now after recapitalization, the new cost of capital, DPS, and stock price can be found: k = 0.066 + (0.06)1.1 = 13.20%. DPS for the remaining (200,000 - 40,000) = 160,000 shares are thus [($2,000,000 - ($2,000,000 x 0.10))(1 - 0.4)]/160,000 = $6.75. And, finally, Po = $6.75/0.132 = $51.14.



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

  1. If investors are not indifferent between dividends and capital gains, regular repurchase programs could drive them away.
    II. The IRS could tax the firm for improper accumulation of capital gains if it felt regular repurchase programs had taken the place of dividends.
    III. The firm might end up paying a higher than fair price if it commits to a repurchase program.
  2. II & III
  3. I & III
  4. III only
  5. II only
  6. I only
  7. I, II & III

Answer(s): F

Explanation:

If shareholders are not indifferent between dividends and capital gains, the stock price might increase more with dividends. This is because cash dividends are generally made very regularly, while stock repurchases are irregularly made. Although this has been rarely done for public corporations, the IRS can impose a tax if it believes regular repurchases are being made to avoid paying dividends. If a company's shares are thinly traded, and the firm wishes to repurchase a large number of shares, it could bid up the stock price above the equilibrium price and overpay for the shares.



As the director of capital budgeting for Denver Corporation, you are evaluating two mutually exclusive projects with the following net cash flows:
YearProject XProject Z
0-$100,000-$100,000
150,000 10,000
240,000 30,000
330,000 40,000
410,000 60,000
If Denver's cost of capital is 15 percent, which project would you choose?

  1. Project Z, since it has the higher NPV.
  2. Project X, since it has the higher NPV.
  3. Neither project.
  4. Project X, since it has the higher IRR.
  5. Project Z, since it has the higher IRR.

Answer(s): C

Explanation:

(In thousands)
NPV(X) = -100 + 50(PVIF(15%,1)) + 40(PVIF(15%,2)) + 30(PVIF(15%,3)) + 10(PVIF(15%,4)) = -100 + 50 (0.8696) + 40(0.7561) + 30(0.6575) + 10(0.5718) = -0.833 = -$833.
NPVZ = -100 + 10(PVIF(15%,1)) + 30(PVIF(15%,2)) + 40(PVIF(15%,3)) + 60(PVIF(15%,4)) = -100 + 10 (0.8696) + 30(0.7561) + 40(0.6575) + 60(0.5718) = -8.013 = -$8,013.
At a cost of capital of 15%, both projects have negative NPVs and, thus, both would be rejected.



Which of the following statements is most correct?

  1. Suppose a firm is losing money and thus, is not paying taxes, and that this situation is expected to persist for a few years whether or not the firm uses debt financing. Thus the firm's after-tax cost of debt will equal its before-tax cost of debt.
  2. The bond-yield-plus-risk-premium approach to estimating a firm's cost of common equity involves adding a subjectively determined risk-premium to the market risk-free bond rate.
  3. The reason that a cost of capital is assigned to retained earnings is because these funds are already earning a return in the business, the reason does not involve the opportunity cost principle.
  4. The component cost of preferred stock is expressed as k(ps)(1 - T), because preferred stock dividends are treated as fixed charges, similar to the treatment of debt interest.
  5. All of these statements are false.

Answer(s): A

Explanation:

Obviously if the firm is paying no taxes, its after-tax cost of debt will equal its before-tax cost of debt.



Firms with higher operating leverage tend to have _______ financial leverage.

  1. lower
  2. same
  3. higher or lower (since the two are not related).
  4. higher

Answer(s): A

Explanation:

Firms with higher operating leverage have a higher fraction of costs in the form of fixed costs and hence, have a higher business risk. This makes them more averse to debt. Consequently, firms with higher operating leverage tend to have lower D/E ratios i.e. lower financial leverage.



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