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Free Test Prep CFA-Level-I Exam Questions (page: 15)

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If debt financing is used, which of the following is correct?

  1. The percentage change in net operating income is greater than a given percentage change in net income.
  2. The percentage change in net operating income is less than the percentage change in net income.
  3. The percentage change in net operating income is equal to a given percentage change in net income.
  4. The percentage change in net operating income depends on the interest rate charged on debt.
  5. The degree of operating leverage is greater than 1.

Answer(s): B

Explanation:

This is because the interest charges on debt are included in net income and not operating income.



The stand-alone risk of a project is measured by:

  1. the project's impact on the systematic risk of the firm's stock.
  2. the project's impact on the unsystematic risk of the firm's stock.
  3. the variability of the project's projected returns.
  4. the project's impact on the uncertainty about the firm's future earnings.

Answer(s): C

Explanation:

Standalone risk evaluates the risk of a project ignoring all portfolio aspects by looking at the variability of the project's projected returns.



If a firm adheres strictly to the residual dividend policy, a sale of new common stock by the company would suggest that ________.

  1. the dividend payout ratio is decreasing
  2. the dividend payout ratio has remained constant
  3. the dollar amount of investments has decreased
  4. the dividend payout ratio is increasing
  5. no dividends were paid for the year

Answer(s): E

Explanation:

The residual dividend model is a model in which the dividend paid is set equal to the actual earnings minus the amount of retained earnings necessary to finance the firm's optimal capital budget. A firm follows 4 steps when using this model:
1. The optimal capital budget is determined.
2. The amount of equity needed to finance that budget, given its target capital structure, is determined.
3. Retained earnings are used to meet equity requirements to the extent possible.
4. Dividends are paid only if more earnings are available than are needed to support the optimal capital budget.
As long as the firm finances with the optimal mix of debt and equity, and provided it uses only internally generated equity (retained earnings), then the marginal cost of each new dollar of capital will be minimized.
Internally generated equity is available for financing some new investment, but beyond that amount, the firm must finance through more expensive common stock. At this point where new stock must be sold, the cost of equity and the marginal cost of capital, increases.



Which of the following statements is most correct?

  1. Stock splits reduce the number of shares outstanding.
  2. A key advantage of the residual dividend policy is that it usually results in a stable dividend policy, which is attractive to investors.
  3. A reduction in the capital gains rate should work to discourage corporations from repurchasing their shares.
  4. The bird-in-hand theory of dividends suggests that firms that increase their dividend payout should expect to realize a higher share price and a lower cost of equity capital.

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. MM disagreed and theorized that k(s) is independent of dividend policy, implying that investors are indifferent between dividends and capital gains. MM called the Gordon-Lintner's study the bird-in- the- hand fallacy, because MM thought the riskiness of the firm's cash flows to investors in the long run is determined by the riskiness of the operating cash flows, not by dividend policy.



Consider the following argument: "By selling predetermined amounts of stock in an environment of no taxes or transaction costs, investors can create their own dividend policy. For example, a shareholder that wants a 5% dividend can "create" it by selling 5% of her stock. Conversely, if a company pays a higher dividend than an investor desires, the investor can use the unwanted portion of this dividend to purchase additional stock." This argument applies to which of the following theories? Choose the best answer.

  1. Dividend Relevance Theory
  2. Tax Preference Theory
  3. Trade-off Theory
  4. Bird-in-hand Theory
  5. Dividend Irrelevance Theory

Answer(s): E

Explanation:

Modigliani and Miller established the Dividend Irrelevance Theory, which stated that in an environment of no taxes or transaction costs, dividend policy is irrelevant. Modigilani and Miller grounded this assumption in the fact that in such an environment, investors could create their own dividend policy by selling and buying shares of stock.



Which of the following statements is most correct?

  1. One advantage of adopting a residual dividend policy is that it makes it easier for corporations to maintain dividend clienteles.
  2. None of these answers are correct.
  3. The clientele effect can explain why firms often change their dividend policies.
  4. The bird-in-hand theory would predict that companies could decrease their cost of equity financing by raising their dividend payout.
  5. All of these answers are correct.

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. MM disagreed and theorized that k(s) is independent of dividend policy, implying that investors are indifferent between dividends and capital gains. MM called the Gordon-Lintner's study the bird-in- the- hand fallacy, because MM thought the riskiness of the firm's cash flows to investors in the long run is determined by the riskiness of the operating cash flows, not by dividend policy.



Which of the following methods of evaluating capital projects incorporate an explicit discount rate into the equation?

  1. Net Present Value, Payback Period
  2. Internal Rate of Return, Modified Internal Rate of Return
  3. Discounted Payback Period, Net Present Value, Payback Period
  4. Discounted Payback Period, Net Present Value, Modified Internal Rate of Return
  5. Discounted Payback Period, Net Present Value, Internal Rate of Return

Answer(s): D

Explanation:

Of the methods for evaluating capital projects, the Net Present Value, Modified Internal Rate of Return, and Discounted Payback Period Methods incorporate an explicit discount rate into their equations. This discount rate is often referred to as the "cost of capital" for the project being examined. Remember that the Internal Rate of Return equation does not involve the incorporation of an explicit discount rate,rather solves to find that rate which equates the present value of a project's cash inflows with that of its cash outflows. Additionally, the "Payback Period" method does not involve an explicit discount rate, rather fails to incorporate any form of discounting into its calculation. The Payback Period is an overtly simplistic method, and as such, the figures produced by this method should be viewed with a degree of caution.



Which of the following figures is not explicitly incorporated into the earnings per share (EPS) calculation?

  1. Interest Expense
  2. Sales
  3. Fixed Costs
  4. Tax Rate
  5. Weighted Average Cost of Capital
  6. Variable Costs

Answer(s): E

Explanation:

The WACC is not incorporated into the EPS calculation. The EPS calculation is found by the following equation:
{EPS = [(Sales - Fixed Costs - Variable Costs - Interest Expense)(1 - Tax Rate)] / [# of Common Shares Outstanding]}
Additionally, the EPS figure can be found by:
{EPS = [(EBIT - Interest Expense)(1 - Tax Rate) / # of Common Shares Outstanding]}.



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