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Test Prep CFA-Level-I Exam
CFA® Level I Chartered Financial Analyst (Page 8 )

Updated On: 12-Jan-2026
Page 8 of 793
PDF with 3963 Questions

The following facts apply to your company:
Target capital structure: 50% debt; 50% equity.
EBIT:$200 million
Assets:$500 million
Tax rate:40%
Cost of new and old debt:8%
Based on the residual dividend policy, the payout ratio is 60 percent. How large (in millions of dollars) will the capital budget be?

  1. $43.2
  2. $50.0
  3. $108.0
  4. $86.4
  5. $64.8

Answer(s): D

Explanation:

Debt = 0.5(Assets) = 0.5($500) = $250 million.
Interest = 0.08($250) = $20 million.
EBT = EBIT - I = $200 - $20 = $180.
NI = $180 - Taxes = $180 - $180(0.4) = 0.6($180) = $108 million.
Dividends = $108(0.6) = $64.80 million.
Retained earnings = NI - D = $108.00 - $64.80 = $43.20 million.
Half of the capital budget will be debt, half will be common equity from retained earnings, so the capital budget will = $86.40 million.



Which of the following companies has the highest degree of financial leverage? Choose the best answer.

Firm A
EBIT: $10,000,000
Interest Paid: $750,000
Total Operating Expenses: $25,000,000
Fixed Operating Expenses: $19,750,000
Firm B
EBIT: $8,970,000
Interest Paid: $88,000
Total Operating Expenses: $20,050,000
Fixed Operating Expenses: $17,000,000
Firm C
EBIT: $10,500,000
Interest Paid: $1,050,000
Total Operating Expenses: $50,000,000
Fixed Operating Expenses: $35,000,000
Firm D
EBIT: $10,000,000
Interest Paid: $750,000
Total Operating Expenses: $50,000,000
Fixed Operating Expenses: $41,000,000
Firm E
EBIT: $5,195,000
Interest Paid: $400,000
Total Operating Expenses: $35,000,000
Fixed Operating Expenses: $9,875,000

  1. Firm A
  2. Firm E
  3. Firm B
  4. Firm C
  5. Firm D
  6. Firm A and D have identical DFL's

Answer(s): D

Explanation:

The Degree of Financial Leverage (DFL) measures the percentage change in EPS that results from a given percentage change in EBIT. Financial Leverage is the second component of total leverage, along with Operating Leverage. The equation used to calculate the Degree of Financial Leverage is as follows: {DFL = [EBIT/(EBIT - Interest Paid)]}.
In this example, Firm C has the highest DFL, with a figure of 1.11. While Firm A and D do have identical Degree of Financial Leverage calculations, the question asks which firm has the highest DFL, which is firm C.
When calculating the DFL figure, remember that the answer can never be less than one, and can never be negative. In a situation where the company under examination has zero interest expense, the DFL would be equal to one; i.e. the EBIT is equal to the EBIT minus the interest expense. Another important note to remember is that in calculating the Degree of Financial Leverage, dividend payments to preferred stockholders should be included in the interest expense figure. Operating expenses are not factored into the DFL calculation, rather are used in the determination of Operating Leverage.



A stock's P/E ratio is 10.4, with an expected return on equity of 14% and a dividend growth rate of 5.7%. The firm's dividend payout ratio equals ________.

  1. 24.19%
  2. 56.17%
  3. 86.32%
  4. 13.68%

Answer(s): C

Explanation:

Po/E1 = dividend payout/(k - g)
Therefore, 10.4 = dividend payout /(0.14 - 0.057), giving dividend payout = 86.32%.



Kulwicki Corporation wants to determine the effect of an expansion of its sales on its operating income (EBIT). The firm's current degree of operating leverage is 2.5. It projects new unit sales to be 170,000, an increase of 45,000 over last year's level of 125,000 units. Last year's EBIT was $60,000. Based on a degree of operating leverage of 2.5, what is this year's expected EBIT with the increase in sales?

  1. $175,000
  2. $60,000
  3. $114,000
  4. $90,000
  5. $100,000

Answer(s): C

Explanation:

Set up the DOL equation, letting x be the unknown new EBIT:
Let x = New EBIT.
DOL(Q) = % change EBIT/ % change Sales
% change in sales = 45000/125000 = 36%
2.5 = (x - $60,000/$60,000) / .36
2.5 (0.36) = ((x - $60,000)/$60,000)
0.90 = (x - $60,000/$60,000)
$54,000 = x - $60,000
x = $114,000.
New EBIT = $114,000.



Which of the following statements is most correct?

  1. All of these answers.
  2. All else equal, an increase in a company's stock price will increase the marginal cost of issuing new common equity.
  3. None of these answers.
  4. If a company's tax rate increases but the yield to maturity of its noncallable bonds remains the same, the company's marginal cost of debt capital used to calculate its weighted average cost of capital will fall.
  5. All else equal, an increase in a company's stock price will increase the marginal cost of retained earnings.

Answer(s): D

Explanation:

The debt cost used to calculate a firm's WACC is k(d)(1 - T). If k(d) (interest rate on the firm's new debt) remains constant but T increases, then the term (1 - T) decreases and the value of the entire equation, k(d)(1 - T), decreases.



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