Professional Documents
Culture Documents
INVESTMENT RISK
1
. Catherine & Co. has extra cash at the end of the year and is analyzing the best way to invest the funds. The company 2. Business risk is concerned with the operations of the firm. Which of the following is not associated with (or not a part of)
should invest in a project only if business risk? (E)
A. The expected return on the project exceeds the return on investments of comparable risk. a. Demand variability.
B. The return on investments of comparable risk exceeds the expected return on the project. b. Sales price variability.
C. The expected return on the project is equal to the return on investments of comparable risk. Gleim c. The extent to which operating costs are fixed.
D. The return on investments of comparable risk equals the expected return on the project. d. Changes in required returns due to financing decisions.
e. The ability to change prices as costs change. Brigham
Interest-rate Risk
7
4. Long-term government bonds have: . Which of the following affects a firm’s business risk? (E)
A. Interest rate risk C. Market risk a. The level of uncertainty about future sales.
B. Default risk D. None of the above B&M b. The degree of operating leverage.
c. The degree of financial leverage.
2
. Which of the following are components of interest-rate risk? Gleim d. Statements a and b are correct.
A. Purchasing-power risk and default risk. C. Portfolio risk and reinvestment-rate risk. e. All of the statements above are correct. Brigham
B. Price risk and market risk. D. Price risk and reinvestment-rate risk.
Financial Risk
Liquidity Risk *. Which of the following would increase risk? (M)
3
. The risk that securities cannot be sold at a reasonable price on short notice is called a. Increase the level of working capital.
A. Default risk. C. Purchasing-power risk. b. Change the composition of working capital to include more liquid assets.
B. Interest-rate risk. D. Liquidity risk. CIA 1190 IV-51 c. Increase the amount of short-term borrowing.
d. Increase the amount of equity financing. RPCPA 1091
4
. When purchasing temporary investments, which one of the following best describes the risk associated with the ability to
8
sell the investment in a short period of time without significant price concessions? (E) . A firm’s financial risk is a function of how it manages and maintains its debt. Which one of the following sets of ratios
A. Interest rate risk. C. Financial risk. characterizes the firm with the greatest amount of financial risk?
B. Purchasing power risk. D. Liquidity risk. CMA 0697 1-11 A. High debt-to-equity ratio, high interest coverage ratio, stable return on equity.
B. Low debt-to-equity ratio, low interest coverage ratio, volatile return on equity.
Business Risk C. High debt-to-equity ratio, low interest coverage ratio, volatile return on equity.
5
. Business risk is the risk inherent in a firm's operations that excludes financial risk. It depends on all of the following factors D. Low debt-to-equity ratio, high interest coverage ratio, stable return on equity. CMA 1291 1-4
except (E)
A. Amount of financial leverage. C. Demand variability. Business and financial risk
B. Sales price variability. D. Input price variability. Gleim 3. Which of the following statements is most correct? (E)
a. A firm’s business risk is solely determined by the financial characteristics of its industry.
6
. Business risk excludes such factors as b. The factors that affect a firm’s business risk are determined partly by industry characteristics and partly by economic
A. Financial risk. C. Demand variability. conditions. Unfortunately, these and other factors that affect a firm’s business risk are not subject to any degree of
B. Amount of operating leverage. D. Fluctuations in suppliers' prices. Gleim managerial control.
c. One of the benefits to a firm of being at or near its target capital structure is that financial flexibility becomes much
1. A decrease in the debt ratio will generally have no effect on __________ ______. (E) less important.
a. Financial risk. d. The firm’s financial risk may have both market risk and diversifiable risk components. Brigham
b. Total risk.
c. Business risk. Exchange-rate Risk
9
d. Market risk. Brigham . The risk of loss because of fluctuations in the relative value of foreign currencies is called
RPCPA, AICPA. CMA & CIA EXAMINATION QUESTIONS Page 1 of 45
MANAGEMENT ADVISORY SERVICES RISKS
10
A. Expropriation risk. C. Multinational beta. . O & B Company, a U.S. corporation, is in possession of accounts receivable denominated in German deutsche marks. To
B. Sovereign risk. D. Exchange rate risk. CIA 1191 IV-60 what type of risk are they exposed? (E)
A. Liquidity risk. C. Exchange-rate risk.
B. Business risk. D. Price risk. Gleim
11
. Bonner Electronics has subsidiaries in several international locations and is concerned about its exposure to foreign
exchange risk. In countries where currency values are likely to fall, Bonner should encourage all of the following policies
except
A. Granting trade credit whenever possible.
B. Investing excess cash in inventory or other real assets.
C. Purchasing materials and supplies on a trade credit basis. CFM Sample Q. 5
D. Borrowing local currency funds if an appropriate interest rate can be obtained.
12
. A firm may seek to avoid exchange-rate risk by
A. Maintaining a net monetary debtor position in countries with strengthening currencies.
B. Maintaining a net monetary creditor position in countries with weakening currencies.
C. Avoiding diversification of foreign-currency transactions. Gleim
D. Buying forward exchange contracts to cover liabilities denominated in a foreign currency.
Cultural Risk
56. A U.S. manufacturer of which of the following goods would be likely to face the most cultural risks in operating globally?
a. Furniture c. Clothing
b. Automobiles d. Food Barfields
57. A U.S. manufacturer of which of the following goods would be likely to face the fewest cultural risks in operating globally?
a. Toys c. Clothing
b. Food d. Furniture Barfields
Political Risk
58. Which of the following would be considered a political risk in doing business globally?
a. Asset expropriation c. Workplace diversity
b. Inflation d. All of the above Barfields
13
. Political risk may be reduced by
A. Entering into a joint venture with another foreign company.
B. Making foreign operations dependent on the domestic parent for technology, markets, and supplies.
C. Refusing to pay higher wages and higher taxes.
D. Financing with capital from a foreign country. Gleim
Comprehensive
*. All of the following statements are correct except:
a. The matching of asset and liability maturities is considered desirable because this strategy minimizes interest rate
risk. RISK MANAGEMENT METHODS
b. Default risk refers to the inability of the firm to pay off its maturing obligations. Risk
c. The matching of assets and liability maturities lowers default risk. Default Risk
d. An increase in the payables deferral period will lead to a reduction in the need to non-spontaneous funding. RPCPA 26. The portion of the risk that can be eliminated by diversification is called:
1095 A. Unique risk C. Interest rate risk
B. Market risk D. Default risk B&M
14
. The marketable securities with the least amount of default risk are (E)
a. Federal government agency securities. c. Repurchase agreements.
b. U.S. Treasury securities. d. Commercial paper. CMA 0691 1-11
Market Risk
15
. The type of risk that is not diversifiable and even affects the value of a portfolio is (E)
A. Purchasing-power risk. C. Nonmarket risk.
B. Market risk. D. Interest-rate risk. Gleim
Market Portfolio 34
According to the Capital Asset Pricing Model (CAPM) a well diversified portfolio's rate of return is a function of (E)
29
Which statement is not true regarding the market portfolio? (M) a. market risk c. unique risk.
a. It includes all assets of the universe. b. unsystematic risk d. reinvestment risk. Bodie
b. It lies on the efficient frontier. Bodie
c. All securities in the market portfolio are held in proportion to their market values. 35
. According to the capital asset pricing model (CAPM), the relevant risk of a security is its
d. It is the tangency point between the capital market line and the indifference curve. A. Company-specific risk. C. Systematic risk.
RPCPA, AICPA. CMA & CIA EXAMINATION QUESTIONS Page 5 of 45
MANAGEMENT ADVISORY SERVICES RISKS
40. The beta of a risk-free portfolio is: 32. The variance formula for a four stock portfolio contains:
A. 0 C. +1.0 A. 4 individual variance terms and 6 unique covariance terms
B. +0.5 D. –1.0 B&M B. 3 individual variance terms and 6 unique covariance terms
C. 6 individual variance terms and 9 unique covariance terms
34. Beta of Treasury bills portfolio is: D. 6 individual variance terms and 6 unique covariance terms B&M
A. Zero C. –1.0
B. +0.5 D. +1.0 B&M Coefficient of Variation
24. Which of the following can be computed and compared for each alternative to determine the relative riskiness of
Equity Beta investments that have different levels of expected return?
37. If beta of debt is zero, then the beta of equity is equal to: A. coefficient of variation C. standard deviation
B. variance D. expected value Carter & Usry
A. (1 + Debt-equity ratio)(beta of assets) C. (Beta of assets)/(debt-equity ratio)
B. (Debt-equity ratio)(beta of assets) D. None of the above B&M
Covariance
38
. Which of the following specifically measures the volatility of returns together with their correlation with the returns of other
37. In many situations debt beta can be safely assumed to be zero. Under this assumption, equity beta can be expressed as:
securities? (M)
[E = market value of equity and D = market value of debt]
A. Variance. C. Coefficient of variation.
A. equity beta = (1-(D/E.) (asset beta) C. equity beta = (asset beta)/(1+(D/E.)
B. Standard deviation. D. Covariance. Gleim
B. equity beta = (1+(D/E.) (asset beta) D. None of the above B&M
39
. If the covariance of stock A with stock B is -.0076, then what is the covariance of stock B with stock A?
Asset Beta, Debt Beta & Equity Beta
A. +.0076 C. Greater than .0076.
32. Which of the following is true?
B. -.0076 D. Less than -.0076. Gleim
A. bD > bA > bE C. bA > bE > bD
B. bE > bA > bD D. None of the above are true B&M
Currency Swaps Yes No Yes No B. Agrees to service the debt of the second company by making interest payments directly to the bank of the second
company, while the second company agrees in exchange to make interest payments to the bank of the first company.
Duration Hedging C. Buys the outstanding public debt of the second company and swaps the interest payments it receives on that debt for
46
. Duration hedging involves hedging interest-rate risk by matching the duration of assets with the duration of liabilities. Which the interest payments it must make on its own debt.
of the following is a true statement about duration hedging? (M) D. Agrees to exchange with the second company the difference between the interest charges on its own borrowings and
A. If duration increases, the volatility of the price of a debt instrument decreases. the interest charges on the borrowings of the second company. CIA 0596 IV-29
B. The goal of duration hedging is to equate the duration of assets with the duration of liabilities.
C. The firm is immunized against interest-rate risk when the total price change for assets equals the total price change Put Option
52
for liabilities. . A company has recently purchased some stock of a competitor as part of a long-term plan to acquire the competitor.
D. Duration is higher if the nominal rate on a debt instrument is higher. Gleim However, it is somewhat concerned that the market price of this stock could decrease over the short run. The company
could hedge against the possible decline in the stock's market price by CIA 0590 IV-57
Forward Contract A. Purchasing a call option on that stock. C. Selling a put option on that stock.
47
. A forward contract involves (E) B. Purchasing a put option on that stock. D. Obtaining a warrant option on that stock.
A. A commitment today to purchase a product on a specific future date at a price to be determined some time in the
future.
B. A commitment today to purchase a product some time during the current day at its present price. METHODS OF ANALYZING RISK
C. A commitment today to purchase a product on a specific future date at a price determined today. Sensitivity Analysis
53
D. A commitment today to purchase a product only when its price increases above its current exercise price. Gleim . Which of the following approaches would best analyze the risk of increasing the price of a table by $50? (E)
A. Sensitivity analysis. C. Informal method.
48
. If a corporation holds a forward contract for the delivery of U.S. Treasury bonds in 6 months and, during those 6 months, B. Simulation analysis. D. Certainty equivalent adjustments. Gleim
interest rates decline, at the end of the 6 months the value of the forward contract will have
A. Decreased. Simulation Analysis
54
B. Increased. . Which method for measuring risk considers both the sensitivity of changing NPVs and the range of values of the variables
C. Remained constant. that are changed?
D. Any of the answers may be correct, depending on the extent of the decline in interest rates. Gleim A. Simulation analysis. C. Sensitivity analysis.
B. The Capital Asset Pricing Model. D. Certainty equivalent adjustments. Gleim
Futures Contract
49
. A distinguishing feature of a futures contract is that Analysis of Pricing Technique
A. Performance is delayed. C. Delivery is to be on a specific day. Gleim 50. The acronym APT stands for:
B. It is a hedge, not a speculation. D. The price is marked to market each day. A. Arbitrage Pricing Model C. Analysis of Pricing Technique
B. Asset Pricing Tool D. Analysis Pricing Theory B&M
50
. An automobile company that uses the futures market to set the price of steel to protect a profit against price increases is an
example of 51. A "factor" in APT is a variable that:
A. A short hedge. A. Affects the return of risky assets in a systematic manner
B. A long hedge. B. Correlates with risky asset returns in an unsystematic manner
C. Selling futures to protect the company from loss. C. Is purely "noise"
D. Selling futures to protect against price declines. Gleim D. Affects the return of a risky asset in a random manner B&M
C. The financial markets will penalize firms that borrow even in moderate amounts.
COST OF CAPITAL D. Use of at least some debt financing will enhance the value of the firm. CMA 1288 1-5
In general
42. Cost of capital is (E) 26. The pre-tax cost of capital is higher than the after-tax cost of capital because (E)
a. The interest rate an entity must pay to borrow money. a. interest expense is deductible for tax purposes.
b. The return an entity’s stockholders expect on their investment . b. principal payments on debt are deductible for tax purposes.
c. The rate of return the entity can earn from investing available cash. c. the cost of capital is a deductible expense for tax purposes.
d. A concept of managerial finance incorporating all of the above. L&H d. dividend payments to stockholders are deductible for tax purposes. Barfield
58
13. Cost of capital is . The overall cost of capital is the
a. The amount the company must pay for its plant assets. A. Rate of return on assets that covers the costs associated with the funds employed.
b. The dividends a company must pay on its equity securities. B. Average rate of return a firm earns on its assets.
c. The cost the company must incur to obtain its capital resources. C. Minimum rate a firm must earn on high-risk projects.
d. The cost the company is charged by investment bankers who handle the issuance of equity or long-term debt D. Cost of the firm's equity capital at which the market value of the firm will remain unchanged. CMA 0692 1-11
securities. L&H
*. Which of these statements are pertinent to cost of capital? (D)
55
. The theory underlying the cost of capital is primarily concerned with the cost of 1. It is the expected return that investors demand for a given level of risk.
A. Long-term funds and old funds. 2. It may be employed as a benchmark for the evaluation of performance.
B. Short-term funds and new funds. 3. For investment decisions, it must be based on the current or prospective cost of the various capital components rather
C. Long-term funds and new funds. than on their historical costs.
D. Any combination of old or new, short-term or long-term funds. CMA 0692 1-13 4. It may also be used in acquisition analysis, liquidation studies and source of financing decisions.
5. It may differ from the hurdle rate used to reflect relative risk attributed to a specific project, division, or business unit.
56
. Management knowledge of the cost of capital is useful for each of the following except (D) RPCPA 1094
a. Making capital investment decisions. a. All five statements. c. Statements 1, 2, 3, and 4 only.
b. Managing working capital. b. Statements 1, 2 and 3 only. d. Statements 1, 2, 4 and 5 only.
c. Setting the maximum rate of return on new investments.
d. Evaluating performance. Gleim 25. Which of the following is incorrect?
a. The after-tax cost of debt for a firm with losses is equal to the interest rate on the debt.
57
. In referring to the graph of a firm's cost of capital, if e is the current position, which one of the following statements best b. Most debt is placed privately and thus there is no flotation cost.
explains the saucer or U-shaped curve? c. Flotation costs for preferred stock are higher than for debt.
d. Firms always pay dividends on their common stock issues because of the ease with which common shareholders can
assume control of the firm. S, S & S
a. Increase in the cost of debt as the debt-to-equity ratio increases. Cost of Debt Capital
61
b. Increases in the cost of debt and equity as the debt-to-equity ratio increases. . In computing the cost of capital, the cost of debt capital is determined by (E)
c. Increase in the cost of equity as the debt-to-equity ratio decreases. CMA 1291 1-2 a. Annual interest payment divided by the proceeds from debt issuance.
d. Decrease in the weighted-average cost of capital as the debt-to-equity ratio increases. b. Interest rate times (1 – the firm’s tax rate)
c. Annual interest payment divided by the book value of the debt.
d. The capital asset pricing model. Gleim
62
. If k is the cost of debt and t is the marginal tax rate, the after-tax cost of debt k, is best represented by the formula
a. ki = k/t c. ki = k(t)
b. ki =k/(1 – t) d. ki = k (1 – t) CMA 1288 1-3
63
. If Brewer Corporation's bonds are currently yielding 8% in the marketplace, why is the firm's cost of debt lower? (E)
A. Market interest rates have increased.
B. Additional debt can be issued more cheaply than the original debt.
C. There should be no difference; cost of debt is the same as the bonds' market yield.
D. Interest is deductible for tax purposes. CMA 0692 1-12
64
. Which of the following statements is most correct? (E)
a. Since the money is readily available, the cost of retained earnings is usually a lot cheaper than the cost of debt
financing.
b. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends
are tax deductible.
c. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are tax
deductible.
d. Statements a and b are correct.
e. Statements b and c are correct. Brigham
65
The interest rate on the bonds is greater for the second alternative consisting of pure debt than it is for the first alternative
consisting of both debt and equity because
A. The diversity of the combination alternative creates greater risk for the investor.
B. The pure debt alternative would flood the market and be more difficult to sell.
C. The pure debt alternative carries the risk of increasing the probability of default.
D. The combination alternative carries the risk of increasing dividend payments.
66
If a $1,000 bond sells for $1,125, which of the following statements are correct?
I. The market rate of interest is greater than the coupon rate on the bond.
II. The coupon rate on the bond is greater than the market rate of interest.
III. The coupon rate and the market rate are equal.
IV. The bond sells at a premium.
V. The bond sells at a discount.
a. I and IV. c. II and IV.
b. I and V. d. II and V. CMA 0695 1-6
RPCPA, AICPA. CMA & CIA EXAMINATION QUESTIONS Page 10 of 45
MANAGEMENT ADVISORY SERVICES RISKS
D. after-tax rate of interest for bonds and stated annual dividend rate less the expected earnings per share for preferred
*. If the return on total assets is 10% and if the return on common stockholders’ equity is 12% then (D) stock AICPA adapted
a. The after-tax cost of long-term debt is probably greater than 10%.
b. The after-tax cost of long-term debt is 12%. Cost of Debt vs. Cost of Equity Capital
69
c. Leverage is negative. . In general, it is more expensive for a company to finance with equity capital than with debt capital because (E)
d. The after-tax cost of long-term debt is probably less than 10%. RPCPA 1095 A. Long-term bonds have a maturity date and must therefore be repaid in the future.
B. Investors are exposed to greater risk with equity capital.
. Which of the following statements is most correct? (M) C. Equity capital is in greater demand than debt capital.
a. Suppose a firm is losing money and thus, is not paying taxes, and that this situation is expected to persist for a few D. Dividends fluctuate to a greater extent than interest rates. CMA 0690 1-15
years whether or not the firm uses debt financing. Then the firm’s after-tax cost of debt will equal its before-tax cost of
debt. Security Market Line
b. The component cost of preferred stock is expressed as k p(1 - T), because preferred stock dividends are treated as 46. The security market line (SML) shows the relationship between.
fixed charges, similar to the treatment of debt interest. A. Expected return and standard deviation
c. The reason that a cost is assigned to retained earnings is because these funds are already earning a return in the B. Expected return and beta
business; the reason does not involve the opportunity cost principle. Brigham C. Standard deviation and risk
d. The bond-yield-plus-risk-premium approach to estimating a firm’s cost of common equity involves adding a D. Variance and beta
subjectively determined risk-premium to the market risk-free bond rate.
38. The security market line (SML) is the graph of:
Marginal Cost of Debt A. Expected rate on investment (Y-axis) vs. variance of return
67
. The marginal cost of debt for a firm is defined as the interest rate on <List A> debt minus the <List B>. (M) B. Expected return on investment vs. standard deviation of return
CIA 0594 IV-48 List A List B C. Expected rate of return on investment vs. beta
A. New Firm's marginal tax rate D. A and B B&M
B. Outstanding Firm's marginal tax rate 70
C. New Interest rate times the firm's marginal tax rate The Security Market Line (SML) is (M)
D. Outstanding Interest rate times the firm's marginal tax rate a. the line that describes the expected return-beta relationship for well-diversified portfolios only.
b. also called the Capital Allocation Line.
68
. Which of the following statements is most correct? (E) c. the line that is tangent to the efficient frontier of all risky assets.
a. If a company’s tax rate increases but the yield to maturity of its noncallable bonds remains the same, the company’s d. the line that represents the expected return-beta relationship.
marginal cost of debt capital used to calculate its weighted average cost of capital will fall. e. the line that represents the relationship between an individual security’s return and the market’s return. Bodie
b. All else equal, an increase in a company’s stock price will increase the marginal cost of retained earnings, k s. 71
c. All else equal, an increase in a company’s stock price will increase the marginal cost of issuing new common equity, . The security market line (SML) (M)
ke. a. can be portrayed graphically as the expected return-beta relationship.
d. Statements a and b are correct. b. can be portrayed graphically as the expected return-standard deviation of market returns relationship.
e. Statements b and c are correct. Brigham c. provides a benchmark for evaluation of investment performance.
d. a and c.
Cost of Debt & Cost of Preferred Stock e. b and c. Bodie
17. The basis for measuring the cost of capital derived from bonds and preferred stock, respectively, is the (M) 72
A. after-tax rate of interest for bonds and stated annual dividend rate for preferred stock . In equilibrium, the marginal price of risk for a risky security must be (M)
B. pretax rate of interest for bonds and stated annual dividend rate less the expected earnings per share for preferred a. equal to the marginal price of risk for the market portfolio.
stock b. greater than the marginal price of risk for the market portfolio.
C. pretax rate of interest for bonds and stated annual dividend rate for preferred stock c. less than the marginal price of risk for the market portfolio.
d. adjusted by its degree of nonsystematic risk. Bodie
RPCPA, AICPA. CMA & CIA EXAMINATION QUESTIONS Page 11 of 45
MANAGEMENT ADVISORY SERVICES RISKS
77
. Which of the following statements is most correct? (M)
73
. An underpriced security will plot (E) a. The cost of retained earnings is the rate of return stockholders require on a firm’s common stock.
a. on the Security Market Line. b. The component cost of preferred stock is expressed as k p(1 - T), because preferred stock dividends are treated as
b. below the Security Market Line. fixed charges, similar to the treatment of debt interest.
c. above the Security Market Line. Bodie c. The bond-yield-plus-risk-premium approach to estimating a firm’s cost of common equity involves adding a
d. either above or below the Security Market Line depending on its covariance with the arket. subjectively determined risk-premium to the market risk-free bond rate.
e. either above or below the Security Market Line depending on its standard deviation. d. The higher the firm’s flotation cost for new common stock, the more likely the firm is to use preferred stock, which has
no flotation cost. Brigham
47. If a stock is overpriced it would plot:
A. Above the security market line C. Below the security market line Marginal Cost of Capital
78
B. On the security market line D. On the Y-axis B&M . If a company has a higher dividend-payout ratio, then, if all else if equal, it will have
a. A higher marginal cost of capital.
74
Which statement is not true regarding the Capital Market Line (CML)? (M) b. A lower marginal cost of capital.
a. The CML is the line from the risk-free rate through the market portfolio. c. A higher investment opportunity schedule.
b. The CML is the best attainable capital allocation line. d. A lower investment opportunity schedule. CIA 0597 IV-53
c. The CML is also called the security market line.
79
d. The CML always has a positive slope. Bodie . The firm’s marginal cost of capital (E)
a. Should be the same as the firm’s rate of return on equity.
Cost of Equity Capital b. Is unaffected by the firm’s capital structure. CMA 1291 1-8
24. Which of the following is true? c. In inversely related to the firm’s required rate of return used in capital budgeting.
a. Companies can raise common equity only by issuing new shares of common stock. d. Is a weighted-average of the investors’ required returns on debt and equity.
b. There is no opportunity cost associated with use of retained earnings as a source of common equity.
c. Most large mature firms issue new shares of common stock on a regular basis. Discounted Cash Flow Approach
d. Companies can raise common equity by issuing new shares of common stock and through retained earnings. . Which of the following factors in the discounted cash flow (DCF) approach to estimating the cost of common equity is the
S, S & S least difficult to estimate? (E)
a. Expected growth rate, g. c. Required return, ks.
Cost of Preferred Stock b. Dividend yield, D1/P0. d. Expected rate of return, k̂s . Brigham
75
. Which of the following statements is most correct? (M)
a. The before-tax cost of preferred stock may be lower than the before-tax cost of debt, even though preferred stock is 80
. Assume that nominal interest rates just increased substantially but that the expected future dividends for a company over
riskier than debt.
the long run were not affected. As a result of the increase in nominal interest rates, the company's stock price should
b. If a company’s stock price increases, this increases its cost of common equity.
A. Increase. C. Stay constant. CIA 0593 IV-49
c. If the cost of equity capital is low enough, it may be cheaper to issue common stock than it is to finance projects with
B. Decrease. D. Change, but in no obvious direction.
retained earnings.
d. Statements a and b are correct. Brigham
Dividend Growth Model
Variables
Cost of Retained Earnings 81
76 . The three elements needed to estimate the cost of equity capital for use in determining a firm's weighted-average cost of
. When calculating the cost of capital, the cost assigned to retained earnings should be (E)
capital are (E)
A. Zero.
A. Current dividends per share, expected growth rate in dividends per share, and current book value per share of
B. Lower than the cost of external common equity.
common stock.
C. Equal to the cost of external common equity.
B. Current earnings per share, expected growth rate in dividends per share, and current market price per share of
D. Higher than the cost of external common equity. CIA 1195 IV-43
common stock.
C. Current earnings pers share, expected growth rate in earnings per share, and current book value per share of Dividend Growth Model Formula
common stock. 12. The required rate of return on the market capitalization rate is estimated as follows:
D. Current dividends per share, expected growth rate in dividends per share, and current market price per share of A. Dividend yield + expected rate of growth in dividends
common stock. CMA 1291 1-3 B. Dividend yield - expected rate of growth in dividends
C. Dividend yield / expected rate of growth in dividends
Market Value of the Stock D. (Dividend yielD. * (expected rate of growth in dividends) B&M
82
. Which of the following criteria theoretically should be used to determine the valuation of common stock? (E)
A. Book value. C. Beta coefficient. Capital Asset Pricing Model (CAPM)
B. Dividends. D. Standard deviation of returns. Gleim 49. The acronym CAPM stands for:
A. Capital Asset Pricing Model C. Current Arbitrage Pricing Method B&M
83
. Which of the following is directly applied in determining the value of a stock when using the dividend growth model? B. Certainty Asset Pricing Method D. Cumulative Arbitrage Pricing Model
A. The firm's capital structure.
85
B. The firm's cash flows. . The capital asset pricing model assumes (E)
C. The firm's liquidity. a. all investors are price takers.
D. The investor's required rate of return on the firm's stock. CIA 1190 IV-53 b. all investors have the same holding period.
c. investors pay taxes on capital gains.
84
. The market value of a firm’s outstanding common shares will be higher, everything else equal, if (M) d. both a and b are true.
a. Investors have a lower required return on equity. e. a, b and c are all true. Bodie
b. Investors expect lower dividend growth.
c. Investors have longer expected holding periods. 33. If investors do not know their investment horizons for certain (M)
d. Investors have shorter expected holding periods. CIA 1196 IV-25 a. the CAPM is no longer valid.
b. the CAPM underlying assumptions are not violated.
25. The value of the stock: c. the implications of the CAPM are not violated as long as investors’ liquidity needs are not priced.
A. Increases as the dividend growth rate increases d. the implications of the CAPM are no longer useful. Bodie
B. Increases as the required rate of return decreases
C. Increases as the required rate of return increases 37. The capital asset pricing model (CAPM) states that:
D. Both A and B B&M A. The expected risk premium on an investment is proportional to its beta
B. The expected rate of return on an investment is proportional to its beta
Dividend Growth Rate C. The expected rate of return on an investment depends on the risk-free rate and the market rate of return B&M
14. Dividend growth rate for a stable firm can be estimated as: D. The expected rate of return on an investment is dependent on the risk-free rate
A. Plow back rate * the return on equity (ROE)
B. Plow back rate / the return on equity (ROE) 56. The drawback of the CAPM is that it:
C. Plow back rate +the return on equity (ROE) A. Ignores the return on the market portfolio
D. Plow back rate - the return on equity (ROE) B&M B. Required a single measure of systematic risk
C. Ignores risk-free return
24. The growth rate in dividends can be thought of as a sum of two parts. They are: D. Utilizes too many factors B&M
A. ROE and the Retention Ratio.
B. Dividend yield and growth rate in dividends Variables
86
C. ROA and ROE . An analysis of a company’s planned equity financing using the capital asset pricing model (or security market line) would
D. Book value per share and EPS B&M incorporate only the
a. Expected market earnings, the current U.S. Treasury bond yield, and the beta coefficient.
b. Expected market earnings and the price-earnings ratio.
RPCPA, AICPA. CMA & CIA EXAMINATION QUESTIONS Page 13 of 45
MANAGEMENT ADVISORY SERVICES RISKS
c. Current U.S. Treasury bond yield, the price-earnings ratio, and the beta coefficient. A. The ability to diversify risk
d. Current U.S. Treasury bond yield and the dividend payout ratio. CMA 1291 1-16 B. The change in the rate of return of an investment for a given change in the market rate of return
C. The actual return on an asset
Formula D. A and C B&M
87
According to the Capital Asset Pricing Model (CAPM), the expected rate of return on any security is equal to (M)
a. Rf + [E(RM)]. c. Rf + [E(RM - Rf]. 93
The market portfolio has a beta of (E)
b. Rf + [E(RM) - Rf]. d. E(RM) + Rf. Bodie a. 0. c. -1.
b. 1. d. 0.5. Bodie
Alpha Coefficient
88
According to the Capital Asset Pricing Model (CAPM), fairly priced securities (M) 44. A stock with a beta of zero would be expected to:
a. have positive betas. c. have negative betas. A. Have a rate of return equal to the risk-free rate
b. have zero alphas. d. have positive alphas. Bodie B. Have a rate of return equal to the market risk premium
C. Have a rate of return equal to zero
89
. According to the Capital Asset Pricing Model (CAPM), (M) D. Have a rate of return equal to the market rate of return B&M
a. a security with a positive alpha is considered overpriced.
b. a security with a zero alpha is considered to be a good buy. . Which of the following statements is most correct? (M)
c. a security with a negative alpha is considered to be a good buy. a. Beta measures market risk, but if a firm’s stockholders are not well diversified, beta may not accurately measure
d. a security with a positive alpha is considered to be underpriced. Bodie stand-alone risk.
xxx b. If the calculated beta underestimates the firm’s true investment risk, then the CAPM method will overestimate k s.
Beta Coefficient c. The discounted cash flow method of estimating the cost of equity can’t be used unless the growth component, g, is
37. The "beta" is a measure of: constant during the analysis period. Brigham
A. Unique risk C. Total risk d. An advantage shared by both the DCF and CAPM methods of estimating the cost of equity capital, is that they yield
B. Market risk D. None of the above B&M precise estimates and require little or no judgement.
90
. A measure that describes the risk of an investment project relative to other investments in general is the (E) . Which of the following statements is correct? (M)
A. Coefficient of variation. C. Standard deviation. a. The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that
B. Beta coefficient. D. Expected return. CIA 1187 IV-66 project.
b. The cost of debt used to calculate the weighted average cost of capital is based on an average of the cost of debt
91
. What is the formula for the beta coefficient of a security? already issued by the firm and the cost of new debt.
A. Covariance of the returns on the market and on the security ÷ Variance of the return on the market. c. One problem with the CAPM approach to estimating the cost of equity capital is that if a firm’s stockholders are, in
B. Covariance of the returns on the market and on the security x Variance of the return on the market. fact, not well diversified, beta may be a poor measure of the firm’s true investment risk.
C. Variance of the return on the market ÷ Variance of the return on the security. d. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method of estimating a firm’s cost
D. Variance of the return on the market x Variance of the return on the security ÷ Covariance of the returns on the market of equity capital.
and on the security. Gleim e. The cost of equity capital is generally easier to measure than the cost of debt, which varies daily with interest rates, or
the cost of preferred stock since preferred stock is issued infrequently. Brigham
92
The market risk, beta, of a security is equal to (M)
94
a. the covariance between the security’s return and the market return divided by the variance of the market's returns. . In the context of the Capital Asset Pricing Model (CAPM) the relevant measure of risk is (E)
b. the covariance between the security and market returns divided by the standard deviation of the market's returns. a. unique risk. c. standard deviation of returns.
c. the variance of the security's returns divided by the covariance between the security and market returns. Bodie b. beta. d. variance of returns. Bodie
d. the variance of the security's returns divided by the variance of the market's returns.
45. A stock with a beta of 1.2 would be expected to:
39. Beta measures: A. Increase 20% faster than the market in up markets
RPCPA, AICPA. CMA & CIA EXAMINATION QUESTIONS Page 14 of 45
MANAGEMENT ADVISORY SERVICES RISKS
B. Increase 20% faster than the market in down markets A. 3% increase C. No change
C. Increase 120% faster than the market in up markets B. 1.5% increase D. 1.5% decrease Gleim
D. Increase 120% faster than the market in down markets B&M
12 According to the Capital Asset Pricing Model (CAPM), which one of the following statements is false? (M)
Risk-free Rate a. The expected rate of return on a security decreases in direct proportion to a decrease n the risk-free rate.
95
. What is the expected return of a zero-beta security? (M) b. The expected rate of return on a security increases directly with its beta.
a. The market rate of return. c. A negative rate of return. c. A fairly priced security has an alpha of zero.
b. Zero rate of return. d. The risk-free rate. Bodie d. In equilibrium, all securities lie on the security market line. Bodie
Risk Premium
96
. The difference between the required rate of return on a given risky investment and that on a riskless investment with the Weighted-Average Cost of Capital (WACC)
same expected return is the In general
A. Risk premium. C. Standard deviation. 1. The cost of capital is defined as (E)
B. Coefficient of variation. D. Beta coefficient. CIA 1192 IV-48 a. the simple average of the interest rates of all debt outstanding.
b. the simple average of the cost of debt and equity.
36. The market risk premium is: c. the weighted average of the interest rates of all debt outstanding.
A. The difference between the rate of return on an asset and the risk-free rate d. the weighted average of the cost of debt and equity. S, S & S
B. The difference between the rate of return on the market portfolio and the risk-free rate
C. The risk-free rate 28. The combined weighted average interest rate that a firm incurs on its long-term debt, preferred stock, and common stock is
D. The market rate of return B&M the
a. cost of capital. c. cutoff rate.
Pure Play Method b. discount rate. d. internal rate of return. Barfield
. Which of the following methods involves calculating an average beta for firms in a similar business and then applying that
100
beta to determine a project’s beta? (M) . A company has made the decision to finance next year's capital projects through debt rather than additional equity. The
a. Risk premium method. c. Accounting beta method. benchmark cost of capital for these projects should be (M)
b. Pure play method. d. CAPM method. Brigham A. The before-tax cost of new-debt financing.
B. The after-tax cost of new-debt financing.
Sensitivity Analysis C. The cost of equity financing.
97
. According to the CAPM, the risk premium an investor expects to receive on any stock or portfolio increases: (E) D. The weighted-average cost of capital. CIA 0597 IV-42
a. directly with alpha. d. inversely with beta.
b. inversely with alpha. e. in proportion to its standard deviation. . Which of the following is not considered a capital component for the purpose of calculating the weighted average cost of
c. directly with beta. Bodie capital as it applies to capital budgeting? (E)
a. Long-term debt. c. Short-term debt.
98
. The risk premium on the market portfolio will be proportional to (M) b. Common stock. d. Preferred stock. Brigham
a. the average degree of risk aversion of the investor population.
101
b. the risk of the market portfolio as measured by its variance. . Which of the following is true regarding the calculation of a firm's cost of capital? (E)
c. the risk of the market portfolio as measured by its beta. A. The cost of capital of a firm is the weighted-average cost of its various financing components.
d. both a and b are true. B. All costs should be expressed as pre-tax costs.
e. both a and c are true. Bodie C. The time value of money should be excluded from the calculations.
D. The cost of capital is the cost of equity. CMA 1288 1-2
99
. If the return on the market portfolio is 10% and the risk-free rate is 5%, what is the effect on a company's required rate of
return on its stock of an increase in the beta coefficient from 1.2 to 1.5? 108. The weighted average cost of capital represents the
RPCPA, AICPA. CMA & CIA EXAMINATION QUESTIONS Page 15 of 45
MANAGEMENT ADVISORY SERVICES RISKS
a. cost of bonds, preferred stock, and common stock divided by the three sources. D. The time value of money should be incorporated into the calculations. CMA 1288 1-2
b. equivalent units of capital used by the organization.
c. overall cost of capital from all organization financing sources. 23. Which of the following is true regarding the weighted-average cost of capital?
d. overall cost of dividends plus interest paid by the organization. Barfield a. A company may have two weighted-average costs of capital if the firm's capital structure is so large that new common
stock must be sold.
29. The weighted average cost of capital that is used to evaluate a specific project should be based on the b. The book value of the components of capital should always be used to calculate the weighted-average cost of capital.
a. mix of capital components that was used to finance a project from last year. c. The cost of common equity is lower than the cost of retained earnings.
b. overall capital structure of the corporation. d. The cost of preferred stock is adjusted for the tax deduction associated with preferred dividends. S, S & S
c. cost of capital for other corporations with similar investments.
d. mix of capital components for all capital acquired in the most recent fiscal year. Barfield Sensitivity Analysis
. For a typical firm with a given capital structure, which of the following is correct? (Note: All rates are after taxes.) (E)
102
. Which of the following statements is most correct? (E) a. kd > ke > ks > WACC. c. WACC > ke > ks > kd.
a. The WACC is a measure of the before-tax cost of capital. b. ks > ke > kd > WACC. d. ke > ks > WACC > kd. Brigham
b. Typically the after-tax cost of debt financing exceeds the after-tax cost of equity financing.
c. The WACC measures the marginal after-tax cost of capital. 33. Which of the following is true?
d. Statements a and b are correct. A. rD < rA < rE C. rE < rA < rD
e. Statements b and c are correct. Brigham B. rE < rD < rA D. None of the above are true B&M
103
. Which of the following statements is most correct? (E)
a. The WACC represents the after-tax cost of capital. 31. Generally, which of the following is true?
b. The WACC represents the marginal cost of capital. A. rD > rA > rE C. rE > rA > rD
c. The cost of retained earnings is generally more expensive than the cost of issuing new common stock, because it B. rE > rD > rA D. None of the above are true B&M
includes an opportunity cost.
d. Statements a and b are correct. 105
. The weighted-average cost of capital (WACC) increases with
e. All of the statements above are correct. Brigham A. Increases in corporate tax rate.
B. Increases in market price of bonds.
22. Which of the following regarding the weighted-average cost of capital is true? C. Increases in dividend payments.
a. The tax effect of preferred stock dividends should be included in the calculation of weighted-average cost of capital. D. Increases in market price of stocks. CIA MB 1004
b. The tax effect of common stock dividends should be included in the calculation of weighted-average cost of capital.
c. The tax effect of debt should be included in the calculation of the weighted-average cost of capital. 18. The weighted-average cost of capital approach to decision making is not directly affected by the: (E)
d. Taxes do not affect the weighted-average cost of capital. S, S & S A. proposed mix of debt, equity, and existing funds used to implement the project
B. value of the common stock
30. Debt in the capital structure could be treated as if it were common equity in computing the weighted average cost of capital C. cost of debt outstanding
if the debt were D. current budget for expansion AICPA adapted
a. callable. c. cumulative.
b. participating. d. convertible. Barfield 106
. Wyden Brothers has no retained earnings. The company uses the CAPM to calculate the cost of equity capital. The
company’s capital structure consists of common stock, preferred stock, and debt. Which of the following events will reduce
104
. When calculating a firm's cost of capital, all of the following are true except that (E) the company’s WACC? (M)
A. The cost of capital of a firm is the weighted average cost of its various financing components. a. A reduction in the market risk premium.
B. The calculation of the cost of capital should focus on the historical costs of alternative forms of financing rather than b. An increase in the flotation costs associated with issuing new common stock.
market or current costs. c. An increase in the company’s beta.
C. All costs should be expressed as after-tax costs. d. An increase in expected inflation.
RPCPA, AICPA. CMA & CIA EXAMINATION QUESTIONS Page 16 of 45
MANAGEMENT ADVISORY SERVICES RISKS
e. An increase in the flotation costs associated with issuing preferred stock. Brigham C. Equal to the overall rate of return required on the levered firm
D. All of the above B&M
107
. Which of the following statements is correct? (M)
a. Because we often need to make comparisons among firms that are in different income tax brackets, it is best to 111
. Campbell Co. is trying to estimate its weighted average cost of capital (WACC). Which of the following statements is most
calculate the WACC on a before-tax basis. correct? (E)
b. If a firm has been suffering accounting losses and is expected to continue suffering such losses, and therefore its tax a. The after-tax cost of debt is generally cheaper than the after-tax cost of preferred stock.
rate is zero, it is possible that its after-tax component cost of preferred stock as used to calculate the WACC will be b. Since retained earnings are readily available, the cost of retained earnings is generally lower than the cost of debt.
less than its after-tax component cost of debt. c. If the company’s beta increases, this will increase the cost of equity financing, even if the company is able to rely on
c. Normally, the cost of external equity raised by issuing new common stock is above the cost of retained earnings. only retained earnings for its equity financing.
Moreover, the higher the growth rate is relative to the dividend yield, the more the cost of external equity will exceed d. Statements a and b are correct.
the cost of retained earnings. e. Statements a and c are correct. Brigham
d. The lower a company’s tax rate, the greater the advantage of using debt in terms of lowering its WACC. Brigham
112
. Which of the following statements about the cost of capital is incorrect? (E)
108
. Which of the following statements is correct? (M) a. A company’s target capital structure affects its weighted average cost of capital.
a. The WACC should include only after-tax component costs. Therefore, the required rates of return (or “market rates”) b. Weighted average cost of capital calculations should be based on the after-tax costs of all the individual capital
on debt, preferred, and common equity (k d, kp, and ks) must be adjusted to an after-tax basis before they are used in components.
the WACC equation. Brigham c. If a company’s tax rate increases, then, all else equal, its weighted average cost of capital will increase.
b. The cost of retained earnings is generally higher than the cost of new common stock. d. Flotation costs can increase the weighted average cost of capital.
c. Preferred stock is riskier to investors than is debt. Therefore, if someone told you that the market rates showed k d > kp e. An increase in the risk-free rate is likely to increase the marginal costs of both debt and equity financing. Brigham
for a given company, that person must have made a mistake.
d. If a company with a debt ratio of 50 percent were suddenly exempted from all future income taxes, then, all other Expected Return vs. Required Rate of Return
things held constant, this would cause its WACC to increase. 113
. Security X has an expected rate of return of 0.11 and a beta of 1.5. The risk-free rate is 0.05 and the market expected rate of
return is 0.09. According to the Capital Asset Pricing Model, this security is (M)
109
. Which of the following statements is most correct? (M) a. underpriced.
a. The weighted average cost of capital for a given capital budget level is a weighted average of the marginal cost of b. overpriced.
each relevant capital component that makes up the firm’s target capital structure. c. fairly priced.
b. The weighted average cost of capital is calculated on a before-tax basis. d. cannot be determined from data provided. Bodie
c. An increase in the risk-free rate is likely to increase the marginal costs of both debt and equity financing.
d. Statements a and c are correct. Brigham 114
. The risk-free rate is 7 percent. The expected market rate of return is 15 percent. If you expect stock X with a beta of 1.3 to offer
a rate of return of 12 percent, you should (M)
110
. A company has a capital structure that consists of 50 percent debt and 50 percent equity. Which of the following a. buy stock X because it is overpriced.
statements is most correct? (E) b. sell short stock X because it is overpriced.
a. The cost of equity financing is greater than or equal to the cost of debt financing. c. sell stock short X because it is underpriced.
b. The WACC exceeds the cost of equity financing. d. buy stock X because it is underpriced. Bodie
c. The WACC is calculated on a before-tax basis.
d. The WACC represents the cost of capital based on historical averages. In that sense, it does not represent the 115
. Given the following two stocks A and B
marginal cost of capital. Expected rate of return Beta
e. The cost of retained earnings exceeds the cost of issuing new common stock. Brigham A 0.12 1.2
B 0.14 1.8
21. The cost of capital for a firm, rWACC, in a tax-free environment is: If the expected market rate of return is 0.09 and the risk-free rate is 0.05, which security would be considered the better
A. Equal to the expected EBIT divided by market value of the unlevered firm buy and why? (M)
B. Equal to rA, the rate of return for that business risk class a. A because it offers an expected excess return of 1.2%.
RPCPA, AICPA. CMA & CIA EXAMINATION QUESTIONS Page 17 of 45
MANAGEMENT ADVISORY SERVICES RISKS
c. Managers often have a responsibility to provide continuous service; they must preserve the long-run viability of the
120
enterprise. Thus, the goal of employing leverage to maximize short-run stock price and minimize capital cost may . The percentage change in earnings before interest and taxes associated with the percentage change in sales volume
conflict with long-run viability. represents the degree of (E)
d. All of the statements above are correct. A. Operating leverage. C. Breakeven leverage.
e. None of the statements above represents a serious impediment to the practical application of leverage analysis in B. Financial leverage. D. Combined leverage. CIA 1189 IV-54
capital structure determination. Brigham
121
. The degree of operating leverage (DOL) is
Operating Leverage A. Constant at all levels of sales.
119
. Which class of leverage causes earnings before interest and taxes to be more sensitive to changes in sales? (M) B. A measure of the change in earnings available to common stockholders associated with a given change in operating
A. Credit. C. Operating. earnings.
B. Financial. D. Intrinsic. CIA 0593 IV-57 C. A measure of the change in operating income resulting from a given change in sales.
D. Lower if the degree of total leverage is higher, other things held constant. CIA 0594 IV-52
122
. Companies experience changes in interest expenses, variable cost per unit, quantity of units sold, and fixed costs. Their
degree of operating leverage is not affected by the change in
A. Interest expenses. C. Quantity of units sold.
B. Variable cost per unit. D. Fixed costs. CIA 1193 IV-53
123
. A firm with a higher degree of operating leverage when compared to the industry average implies that the
A. Firm has higher variable costs.
B. Firm's profits are more sensitive to changes in sales volume.
C. Firm is more profitable.
D. Firm is less risky. CMA 0695 1-1
Financial Leverage
*. Securing the funds for investment at a fixed rate of return to fund suppliers, to enhance the well-being of the common
stockholders is known as
a. Financial leverage. c. Prudent borrowing.
b. Fund management. d. Financial arbitrage. RPCPA 1097
*. It refers to the practice of financing assets with borrowed capital. Its extensive use may impact on the return on common
stockholders’ equity to be above or below the rate of return on total assets.
a. Discounting. c. Leverage.
b. Mortgage. d. Arbitrage. RPCPA 0597
*. This accounting terminology has reference to long-term debt and means that you borrow somebody’s money at an interest *. The use of borrowed capital by business firms is referred to as leverage or trading on equity. This leverage is likely to be a
rate which is lower than the rate which you can earn on that money. sound financial strategy for stockholders of companies having
a. Pooling of interest. c. Kiting. a. Cyclical high and low amounts of reported earnings.
b. Leverage or trading on equity. d. None of the above. RPCPA 1084 b. Steady amounts of reported earnings.
c. Volatile fluctuation in reported earnings over short periods of time.
d. Steadily declining amounts of reported earnings. RPCPA 1079
124
. The purchase of treasury stock with a firm's surplus cash CMA 1291 1-5
A. Increases a firm's assets. C. Increases a firm's interest coverage ratio.
B. Increases a firm's financial leverage. D. Dilutes a firm's earnings per share.
125
. When a company increases its degree of financial leverage (DFL)
a. The equity beta of the company falls.
b. The systematic risk of the company falls.
c. The systematic risk of the company rises.
d. The standard deviation of returns on the equity of the company rises. CIA 0597 IV-50
126
. Sylvan Corporation has the following capital structure.
Debenture bonds $10,000,000
Preferred equity 1,000,000
Common equity 39,000,000
The financial leverage of Sylvan Corporation would increase as a result of (M)
A. Issuing common stock and using the proceeds to retire preferred stock.
B. Maintaining the same dollar level of cash dividends as the prior year, even though earnings have increased by 7%.
C. Financing its future investments with a higher percentage of bonds.
D. Financing its future investments with a higher percentage of equity funds. CMA 0690 1-9
127
. Everything else being equal, a <List A> highly leveraged firm will have <List B> earnings
per share. (D)
CIA 0595 IV-51 A. B. C. D.
List A More More Less Less
List B Lower Less volatile Less volatile Higher
128
. A company is considering the early retirement of its 10%, 10-year bonds payable. Before retiring the bonds, the company's
capital structure was
Current liabilities $125,000
Long-term liabilities:
Notes payable (due in 5 years) 200,000
Bonds payable 300,000
Premium on bonds payable 25,000
Owner's equity:
RPCPA, AICPA. CMA & CIA EXAMINATION QUESTIONS Page 20 of 45
MANAGEMENT ADVISORY SERVICES RISKS
Common shares ($5 par value) 150,000 d. Statements a and b are correct.
Share premium in excess of par 50,000 e. Statements b and c are correct. Brigham
Retained earnings 450,000
133
If the bonds can be retired at 103.5%, the CIA 1193 IV-48 . Company A and Company B have the same total assets, operating income (EBIT), tax rate, and business risk. Company A,
A. Debt-equity ratio will increase. C. Asset turnover ratio will decrease. however, has a much higher debt ratio than Company B. Company A’s basic earning power (BEP) exceeds its cost of debt
B. Financial leverage will decrease. D. Return on owner's equity will decrease. financing (kd). Which of the following statements is most correct? (M)
a. Company A has a higher return on assets (ROA) than Company B.
Financial leverage and EPS b. Company A has a higher times interest earned (TIE) ratio than Company B.
129
. Volga Publishing is considering a proposed increase in its debt ratio, which will also increase the company’s interest c. Company A has a higher return on equity (ROE) than Company B, and its risk, as measured by the standard deviation
expense. The plan would involve the company issuing new bonds and using the proceeds to buy back shares of its of ROE, is also higher than Company B’s.
common stock. The company’s CFO expects that the plan will not change the company’s total assets or operating income. d. Statements b and c are correct. Brigham
However, the company’s CFO does estimate that it will increase the company’s earnings per share (EPS). Assuming the
CFO’s estimates are correct, which of the following statements is most correct? (E) Comprehensive
a. Since the proposed plan increases Volga’s financial risk, the company’s stock price still might fall even though its EPS 20. Which of the following statements is most correct? (M)
is expected to increase. a. Firms whose sales are very sensitive to changes in the business cycle are more likely to rely on debt financing.
b. If the plan reduces the company’s WACC, the company’s stock price is also likely to decline. b. Firms with large tax loss carry forwards are more likely to rely on debt financing.
c. Since the plan is expected to increase EPS, this implies that net income is also expected to increase. c. Firms with a high operating leverage are more likely to rely on debt financing.
d. Statements a and b are correct. d. Statements a and c are correct.
e. Statements a and c are correct. Brigham e. None of the statements above is correct. Brigham
130
. Which of the following statements is most correct? (E) 134
. Which of the changes in leverage would apply to a company that substantially increases its
a. Increasing financial leverage is one way to increase a firm’s basic earning power (BEP). investment in fixed assets as a proportion of total assets and replaces some of its long-term
b. Firms with lower fixed costs tend to have greater operating leverage. debt with equity? (M)
c. The debt ratio that maximizes EPS generally exceeds the debt ratio which maximizes share price.
d. Statements a and b are correct. CIA 0590 IV-56 A. B. C. D.
e. Statements a and c are correct. Brigham Financial Leverage Increase Decrease Increase Decrease
Operating Leverage Decrease Increase Increase Decrease
Financial leverage and ratios
131
. Company A and Company B have the same tax rate, the same total assets, and the same basic earning power. Both INSURANCE
companies have a basic earning power that exceeds their before-tax costs of debt, k d. However, Company A has a higher In general
135
debt ratio and higher interest expense than Company B. Which of the following statements is most correct? (E) . Insurance may best be defined as
a. Company A has a lower net income than B. A. A system for transferring risk through risk avoidance or loss control.
b. Company A has a lower ROA than B. B. Any contract that conveys an insurable interest.
c. Company A has a lower ROE than B. C. A form of pure risk called gambling. Gleim
d. Statements a and b are correct. Brigham D. A means of combining many loss exposures so that losses are shared by all participants.
136
132
. Firm U and Firm L each have the same total assets. Both firms also have a basic earning power of 20 percent. Firm U is . Which of the following is the best functional definition of insurance?
100 percent equity financed, while Firm L is financed with 50 percent debt and 50 percent equity. Firm L’s debt has a A. A legal contract by which the insurer, in return for consideration, agrees to pay another person if a stated loss or injury
before-tax cost of 8 percent. Both firms have positive net income. Which of the following statements is most correct? (E) occurs.
a. The two companies have the same times interest earned (TIE) ratio. B. A legal contract by which an insurance company, in return for premiums, agrees to pay the policyholder if a certain
b. Firm L has a lower ROA. event occurs.
c. Firm L has a lower ROE. C. A written promise by the insurer to pay the beneficiary if loss occurs from the occurrence of a contingent event.
RPCPA, AICPA. CMA & CIA EXAMINATION QUESTIONS Page 21 of 45
MANAGEMENT ADVISORY SERVICES RISKS
143
D. A writing issued by an insurance company, for a consideration, that promises to indemnify a beneficiary for a loss from . A fire insurance policy ordinarily indemnifies for losses arising from
an existing risk or one which arises later. Gleim A. Friendly, but not hostile, fires.
B. Hostile, but not friendly, fires.
137
. In which way does the formation of an insurance contract differ from any other contract? C. Both hostile and friendly fires.
A. The requirement that the insured must have an insurable interest. D. Smoke produced by friendly or hostile fires. Gleim
B. The insurance contract is not valid unless written.
144
C. Consideration is not needed for the formation of an insurance contract. . Which of the following wrongful acts prevents recovery under a policy of fire insurance?
D. In insurance, only the insured can commit a breach. Gleim A. Arson by the insured's employees or agents.
B. Arson by third persons unrelated to the insured.
Life Insurance C. An act by the insured intended to cause the damage.
138
. Life insurance D. Gross negligence but not amounting to recklessness and willful misconduct. Gleim
A. Is a contract of indemnity. C. Covers only the mortality risk.
145
B. Usually has short-term policies. D. Generally has no cash value. Gleim . Which of the following is not a type of insurance policy that provides liability coverage?
A. Malpractice insurance. C. Automobile insurance.
139
. Life insurance is offered in several forms. The kind that offers no investment feature is B. Homeowners insurance. D. Fire insurance. Gleim
A. Whole life. C. Straight life.
146
B. Endowment. D. Term. Gleim . The purpose of a co-insurance clause is to
A. Encourage policyholders to bear a proportionate part of any loss.
140
. The typical life insurance policy contains B. Encourage insurers to pay the face amount of the policy in the event of a partial loss on the part of the insured.
A. No exclusion for death during military service. C. Encourage policyholders to insure commercial property for an amount that is near to its full replacement cost.
B. A clause allowing coverage for death during noncommercial flight. D. Encourage policyholders to insure commercial property for an amount that is significantly less than its full replacement
C. A prohibition on reinstatement. cost. Gleim
D. A provision for a grace period for premium payment. Gleim
Theft Insurance
141 147
. Jon Berstock is an employee of PR, Inc. During his employment, the corporation's earnings have doubled, largely because . Jewelry, Inc. took out an insurance policy with Insurance Company which covered the stock of jewelry. Insurance agreed to
of Jon's ability to attract new accounts. PR therefore insured his life for a substantial sum. If Jon dies, will PR be able to indemnify for losses due to theft of the jewels displayed. The application contained the following provision: "It is hereby
collect the insurance proceeds? warranted that the maximum value of the jewelry displayed shall not exceed $10,000." The insurance policy's coverage
A. Yes, because a corporation has an insurable interest in all its employees since it can act only through agents. was for $8,000. Subsequently, thieves smashed the store window and stole $4,000 worth of jewels when the total value of
B. Yes, because PR has a pecuniary interest in Jon's continued life. the display was $12,000. Which of the following is correct?
C. No, because PR will continue to exist after Jon's death. A. Jewelry, Inc. will recover nothing.
D. No, because Jon was not a stockholder or officer of PR, Inc. Gleim B. Jewelry, Inc. will recover $2,000, the loss less the amount in excess of the $10,000 display limitation.
C. Jewelry, Inc. will recover the full $4,000 since the warranty will be construed as a mere representation.
Fire Insurance D. Jewelry, Inc. will recover the full $4,000 since attaching the application to the policy is insufficient to make it a part
142
. Which of the following is a characteristic of fire insurance? thereof. AICPA 1181 L-55
A. It is more standardized than life insurance.
B. It is written for a relatively short period but usually includes an incontestability clause.
C. A policy must be valued and contain a pro rata clause.
D. The insurable interest must be an ownership interest in the property itself. Gleim
ANSWER EXPLANATIONS
Investment Risk
Financial Risk
Optimal Capital Structure
Cost of Capital
Debt Capital vs. Equity Capital
Imputed Costs vs. Explicit Costs
Cost of Debt Capital
Marginal Cost of Debt
Cost of Equity Capital
Marginal Cost of Capital
Optimal Cost of Capital
Dividend Growth Model
Capital Asset Pricing Model (CAPM)
Leverage
Probability & Statistics
73
. An underpriced security will have a higher expected return than the SML would predict; therefore it will plot above
the SML.
74
. Both the Capital Market Line and the Security Market Line depict risk/return relationships. However, the risk measure
for the CML is standard deviation and the risk measure for the SML is beta (thus c is not true; the other statements are true).
75
. Statement a is correct. Most preferred stock is owned by corporations which receive a 70 percent exclusion of
dividends. Consequently, the before-tax coupons on preferred stock are often lower than the before-tax coupons on
debt, despite the fact that preferred stock is riskier than debt. All the other statements are false.
76
. Answer (B) is correct. Newly issued or external common equity is more costly than retained earnings. The company
incurs issuance costs when raising new, outside funds.
Answer (A) is incorrect because the cost of retained earnings is the rate of return stockholders require on equity capital
the firm obtains by retaining earnings. The opportunity cost of retained funds will be positive. Answer (C) is incorrect
because retained earnings will always be less costly than external equity financing. Earnings retention does not require
the payment of issuance costs. Answer (D) is incorrect because retained earnings will always be less costly than
external equity financing. Earnings retention does not require the payment of issuance costs.
77
. Statement a is correct; the other statements are false. Preferred stock dividends are not tax deductible; therefore,
the cost of preferred stock is only k p. The risk premium in the bond-yield-plus-risk premium approach would be added to
the firm’s cost of debt, not the risk-free rate. Preferred stock also has flotation costs.
78
. REQUIRED: The effect of a higher dividend-payout ratio.
DISCUSSION: (A) the higher the dividend-payout ratio, the sooner retained earnings are exhausted and the company
must seek external financing. Assuming the same investments are undertaken, the result is a higher marginal cost of
capital because lower-cost capital sources will be used up earlier.
Answer (B) is incorrect because the marginal cost of capital is higher. Answers (C) and (D) are incorrect because the
existence of investment opportunities is unrelated to the dividend payout.
79
. Answer (D) is correct. The marginal cost of capital is the cost of the next dollar of capital. The marginal cost
continually increases because the lower cost sources of funds are used first. The marginal cost represents a weighted
average of both debt and equity capital.
Answer (A) is incorrect because, if the cost of capital were the same as the rate of return on equity (which is usually
higher than that of debt capital), there would be no incentive to invest. Answer (B) is incorrect because the marginal cost
of capital is affected by the degree of debt in the firm's capital structure. Financial risk plays a role in the returns desired
by investors. Answer (C) is incorrect because the rate of return used for capital budgeting purposes should be at least as
high as the marginal cost of capital.
80
. Answer (B) is correct. The dividend growth model is used to calculate the price of stock.
D1
Po =
R-G
If: PO = current price
D1 = next dividend
R = required rate of return
G = EPS growth rate
Assuming that D1 and G remain constant, an increase in R resulting from an increase in the nominal interest rate will
cause PO to decrease.
Answer (A) is incorrect because a higher interest rate raises the required return of investors, which results in a lower
stock price. Answer (C) is incorrect because a higher interest rate raises the required return of investors, which results
in a lower stock price. Answer (D) is incorrect because a higher interest rate raises the required return of investors,
which results in a lower stock price.
81
. Answer (D) is correct. The Gordon (dividend) growth model requires three elements to estimate the cost of equity
capital. These are the dividends per share, the expected growth rate in dividends per share, and the market price of the
stock. Basically, the cost of equity capital can be computed as the dividend yield (dividends ÷ price) plus the growth rate.
Answer (A) is incorrect because book value per share is not a consideration in computing the cost of equity capital.
Answer (B) is incorrect because current dividends, not current earnings, per share are a requirement for the formula.
Answer (C) is incorrect because book value per share is not a consideration in computing the cost of equity capital. Also,
current dividends, not current earnings, per share are a requirement for the formula.
82
. Answer (B) is correct. The measure of the value of an individual stock is dependent entirely upon the stream of
future cash flows that it will produce. To determine the stock's current value, these cash flows should be discounted to
time zero (now) to obtain the stream's present value. Stocks primarily provide cash flows to investors via dividends
(including share repurchases and liquidating dividends) and capital gain (loss) at the time of sale. Once the stream of
cash flows has been discounted over a significant number of periods, it is easy to see that the dividend stream, not the
capital gain (loss) in the final period, drives the value of the stock in question. Of course, all firms do not pay a dividend.
Common financial theory, however, states that it is the intention of every firm to pay a dividend to shareholders at some
time in the future, once the firm feels it is strong enough to do so and still support future operations. After all, it is the
primary goal of a firm's management to maximize shareholder wealth. Although many factors should be considered
when purchasing a security, the primary consideration for a value-seeking investor is the future cash flow stream.
Answer (A) is incorrect because book value is a measure of the stock's worth on a company's accounting records.
Answer (C) is incorrect because the beta coefficient is a measure of how volatile the price movements of a stock are
relative to the market as a benchmark. Answer (D) is incorrect because standard deviation is a measure of risk. While
risk is a consideration for the investor, one of the fundamental concepts in finance is that there is (should be) a trade-off
between risk and return, and as long as risk is compensated for, it is not a primary consideration.
83
. Answer (D) is correct. The dividend growth model is used to calculate the cost of equity. The simplified formula is
D1
R= +G
PO
R is the required rate of return, D1 is the next dividend, PO is the stock's price, and G is the growth rate in earnings per
share. The equation is also used to determine the stock price.
D1
Po =
R-G
Answer (A) is incorrect because the model uses the growth rate in dividends and the investor's required rate of return.
Answer (B) is incorrect because the model uses the growth rate in dividends and the investor's required rate of return.
Answer (C) is incorrect because the model uses the growth rate in dividends and the investor's required rate of return.
84
. REQUIRED: The item resulting in a higher market value for common shares.
DISCUSSION: (A) The dividend growth model is used to calculate the cost of equity. The simplified formula is
D
R= +G
P
R is the required rate of return, D is the next dividend, P is the stock’s price, and G is the growth rate in earnings per
share. The equation is also used to determine the stock price.
D
P=
R-G
Thus, when investors have a lower required return on equity, the denominator is smaller, which translates in to a higher
market value.
Answer (B) is incorrect because, if investors expect lower dividend growth, the market value of common shares will
decrease. Answers (C) and (D) are incorrect because the expected holding periods of investors are not related to the
market value of the common shares.
85
. The CAPM assumes that investors are price-takers with the same single holding period and that there are no taxes
or transaction costs.
86
. Answer (A) is correct. The capital asset pricing model adds the risk-free rate to the product of the market risk
premium and the beta coefficient. The market risk premium is the amount above the risk-free rate (approximated by the
U.S. treasury bond yield) that must be paid to induce investment in the market. The beta coefficient of an individual stock
is the correlation between the price volatility of the stock market as a whole and the price volatility of the individual stock.
Answer (B) is incorrect because the price-earnings ratio is not a component of the model. Answer (C) is incorrect
because the price-earnings ratio is not a component of the model. Answer (D) is incorrect because the dividend payout
ratio is not a component of the model.
87
. The expected rate of return on any security is equal to the risk free rate plus the systematic risk of the security (beta)
times the market risk premium, E(rM - Rf).
88
. A zero alpha results when the security is in equilibrium (fairly priced for the level of risk).
89
. A security with a positive alpha is one that is expected to yield an abnormal rate of return, based on the perceived risk of
the security, and thus is underpriced.
90
. Answer (B) is correct. The required rate of return on equity capital in the Capital Asset Pricing Model is the risk-free
rate (determined by government securities), plus the product of the market risk premium times the beta coefficient (beta
measures the firm's risk). The market risk premium is the amount above the risk-free rate that will induce investment in
the market. The beta coefficient of an individual stock is the correlation between the volatility (price variation) of the stock
market and that of the price of the individual stock. For example, if an individual stock goes up 15% and the market only
10%, beta is 1.5.
Answer (A) is incorrect because the coefficient of variation compares risk with expected return (standard deviation ÷
expected return). Answer (C) is incorrect because standard deviation measures dispersion (risk) of project returns.
Answer (D) is incorrect because expected return does not describe risk.
91
. Answer (A) is correct. The word beta is derived from the regression equation for regressing the return of an
individual security (the dependent variable) to the overall market return. The beta coefficient is the slope of the
regression line. The beta for a security may also be calculated by dividing the covariance of the return on the market and
the return on the security by the variance of the return on the market.
Answer (B) is incorrect because beta equals the covariance of the returns on the market and on the security divided by
the variance of the return on the market. Answer (C) is incorrect because beta equals the covariance of the returns on
the market and on the security divided by the variance of the return on the market. Answer (D) is incorrect because beta
equals the covariance of the returns on the market and on the security divided by the variance of the return on the
market.
92
. Beta is a measure of how a security's return covaries with the market returns, normalized by the market variance.
93
. By definition, the beta of the market portfolio is 1.
94
. Once, a portfolio is diversified, the only risk remaining is systematic risk, which is measured by beta.
95
. E(RS) = rf + 0(RM - rf) = rf.
96
. Answer (A) is correct. The required rate of return on equity capital in the capital asset pricing model is the risk-free
rate (determined by government securities) plus the product of the market risk premium times the beta coefficient (beta
measures the firm's risk). The market risk premium is the amount above the risk-free rate that will induce investment in
the market. The beta coefficient of an individual stock is the correlation between the volatility (price variation) of the stock
market and that of the price of the individual stock.
Answer (B) is incorrect because the coefficient of variation is the standard deviation of an investment's returns divided
by the mean return. Answer (C) is incorrect because the standard deviation is a measure of the variability of an
investment's returns. Answer (D) is incorrect because the beta coefficient measures the sensitivity of the investment's
returns to market volatility.
97
. The market rewards systematic risk, which is measured by beta, and thus, the risk premium on a stock or portfolio varies
directly with beta.
98
. The risk premium on the market portfolio is proportional to the average degree of risk aversion of the investor population
and the risk of the market portfolio measured by its variance.
99
. Answer (B) is correct. To estimate the required rate of return on equity, the capital asset pricing model (CAPM) adds
the risk-free rate (determined by government securities) to the product of the beta coefficient (a measure of the firm's
risk) and the difference between the market return and the risk-free rate. Below is the basic equilibrium equation for the
CAPM.
R = RF + ß (RM - RF )
Thus, given a beta of 1.2, R is 11% [5% + 1.2 (10% - 5%)]. At a beta of 1.5, R is 12.5% [5% + 1.5 (10% - 5%)].
Answer (A) is incorrect because 3% equals the market return times the increase in the beta. Answer (C) is incorrect
because the company's required rate of return is affected by a change in the company's beta coefficient. Answer (D) is
incorrect because the change results in an increase of the company's required rate of return, not a decrease.
100
. Answer (D) is correct. A weighted average of the costs of all financing sources should be used, with the weights
determined by the usual financing proportions. The terms of any financing raised at the time of initiating a particular
project do not represent the cost of capital for the firm. When a firm achieves its optimal capital structure, the weighted-
average cost of capital is minimized.
Answer (A) is incorrect because the cost of capital is a composite, or weighted average, of all financing sources in their
usual proportions. The cost of capital should also be calculated on an after-tax basis. Answer (B) is incorrect because
the cost of capital is a composite, or weighted average, of all financing sources in their usual proportions. The cost of
capital should also be calculated on an after-tax basis. Answer (C) is incorrect because the cost of capital is a
composite, or weighted average, of all financing sources in their usual proportions. The cost of capital should also be
calculated on an after-tax basis.
101
. Answer (A) is correct. The cost of capital of a firm is the current, weighted-average, after-tax cost of the firm's
various financing components. Historical costs are irrelevant.
Answer (B) is incorrect because costs are considered after taxes. For example, the deductibility of interest must be
considered. Answer (C) is incorrect because the time value of money should be incorporated into the calculations.
Answer (D) is incorrect because the cost of capital is a weighted average for all sources of capital.
102
. WACC measures the marginal after-tax cost of capital; therefore, statement a is false. The after-tax cost of debt
financing is less than the after-tax cost of equity financing; therefore, statement b is false. The correct choice is
statement c.
103
. Statements a and b are true. Statement c is false. The cost of new stock is higher than the cost of retained earnings
because there are flotation costs associated with issuing new stock. Since statements a and b are true the correct
choice is statement d.
104
. Answer (B) is correct. The cost of capital of a firm is the current, weighted average, after-tax cost of the firm's
various financing components. Historical costs are irrelevant.
Answer (A) is incorrect because the cost of capital is a weighted average for all sources of capital. Answer (C) is
incorrect because costs are considered after taxes. For example, the deductibility of interest must be considered.
Answer (D) is incorrect because the time value of money should be incorporated into the calculations.
105
. Correct answer is (C). Increase in dividend payments would mean increase cost of issuing shares of stock, hence,
increasing the cost of capital.
106
. Statement a is correct; the other statements are false. If RPM decreases, the cost of equity will be reduced. Answers
b through e will all increase the company’s WACC.
.
107
Because corporations can exclude dividends for tax purposes, preferred stock often has a before-tax market return
that is less than the issuing company’s before-tax cost of debt. Then, if the issuer’s tax rate is zero, its component cost
of preferred would be less than its after-tax cost of debt.
108
. If a firm paid no income taxes, its cost of debt would not be adjusted downward, hence the component cost of debt
would be higher than if T were greater than 0. With a higher component cost of debt, the WACC would be increased. Of
course, the company would have higher earnings, and its cash flows from a given project would be high, so the higher
WACC would not impede its investments, that is, its capital budget would be larger than if it were taxed.
109
. Statements a and c are both correct; therefore, statement d is the correct choice. Statement a recites the definition
of the weighted average cost of capital. Statement c is correct because k d = kRF + LP + MRP + DRP while k s = kRF + (kM -
kRF)b. If kRF increases then the values for kd and ks will increase.
110
. Statement a is correct; the other statements are false. Statement b is incorrect; WACC is an average of debt and
equity financing. Since debt financing is cheaper and is adjusted downward for taxes, it should, when averaged with
equity, cause the WACC to be less than the cost of equity financing. Statement c is incorrect; WACC is calculated on an
after-tax basis. Statement d is incorrect; the WACC is based on marginal, not embedded, costs. Statement e is incorrect;
the cost of issuing new common stock is greater than the cost of retained earnings.
111
. The preferred stock dividend is not tax deductible like the interest payment on debt. Therefore, there is no tax
benefit from preferred stock. Statement a is true. Retained earnings are equity, and equity will have a higher cost than
debt. Therefore, statement b is false. If the beta increases, investors will require a higher rate of return to hold or buy the
stock. Therefore, the cost of equity will go up, and statement c is true. Because statements a and c are true, the correct
choice is statement e.
112
. Statement c is the correct choice. A tax rate increase would lead to a decrease in the after-tax cost of debt and,
consequently, the firm’s WACC would decrease.
113
. 11% = 5% + 1.5(9% - 5%) = 11.0%; therefore, the security is fairly priced.
114
. 12% < 7% + 1.3(15% - 7%) = 17.40%; therefore, stock is overpriced and should be shorted.
115
. A:12% - [5% + 1.2(9% - 5%)] = 2.2%.
116
. Calculate the required return, ks, and compare to the expected return, k s .
k s = 7%.
ks = kRF + (kM - kRF)b = 0.07 + (0.10 - 0.07)0.5 = 0.085 = 8.5%.
ks > k s ; 8.5% > 7.0%; reject the investment.
117
. Calculate the required return, ks, and use to calculate the WACC:
ks = 10% + 1.38(5%) = 16.9%.
WACC = 0.5(12.0%)(0.6) + 0.5(16.9%) = 12.05%.
Compare expected project return, k̂project , to WACC:
But k̂project = 13.0%.
Accept the project since k̂project > WACC: 13.0% > 12.05%.
118
. Calculate the after-tax component cost of debt as 10%(1 - 0.3) = 7%. If the company has earnings of $100,000 and pays
out 50% or $50,000 in dividends, then it will retain earnings of $50,000. The retained earnings breakpoint is $50,000/0.4
= $125,000. Since it will require financing in excess of $125,000 to undertake any of the alternatives, we can conclude
the firm must issue new equity. Therefore, the pertinent component cost of equity is the cost of new equity. Calculate the
expected dividend per share (note this is D1) as $50,000/10,000 = $5. Thus, the cost of new equity is $5/[($35(1 - 0.12)]
+ 6% = 22.23%. Jackson’s WACC is 7%(0.6) + 22.23%(0.4) = 13.09%. Only the return on Project A exceeds the WACC,
so only Project A will be undertaken.
119
. Answer (C) is correct. The degree of operating leverage is the percentage change in EBIT resulting from a given
percentage change in sales. Thus, it causes EBIT to be more sensitive to changes in sales.
Answer (A) is incorrect because the term credit is not applicable to leverage. Answer (B) is incorrect because financial
leverage refers to the sensitivity of EPS to EBIT. Answer (D) is incorrect because the term intrinsic is not applicable to
leverage.
120
. Answer (A) is correct. Operating leverage is based on the degree to which fixed costs are used in production. Firms
may increase fixed costs, such as by automation, to reduce variable costs. The result is a greater degree of operating
leverage (DOL), which is the percentage change in earnings before interest and taxes (net operating profit) divided by
the percentage change in unit sales. It can also be determined from the following formula, given that Q is quantity of
units sold, P is unit price, V is unit variable cost, and F is fixed cost:
Q(P - V)
Q(P - V) - F
Answer (B) is incorrect because the degree of financial leverage equals the percentage change in EPS divided by the
percentage change in net operating profit. Answer (C) is incorrect because the breakeven point is the sales volume at
which total revenue equals total costs. Answer (D) is incorrect because the degree of total (combined) leverage equals
the percentage change in EPS divided by the percentage change in sales.
121
. Answer (C) is correct. The degree of operating leverage (DOL) is a measure of the change in earnings available to
common stockholders associated with a given change in operating earnings. It is calculated, for a particular level of
sales, as:
sales revenue - variable costs
sales revenue - variable costs - fixed operating costs
Answer (A) is incorrect because DOL varies with the sales level. Answer (B) is incorrect because the degree of financial
leverage is a measure of the change in earnings available to common stockholders associated with a given change in
operating earnings. Answer (D) is incorrect because the degree of total leverage is the multiple of the degree of
operating leverage and the degree of financial leverage. Other things being equal, DOL is higher if the degree of total
leverage is higher.
122
. Answer (A) is correct. The degree of operating leverage (DOL) is equal to the percentage change in net operating
income, that is, earnings before interest and taxes (EBIT) divided by the percentage change in sales. Because interest
expenses are not included in EBIT, the DOL is not affected by a change in interest expense.
Answer (B) is incorrect because variable cost per unit affects EBIT and therefore the DOL. Answer (C) is incorrect
because quantity of units sold affects EBIT and therefore the DOL. Answer (D) is incorrect because fixed costs affect
EBIT and therefore the DOL.
123
. Answer (B) is correct. Operating leverage is a measure of the degree to which fixed costs are used in the
production process. A company with a higher percentage of fixed costs (higher operating leverage) has greater risk than
one in the same industry that relies more heavily on variable costs. The DOL equals the percentage change in net
operating income divided by the percentage change in sales. Thus, profits became more sensitive to changes in sales
volume as the DOL increases.
Answer (A) is incorrect because a firm with higher operating leverage has higher fixed costs and lower variable costs.
Answer (C) is incorrect because a firm with higher leverage will be relatively more profitable than a firm with lower
leverage when sales are high. The opposite is true when sales are low. Answer (D) is incorrect because a firm with
higher leverage is more risky. Its reliance on fixed costs is greater.
124
. Answer (B) is correct. A purchase of treasury stock involves a decrease in assets (usually cash) and a
corresponding decrease in shareholders' equity. Thus, equity is reduced and the debt-to-equity ratio and financial
leverage increase.
Answer (A) is incorrect because assets decrease when treasury stock is purchased. Answer (C) is incorrect because a
firm's interest coverage ratio is unaffected. Earnings, interest expense, and taxes will all be the same regardless of the
transaction. Answer (D) is incorrect because the purchase of treasury stock is antidilutive; the same earnings will be
spread over fewer shares. Some firms purchase treasury stock for this reason.
125
. REQUIRED: The effect of increasing the DFL.
DISCUSSION: (D) The DFL equals the percentage change in earnings available to common shareholders divided by
the percentage change in net operating income. When the DFL rises, fixed interest charges and the riskiness of the firm
rise. As a result, the variability of the returns to equity holders will increase. In other words, the standard deviation of
returns on the equity of the company rises.
Answer (A) is incorrect because an increase in the DFL increases the riskiness of the firm’s stock. Thus, beta rises.
Beta is a measure of the volatility of a firm’s stock price relative to the average stock. Answers (B) and (C) are incorrect
because systematic risk, also known as market risk, is unrelated to the DFL. Systematic risk is not specific to a
company. It is the risk associated with a company’s stock that cannot be diversified because it arises from factors that
affect all stocks.
126
. Answer (C) is correct. Financial leverage is the use of borrowed money to earn money for the benefit of
shareholders. The expectation is that investment earnings will be greater than the interest paid on the borrowed funds.
Increasing debt (such as bonds) increases financial leverage.
Answer (A) is incorrect because the issuance of common stock does not increase financial leverage. No increase in
borrowed capital and fixed interest charges occurs when equity is issued. Answer (B) is incorrect because a decrease in
the dividend payout ratio would result in increased owners' equity (retained earnings), and would not increase debt
capital and financial leverage. Answer (D) is incorrect because using debt, not equity, funds to finance new investments
increases financial leverage.
127
. Answer (C) is correct. Earnings per share is less volatile in less highly leveraged firms. Lower fixed costs result in
less variable earnings when sales fluctuate.
Answer (A) is incorrect because higher leverage is associated with higher, not lower, EPS when sales exceed the
breakeven point. Answer (B) is incorrect because earnings per share is more volatile in more highly leveraged firms.
Answer (D) is incorrect because less leverage is associated with lower, not higher, EPS when sales exceed the
breakeven point.
128
. Answer (B) is correct. Financial leverage is the amount of the fixed cost of capital, principally debt, in a firm's capital
structure relative to its operating profit. Leverage creates financial risk and is directly related to the cost of capital.
Because the company is retiring bonds, the total debt is decreased. Given that the amount of debt and leverage are
directly related, a decrease in the amount of debt results in a decrease in financial leverage.
Answer (A) is incorrect because the bond retirement decreases the debt-equity ratio. Answer (C) is incorrect because
the total assets will decrease (assets will be used to retire the debt, resulting in an increased asset turnover ratio (net
sales ÷ average total assets). Answer (D) is incorrect because the interest expense avoided will increase net profit and
the return on shareholders' equity.
129
. Statement a is true; a higher EPS does not always mean that the stock price will increase. Statement b is false; a
lower WACC will mean a higher stock price. Statement c is false; EPS can increase just because shares outstanding
decline.
130
. Statement a is incorrect because BEP = EBIT/Total assets. The extent to which the firm uses debt financing does
not effect EBIT or total assets. Statement b is incorrect because firms with a high percentage of fixed costs have a high
degree of operating leverage by definition.
131
. BEP = EBIT/TA. Since they both have the same total assets and the same BEP, then EBIT must be the same for
both companies. If A has a higher debt ratio and higher interest expense than B, and they both have the same EBIT and
tax rate, then A must have a lower NI than B. Therefore, statement a is true. If A has a lower NI than B but both have the
same total assets, then A’s ROA (NI/TA) must be lower than B’s ROA. Therefore, statement b is true. If both companies
have the same total assets but A’s debt ratio is higher than B’s, then A’s equity must be lower (since Total assets = Total
debt + Total equity). If A has less equity, and a lower NI than B, it is not possible to judge which company’s ROE (NI/EQ)
is higher.
132
. BEP = EBIT/TA. If both firms have the same BEP ratio and same total assets, then they must have the same EBIT.
Since Firm U has no debt in its capital structure, Firm U will have higher net income than Firm L because U has no
interest expense and L does. The TIE ratio is EBIT/Int. If the two companies have the same EBIT, the one with the lower
interest expense (Firm U), will have a higher TIE. Therefore, statement a is false. Firms L and U have the same EBIT,
but Firm L has a higher interest expense, so its net income will be lower than Firm U. Since ROA is equal to NI/TA, and
the two firms have the same total assets, Firm L will have a lower ROA than Firm U. Therefore, statement b is true.
Leverage will increase ROE if BEP > kd. Since BEP is 20 percent and kd is 8 percent, leverage will increase Firm L’s
ROE. Therefore, statement c is false.
133
. Statement a is false; A’s net income is lower than B’s due to higher interest expense, but its assets are equal to B’s,
so A’s ROA must be lower than B’s ROA. Statement b is false; A has the same EBIT as B, but higher interest payments
than B; therefore, A’s TIE is lower than B’s. Statement c is correct.
134
. Answer (B) is correct. Leverage is the amount of the fixed cost of capital, principally debt, in a firm's capital structure
relative to its operating income. It is also defined as the ratio of debt to total assets or debt to capital. Leverage, by
definition, creates financial risk, which relates directly to the question of the cost of capital. The more leverage, the
higher the financial risk, and the higher the cost of debt capital. The degree of financial leverage (DFL) is the percentage
change in earnings available to common stockholders that is associated with a given percentage change in net
operating income (earnings before interest and taxes). The more financial leverage employed, the greater the DFL, and
the riskier the firm. Whenever the return on assets is greater than the cost of debt, additional leverage is favorable. An
increase in the equity component of the capital structure, however, decreases financial leverage. Operating leverage is a
related concept based on the degree that fixed costs are used in the production process. A company with a high
percentage of fixed costs is riskier than a firm in the same industry that relies more on variable costs to produce. The
degree of operating leverage (DOL) is the percentage change in net operating income that is associated with a given
percentage change in sales. When fixed assets increase, operating leverage also increases.
Answer (A) is incorrect because financial leverage would decrease and operating leverage would increase. Answer (C)
is incorrect because financial leverage would decrease and operating leverage would increase. Answer (D) is incorrect
because financial leverage would decrease and operating leverage would increase.
135
. Answer (D) is correct. Insurance is a method of spreading losses that arise from risks to which many persons are
subject. Loss is an unanticipated diminution in economic value as opposed to normal depreciation. Risk is uncertainty
about the occurrence or the amount of loss. For example, buildings are subject to the risk of loss by fire. If the owners all
pay small fees (premiums) for insurance coverage, every participant bears part of the loss instead of a few bearing all
the loss.
Answer (A) is incorrect because risk avoidance and loss control do not transfer risk of loss. Answer (B) is incorrect
because an insurable interest is merely a potential for economic loss if an event occurs. Answer (C) is incorrect because
there must be an insurable interest, which is basically potential for loss if an event occurs. Gambling occurs when only a
bet is at risk.
136
. Answer (A) is correct. An insurance contract (a policy) must satisfy the usual requirements: offer and acceptance,
consideration, legality, and capacity of the parties. The insured must have an insurable interest in the subject matter of
the contract. Also, the subject matter generally must exist at the time of contracting. In the contract, the insurer makes a
promise to pay a stated amount for loss or injury incurred as a result of a contingent event.
Answer (B) is incorrect because the payee may be a stranger to the contract. A person who insures his/her own life
names a third party as a beneficiary. Moreover, not every insurer is an insurance company, and the contingent event
insured against must involve a risk. Answer (C) is incorrect because there is no general requirement that an insurance
contract be written. Answer (D) is incorrect because the contract may often be oral, and, if the risk is not already in
existence, the transaction is in essence a wager, not insurance.
137
. Answer (A) is correct. An insurance contract is very similar to any other contract. However, an additional
requirement is that the insured must have an insurable interest.
Answer (B) is incorrect because there is no general requirement that an insurance contract be written. Oral binders are
given every day in the insurance business. Answer (C) is incorrect because consideration is needed for the initial
formation of an insurance contract. The premium may be paid immediately, or a promise to pay is required. Answer (D)
is incorrect because the insurance company can also commit a breach by refusing to pay the proceeds of the policy
upon the occurrence of the event.
138
. Answer (A) is correct. Life insurance is usually purchased to protect against the cessation of income needed for
support of the family and to shield them from the decedent's debts.
Answer (B) is incorrect because life insurance is customarily long-term, if not for life. Answer (C) is incorrect because,
unlike other forms of insurance, life insurance does not attempt to reimburse for the actual amount of a loss since loss of
life is not measurable. Life insurance is intended to replace economic benefits lost by a person's death. Answer (D) is
incorrect because, except for term policies, life insurance differs from other kinds of coverage in providing cash value.
139
. Answer (D) is correct. Term life insurance provides protection for a specified period. Premiums are level throughout
the period. When the term ends, the insured receives no payment. Term insurance may be renewable (possibly at higher
premiums) or convertible to another form. It is the cheapest kind of life insurance.
Answer (A) is incorrect because whole life furnishes lifetime insurance protection with a cash surrender value. Answer
(B) is incorrect because an endowment policy provides life insurance protection for its duration. A cash payment is made
(the policy endows) at the end of the term. Premiums for endowment policies are higher than for whole life insurance.
Answer (C) is incorrect because a straight life or ordinary policy is whole life insurance with level premiums payable for
life.
140
. Answer (D) is correct. If a premium is not received by the due date, the policyholder has a grace period under state
law, usually a month or 31 days, in which to pay. After the grace period, the cash surrender value is not forfeited but can
be withdrawn or used to buy a paid-up policy.
Answer (A) is incorrect because life insurance policies often do not cover death while the insured is in the military.
Answer (B) is incorrect because life insurance policies often do not cover death as a result of a noncommercial air flight.
Answer (C) is incorrect because a lapsed policy may often be reinstated by payment of overdue premiums plus interest.
141
. Answer (B) is correct. When one person insures the life of another, the policyholder must have an insurable interest
in the insured. That interest is found among persons who have a close family relationship or expect to suffer substantial
economic loss from the death. Business entities are thus permitted to insure key people in their organizations whose
death might have an adverse effect on profits.
Answer (A) is incorrect because a corporation has an insurable interest only in its key employees, i.e., those whose
death would cause loss to the firm. Answer (C) is incorrect because the required loss need not be so great as to cause
cessation of business. Answer (D) because one need not be an owner or an officer to be insurable as a key person.
142
. Answer (A) is correct. Fire insurance is the most standardized kind of insurance. Following the lead of New York,
almost all states have enacted a standard policy either by legislative or administrative action.
Answer (B) is incorrect because, given that fire insurance is usually written for a 1- to 3-year period, an incontestability
clause is not necessary. Such a clause bars insurer defenses after a period specified by law or the policy. Answer (C) is
incorrect because a policy may state a definite value of the insured property or simply a maximum amount of coverage
that is not conclusive as to valuation when loss occurs. A policy may thus be valued or open (unvalued). A pro rata
clause is often included (but not required) which requires the loss to be shared pro rata when there is more than one
insurer. Answer (D) is incorrect because the insurable interest merely requires the person, e.g., mortgagee, bailee, etc.,
to suffer a loss if the event insured against occurs.
143
. Answer (B) is correct. Ordinarily, smoke, water, or other damage caused by hostile, but not friendly, fires will be
indemnified under a fire insurance policy. Hostile fires are those ignited in places where they are not meant to be. A
friendly fire is one that burns where it is intended to burn, such as a fireplace or furnace. For example, if a friendly fire is
kept within its usual container, damage caused by smoke from it will not be reimbursed.
Answer (A) is incorrect because fire insurance usually indemnifies for loss caused by hostile, but not friendly, fires.
Answer (C) is incorrect because fire insurance usually indemnifies for loss caused by hostile, but not friendly, fires.
Answer (D) is incorrect because fire insurance usually indemnifies for loss caused by hostile, but not friendly, fires.
144
. Answer (C) is correct. Arson, fraud, or another intentional act of the insured calculated to cause the damage insured
against will preclude recovery. The parties to an insurance contract have an implied duty not to bring about the very
event that is the subject matter of the policy.
Answer (A) is incorrect because agency rules do not apply; i.e., the intentional act of an agent will not be imputed to the
insured under the doctrine of respondeat superior. Arson by an agent without the actual knowledge or conspiracy of the
insured will not preclude recovery. Answer (B) is incorrect because arson is compensable unless intended by the
insured. Answer (D) is incorrect because negligence without fraud will not prevent recovery by an insured who has acted
in good faith.
145
. Answer (D) is correct. Fire insurance generally protects the insured from damage to the insured property as a result
of fire. It does not cover the insured for causing a fire on someone else's property.
Answer (A) is incorrect because malpractice insurance is a special form of liability insurance protecting professionals
from lawsuits by third parties for negligence. Answer (B) is incorrect because homeowners insurance generally contains
a liability section in the event guests are injured on the premises. Answer (C) is incorrect because a primary purpose of
automobile insurance is to protect the owner or driver from liability in the event (s)he is responsible for damage to
another person or property.
146
. Answer (C) is correct. Co-insurance is a method of sharing risk between the insurer and the insured. A co-insurance
clause typically provides that, if the policyholder insures his/her property for at least a stated percentage (usually 80%)
of its actual cash value, any loss will be paid in full up to the face amount of the policy. Thus, a co-insurance clause is
used by many property and casualty insurers to encourage policyholders to insure commercial property for an amount
that is near to its full replacement cost.
Answer (A) is incorrect because, if a policyholder does not insure the property for an amount close enough to its full
replacement cost, the policyholder must bear a proportionate part of any partial loss. Answer (B) is incorrect because the
co-insurance requirement applies only to partial losses. Total losses result in recovery of the face amount of the policy.
Answer (D) is incorrect because a co-insurance clause encourages policyholders to insure commercial property for an
amount that is near to its full replacement cost.
147
. Answer (A) is correct. Conditions precedent, called warranties, are part of the property insurance policy. Breach of a
warranty precludes recovery and results in a forfeiture. Since the law disfavors forfeitures, courts construe questions of
interpretation favorably to the insured and against the insurer that drafted the policy. However, if the parties expressly
agree that certain statements are warranties, then a court would recognize them as warranties. Since Jewelry warranted
never to display more than $10,000 of jewelry, the breach of warranty prevents recovery.
Answer (B) is incorrect because Jewelry will recover nothing; it is not entitled to $2,000. Answer (C) is incorrect because
the warranty will not be construed as a mere representation; the intention of the parties clearly was to make it a
warranty. Answer (D) is incorrect because attachment of the application to the policy is usually sufficient to make it a
part thereof. It may also be incorporated into the policy by reference to it.