shareholders in excess earnings of the company.

In
CMA PART 1F other words, 8% participating preferred stock might
Long-term Finance pay a dividend each year greater than 8% when the
corporation is extremely profitable. Therefore,
and Capital Structure nonparticipating preferred stock will receive no more
than is stated on the face of the stock. Preferred
ANSWERS shareholders rarely have voting rights. Voting rights
are exchanged for preferences regarding dividends
and liquidation of assets.

[1] Source: CMA 0685 1-1 Answer (B) is incorrect because a corporation does
not receive a tax deduction for making dividend
Answer (A) is incorrect because, if the lessee's cost payments on any type of stock.
of capital is lower than the lessor's, the rate of interest
on the loan may be less than that implicit in the lease. Answer (C) is incorrect because preferred stock
normally need not be redeemed as long as the
Answer (B) is incorrect because equipment that may corporation remains in business.
become obsolete before it wears out is more likely to
be leased. Answer (D) is incorrect because preferred
shareholders do have priority over common
Answer (C) is incorrect because relative tax shareholders in a liquidation.
considerations affect the costs of leasing and buying
(e.g., deductibility of depreciation and interest favors
ownership). [4] Source: CMA 0688 1-10

Answer (D) is correct. A lease-or-buy decision is Answer (A) is incorrect because holders of
often complicated. For a lease, one must consider the subordinated bonds have claims junior to those of
present value of the lease payments, whether the other debt holders.
lessor will service the asset, and if, when the lease
ends, another asset can be leased or purchased to Answer (B) is correct. Subordinated means that the
continue production. When buying an asset, one must bond has a lower priority in the case of liquidation
consider the net purchase price, the possible loan than other debt of the company. A debenture is a
payments and interest rates, depreciation, salvage bond that is unsecured; no specific property has been
value, and maintenance. Presumably, however, the pledged as collateral. A convertible bond can be
capacity of equipment does not affect the exchanged, at the option of the investor, into shares
lease-or-buy decision since the same equipment will of the issuer's common stock. The call provision
be obtained whichever choice is made. permits the bond to be redeemed by the issuer at the
time stated in the bond indenture (agreement). Only
the corporation can decide to exercise the call
[2] Source: CMA 0688 1-11 provision. Thus, the investor cannot elect to have the
bond redeemed before maturity.
Answer (A) is incorrect because a sinking fund is not
a means of financing; it is a means of paying off Answer (C) is incorrect because the conversion
traditional long-term debt financing. feature permits exchange of the bond before maturity
for common stock.
Answer (B) is correct. A bond sinking fund is
sometimes required in a bond agreement as an Answer (D) is incorrect because the call provision
additional protection for investors. Under such an permits redemption before maturity. The rate that the
agreement, the issuing corporation must make annual corporation will have to pay for early redemption is
payments into a sinking fund. The money in the usually stated on the face of the bond.
sinking fund will accumulate for the purpose of paying
off the bonds at maturity. Often, the agreement
requires that a certain amount of the bonds be retired [5] Source: CMA 1288 1-7
each year.
Answer (A) is incorrect because Eurobonds are not
Answer (C) is incorrect because the funds are used denominated in the currency of the nation in which
to retire the principal of the bonds at maturity. they are sold. The difference is a possible
disadvantage because of exchange rate risk.
Answer (D) is incorrect because the periodic Nevertheless, many foreign bonds are denominated in
payments into a sinking fund are for payment of U.S. dollars.
principal, not interest.
Answer (B) is correct. International bonds are of two
types: foreign bonds and Eurobonds. Foreign bonds
[3] Source: CMA 0688 1-9 are denominated in the currency of the nation in
which they are sold. Eurobonds are denominated in a
Answer (A) is correct. Dividends on cumulative currency other than that of the nation where they are
preferred stock accrue until declared; that is, the sold. Foreign bonds issued in the United States and
book value of the preferred stock increases by the denominated in dollars must be registered with the
amount of any undeclared dividends. Participating SEC, but such extensive disclosure is not required in
preferred stock participates with common most European nations. Thus, an American company
 may elect to issue Eurobonds denominated in dollars Answer (A) is incorrect because the issuance costs
in a foreign nation because of the convenience of not are no lower than for any other bond issue.
having to comply with governmental registration
requirements. Answer (B) is incorrect because interest income and
expense must be calculated annually based on the
Answer (C) is incorrect because foreign nationals are amount of the initial discount that is amortized.
often hesitant about buying bonds issued by small
companies with which they are not familiar. Answer (C) is incorrect because the annual
amortization must be shown as interest expense. APR
Answer (D) is incorrect because Eurobonds carry means "annual percentage rate."
foreign exchange risk. The foreign lender may suffer a
loss if the dollar declines relative to its domestic Answer (D) is correct. Zero-coupon bonds do not
currency. pay periodic interest. The bonds are sold at a
discount from their face value, and the investors do
not receive interest until the bonds mature. The issuer
[6] Source: CMA 1288 1-6 does not have to make annual cash outlays for
interest. However, the discount must be amortized
Answer (A) is incorrect because shelf registration is annually and reported as interest expense.
not an exception to the registration requirements.

Answer (B) is incorrect because the use of [9] Source: CMA 1288 1-11
investment bankers is irrelevant to shelf registration.
Answer (A) is correct. The times-interest-earned
Answer (C) is correct. SEC Rule 415 (under the (interest coverage) ratio is computed by dividing the
Securities Act of 1933) allows corporations to file income available for paying interest (pretax,
registration statements covering a stipulated amount pre-interest income) by the annual interest expense.
of securities that may be issued over the 2-year The first step is to determine the annual interest
effective period of the statement. The securities are expense:
placed "on the shelf" and issued at an opportune
moment without the necessity of filing a new First Mortgage 9.0% x $ 5,000 = $ 450
registration statement, observing a 20-day waiting Debenture 10.2% x 10,000 = 1,020
period, or preparing a new prospectus. The issuer is Subordinated 12.0% x 6,000 = 720
only required to provide updating amendments or to ------
refer investors to quarterly and annual statements filed Total Expense $2,190
with the SEC. It is most advantageous to large ======
corporations that frequently offer securities to the Dividing the pretax, pre-interest income of $10,000
public. by the $2,190 of interest expense produces an
interest coverage ratio of 4.57.
Answer (D) is incorrect because the use of small
underwriters is determined by the size of the issue, Answer (B) is incorrect because 2.92 times equals
not whether shelf registration is used. after-tax, pre-interest income of $6,400 divided by
the interest expense.

[7] Source: CMA 1288 1-9 Answer (C) is incorrect because pre-tax, pre-interest
income of $10,000 should be divided by $2,190 of
Answer (A) is incorrect because preferred dividends interest expense ($450 + $1,020 + $720) to find the
are viewed as fixed payments since they must be times interest earned ratio.
made before any dividends or distributions in
liquidation can be made to common shareholders. Answer (D) is incorrect because 3.57 times equals
pre-tax, after-interest income ($7,810) divided by
Answer (B) is incorrect because it states a reason to $2,190.
issue debt, not preferred stock.

Answer (C) is incorrect because in the sense that [10] Source: CMA 0689 1-1
they cannot be avoided, interest payments are
cumulative. Answer (A) is incorrect because the bonds will sell
for less than their face value (at a discount).
Answer (D) is correct. For a financial manager,
preferred stock is preferable to debt because Answer (B) is incorrect because the face value is the
dividends do not have to be paid on preferred stock, amount printed on the face of the instruments.
but failure to pay interest on debt could lead to
bankruptcy. Thus, preferred stock is less risky than Answer (C) is correct. Because the market rate is
debt. However, debt has some advantages over greater than 8%, the company's 8% bonds are not as
preferred stock, the most notable of which is that desirable as other bonds in the market. Thus, the
interest payments are tax deductible. Preferred stock company will be forced to sell at a discount because
dividends are not. investors will not be willing to pay the face amount for
a bond that pays less interest than other similar
bonds. The discount must increase the effective rate
[8] Source: CMA 1288 1-10 of return to investors to at least the market rate.
 Answer (D) is incorrect because the value of the
bonds will be less than their face value. Answer (C) is incorrect because a stock dividend has
no effect except on the composition of the
shareholders' equity section of the balance sheet.
[11] Source: CMA 0689 1-2
Answer (D) is incorrect because a stock dividend has
Answer (A) is incorrect because serial bonds mature no effect except on the composition of the
on different dates. shareholders' equity section of the balance sheet.

Answer (B) is incorrect because bonds maturing on

different dates may have different yields, or they may [14] Source: CMA 0689 1-8
be the same. Usually, the earlier date maturities carry
slightly lower yields than the later maturities. Answer (A) is incorrect because the share of profits
available to preferred stockholders is normally limited
Answer (C) is correct. Serial bonds have staggered to a percentage of the stock's par value. Thus, they
maturities; that is, they mature over a period (series) may get more or less than the common shareholders.
of years. Thus, investors can choose the maturity date
that meets their investment needs. For example, an Answer (B) is incorrect because preferred
investor who will have a child starting college in 16 stockholders ordinarily do not have voting rights.
years can choose bonds that mature in 16 years.
Answer (C) is correct. Preferred stockholders have
Answer (D) is incorrect because the coupon rate is preference over common stockholders with respect
the same for all bonds; only the selling price and yield to dividend and liquidation rights, but payment of
differ. preferred dividends, unlike bond interest is not
mandatory. In exchange for these preferences, the
preferred stockholders give up the right to vote.
[12] Source: CMA 0689 1-4 Consequently, preferred stock is a hybrid of debt and
equity.
Answer (A) is incorrect because $362,500 is the
common stock dividend. Answer (D) is incorrect because the passing of
preferred dividends does not put the corporation into
Answer (B) is incorrect because $392,500 is equal default. For this reason, preferred stock is sometimes
to the common stock dividend plus 1 year of viewed more favorably than debt by corporate
preferred dividends. management. If the preferred stock is cumulative
(which most is), the corporation may not pay
Answer (C) is incorrect because $407,500 equals dividends to common shareholders until the
the common stock dividend plus 1.5 years of arrearages to preferred stockholders have been paid.
preferred dividends.

Answer (D) is correct. Because the preferred stock [15] Source: CMA 0689 1-9
is cumulative; that is, preferred dividends accumulate
until paid, no dividends can be paid on common Answer (A) is incorrect because the purchase of
stock until the preferred stockholders have been paid treasury stock increases the debt-to-equity ratio.
for each of the past 2 years. The total par value of the Equity but not debt is reduced by the acquisition.
preferred stock is $500,000. At 6%, the dividend for
2 years is $60,000. The company wishes to pay a Answer (B) is incorrect because the purchase of
dividend to common shareholders of $362,500 (25% treasury stock decreases assets. Cash is paid out and
x $1,450,000). Accordingly, the total for both stockholders' equity is decreased.
preferred and common shareholders would be
$422,500. Answer (C) is incorrect because treasury stock is
recorded as a negative stockholders' equity account,
not as a marketable security. The theory of this
[13] Source: CMA 0689 1-7 treatment is that a company cannot own itself.

Answer (A) is incorrect because a stock dividend has Answer (D) is correct. There are many reasons a
no effect except on the composition of the corporation might buy back its own stock. These
shareholders' equity section of the balance sheet. include meeting the needs created by potential
mergers or pension and profit-sharing plans. Also,
Answer (B) is correct. A stock dividend is a transfer management may want to buy out a dissident
of equity from retained earnings to paid-in capital. stockholder. Sometimes, a company has excess cash
The debit is to retained earnings and the credits are to and can find no better investment than its own stock.
common stock and additional paid-in capital. Moreover, management may believe the stock is
Additional shares are outstanding following the stock selling for a low price for no apparent reason. Thus, a
dividend, but every shareholder maintains the same purchase may not only be a good investment but may
percentage of ownership. In effect, a stock dividend also support the market price of the stock.
divides the pie (the corporation) into more pieces, but
the pie is still the same size. Hence, a corporation will
have a lower EPS and a lower book value per share [16] Source: CMA 0690 1-15
following a stock dividend, but every shareholder will
be just as well off as previously. Answer (A) is incorrect because the obligation to
 repay at a specific maturity date reduces the risk to
investors and thus the required return. Answer (D) is incorrect because equity costs decline
as leverage decreases.
Answer (B) is correct. Providers of equity capital are
exposed to more risk than are lenders because the
firm is not obligated to pay them a return. Also, in [19] Source: CMA 1291 1-5
case of liquidation, creditors are paid before equity
investors. Thus, equity financing is more expensive Answer (A) is incorrect because assets decrease
than debt because equity investors require a higher when treasury stock is purchased.
return to compensate for the greater risk assumed.
Answer (B) is correct. A purchase of treasury stock
Answer (C) is incorrect because the existence of a involves a decrease in assets (usually cash) and a
legal obligation is but one reason that debt poses less corresponding decrease in stockholders' equity.
risk to investors. Thus, equity is reduced and the debt-to-equity ratio
and financial leverage increase.
Answer (D) is incorrect because the demand for
equity capital is directly related to its greater cost to Answer (C) is incorrect because equity (assets -
the issuer. liabilities) declines. A treasury stock purchase is
equivalent to a special dividend because assets are
paid out to one or more stockholders.
[17] Source: CMA 0690 1-17
Answer (D) is incorrect because a firm's
Answer (A) is incorrect because $60 million of this interest-coverage ratio is unaffected. Earnings,
facility will be financed. Common stock will finance interest expense, and taxes will all be the same
$42 million (70% x $60 million) of this amount. regardless of the transaction.
Dividing $42 million by the $75 million total project
cost yields 56.00%.
[20] Source: CMA 1291 1-6
Answer (B) is incorrect because $60 million of this
facility will be financed. Common stock will finance Answer (A) is correct. Warrants are long-term
$42 million (70% x $60 million) of this amount. options that give holders the right to buy common
Dividing $42 million by the $75 million total project stock in the future at a specific price. If the market
cost yields 56.00%. price goes up, the holders of warrants will exercise
their rights to buy stock at the special price. If the
Answer (C) is incorrect because the new issue of market price does not exceed the exercise price, the
common stock will fund 70% of the financed amount, warrants will lapse. Issuers of debt sometimes attach
not 70% of the total project cost. The financed stock purchase warrants to debt instruments as an
amount is $60 million ($75 million - $15 million cash). inducement to investors. The investor then has the
security of fixed-return debt plus the possibility for
Answer (D) is correct. Because $15 million is already large gains if stock prices increase significantly. If
available, the company must finance $60 million ($75 warrants are attached, debt can sell at an interest rate
million - $15 million). Of this amount, 70%, or $42 slightly lower than the market rate.
million, should come from the issuance of common
stock to maintain the current capital structure. The Answer (B) is incorrect because outstanding warrants
$42 million represents 56% of the total $75 million. dilute earnings per share. They are included in the
denominator of the EPS calculation even if they have
not been exercised.
[18] Source: CMA 1291 1-2
Answer (C) is incorrect because warrants can, if
Answer (A) is incorrect because both debt and exercised, result in a dilution of management's
equity sources increase in cost as leverage increases. holdings.

Answer (B) is correct. The implicit costs are Answer (D) is incorrect because a call provision in a
attributable to the increased risk created by the bond indenture, not the use of warrants, permits the
additional debt burden. Thus, as the debt-to-equity buyback of bonds.
ratio increases, the cost of both debt and equity will
increase given the increased risk to both shareholders
and creditors from a higher degree of leverage. An [21] Source: CMA 1291 1-7
explanation based on the marginal cost of capital and
the marginal efficiency of investment leads to the Answer (A) is incorrect because the early retirement
same conclusion. Lower cost capital sources are option is solely at the discretion of the issuer.
used first. Additional projects must then be
undertaken with funds from higher cost sources. Answer (B) is incorrect because a call provision will
Similarly, risk is increased because the most either not affect the rate of return or cause the
profitable investments are made initially, leaving the investor to require a higher rate to compensate for the
less profitable investments for the future. possibility that the contract rate will not continue until
maturity.
Answer (C) is incorrect because equity cost rises as
a result of the increased risk caused by greater Answer (C) is correct. A call provision allows the
leverage. issuer of a bond to redeem the bond (call it in) earlier
 than the specified maturity date. This provision is an convert their bonds into stock. The corporation will
advantage to the issuer but not the investor. It then have to make interest and principal payments.
provides the issuer with flexibility if interest rates
decline and refinancing becomes appropriate.
[24] Source: CMA 1291 1-10
Answer (D) is incorrect because a margin call by a
broker who holds stock purchased on credit (on Answer (A) is correct. According to the residual
margin) is a demand for additional money from theory of dividends, the amount (residual) of earnings
investors. A margin call is likely when prices decline paid as dividends depends on the available
and margin requirements, stated as a percentage of investment opportunities and the debt-equity ratio at
price, are inadequately covered. which cost of capital is minimized. The rational
investor should prefer reinvestment of retained
earnings when the return exceeds what the investor
[22] Source: CMA 1291 1-9 could earn on investments of equal risk. However,
the firm may prefer to pay dividends when investment
Answer (A) is incorrect because increased economic opportunities are poor and the use of internal equity
uncertainty makes equity financing more desirable. financing would move the firm away from its ideal
There is no legal mandate to make regular payments capital structure.
to equity holders.
Answer (B) is incorrect because a residual theory
Answer (B) is incorrect because increased operating assumes that investors want the company to reinvest
leverage (a greater degree of fixed production costs) earnings in worthwhile projects, not pay dividends.
increases risk. Hence, debt holders will require higher
rates of interest. Higher interest costs will reduce the
desirability of debt as a means of financing. Answer (C) is incorrect because dividend payments
will not be consistent under a residual theory. The
Answer (C) is incorrect because an increase in the corporation will pay dividends only when internal
price-earnings ratio makes equity financing less costly investment options are unacceptable.
and more desirable. Hence, a given level of earnings
will support a higher share price. In the Gordon Answer (D) is incorrect because dividends would not
growth model, the cost of equity capital declines be important to a financing decision under the residual
when the share price increases. theory.

Answer (D) is correct. Debt financing usually has a

lower cost than equity financing because interest [25] Source: CMA 1291 1-11
payments are tax deductible. If tax rates rise, debt
becomes even more desirable because the tax shield Answer (A) is correct. Stock prices often move in
becomes more valuable. The disadvantages of debt the same direction as dividends. Moreover,
include the increase in fixed payments (interest). companies dislike cutting dividends. They tend not to
Thus, in an unstable economy, debt represents a raise dividends unless anticipated future earnings will
greater risk to a firm than equity financing. be sufficient to sustain the higher payout. Thus, some
theorists have proposed the information content or
signaling hypothesis. According to this view, a change
[23] Source: CMA 1291 1-12 in dividend policy is a signal to the market regarding
management's forecast of future earnings.
Answer (A) is incorrect because an advantage of Consequently, the relation of stock price changes to
convertible bonds is that covenants in the bond changes in dividends reflects not an investor
indentures are often less restrictive. preference for dividends over capital gains but rather
the effect of the information conveyed.
Answer (B) is incorrect because an advantage of
convertible bonds is that they defer equity financing Answer (B) is incorrect because the residual theory
until the stock price is higher. of dividends assumes that the firm should pay
dividends only after investing in all investment
Answer (C) is incorrect because an advantage of opportunities having an expected return greater than
convertible bonds is that they carry a lower interest the cost of capital.
rate at issuance.
Answer (C) is incorrect because an active dividend
Answer (D) is correct. A conversion feature permits policy suggests management assumes that dividends
bondholders to convert their bonds into common are relevant to investors.
stock at some future time if the stock price rises. This
provision is sometimes incorporated into a bond Answer (D) is incorrect because an active dividend
contract to entice investors to lend money to the policy recognizes that investors want dividends.
issuer at a lower interest rate. Another purpose of
issuing convertible bonds is to obtain equity financing
at a time when market prices are unfavorable. Issuing [26] Source: CMA 1291 1-17
convertible bonds is tantamount to selling the stock at
a higher price, assuming that bondholders eventually Answer (A) is incorrect because agency obligations
exercise their option to convert. The disadvantage to are not insured by the U.S. government.
the corporation is that stock prices may never reach
the conversion price, and bondholders will not Answer (B) is incorrect because agency obligations
 are guaranteed by the issuing agency. not as risky as Mustang, which has a standard
deviation of 9% relative to a mean of only 10%. The
Answer (C) is correct. Obligations issued by the coefficient of variation (standard deviation ・
Treasury Department are insured by the full faith and expected return) is much higher for Mustang (0.9 ・
credit of the U.S. government. However, obligations .10 = .9) than for Cornhusker (.15 ・.20 = .75).
of other federal agencies (agency securities) are
guaranteed only by the issuing agency, not the federal
government. Exceptions are securities issued by the [29] Source: CMA 0692 1-7
Government National Mortgage Association (Ginnie
Mae), which have the full backing of the U.S. Answer (A) is incorrect because debentures must
government. pay interest regardless of earnings levels.

Answer (D) is incorrect because agency securities Answer (B) is incorrect because debentures are not
are widely marketed with an active secondary subordinated except to the extent of assets
market. mortgaged against other bond issues. Debentures are
a general obligation of the borrower and rank equally
with convertible bonds.
[27] Source: CMA 0692 1-5
Answer (C) is correct. Debentures are unsecured
Answer (A) is incorrect because 6% is the risk-free bonds. Although no assets are mortgaged as security
rate based on insured government securities and for the bonds, debentures are secured by the full faith
bears no relation to the return of the stock market. and credit of the issuing firm. Debentures are a
general obligation of the borrower. Only companies
Answer (B) is incorrect because 7.5% is calculated with the best credit ratings can issue debentures
by multiplying the beta times the risk-free rate; the because only the company's credit rating and
beta should be multiplied times the risk premium that reputation secure the bonds.
is required by investors.
Answer (D) is incorrect because debentures have
Answer (C) is incorrect because 17.5% is calculated nothing to do with lease financing. Debentures are not
by multiplying the market rate times beta. This ignores secured by assets.
the risk premium. The beta should be multiplied times
the risk premium that is desired by investors.
[30] Source: CMA 0692 1-15
Answer (D) is correct. The CAPM adds the risk-free
rate to the product of the beta coefficient and the Answer (A) is incorrect because the cost to the
difference between the market return and the company of equity instruments is in the form of
risk-free rate. The market-risk premium is the amount dividends. Because dividends are not deductible for
above the risk-free rate for which investors must be tax purposes, equity sources of capital have a higher
compensated to induce them to invest in the after-tax cost than debt sources.
company. The beta coefficient of an individual stock
is the correlation between volatility (price variation) of Answer (B) is correct. Debt financing, such as bonds,
the stock market and the volatility of the price of the normally has a lower after-tax cost than does equity
individual stock. Thus, the required rate is 16% [6% financing. The interest on debt is tax deductible,
+ 1.25 (14% - 6%)]. whereas the dividends on equity are not. Also, bonds
are slightly less risky than stock because the bond
holders have a first right to assets at liquidation.
[28] Source: CMA 0692 1-6
Answer (C) is incorrect because preferred stock has
Answer (A) is incorrect because the existence of a a higher after-tax cost than debt.
higher return is not necessarily indicative of high risk.
Answer (D) is incorrect because common stock has
Answer (B) is incorrect because the higher standard a higher after-tax cost than debt.
deviation must be viewed relative to the mean of the
population; the absolute level of the standard
deviation is meaningless without a knowledge of the [31] Source: CMA 0693 1-4
mean.
Answer (A) is correct. The primary market is the
Answer (C) is incorrect because Mustang does not market for new stocks and bonds. In this market,
have the higher standard deviation. wherein investment money flows directly to the issuer,
securities are initially sold by investment bankers who
Answer (D) is correct. The standard deviation is a purchase them from issuers and sell them through an
measure of the degree of compactness of the values underwriting group. Later transactions occur on
in a population. It is a measure of dispersion. The securities exchanges or other markets.
standard deviation is found by taking the square root
of the quotient of the sum of the squared deviations Answer (B) is incorrect because existing securities
from the mean, divided by the number of items in the are traded on a secondary market (e.g., securities
population. In other words, the standard deviation exchanges).
describes how far from the mean the various elements
of the population are. Cornhusker has a mean return Answer (C) is incorrect because the futures market is
of 20% and a standard deviation of 15%. Hence, it is where commodities contracts are sold, not the capital
 market.
Answer (B) is correct. A reverse stock split
Answer (D) is incorrect because exchanges of decreases the number of shares outstanding, thereby
existing securities do not occur in the primary market. increasing the market price per share. A reverse
stock split may be desirable when a stock is selling at
such a low price that management is concerned that
[32] Source: CMA 0693 1-5 investors will avoid the stock because it has an
undesirable image.
Answer (A) is incorrect because the underwriting
spread is not based on a commission. The Answer (C) is incorrect because a sale of preferred
underwriter actually buys the new securities and stock will take dollars out of investors' hands, thereby
resells them at a price that is expected to result in a reducing funds available to invest in common stock;
profit. therefore, market price per share of common stock
will not increase.
Answer (B) is incorrect because the underwriting
spread is not a genuine discount; it is simply the Answer (D) is incorrect because a stock split
difference between the price paid and the price increases the shares issued and outstanding. The
received for a new security. market price per share is likely to decline as a result.

Answer (C) is correct. An investment banker

performs an underwriting or insurance function when [35] Source: CMA 0693 1-8
it purchases an issue of securities and then resells
them. The risk of price fluctuations during the Answer (A) is incorrect because warrants do not
distribution period is borne entirely by the investment have to be used; the requirement is that stockholders
banker. Investment banking is also an efficient vehicle be allowed to maintain their percentage of ownership.
for marketing the securities because investment
bankers are specialists in such activities. The profit Answer (B) is correct. The preemptive right gives an
earned is the underwriting spread, or the difference existing common stockholder the right to purchase
between the purchase and resale prices of the any additional stock issuances in proportion to the
securities (effectively, the wholesale and retail prices). current percentage ownership. This right gives
existing shareholders the opportunity to maintain their
Answer (D) is incorrect because the underwriting ownership percentage without having their voting
spread is not based on a commission. The power diluted.
underwriter actually buys the new securities and
resells them at a price that is expected to result in a Answer (C) is incorrect because the preemptive right
profit. has nothing to do with dividends. Moreover,
preferred stockholders have preference over
common stockholders with respect to dividends.
[33] Source: CMA 0693 1-6
Answer (D) is incorrect because the corporation is
Answer (A) is incorrect because prices are not not required to sell new issues to existing
registered. stockholders; the requirement is that the existing
shareholders must be given the first opportunity to
Answer (B) is incorrect because prices are not buy new issues. If a stockholder declines to exercise
registered. the right, the new issue may be sold to others.

Answer (C) is correct. SEC Rule 415 allows

corporations to file registration statements covering a [36] Source: CMA 0693 1-9
stipulated amount of securities that may be issued
over the 2-year effective period of the statement. The Answer (A) is incorrect because the right is worth
securities are placed on the shelf and issued at an $2.50.
opportune moment without the necessity of filing a
new registration statement, observing a 20-day Answer (B) is correct. Plugging the amounts into the
waiting period, or preparing a new prospectus. The formula produces a theoretical value of $2.50 per
issuer is required only to provide updating right:
amendments or to refer investors to quarterly and
annual statements filed with the SEC. Shelf ($50 - $40) ・(3 + 1) = $2.50.
registration is most advantageous to large To check the answer, assume that an investor
corporations that frequently offer securities to the purchases three rights at $2.50 each (a total of
public. $7.50) and uses them to buy a share of stock for
$40. The total investment is $47.50. Similarly, a
Answer (D) is incorrect because the market price of person holding a $50 share of stock before the rights
securities is not frozen by shelf registration. are issued will have a basis of $47.50 after selling the
right for $2.50. Thus, the value of the stock ex-rights
is $47.50, and the value of the right is $2.50.
[34] Source: CMA 0693 1-7
Answer (C) is incorrect because $10 is the difference
Answer (A) is incorrect because a sale of treasury between the price of the stock with rights ($50) and
stock increases the supply of shares and could lead the exercise price ($40).
to a decline in market price.
 Answer (D) is incorrect because $40 is the exercise when the debt ratio is very high. Thus, the
price of the new issue. bondholders have as much risk as the holders of
equity securities. Such bonds are not highly rated by
credit evaluation companies. Junk bonds have
[37] Source: CMA 0693 1-10 become accepted because of the tax deductibility of
the interest paid.
Answer (A) is correct. Plugging the amounts into the
given formula produces a theoretical value of $2.50 Answer (B) is incorrect because junk bonds are not
per right, which leaves a theoretical value of $47.50 yet worthless; they simply bear high interest rates and
for the stock: high risk.

P -S Answer (C) is incorrect because junk bonds typically

on offer high yields.
R = -------
on N + 1 Answer (D) is incorrect because Drexel Burnham
($50 - $40) ・(3 + 1) = $2.50. was not the only underwriter to package junk bonds,
However, if the stock declines to $47.50 when the and they were never illegal.
right is worth only $2, the original investor is worse
off then before the rights issuance; i.e., the investor
would have only $49.50 worth of investments. [40] Source: CMA 0693 1-17
Hence, the original shareholder receives no benefit
from the issuance of the rights. Answer (A) is incorrect because bondholders will
receive an income only if the issuing company earns
Answer (B) is incorrect because the stockholder sufficient income to pay the interest.
would be worse off after the rights offering ($49.50)
than before the rights offering ($50). Answer (B) is incorrect because all bonds have
priority over preferred and common stock.
Answer (C) is incorrect because the shareholder
receives only a certificate granting the right to make Answer (C) is incorrect because subordinated debt is
an additional investment. junior to nonsubordinated debt.

Answer (D) is incorrect because an investor cannot Answer (D) is correct. An income bond is one that
redeem a right before the ex-rights date, i.e., while pays interest only if the issuing company has earned
the stock is still rights-on. the interest, although the principal must still be paid
on the due date. Such bonds are riskier than normal
bonds.
[38] Source: CMA 0693 1-15

Answer (A) is incorrect because venture capital [41] Source: CMA 0693 1-18
investments are typically private placements.
Answer (A) is incorrect because par value is rarely
Answer (B) is correct. The concept of venture (risk) the same as market value. Normally, market value
capital applies to new enterprises that might not be will be equal to or greater than par value, but there is
able to obtain funds in the usual capital markets no relationship between the two.
because of the riskiness of new products. Such
companies sometimes try to place securities, normally Answer (B) is correct. Par value represents a stock's
common stock, with venture capital firms. These are legal capital. It is an arbitrary value assigned to stock
normally private placements of the securities and thus before it is issued. Par value represents a
not subject to SEC regulation. The venture capitalists shareholder's liability ceiling because, as long as the
risk low liquidity for their investments until the young par value has been paid in to the corporation, the
corporation becomes successful. The payoff may be shareholders obtain the benefits of limited liability.
substantial if the company does succeed. There is no
minimum holding period for venture capital Answer (C) is incorrect because all assets received
investments. for stock must be entered into a corporation's
records. The amount received is very rarely the par
Answer (C) is incorrect because common stock is value.
usually a part of most venture capital deals. Venture
capitalists want large payoffs in exchange for the risk Answer (D) is incorrect because par value can be
assumed. any amount more or less than $100.

Answer (D) is incorrect because venture capital

investments typically are not liquid for a substantial [42] Source: CMA 0688 1-1

time after the investment is made. Answer (A) is incorrect because $.40 results from
using taxes, not after-tax net income, in the
numerator.
[39] Source: CMA 0693 1-16
Answer (B) is correct. Annual interest on the bonds
Answer (A) is correct. Junk bonds are high-risk and would be $500,000, resulting in a pretax income of
therefore high-yield securities that are normally issued $500,000. Given a 40% tax rate, after-tax net
 income would be $300,000. EPS would therefore be value has two components: the sales price and
$.60 ($300,000 NI ・500,000 shares). income. The present values of the future $25 selling
price and the related annual dividends of $2.00,
Answer (C) is incorrect because $1.00 is the EPS $2.10, and $2.25 for year 2, year 3, and year 4,
amount calculated without adjusting for taxes. respectively, can be determined by applying the
relevant time value of money factors rounded to the
Answer (D) is incorrect because $1.20 is calculated nearest dollar. Accordingly, the sum of the present
using the company's after-tax net income of values (the intrinsic value of a share of stock) is $24.
$600,000 which is not adjusted for the $500,000
interest expense resulting from the bond issuance. Dividends TVMF PV
--------- ---- ------
$ 2.00 x .909 = $ 1.82
[43] Source: CMA 0688 1-2 2.10 x .826 = 1.73
2.25 x .751 = 1.69
Answer (A) is incorrect because $.60 is the primary 25.00 x .751 = 18.77
EPS assuming the bonds are issued. ------------------ ------
TOTAL $24.01
Answer (B) is correct. The $1,000,000 of pretax ================== ======
income would be reduced by 40%, leaving after-tax
net income of $600,000. Dividing the $600,000 of Answer (D) is incorrect because $19 is the
net income by 600,000 shares (the original 500,000 discounted value of the $25 expected selling price.
plus the 100,000 new shares) produces an EPS of
$1.
[46] Source: CMA 1288 1-8
Answer (C) is incorrect because $1.20 assumes
after-tax net income of $600,000 and a denominator Answer (A) is incorrect because $10.00 is the
of 500,000 shares. current market price of a share of stock.

Answer (D) is incorrect because $1.67 is calculated Answer (B) is incorrect because, when the new
using pretax net income of $1,000,000 in the shares are issued, the market value of a share will be
numerator. approximately $9.91. A shareholder with 10 rights
will be able to buy a share of stock for $9. The 10
rights are worth about $0.91 ($9.91 - $9.00), or
[44] Source: CMA 0688 1-6 about $0.09 each.

Answer (A) is correct. Book value per share equals Answer (C) is incorrect because $0.91 is the value of
stockholders' equity attributable to common 10 rights.
shareholders (the residual equity) divided by the
common shares outstanding. Given no preferred
stock, the total shareholders' equity of $5,000,000 Answer (D) is correct. Since 5,000 shares are
($10,000,000 - $3,000,000 long-term debt - outstanding, and only 500 new shares will be issued,
$2,000,000 current liabilities) is the residual equity. 10 rights will be needed to buy one share of stock.
The book value per common share is therefore $50 Currently, the market value of the 5,000 shares of
($5,000,000 ・100,000 shares outstanding). stock is $10 per share, or $50,000. When the
additional 500 shares are issued at $9 each (a total of
Answer (B) is incorrect because $29 is calculated by $4,500), the total market value will have increased to
dividing the 100,000 shares of stock into retained $54,500. Dividing the $54,500 by the 5,500 shares
earnings. that will be outstanding produces a probable market
value of approximately $9.91 per share immediately
Answer (C) is incorrect because $100 is calculated after the purchase. A shareholder with 10 rights will
by dividing the 100,000 shares of stock into the sum be able to buy a share of stock for $9, so the 10
of the liabilities and stockholders' equity. rights are worth about $0.91 ($9.91 - $9.00), or
about $.09 each.
Answer (D) is incorrect because $5 is calculated by
dividing the 100,000 shares into common stock.
[47] Source: CMA 0689 1-5

[45] Source: CMA 0688 1-7 Answer (A) is incorrect because $5.00 is the par
value of the stock.
Answer (A) is incorrect because $31 is the
undiscounted sum of the anticipated receipts. Answer (B) is incorrect because $17.00 does not
include retained earnings.
Answer (B) is incorrect because the intrinsic value in
year 2 will be less than the anticipated value in year 4. Answer (C) is incorrect because $31.00 is calculated
using total stockholders' equity. The par value of the
Answer (C) is correct. The intrinsic value of the stock preferred is not available to common stockholders
is its discounted present value given the 10% required and should not be included.
rate of return (discount rate), annual dividend
payments, and the expectation of sale at the end of 3 Answer (D) is correct. Assuming no dividends in
years for a specified price ($25). Hence, the intrinsic arrears on the preferred stock, the common
 shareholders are entitled to all of the stockholders' Answer (B) is incorrect because 5.74% is calculated
equity other than the par value of the preferred stock. by dividing the annual dividend of $3.90 (6% x $65)
Hence, $23,000,000 ($31,000,000 net worth - by the $68 issue price.
$8,000,000 preferred) is available to common
shareholders. Given 1,000,000 shares of common Answer (C) is incorrect because 6.00% is calculated
stock outstanding ($5,000,000 ・$5 par value), the by dividing the annual dividend of $3.90 (6% x $65)
book value is $23 per share ($23,000,000 ・ by the $65 par value.
1,000,000 shares).
Answer (D) is correct. The company will receive the
use of only $64 per share. The annual dividend
[48] Source: CMA 0689 1-6 requirement is 6% of $65, or $3.90 per share.
Dividing the $3.90 by the $64 received results in a
Answer (A) is correct. The preemptive right gives financing cost of 6.09%.
stockholders the opportunity to maintain their
percentage share of ownership even if additional
shares are issued. Because 1,000,000 shares are [51] Source: CMA 0690 1-13
currently outstanding, and 200,000 additional shares
are to be issued, each shareholder is entitled to buy Answer (A) is incorrect because the cost of retained
20% of any new shares (200,000 ・1,000,000). earnings is 12.99% [8.5% + 1.15 (12.4% - 8.5%)].
Thus, a shareholder who currently owns 10,000
shares is entitled to buy 2,000 new shares. Answer (B) is correct. The CAPM determines the
cost of capital by adding the risk-free rate to the
Answer (B) is incorrect because a preemptive right product of the market risk premium and the beta
gives stockholders the opportunity to maintain their coefficient (the beta coefficient is a measure of the
percentage share of ownership. Given an increase of firm's risk). The market risk premium is the amount in
20% in the number of shares outstanding (200,000 ・ excess of the risk-free rate that investors must be
1,000,000), a shareholder who currently owns paid to induce them to enter the market. The 7%
10,000 shares is entitled to buy 2,000 shares. flotation costs do not enter into the calculations
because the company does not plan to issue common
Answer (C) is incorrect because a preemptive right stock. Hence, the cost of retained earnings for Colt is
gives stockholders the opportunity to maintain their 12.99% [8.5% + 1.15 (12.4% - 8.5%)].
percentage share of ownership. Given an increase of
20% in the number of shares outstanding (200,000 ・ Answer (C) is incorrect because 12.40% is the
1,000,000), a shareholder who currently owns market return.
10,000 shares is entitled to buy 2,000 shares.
Answer (D) is incorrect because the cost of retained
Answer (D) is incorrect because a preemptive right earnings is 12.99% [8.5% + 1.15 (12.4% - 8.5%)].
gives stockholders the opportunity to maintain their
percentage share of ownership. Given an increase of
20% in the number of shares outstanding (200,000 ・ [52] Source: CMA 0690 1-14
1,000,000), a shareholder who currently owns
10,000 shares is entitled to buy 2,000 shares. Answer (A) is incorrect because 11.50% uses the
current dividend and does not consider flotation
costs.
[49] Source: CMA 0690 1-11
Answer (B) is incorrect because 11.79% is
Answer (A) is correct. Interest is 12%, and the calculated by using the current dividend instead of
annual interest payment on one bond is $120. Thus, allowing for a 6% growth rate.
the effective rate is 12.18% ($120 ・$985).
Reducing this rate by the 40% tax savings lowers the Answer (C) is incorrect because 11.83% does not
cost to 7.31%. consider flotation costs.

Answer (B) is incorrect because 4.87% is calculated Answer (D) is correct. The cost of equity using the
by multiplying the pretax effective rate 12.18% ($120 Gordon Growth Model equals the quotient of the
・$985) by the tax rate of .40 instead of by (1 - .40). next dividend divided by the stock price, plus the
growth rate in earnings per share. To account for
Answer (C) is incorrect because 12% is the nominal flotation costs, the stock price is multiplied by one
interest rate. minus the flotation cost. Given that the next dividend
is $2.332 (1.06 x $2.20), the cost of new common
Answer (D) is incorrect because the after-tax cost of stock is 12.14% {[$2.332 ・($40 x (1 - .05))] +
the bonds equals the effective rate 12.18% ($120 ・ .06}.
$985) times the tax effect (1 - .40), or 7.31%.

[53] Source: CIA 1190 IV-55

[50] Source: CMA 0690 1-12
Answer (A) is incorrect because an operating lease
Answer (A) is incorrect because 5.42% is calculated does not affect the debt ratio.
by dividing the annual dividend of $3.90 (6% x $65)
by $72 ($68 issue price + $4 issuance costs). Answer (B) is correct. Under an operating lease, the
lessee reports neither an asset nor a liability in the
 balance sheet. The ratio of debt to total assets is
therefore unchanged if the lessee enters into an
operating lease. Borrowing, however, will increase [56] Source: CIA 1193 IV-50
the ratio. Increasing the numerator (debt) and the
denominator (total assets) by the same amount (cost Answer (A) is incorrect because $15,000 is the
of the fixed assets) increases a ratio that is less than pre-tax income from the project.
100%.
Answer (B) is incorrect because $9,000 includes
Answer (C) is incorrect because, if the assets are depreciation as a cash outflow.
purchased, the debt ratio will increase.
Answer (C) is incorrect because $19,000 equals
Answer (D) is incorrect because the debt ratio will expected annual cash flow plus depreciation.
increase if the assets are purchased. Moreover, an
operating lease does not affect the debt ratio. Answer (D) is correct. Depreciation expense is not a
cash outflow and is not considered in the cash
analysis except for its effects on taxes paid. Thus, the
[54] Source: CIA 0591 IV-49 expected annual cash flow is $14,000 {(1.0 - .4 tax
rate)[$50,000 cash sales - $10,000 fixed cost - (.4 x
Answer (A) is incorrect because total demand for the $50,000) variable costs - $5,000 depreciation] +
product, market share, advertising campaigns, $5,000 depreciation}.
promotional discounts, and credit terms are important
factors in the determination of a sales forecast.
[57] Source: CIA 0592 IV-48
Answer (B) is incorrect because total demand for the
product, market share, advertising campaigns, Answer (A) is incorrect because the current market
promotional discounts, and credit terms are important value of the firm reflects, in part, the inefficient
factors in the determination of a sales forecast. manner in which it is run. This value understates its
acquisition value to an acquirer that would
Answer (C) is correct. A sales projection is a subsequently increase operating efficiency.
complex determination based on numerous factors.
For example, total demand for the product, which is Answer (B) is incorrect because the discounted net
usually based on trend analysis, must be present value of EBIT, current net profits, and current
approximated. The business activity in the company's cash flows are reduced by inefficiency, and thus
market areas must also be considered, along with its provide only a partial measure of acquisition value to
expected market share. The company's production an acquirer who will subsequently improve operating
capacity and that of each competitor, the introduction efficiency.
of new or improved products, pricing strategies, and
exchange rates are among the factors affecting Answer (C) is incorrect because the discounted net
market share. Advertising, discounts, and credit present value of EBIT, current net profits, and current
terms are still other factors to be weighed. However, cash flows are reduced by inefficiency, and thus
although a company's fixed assets are dependent on provide only a partial measure of acquisition value to
forecasted sales, they are not normally considered to an acquirer who will subsequently improve operating
influence forecasted sales. efficiency.

Answer (D) is incorrect because total demand for the Answer (D) is correct. The discounted net present
product, market share, advertising campaigns, value of expected future cash flows reflects the
promotional discounts, and credit terms are important favorable effects of enhanced operating efficiency
factors in the determination of a sales forecast. after the acquisition. It provides a measure of the
maximum value of the firm to an acquirer. The flows
themselves may be estimated from pro forma financial
[55] Source: CIA 1192 IV-51 statements. Also, the cash flows are equity flows, so
the acquired firm's cost of equity should be used as
Answer (A) is incorrect because a budget does not the discount rate. This rate reflects the risk inherent in
allow for the estimation of the beta coefficient, which the acquired firm's equity flows. The capital asset
is a measure of stock market volatility. pricing model equation (security market line) may be
used to estimate the discount rate.
Answer (B) is correct. A budget is a quantitative
model of a plan of action developed by management.
A budget functions as an aid to planning, [58] Source: CIA 0593 IV-59
coordination, and control. Thus, a budget helps
management to allocate resources efficiently and to Answer (A) is correct. A company with cash flow
ensure that subunit goals are congruent with those of problems may replace debt with common stock to
other subunits and of the organization. eliminate the fixed charges associated with the debt.
The holders of common stock are not legally entitled
Answer (C) is incorrect because the cost of capital is to a return when the company is in difficulty.
the weighted average of the costs of the elements in
the firm's capital structure. Answer (B) is incorrect because replacing common
stock by debt would make cash flow problems
Answer (D) is incorrect because the optimal capital worse.
structure is a function of the cost of capital.
 Answer (C) is incorrect because replacing debt or
common stock with preferred stock is less effective Answer (B) is incorrect because such provisions
than issuing common stock to replace debt. Preferred would be highly disadvantageous for the issuer.
stock may be cumulative, and its holders have claims
superior to those of the common stockholders. Answer (C) is incorrect because such provisions
would be highly disadvantageous for the issuer.
Answer (D) is incorrect because replacing debt or
common stock with preferred stock is less effective Answer (D) is incorrect because it describes a call
than issuing common stock to replace debt. Preferred option, a form of stock option.
stock may be cumulative, and its holders have claims
superior to those of the common stockholders.
[62] Source: CIA 1191 IV-59

[59] Source: CIA 0593 IV-56 Answer (A) is incorrect because a stock split is
merely an accounting action that increases (or
Answer (A) is incorrect because the company will occasionally decreases) the number of shares
not benefit from short-term loans if interest rates rise. outstanding. It does not generate additional capital.

Answer (B) is incorrect because the company should Answer (B) is incorrect because conversion of
maintain the existing debt if prevailing interest rates convertible bonds to common stock simply replaces
are higher. debt with outstanding common stock.

Answer (C) is correct. If interest rates have declined, Answer (C) is correct. Warrants are options that
refunding with short-term debt may be appropriate. permit the holder to buy stock for a stated price.
The bonds pay a higher interest rate than the new Their exercise results in inflows and the issuance of
short-term debt. Assuming that rates continue to fall, stock.
the short-term debt can itself be refunded with debt
having a still lower interest charge. The obvious risk is Answer (D) is incorrect because options purchased
that interest rates may rise, thereby compelling the and exercised through option exchanges are
company to choose between paying off the debt or transactions between individual investors not affecting
refunding it at higher rates. the firm whose stock is involved.

Answer (D) is incorrect because the company

increases the cash flow problem by shifting to [63] Source: CIA 1190 IV-52
short-term loans.
Answer (A) is incorrect because, in a competitive bid
issue, investment bankers bid for the opportunity to
[60] Source: CIA 1192 IV-57 issue the securities of a valued client firm.

Answer (A) is incorrect because income bonds pay Answer (B) is incorrect because, in a negotiated
interest only if interest is earned. issue, the terms of an underwriting are set through
negotiation between the firm and an investment
Answer (B) is incorrect because debentures are banker.
unsecured bonds.
Answer (C) is correct. If a firm decides to issue
Answer (C) is incorrect because subordinated securities, it will seek the assistance of an investment
debentures are subordinated to other debt. banker to market them. A few large firms, whose
business will be very profitable to investment
Answer (D) is correct. A mortgage bond is secured bankers, seek competitive bids, but most operate on
with specific fixed assets, usually real property. Thus,
under the rights enumerated in the bond indenture, a negotiated basis, that is, the terms of the
creditors will be able to receive payments from underwriting are set by negotiation between the firm
liquidation of the property in case of default. In a and its banker. The firm and its chosen investment
bankruptcy proceeding, these amounts are paid banker must make final decisions about the amount
before any transfers are made to other creditors, and types of securities to issue and the basis for
including those preferences. Hence, mortgage bonds pricing. The firm and its banker must also agree on
are less risky than the others listed. the allocation of risks, for example, those arising from
changes in stock prices and interest rates. Thus, in a
best efforts issue, the banker gives no guarantee that
[61] Source: CIA 0589 IV-56 the securities will be sold. If the issue is underwritten,
however, the investment banker accepts the risk of
Answer (A) is correct. Call provisions give the guaranteeing the sale.
corporation the right to call in the bonds for
redemption. This right is an advantage to the firm but Answer (D) is incorrect because an underwritten
not for the investor. If interest rates decline, the issue is an issue for which the investment bank
company can call in the high-interest bonds and guarantees the sale of the securities.
replace them with low-interest bonds, a process
known as refunding. The call premium is some
amount in excess of the par value. In the first year, for [64] Source: CIA 0590 IV-49
example, it might equal 1 year's interest.
 Answer (A) is incorrect because a very high debt divides ownership interests into smaller pieces
ratio would minimize the firm's tax liability but might without changing any stockholder's proportionate
not maximize shareholder wealth. The risk level share of ownership.
would be unacceptable.
Answer (D) is incorrect because a project with a
Answer (B) is incorrect because a very low debt positive NPV or a high internal rate of return should
ratio would minimize the firm's risk but might not increase the value of the firm.
maximize shareholder wealth. The potential return to
shareholders would be unacceptable.
[67] Source: CIA 0590 IV-48
Answer (C) is incorrect because a maximum degree
of leverage would result in excessive risk and Answer (A) is correct. The ex-dividend date is 4
therefore would not maximize shareholder wealth. days before the date of record. Unlike the other
relevant dates, it is not established by the corporate
Answer (D) is correct. Standard financial theory board of directors but by the stock exchanges. The
states that there is an optimal capital structure. The period between the ex-dividend date and the date of
optimal capital structure of a firm is defined as the record gives the stock exchange members time to
permanent, long-term financing of the firm process any transactions in time for the new
represented by long-term debt, preferred stock, and stockholders to receive the dividend to which they
common stock. Capital structure is distinguished from are entitled. An investor who buys a share of stock
financial structure, which includes short-term debt before the ex-dividend date will receive the dividend
plus the long-term accounts. The optimal capital that has been previously declared. An investor who
structure minimizes the weighted-average cost of buys after the ex-dividend date (but before the date
capital and thereby maximizes the value of the firm. of record or payment date) will not receive the
This value is reflected in the price of the firm's stock. declared dividend. Instead, the individual who sold
the stock will receive the dividend because (s)he
owned it on the ex-dividend date. A stock price will
usually drop on the ex-dividend date by the amount
[65] Source: CIA 1191 IV-58 of the dividend because the new investor will not
receive it.
Answer (A) is incorrect because EPS is not a
function of investor confidence and is not maximized Answer (B) is incorrect because the date of record is
by concurrent proportional increases in both debt and the date on which the corporation determines which
equity. EPS are usually higher if debt is used instead stockholders will receive the declared dividend.
of equity to raise capital, at least initially. Essentially, the corporation closes its stockholder
records as of this date. Only those stockholders who
Answer (B) is correct. Earnings per share will own the stock on the date of record will receive the
ordinarily be higher if debt is used to raise capital dividend. It typically falls from 2 to 6 weeks after the
instead of equity, provided that the firm is not declaration date.
over-leveraged. The reason is that the cost of debt is
lower than the cost of equity because interest is tax Answer (C) is incorrect because the date of payment
deductible. However, the prospect of higher EPS is is the date on which the dividend is actually paid; i.e.,
accompanied by greater risk to the firm resulting from the checks are put into the mail to the investors on
required interest costs, creditors' liens on the firm's this date. The payment date is usually from 2 to 4
assets, and the possibility of a proportionately lower weeks after the date of record.
EPS if sales volume fails to meet projections.
Answer (D) is incorrect because the date of record is
Answer (C) is incorrect because equity capital is
initially more costly than debt. the date on which the corporation determines which
stockholders will receive the declared dividend.
Answer (D) is incorrect because using only current Essentially, the corporation closes its stockholder
cash flow to raise capital is usually too conservative records as of this date. Only those stockholders who
an approach for a growth-oriented firm. Management own the stock on the date of record will receive the
is expected to be willing to take acceptable risks to dividend. It typically falls from 2 to 6 weeks after the
be competitive and attain an acceptable rate of declaration date.
growth.

[68] Source: CIA 0590 IV-58

[66] Source: CIA 0593 IV-46
Answer (A) is incorrect because the business could
Answer (A) is incorrect because a project with a possibly be reorganized.
positive NPV or a high internal rate of return should
increase the value of the firm. Answer (B) is incorrect because the business can
possibly be liquidated.
Answer (B) is incorrect because the higher credit
rating should reduce the cost of capital and therefore Answer (C) is correct. A financially troubled business
increase the value of the firm. that has a reasonable chance to emerge from its
difficulties can restructure its debts under Chapter 11
Answer (C) is correct. A stock dividend does not of the Federal Bankruptcy Act. Chapter 11 is a
significantly affect the value of the firm. It simply voluntary alternative to liquidation proceedings in
 bankruptcy. The corporation submits a plan of [71] Source: CMA 1294 1-29
reorganization to restructure its debts and take any
other appropriate action, including a change in Answer (A) is correct. An increase in the corporate
management. The corporation remains in business income tax rate might encourage a company to
and does not lose all its assets. The plan of borrow because interest on debt is tax deductible,
reorganization must be approved by the court. But whereas dividends are not. Accordingly, an increase
first a majority of creditors of each class of debt in the tax rate means that the after-tax cost of debt
holding at least two-thirds in amount of that debt must capital will decrease. Given equal interest rates, a firm
approve the plan. However, only one class of with a high tax rate will have a lower after-tax cost of
creditors need approve the plan if the court finds that debt capital than a firm with a low tax rate.
it is "fair and equitable."
Answer (B) is incorrect because increased
Answer (D) is incorrect because the business could uncertainty encourages equity financing. Dividends do
be reorganized without paying creditors in full. not have to be paid in bad years, but interest on debt
is a fixed charge.

[69] Source: CIA 0594 IV-55 Answer (C) is incorrect because an increase in
interest rates discourages debt financing.
Answer (A) is incorrect because administrative
expenses are paid before all other claims except Answer (D) is incorrect because an increase in the
those of secured creditors to the proceeds of their price-earnings ratio means that the return to
specific collateral. shareholders (equity investors) is declining; therefore,
equity capital is a more attractive financing alternative.
Answer (B) is incorrect because administrative
expenses are paid before all other claims except
those of secured creditors to the proceeds of their [72] Source: CMA 0695 1-2
specific collateral.
Answer (A) is incorrect because callable bonds
Answer (C) is incorrect because unsecured creditors sometimes pay a slightly higher rate of interest.
are paid before preferred stockholders. Investors may demand a greater return because of
the uncertainty over the true maturity date.
Answer (D) is correct. The priority of claims in
bankruptcy is determined by federal statute. Secured Answer (B) is incorrect because conversion is at the
creditors are paid in full to the extent of the proceeds option of the investor.
available from the sale of their specific collateral. If
those proceeds are insufficient, the unpaid secured Answer (C) is correct. A callable bond can be
claims are treated as those of general unsecured recalled by the issuer prior to maturity. A call
creditors. The expenses of administration are paid provision is detrimental to the investor because the
next followed by unsecured claims arising after the issuer can recall the bond when market interest rates
case has begun but before appointment of a trustee. decline. It is usually exercised only when a company
Other clams are then paid in the following order: wishes to refinance high-interest debt.
certain wages, certain contributions to employee
benefit plans, claims of grain producers and Answer (D) is incorrect because the call premium is
fishermen, unsecured customer deposits, taxes, the amount in excess of par that the issuer must pay
claims of unsecured general creditors, the interests of when bonds are called.
preferred stockholders, and, finally, the interests of
common stockholders.
[73] Source: CMA 0695 1-3

[70] Source: CMA 1294 1-28 Answer (A) is incorrect because $2.34 results from
treating preferred dividends as tax deductible.
Answer (A) is incorrect because the growth rate
(10%) is added to the dividend yield (10%). Answer (B) is incorrect because $2.70 ignores the
effect of preferred dividends.
Answer (B) is incorrect because the growth rate
(10%) is added to the dividend yield (10%). Answer (C) is incorrect because $1.80 is based on a
60% effective tax rate and ignores the effect of
Answer (C) is incorrect because 11.0% equals the preferred dividends.
growth rate (10%) plus 10% of the current dividend
yield (10%). Answer (D) is correct. The company's net income is
$18,000,000 [($35,000,000 EBIT - $5,000,000
Answer (D) is correct. Under the dividend growth interest) x (1.0 - .4 tax rate)]. Thus, the earnings
model, the cost of equity equals the expected growth available to common shareholders equal
rate plus the quotient of the next dividend and the $14,000,000 ($18,000,000 - $4,000,000 preferred
current market price. Thus, the cost of equity capital dividends), and EPS is $7 ($14,000,000 ・
is 20% [10% + ($3 ・$30)]. This model assumes 2,000,000 common shares). Given a
that the payout ratio, retention rate, and the earnings dividend-payout ratio of 30%, the dividend to
per share growth rate are all constant. common shareholders is expected to be $2.10 per
share (30% x $7).
[74] Source: CMA 0695 1-4 [77] Source: CMA 0697 1-21

Answer (A) is incorrect because $104 ignores Answer (A) is correct. Dividend policy determines
income taxes. the portion of net income distributed to stockholders.
Corporations normally try to maintain a stable level of
Answer (B) is correct. Net income is $18,000,000 dividends, even though profits may fluctuate
[($35,000,000 EBIT - $5,000,000 interest) x (1.0 - considerably, because many stockholders buy stock
.4 tax rate)], and EPS is $7 [($18,000,000 NI with the expectation of receiving a certain dividend
-$4,000,000 preferred dividends) ・2,000,000 every year. Thus, management tends not to raise
common shares]. Consequently, the market price is dividends if the payout cannot be sustained. The
$56 ($7 EPS x $8 P-E ratio).
desire for stability has led theorists to propound the
Answer (C) is incorrect because $72 ignores the information content or signaling hypothesis: a change
effect of preferred dividends. in dividend policy is a signal to the market regarding
management's forecast of future earnings. This
Answer (D) is incorrect because $68 ignores the stability often results in a stock that sells at a higher
deductibility of interest. market price because stockholders perceive less risk
in receiving their dividends.

[75] Source: CMA 0695 1-5 Answer (B) is incorrect because most companies try
to maintain stable dividends.
Answer (A) is incorrect because the present value of
any liabilities assumed, the cash paid to the seller's Answer (C) is incorrect because mature firms have
shareholders, and the incremental future cash flows less need of earnings to reinvest for expansion; thus,
must be known. they tend to pay a higher percentage of earnings as
dividends.
Answer (B) is incorrect because the present value of
any liabilities assumed, the cash paid to the seller's Answer (D) is incorrect because most companies try
shareholders, and the incremental future cash flows to maintain stable dividends.
must be known.

Answer (C) is correct. If a company is being [78] Source: CMA 0695 1-10
purchased for cash, the buyer needs to determine the
net investment or gross cash requirement (after Answer (A) is incorrect because $250 represents the
adjustments for taxes and recoveries from sales of annual earnings on 100 shares.
existing assets) and the incremental future after-tax
cash flows from operations to calculate a rate of Answer (B) is incorrect because $1,333 assumes that
return on the investment. The cash flow calculation is the value of the total investment declines after the
a function of reliable estimates of revenues, cost split.
savings, etc. The future returns will be compared with
the initial investment, which consists of the cash paid Answer (C) is correct. EPS equals $2.50 ($500,000
to the seller's shareholders and the present value of NI ・200,000 pre-split shares). Thus, 100 shares
any liabilities assumed by the buyer. had a value of $2,000 (100 shares x 8 P-E ratio x
$2.50 EPS) before the split. This value is unchanged
Answer (D) is incorrect because the present value of by the stock split. Although the stockholder has more
any liabilities assumed, the cash paid to the seller's shares, the total value of the investment is the same.
shareholders, and the incremental future cash flows
must be known. Answer (D) is incorrect because $3,000 assumes
that the value of the investment as well as the number
of shares increases by 50%.
[76] Source: CMA 0695 1-6

Answer (A) is incorrect because, if a bond sells at a [79] Source: CMA 0695 1-11
premium, the market rate of interest is less than the
coupon rate. Answer (A) is incorrect because $350,000 is the
common stock dividend.
Answer (B) is incorrect because a bond sells at a
discount when the price is less than the face amount. Answer (B) is incorrect because $380,000 omits the
$30,000 of cumulative dividends for year 2.
Answer (C) is correct. The excess of the price over
the face value is a premium. A premium is paid Answer (C) is incorrect because $206,000 is based
because the coupon rate on the bond is greater than on a flat rate of $1 per share of stock.
the market rate of interest. In other words, because
the bond is paying a higher rate than other similar Answer (D) is correct. If a company has cumulative
bonds, its price is bid up by investors. preferred stock, all preferred dividends for the
current and any unpaid prior years must be paid
Answer (D) is incorrect because a bond sells at a before any dividends can be paid on common stock.
discount when the price is less than the face amount. The total preferred dividends that must be paid equal
$60,000 (2 years x 5% x $100 par x 6,000 shares),
 and the common dividend is $350,000 ($1,750,000 20,000 shares has a 1% ownership. Hence, this
x 20%), for a total of $410,000. investor must be allowed to purchase 4,000 (1% x
400,000 shares) of the additional shares.

[80] Source: CMA 0697 1-24 Answer (D) is incorrect because preferred
shareholders do not share in preemptive rights.
Answer (A) is incorrect because 90% is the
reinvestment ratio.
[83] Source: CMA 1295 1-16
Answer (B) is incorrect because 66.7% is the ratio
between earnings and investment. Answer (A) is incorrect because EPS is based on the
relationship between costs and revenues, whereas the
Answer (C) is incorrect because 40% is the ratio of capital structure is related only to the cost of capital.
debt in the ideal capital structure.
Answer (B) is incorrect because the cost of equity
Answer (D) is correct. Under the residual theory of capital must also be considered when optimizing
dividends, the residual of earnings paid as dividends capital structure.
depends on the available investments and the
debt-equity ratio at which cost of capital is minimized. Answer (C) is incorrect because the minimum risk
The rational investor should prefer reinvestment of may be associated with high costs.
retained earnings when the return exceeds what the
investor could earn on investments of equal risk. Answer (D) is correct. Ideally, a firm will have a
However, the firm may prefer to pay dividends when capital structure that minimizes its weighted-average
investment returns are poor and the internal equity cost of capital. This requires a balancing of both debt
financing would move the firm away from its ideal and equity capital and their associated risk levels.
capital structure. If Residco wants to maintain its
current structure, 60% of investments should be
financed from equity. Hence, it needs $720,000 [84] Source: CMA 0691 1-5
(60% x $1,200,000) of equity funds, leaving
$80,000 of net income ($800,000 NI - $720,000) Answer (A) is correct. Historically, one facet of the
available for dividends. The dividend-payout ratio is term structure of interest rates (the relationship of
therefore 10% ($80,000 ・$800,000 NI). yield and time to maturity) is that short-term interest
rates have ordinarily been lower than long-term rates.
One reason is that less risk is involved in the short
[81] Source: CMA 0695 1-12 run. Moreover, future expectations concerning
interest rates affect the term structure. Most
Answer (A) is correct. The book value per common economists believe that a long-term interest rate is an
share equals the net assets (equity) attributable to average of future expected short-term interest rates.
common shareholders divided by the common shares For this reason, the yield curve will slope upward if
outstanding, or $18.50 [($10,000,000 common future rates are expected to rise, slope downward if
stock + $18,000,000 additional paid-in capital + interest rates are anticipated to fall, and remain flat if
$9,000,000 RE) ・($10,000,000 ・$5 par)]. investors think the rate is stable. Future inflation is
incorporated into this relationship. Another
Answer (B) is incorrect because $5 is the par value consideration is liquidity preference: investors in an
per share. uncertain world will accept lower rates on short-term
investments because of their greater liquidity, whereas
Answer (C) is incorrect because $14.00 fails to business debtors often prefer to pay higher rates on
include retained earnings in the portion of equity long-term debt to avoid the hazards of short-term
attributable to common shareholders. maturities.

Answer (D) is incorrect because $100 is the par Answer (B) is incorrect because short-term rates are
value of a preferred share. usually lower than long-term rates.

Answer (C) is incorrect because short-term rates are

[82] Source: CMA 0695 1-13 more likely to be greater than long-term rates if
current levels of inflation are high.
Answer (A) is incorrect because the investor would
be allowed to purchase 1% of any new issues. Answer (D) is incorrect because long-term rates may
be viewed as short-term rates adjusted by a risk
Answer (B) is incorrect because preferred factor.
shareholders do not share in preemptive rights.

Answer (C) is correct. Common shareholders usually [85] Source: CIA 1196 IV-39
have preemptive rights, which means they have first
right to purchase any new issues of stock in Answer (A) is incorrect because 2.20 times uses net
proportion to their current ownership percentages. income instead of earnings before interest and taxes.
The purpose of a preemptive right is to allow
stockholders to maintain their current percentages of Answer (B) is incorrect because 2.94 times uses
ownership. Given that Smith had 2,000,000 shares Year 2 information and also uses net income instead
outstanding ($10,000,000 ・$5 par), an investor with of earnings before interest and taxes.
 Answer (C) is correct. The interest-coverage
(times-interest-earned) ratio equals earnings before [88] Source: CMA 0696 1-1
interest and taxes divided by interest charges. For
Year 1, the ratio is 5.40 times ($540,000 ・ Answer (A) is incorrect because $0.40 is the
$100,000). rights-on value if P is $50 and S is $48.

Answer (D) is incorrect because 6.88 times is the Answer (B) is incorrect because $0.50 is the
interest-coverage ratio for Year 2. ex-rights value if P is $50 and S is $48.

Answer (C) is incorrect because $1.60 is the

[86] Source: CIA 0595 IV-52 rights-on value if P is $48 and S is $40.

Answer (A) is correct. The projected sales increase Answer (D) is correct. Until rights are actually issued,
of $100,000 requires $38,000 of additional asset the stock trades rights-on, meaning that the stock and
financing. Profits for the year are projected to be rights are inseparable. If P is the value of a share
20% of sales, or $120,000 (20% x $600,000), of rights-on, S is the subscription price of a new share,
which 60%, or $72,000 (60% x $120,000), is and N is the number of rights needed to buy a new
available for reinvestment. No new external financing share, the value of a right when the stock is selling
will be required. rights-on is (P - S) ・(N + 1). Thus, the value of a
right when the stock is selling rights-on is $2.00 [($50
Answer (B) is incorrect because $38,000 results if - $40) ・(4 + 1)].
internally generated funds are not considered as a
source of financing.
[89] Source: CMA 0696 1-2
Answer (C) is incorrect because $86,000 results if
the dividend payment is considered to be a use of Answer (A) is incorrect because $0.40 is the
cash and internally generated funds are not rights-on value if P is $50 and S is $48.
considered.
Answer (B) is incorrect because $0.50 is the
Answer (D) is incorrect because $110,000 results if ex-rights value if P is $50 and S is $48.
internally generated funds available for reinvestment
are treated as a use, rather than a source, of Answer (C) is correct. If a stock can be purchased
financing. for $48 on the open market, or for $40 with four
rights, each right must be worth $2.00 ($8 savings ・
4 rights).
[87] Source: CIA 1192 IV-50
Answer (D) is incorrect because $2.50 is the
Answer (A) is incorrect because $1,572,000 is ex-rights value if P is $50 and S is $40.
based on adding the percentage increase in net
income to the previous amount of receivables {[6% x
($11,200,000 - $10,000,000)] + $1,500,000}. [90] Source: CMA 0696 1-8

Answer (B) is correct. In financial analysis, pro forma Answer (A) is incorrect because $4 was the market
financial statements reflect a forecast of actual events price at the beginning of the exercise period.
if certain assumptions are realized. One method of
preparing pro forma statements is to state certain Answer (B) is incorrect because the call option has
balance sheet amounts as percentages of expected some value if the market price exceeds the exercise
sales. Items that vary directly with sales (inventory, price.
receivables, accounts payable, plant assets, etc.) are
estimated in this way. Other balance sheet amounts Answer (C) is incorrect because $6.00 exceeds the
that do not necessarily vary directly with sales (notes difference between the market price and exercise
payable, marketable equity securities, common stock, price.
etc.) are taken from the most recent financial
statements. This method is based on the assumptions Answer (D) is correct. A call option permits a holder
that most balance sheet amounts directly correlate to purchase stock at a certain price (the exercise
with sales and that the current levels of all assets are price) regardless of the current market price. The
optimal for the current sales level. Thus, given that value of the option just prior to its expiration will be
last year's receivables equaled 15% of sales the difference between the exercise price and the
($1,500,000 ・$10,000,000), this year's ending current market price ($42 - $40 = $2.00), assuming
receivables balance is expected to be $1,680,000 that the market price is higher. If the exercise price is
(15% x $11,200,000). higher than the market price just prior to the
expiration date, the call option will have no value. A
Answer (C) is incorrect because $2,172,000 is call option permits an investor to share in a price rise
based on adding profit as a percentage of sales to last by making only a small investment. Hence, the
year's receivables [$1,500,000 + (6% x downside risk is small because it is limited to the cost
$11,200,000)]. of the option.

Answer (D) is incorrect because $2,700,000 equals

past receivables plus the additional sales. [91] Source: CMA 0696 1-9
 from common stock.
Answer (A) is incorrect because the theoretical
exercise value is zero when the exercise price Answer (C) is incorrect because simply increasing
exceeds the market price. debt may not be disadvantageous to the raider unless
the corporation distributes the new assets as
Answer (B) is correct. Theoretically, the call option dividends.
had no exercise value on the date of grant because it
permitted the purchase of a $34 stock at $40. No Answer (D) is incorrect because greenmail is an
reasonable person would exercise such an option. agreement to buy back a large block of stock from a
hostile raider.
Answer (C) is incorrect because the theoretical
exercise value is zero when the exercise price
exceeds the market price. [94] Source: CIA 1188 IV-50

Answer (D) is incorrect because the theoretical Answer (A) is correct. The percentage-of-sales
exercise value is zero when the exercise price method of forecasting financial statements assumes
exceeds the market price. that most balance sheet accounts are tied to sales and
that current asset levels are the best for the current
sales level. If the firm is operating at full fixed asset
[92] Source: CMA 1296 1-9 capacity and no unnecessary amounts of current
assets are held, total assets must increase by $.55 for
Answer (A) is incorrect because a stock dividend has each $1.00 increase in sales if assets are to be
no effect except on the composition of the maintained at their present percentage of sales ($550
shareholders' equity section of the balance sheet. million assets ・$1,000 million sales). Because
accounts payable and accruals account for 7% ($70
Answer (B) is incorrect because a stock dividend has million ・$1,000 million) of current sales, they should
no effect except on the composition of the finance $21 million of the $300 million sales increase.
shareholders' equity section of the balance sheet. These items rise spontaneously with sales because
higher sales require more purchases, accruals of
Answer (C) is correct. A stock dividend is a transfer wages and taxes, etc. Thus, the remaining $144
of equity from retained earnings to paid-in capital. million [(55% x $300 million) - $21 million] must be
The debit is to retained earnings, and the credits are generated in other ways, such as by nontrade debt
to common stock and additional paid-in capital. and equity. Given an after-tax margin on sales of 5%,
Additional shares are outstanding following the stock $1,300 million in sales generates $65 million in
dividend, but every shareholder maintains the same after-tax profits, of which 50% will be distributed.
percentage of ownership. In effect, a stock dividend Hence, the external funds required equal $111.50
divides the pie (the corporation) into more pieces, but million [$144 million - (.5 x $65 million)].
the pie is still the same size. Hence, a corporation will
have a lower EPS and a lower book value per share Answer (B) is incorrect because $165 million is the
following a stock dividend, but every shareholder will projected increase in total assets.
be just as well off as previously.
Answer (C) is incorrect because $65 million is the
Answer (D) is incorrect because a stock dividend has estimated after-tax profit.
no effect except on the composition of the
shareholders' equity section of the balance sheet. Answer (D) is incorrect because $144 million is the
projected increase in total assets minus the estimated
increase in accounts payable and accruals.
[93] Source: CMA 1296 1-26

Answer (A) is incorrect because a crown jewel [95] Source: CMA 1291 1-4
transfer is the selling off of profitable units in an
attempt to dissuade the hostile corporate raider. Answer (A) is incorrect because high interest
coverage suggests lower risk. Also, stable returns on
Answer (B) is correct. A target corporation's charter, equity indicate a low level of risk.
bylaws, or contracts may include a wide variety of
provisions that reduce the value of the target to Answer (B) is incorrect because high interest
potential tender offerors. For example, a valuable coverage suggests lower risk. Also, stable returns on
contract may terminate by its terms upon a specified equity indicate a low level of risk.
form of change of ownership of the target. A poison
pill is typically a right to purchase shares, at a Answer (C) is incorrect because a low
reduced price, in the merged firm resulting from a debt-to-equity ratio indicates a low level of risk.
takeover. A corporation may issue warrants to
shareholders that permit purchase of stock at a small Answer (D) is correct. A firm with high risk will have
percentage (often half) of market price in the event of a higher debt-to-equity ratio than a low-risk firm, a
a takeover attempt. In the event of a friendly tender lower interest coverage, and a volatile return on
offer, the outstanding stock rights can be repurchased equity. A higher debt-to-equity ratio poses a greater
for a few cents per share, thereby facilitating the risk of insolvency. Debtholders must be paid
combination. In many cases, these rights are not regardless of whether the firm is profitable. Low
issued in certificate form because they are not interest coverage means that the margin of safety of
immediately exercisable and are not traded separately earnings before interest and taxes is small. A volatile
 return on equity signifies that earnings are
unpredictable. Lack of predictability increases risk. Answer (C) is incorrect because 10 equals share
price divided by dividends per share.

[96] Source: CIA 0595 IV-35 Answer (D) is incorrect because 50 equals price per
share divided by the dividend payout percentage.
Answer (A) is incorrect because 1.03 results if
depreciation expense is omitted from the calculation
of EBIT. [100] Source: CIA 1194 IV-14

Answer (B) is correct. The degree of financial Answer (A) is correct. The return on assets equals
leverage for Company B may be calculated as the product of the profit margin and the asset
earnings before interest and taxes, divided by EBIT turnover.
minus interest. EBIT is $200 ($95 NI + $10 interest
+ $95 tax expense). Thus, the DFL is 1.05 [$200 ・ Return on assets = profit margin x asset turnover
($200 - $10)]. Net Income Net Income Sales
---------- = ---------- x ------
Answer (C) is incorrect because 1.12 results if net Assets Sales Assets
income is used instead of EBIT. If one company has a higher return on assets than
another, it may have a higher profit margin, a higher
Answer (D) is incorrect because 1.25 is the degree asset turnover, or both.
of financial leverage for Company A.
Answer (B) is incorrect because a higher profit
margin on sales or a higher asset turnover ratio may
[97] Source: CIA 0595 IV-36 explain a higher return on assets.

Answer (A) is incorrect because $1.67 results if Answer (C) is incorrect because a higher profit
retained earnings is omitted from the numerator. margin on sales or a higher asset turnover ratio may
explain a higher return on assets.
Answer (B) is incorrect because $2.50 results if
common stock is omitted from the numerator. Answer (D) is incorrect because a higher profit
margin on sales or a higher asset turnover ratio may
Answer (C) is correct. The book value per share for explain a higher return on assets.
Company A equals the sum of common stock and
retained earnings, divided by the number of shares, or
4.17 [($100 + $150) ・60]. [101] Source: CIA 0596 IV-33

Answer (D) is incorrect because $5.00 is the book Answer (A) is incorrect because 222,500 is the
value per share for Company B. weighted-average number of shares if the stock
dividend is not treated as retroactive.

[98] Source: CIA 0595 IV-51 Answer (B) is incorrect because 225,000 ignores the
November 1 issuance.
Answer (A) is incorrect because higher leverage is
associated with higher, not lower, EPS when sales Answer (C) is correct. The weighted-average of
exceed the breakeven point. shares outstanding during the year is used in the EPS
denominator. Shares issued in a stock dividend are
Answer (B) is incorrect because earnings per share is assumed to have been outstanding as of the beginning
more volatile in more highly leveraged firms. of the earliest accounting period presented. Thus, the
75,000 shares issued on March 1 are deemed to
Answer (C) is correct. Earnings per share is less have been outstanding on January 1. The EPS
volatile in less highly leveraged firms. Lower fixed denominator equals 235,000 shares {[150,000 x (12
costs result in less variable earnings when sales months ・12 months)] + [75,000 x (12 months ・12
fluctuate. months)] + [60,000 x (2 months ・12 months)]}.

Answer (D) is incorrect because less leverage is Answer (D) is incorrect because 285,000 is the
associated with lower, not higher, EPS when sales year-end number of outstanding shares.
exceed the breakeven point.

[102] Source: CIA 1196 IV-53

[99] Source: CIA 1195 IV-32
Answer (A) is incorrect because the current ratio will
Answer (A) is incorrect because 2.5 equals EPS be lower.
divided by dividends per share.
Answer (B) is correct. A company with a higher
Answer (B) is correct. The P-E ratio equals the share dividend payout ratio is distributing more of its
price divided by EPS. If the dividends per share earnings as dividends to common shareholders. It will
equaled $2 and the dividend payout ratio was 40%, have less cash and less total assets than a comparable
EPS must have been $5 ($2 ・.4). Accordingly, the firm with a lower payout ratio. The debt-to-assets
P-E ratio is 4 ($20 share price ・$5 EPS). ratio will be higher because total assets are lower,
 and the current ratio will be lower because cash is
lower. Answer (A) is correct. The return on assets is the
ratio of net income to total assets. It equals 21.1%
Answer (C) is incorrect because the debt-to-assets ($200 NI ・$950 total assets).
ratio will be higher and the current ratio will be lower.
Answer (B) is incorrect because 39.2% is the ratio of
Answer (D) is incorrect because the debt-to-assets net income to common equity.
ratio will be higher.
Answer (C) is incorrect because 42.1% is the ratio of
income before tax to total assets.
[103] Source: CIA 0596 IV-12
Answer (D) is incorrect because 45.3% is the ratio of
Answer (A) is incorrect because $2.67 includes all income before interest and tax to total assets.
outstanding shares, common and preferred, in the
denominator.
[107] Source: CIA 0596 IV-40
Answer (B) is incorrect because $3.33 fails to deduct
the preferred dividends from the numerator and Answer (A) is correct. The profit margin is the ratio
includes all outstanding shares in the denominator. of net income to sales. It equals 6.67% ($200 NI ・
$3,000 sales).
Answer (C) is correct. EPS equals the income
available for distribution to common shareholders Answer (B) is incorrect because 13.33% is the ratio
divided by the number of common shares of income before tax to sales.
outstanding, or $4.00 [($250,000 NI - $50,000
preferred dividends) ・50,000 common shares]. Answer (C) is incorrect because 14.33% is the ratio
of income before interest and taxes to sales.
Answer (D) is incorrect because $5.00 fails to
deduct the preferred dividends from the numerator. Answer (D) is incorrect because 46.67% is the ratio
of gross profit to sales.

[104] Source: CIA 0596 IV-13

[108] Source: Publisher
Answer (A) is incorrect because 26.67% includes the
book value of preferred shares in the denominator. Answer (A) is incorrect because a sale-leaseback
involves a sale of individual assets--not an entire
Answer (B) is incorrect because 33.33% includes the company.
book value of preferred shares in the denominator
and fails to subtract the preferred dividends from the Answer (B) is correct. A roll-up is a technique used
numerator. by an underwriter to combine several mom-and-pop
type businesses in the same industry into a company
Answer (C) is correct. The return on common equity large enough for an IPO.
equals the net income available to the common
shareholders divided by the book value of the Answer (C) is incorrect because DRIP is an acronym
common shares, or 40% [($250,000 NI - $50,000 for a dividend reinvestment plan.
preferred dividends) ・$500,000].
Answer (D) is incorrect because an ESOP is used to
Answer (D) is incorrect because 50.00% fails to give employees an ownership interest in a
subtract the preferred dividends from the numerator. corporation.

[105] Source: CIA 0596 IV-36 [109] Source: CIA 0596 IV-34

Answer (A) is incorrect because 19.6% is the ratio of Answer (A) is correct. The weighted-average
dividends paid to the December 31 book value of number of shares outstanding must be increased to
common equity. reflect the shares into which the bonds could be
converted. Also, the effect of the bond interest on net
Answer (B) is incorrect because 28.6% is the ratio of income must be eliminated. In this way, earnings per
dividends paid to the sum of beginning retained share is calculated as if the bonds had been
earnings and net income. converted into common shares as of the start of the
year.
Answer (C) is incorrect because 40.0% is the ratio of
dividends paid to the December 31 retained earnings. Answer (B) is incorrect because the net income must
be increased.
Answer (D) is correct. The dividend payout ratio is
the ratio of dividends paid to net income for the Answer (C) is incorrect because the
period. Hence, it equals 50.0% ($100 dividends ・ weighted-average number of shares outstanding must
$200 NI). be increased.

Answer (D) is incorrect because the

[106] Source: CIA 0596 IV-38 weighted-average number of shares outstanding must
 be increased, and the net income must be increased. curve with a rate of return on the vertical axis and
time to maturity on the horizontal axis. If short-term
rates are higher than long-term rates, the curve will be
[110] Source: CIA 0593 IV-39 downward sloping. If the reverse is true, the curve
will be upward sloping.
Answer (A) is incorrect because a horizontal analysis
indicates the proportionate change over a period of
time and is useful in trend analysis of an individual [113] Source: CMA 0697 1-23
entity.
Answer (A) is incorrect because a sinking fund is a
Answer (B) is correct. Vertical analysis is the feature attractive to investors that may result in their
expression of each item on a financial statement in a acceptance of a lower coupon rate.
given period in relation to a base figure. On the
income statement, each item is stated as a percentage Answer (B) is correct. A bond issued at par may
of sales. Thus, the percentages for the company in carry a lower coupon rate than other similar bonds in
question can be compared with industry norms. the market if it has some feature that makes it more
attractive to investors. For example, a sinking fund
Answer (C) is incorrect because activity ratio analysis reduces default risk. Hence, investors may require a
includes the preparation of turnover ratios such as lower risk premium and be willing to accept a lower
those for receivables, inventory, and total assets. coupon rate. Other features attractive to investors
include covenants in the bond indenture that restrict
Answer (D) is incorrect because the risky undertakings by the issuer and an option to
defensive-interval ratio is part of a liquidity analysis. convert the debt instruments to equity securities. The
opportunity to profit from appreciation of the firm's
stock justifies a lower coupon rate. An improvement
[111] Source: CIA 0596 IV-56 in a bond's rating from Aa to Aaa (the highest
possible) also justifies reduction in the risk premium
Answer (A) is incorrect because, if economies of and a lower coupon rate. However, a call provision is
scale exist in the use of assets, the ratios of assets to usually undesirable to investors. The issuer may take
sales are not constant. advantage of a decline in interest rates to recall the
bond and stop paying interest before maturity.
Answer (B) is correct. This method states balance
sheet amounts as percentages of sales and then Answer (C) is incorrect because an improved rating
multiplies future sales by these percentages to is a feature attractive to investors that may result in
develop pro forma financial statements. Thus, a their acceptance of a lower coupon rate.
greater amount of assets will be required for a greater
amount of sales (e.g., receivables and cash Answer (D) is incorrect because a conversion option
requirements will increase). The asset-to-sales ratios is a feature attractive to investors that may result in
must be constant when applying the their acceptance of a lower coupon rate.
percentage-of-sales forecasting method. If the current
levels of assets are considered to be optimal for the
current sales level, that is, if assets are efficiently [114] Source: Publisher
used, the asset-to-sales ratios are constant.
Answer (A) is correct. The formula for the value of a
Answer (C) is incorrect because, if fixed assets must stock right when the stock price is rights-on follows.
be added in large, discrete amounts, the ratios are not
constant. P-S
-----
Answer (D) is incorrect because, if ratios vary with N+1
economic cycles, the percentage-of-sales method is If P is the value of a share rights-on, S is the
inappropriate. subscription price, and N is the number of rights
needed to buy a share, the value of a right is

[112] Source: CIA 1192 IV-47 $100 - $91

---------- = $1.50
Answer (A) is incorrect because the yield curve does 6
not reflect past interest rate trends.
Answer (B) is incorrect because $1.80 results from a
Answer (B) is incorrect because the yield curve does failure to adjust for the decline in share value once the
not reflect past interest rate trends. rights are issued.

Answer (C) is incorrect because the Answer (C) is incorrect because $2.25 is based on
downward-sloping yield curve implies that prevailing deducting 1 from N rather than adding 1.
short-term interest rates are higher than prevailing
long-term interest rates. Answer (D) is incorrect because $9.00 results from a
failure to consider that five rights are needed to
Answer (D) is correct. The term structure of interest purchase one share.
rates is the relationship between long- and short-term
interest rates, that is, between yield to maturity and
time to maturity. It is graphically depicted by a yield [115] Source: Publisher
 greater, not less, than the rights required.
Answer (A) is incorrect because $91 is the
subscription price. Answer (D) is incorrect because $3 is the numerator,
which must be divided by 5.
Answer (B) is incorrect because $98.20 is based on
the assumption that a right is worth $1.80, as a result
of dividing by N instead of N + 1. [119] Source: Publisher

Answer (C) is correct. The stock will decline in value Answer (A) is incorrect because it is the ratio of
by the value of the right. The theoretical value of a stock price to bond price, not the conversion price.
right is $1.50. Thus, the value of the stock should
decline to $98.50 ($100.00 - $1.50). Answer (B) is incorrect because $46 is the market
price.
Answer (D) is incorrect because the value of the
stock will decline with the distribution of the rights. Answer (C) is correct. The conversion price is the
assumed price of the stock, which was set at the time
the bonds were issued. Dividing the $1,000 face
[116] Source: Publisher value by the 20 shares results in a conversion price of
$50.
Answer (A) is incorrect because there is no tax
deductibility of preferred dividends. Answer (D) is incorrect because $52 is the effective
price that a bond holder would pay in the event of a
Answer (B) is incorrect because there is no tax conversion.
deductibility of preferred dividends.

Answer (C) is incorrect because the denominator is [120] Source: Publisher

the current market price, not the par value.
Answer (A) is correct. The conversion price, in this
Answer (D) is correct. Dividends on preferred stock case $20 ($1,000 ・50 shares), is normally greater
are not deductible for tax purposes; therefore, there than the market price at the time the bonds are
is no adjustment for tax savings. The annual dividend issued. Therefore, the market price must be less than
on preferred stock is $100 when the price of the $20.
stock is $960. This results in a cost of about 10.4%
($100 ・$960). Answer (B) is incorrect because a conversion price
equal to market price would be of little benefit to the
issuer.
[117] Source: Publisher
Answer (C) is incorrect because the market price
Answer (A) is incorrect because $108 is the cannot be greater than the conversion price;
subscription price of the new shares. otherwise, investors would immediately convert for a
short-term gain.
Answer (B) is incorrect because the stock value will
decline by the value of one right, not four rights. Answer (D) is incorrect because the market price
cannot be greater than the conversion price;
Answer (C) is correct. The common stock will otherwise, investors would immediately convert for a
decline in value when it goes ex-rights by the short-term gain.
theoretical value of one right. Thus, deducting the
$2.40 value of a right from the $120 price results in a
stock value of $117.60. [121] Source: CMA Samp Q1-9

Answer (D) is incorrect because the $120 market Answer (A) is incorrect because the quarterly
price will decline when the right is unbundled from the payment is $3,655.64.
stock.
Answer (B) is incorrect because the quarterly
payment is $3,655.64.
[118] Source: Publisher
Answer (C) is incorrect because $12,107 equals the
Answer (A) is correct. The theoretical value of a right quarterly payment times the present value interest
is calculated by taking the difference between the factor for 4 periods at 8%.
market price and the subscription price ($30 - $27 =
$3) and dividing by the number of rights required, Answer (D) is correct. The level quarterly payments
plus 1. Thus, the calculation would be to divide $3 by based on a full-amortization life of 10 years constitute
5, or a theoretical value of $.60. The denominator is an annuity with a present value of $100,000.
1 greater than the number of rights required because Assuming payments are due at the end of each
the new share will not have a right attached. quarter, the payment equals $100,000 divided by the
present value interest factor for an ordinary annuity of
Answer (B) is incorrect because the denominator is 40 periods (4 x 10 years) at 2% (8% ・4), or
5, not 4. $3,655.64 ($100,000 ・27.355). The balloon
payment is the present value of the remaining
Answer (C) is incorrect because the denominator is 1 payments. It equals the quarterly payment times the
 present value interest factor for an ordinary annuity of double.
16 periods [(10 years - 6 years) x 4] at 2% (8% ・
4), or $49,636 ($3,655.64 x 13.578). Answer (B) is correct. The investment doubles twice
in 16 years (from $250 to $500 and from $500 to
$1,000). Thus, it doubles once in eight years.
[122] Source: Publisher Dividing 72 by 8 years results in an approximate
return of 9%.
Answer (A) is incorrect because .667 is based on the
acquiree rather than the acquiror and ignores the Answer (C) is incorrect because they would result in
partial share. the investment doubling even sooner than would a
9% return.
Answer (B) is incorrect because .75 results from
ignoring the difference in share values. Answer (D) is incorrect because they would result in
the investment doubling even sooner than would a
Answer (C) is correct. The ratio of exchange refers 9% return.
to the value of one stock offering compared to
another. Kramer Corporation is offering three-fourths
of a share, or $33.75 (3/4 x $45) for each $30 share [126] Source: Publisher
of Garvin Corporation. The ratio of the offer is
therefore $33.75 to $30, or 1.125. Answer (A) is incorrect because he beat inflation.

Answer (D) is incorrect because 1.5 results from Answer (B) is correct. A ten-fold increase would be
ignoring the partial share. equivalent to a factor of 10.0 on an amount-of-one
table. On the 40-year-line, 10 occurs at about 6%.
Thus, your uncle beat inflation by about 1% per year.
[123] Source: Publisher
Answer (C) is incorrect because he beat inflation by
Answer (A) is correct. The quarterly payment is only 1%.
determined by dividing the amount of the loan,
$200,000, by the factor for the present value of an Answer (D) is incorrect because he beat inflation by
annuity of 40 periods (10 years of quarterly only 1%.
payments) at 2% (8% per year divided by 4 quarters
each year). Thus, $200,000 ・27.3555 = $7,311.
[127] Source: Publisher
Answer (B) is incorrect because $7,451 is based on
annual periods at 8% rather than quarterly periods at Answer (A) is incorrect because the rate used is 4%.
2%.
Answer (B) is correct. The solutions approach is
Answer (C) is incorrect because they are based on a strictly trial and error. The answer is 4%, calculated
six-year amortization period. as follows:

Answer (D) is incorrect because they are based on a $ 500 x .96153 = 480.77
six-year amortization period. 2,000 x .92455 = 1,849.10
5,000 x .88899 = 4,444.95
--------
[124] Source: Publisher 6,774.82
========
Answer (A) is incorrect because $20 is the exercise
price. Answer (C) is incorrect because the rate used is 4%.

Answer (B) is incorrect because $10 is half of the Answer (D) is incorrect because the rate used is 4%.
exercise price.

Answer (C) is correct. The theoretical value of a [128] Source: Publisher

warrant is the excess of the market price over the
exercise price. The difference between the market Answer (A) is correct. The formula is to divide the
price ($30) and the exercise price ($20) is $10. mortgage by the present value factor for an annuity of
Since it takes two warrants to buy one share, the $10 360 payments at 10/12 of 1% interest per period.
is divided between the two warrants, resulting in a Thus, (x ・113.950819) = $800, or x = $91,160.
theoretical value of $5 per warrant.
Answer (B) is incorrect because $100,300 is based
Answer (D) is incorrect because a warrant will have on 9% interest.
value if the exercise price is less than the market
price. Answer (C) is incorrect because they are based on
the wrong present value tables.

[125] Source: Publisher Answer (D) is incorrect because they are based on
the wrong present value tables.
Answer (A) is incorrect because an 8% return would
require nine years before an investment would
[129] Source: Publisher necessary to purchase one share of stock, and S is
the subscription price per share. Thus, the theoretical
Answer (A) is correct. The tripling occurs when the value is $1.20 per right [($60 - $54) ・(4 + 1)].
factor on an amount-of-one table reaches 3.0. At
9%, this first occurs at 13 years. Answer (C) is incorrect because $1.50 is the
difference between the market price of the stock
Answer (B) is incorrect because it takes 16 years to ($60) with rights and the exercise price ($54),
triple at 7.5%. divided by the number of rights.

Answer (C) is incorrect because it takes 17 years to Answer (D) is incorrect because $6.00 is merely the
triple at 7%. difference between the market price of the stock
($60) and the exercise price ($54).
Answer (D) is incorrect because it takes 22 years to
triple at 5 ｼ% interest.
[133] Source: CFM CH19 II-13

[130] Source: Publisher Answer (A) is incorrect because $54.00 is the

difference between the market price of the stock
Answer (A) is incorrect because 0.075 reverses the prior to the ex-rights date.
numerator and denominator.
Answer (B) is incorrect because $1.50 is not the
Answer (B) is incorrect because the two amounts are value of the stock right.
divided, not added.
Answer (C) is correct. After rights are received,
Answer (C) is correct. The P/E ratio is computed by stock trades ex-rights because the rights can be sold
dividing the market price by EPS. Thus, $40 ・$3 = separately. The value of the stock right when the
13.33. price of the stock is trading rights-on was found to be
$1.20 found by the equation
Answer (D) is incorrect because the ratio is 13.33.
P-S
R = -----
[131] Source: CIA 0593 IV-48 N-1
The value of the common stock when ex-rights would
Answer (A) is incorrect because the yield curve does be $58.80, the market price of the stock minus the
not reflect the credit risk premium of bonds. value of the right ($60 - $1.20).

Answer (B) is incorrect because the yield curve does Answer (D) is incorrect because $0.96 is not the
not reflect the credit risk premium of bonds. value of the stock right.

Answer (C) is correct. The term structure of interest

rates is the relationship between yield to maturity and [134] Source: CMA 1294 1-29
time to maturity. This relationship is depicted by a
yield curve. Assuming the long-term interest rate is an Answer (A) is correct. An increase in the corporate
average of expected future short-term rates, the income tax rate might encourage a company to
curve will be upward sloping when future short-term borrow because interest on debt is tax deductible,
interest rates are expected to rise. Furthermore, the whereas dividends are not. Accordingly, an increase
normal expectation is for long-term investments to in the tax rate means that the after-tax cost of debt
pay higher rates because of their higher risk. Thus, capital will decrease. Given equal interest rates, a firm
long-term interest rates have a higher annualized yield with a high tax rate will have a lower after-tax cost of
than short-term rates. debt capital than a firm with a low tax rate.

Answer (D) is incorrect because long-term interest Answer (B) is incorrect because increased
rates should be higher than short-term rates. uncertainty encourages equity financing. Dividends do
not have to be paid in bad years, but interest on debt
is a fixed charge.
[132] Source: CFM CH19 II-12
Answer (C) is incorrect because an increase in
Answer (A) is incorrect because $1.20 is the interest rates discourages debt financing.
theoretical value of one right.
Answer (D) is incorrect because an increase in the
Answer (B) is correct. The formula for determining price-earnings ratio means that the return to
the value of a stock when the price of the stock is shareholders (equity investors) is declining; therefore,
rights-on is equity capital is a more attractive financing alternative.

P-S
R = ----- [135] Source: CMA 0684 1-5
N-1
If R is the market value of one right when the stock is Answer (A) is incorrect because financial leverage
selling rights-on, P is the market value of one share of concerns the extent to which debt financing is used.
stock with rights-on, N is the number of rights
 Answer (B) is incorrect because operating leverage capital asset pricing model for a multinational firm is
concerns the proportion of fixed operating costs. the systematic risk of a given multinational firm
relative to that of the market as a whole.
Answer (C) is correct. The trade-off between risk
and return must be considered because liquid assets Answer (C) is correct. When amounts to be paid or
are usually less profitable than less-liquid alternatives. received are denominated in a foreign currency,
However, a greater liquidity means less risk of being exchange rate fluctuations may result in exchange
unable to meet obligations when they are due. gains or losses. For example, if a U.S. firm has a
receivable fixed in terms of units of a foreign
Answer (D) is incorrect because the costs of issuing currency, a decline in the value of that currency
securities relate to capital structure finance. relative to the U.S. dollar results in a foreign
exchange loss.

[136] Source: CMA 0688 1-17 Answer (D) is incorrect because the beta value in the
capital asset pricing model for a multinational firm is
Answer (A) is correct. An increase in the proportion the systematic risk of a given multinational firm
of short-term financing will not affect a company's relative to that of the market as a whole. It is an
degree of leverage, but risk is increased because of undiversifiable risk.
the need for frequent refinancing. Because the debtor
company will be forced to meet principal and interest
payments quickly, perhaps before expected funds [139] Source: CMA 1291 1-8
from a new project, the danger of default is
increased. Also, future interest rates are difficult to Answer (A) is incorrect because, if the cost of capital
predict. were the same as the rate of return on equity (which
is usually higher than that of debt capital), there would
Answer (B) is incorrect because leverage is the use be no incentive to invest.
of borrowed funds to earn returns for stockholders. It
is irrelevant whether the borrowed funds are long- or Answer (B) is incorrect because the marginal cost of
short-term. capital is affected by the degree of debt in the firm's
capital structure. Financial risk plays a role in the
Answer (C) is incorrect because the length of a loan returns desired by investors.
does not affect the amount of liquid assets. Both
long- and short-term loans result in liquid assets. Answer (C) is incorrect because the rate of return
used for capital budgeting purposes should be at least
Answer (D) is incorrect because an increase in as high as the marginal cost of capital.
current liabilities decreases the current ratio.
Answer (D) is correct. The marginal cost of capital is
the cost of the next dollar of capital. The marginal
[137] Source: CMA 0691 1-11 cost continually increases because the lower cost
sources of funds are used first. The marginal cost
Answer (A) is incorrect because securities issued by represents a weighted average of both debt and
a federal agency are first backed by that agency and equity capital.
secondarily by the U.S. government. Agency

securities are issued by agencies and corporations [140] Source: CMA 0692 1-5
created by the federal government, such as the
Federal Housing Administration. Answer (A) is incorrect because 6% is the risk-free
rate based on insured government securities and
Answer (B) is correct. The least risky marketable bears no relation to the return of the stock market.
securities are those issued by the federal government
because they are backed by the full faith and credit of Answer (B) is incorrect because 7.5% is calculated
the U.S. government. by multiplying the beta times the risk-free rate; the
beta should be multiplied times the risk premium that
Answer (C) is incorrect because repurchase is required by investors.
agreements could become worthless if the
organization agreeing to make the repurchase goes Answer (C) is incorrect because 17.5% is calculated
bankrupt. by multiplying the market rate times beta. This ignores
the risk premium. The beta should be multiplied times
Answer (D) is incorrect because commercial paper is the risk premium that is desired by investors.
unsecured.
Answer (D) is correct. The CAPM adds the risk-free
rate to the product of the beta coefficient and the
[138] Source: CIA 1191 IV-60 difference between the market return and the
risk-free rate. The market-risk premium is the amount
Answer (A) is incorrect because expropriation risk is above the risk-free rate for which investors must be
the risk that the sovereign country in which the assets compensated to induce them to invest in the
backing an investment are located will seize the assets company. The beta coefficient of an individual stock
without adequate compensation. is the correlation between volatility (price variation) of
the stock market and the volatility of the price of the
Answer (B) is incorrect because the beta value in the individual stock. Thus, the required rate is 16% [6%
 + 1.25 (14% - 6%)].
k = k(1 - t).
i
[141] Source: CMA 1280 1-11
Answer (B) is incorrect because the formula to find
Answer (A) is incorrect because the cost of new the after-tax cost of debt is:
common stock is 15.56%. The formula to calculate
this percentage is: next dividend divided by (current k = k(1 - t).
price of the stock times one minus the percentage i
flotation cost), plus the dividend growth rate.
Answer (C) is incorrect because the formula to find
Answer (B) is correct. The formula to determine the the after-tax cost of debt is:
cost of retained earnings, with the additional flotation
cost entered into the calculation, is k = k(1 - t).
i
D
1 Answer (D) is correct. The after-tax cost of debt is
K = -------------------- + G the cost of debt times the quantity one minus the tax
s P (1-Flotation Cost) rate. For example, the after-tax cost of a 10% bond
0 is 7% [10%(1 - 30%)] if the tax rate is 30%.
If: K = Cost of retained earnings
s
P = Current price of the stock
0
D = Next dividend [145] Source: CMA 0690 1-9
1
G = Dividend growth rate Answer (A) is incorrect because the issuance of
This yields a cost of new common stock of 15.56%. common stock does not increase financial leverage.
$2.50 No increase in borrowed capital and fixed interest
K = ------------ + 10% charges occurs when equity is issued.
s $50.00 x 90%
$2.50 Answer (B) is incorrect because a decrease in the
= ------------ + 10% = 15.56% dividend payout ratio would result in increased
$45.00 owners' equity (retained earnings), and would not
increase debt capital and financial leverage.
Answer (C) is incorrect because the cost of new
common stock is 15.56%. The formula to calculate Answer (C) is correct. Financial leverage is the use of
this percentage is: next dividend divided by (current borrowed money to earn money for the benefit of
price of the stock times one minus the percentage shareholders. The expectation is that investment
flotation cost), plus the dividend growth rate. earnings will be greater than the interest paid on the
borrowed funds. Increasing debt (such as bonds)
Answer (D) is incorrect because the cost of new increases financial leverage.
common stock is 15.56%. The formula to calculate
this percentage is: next dividend divided by (current Answer (D) is incorrect because using debt, not
price of the stock times one minus the percentage equity, funds to finance new investments increases
flotation cost), plus the dividend growth rate. financial leverage.

[142] Source: CMA 1288 1-2 [146] Source: CMA 0690 1-16

Answer (A) is incorrect because the cost of capital is Answer (A) is incorrect because the degree of
a weighted average for all sources of capital. financial leverage is calculated by dividing the
percentage change in net income by the percentage
Answer (B) is correct. The cost of capital of a firm is change in EBIT.
the current, weighted average, after-tax cost of the
firm's various financing components. Historical costs Answer (B) is incorrect because the degree of
are irrelevant. financial leverage is calculated by dividing the
percentage change in net income by the percentage
Answer (C) is incorrect because costs are change in EBIT.
considered after taxes. For example, the deductibility
of interest must be considered. Answer (C) is correct. If earnings before interest and
taxes increased by 17%, and net income was up
Answer (D) is incorrect because the time value of 42%, the firm is using leverage effectively. The
money should be incorporated into the calculations. degree of financial leverage is the percentage change
in net income divided by the percentage change in
EBIT. Accordingly, Nelson's degree of financial
[143] Source: CMA 1288 1-3 leverage is 2.47.

Answer (A) is incorrect because the formula to find Answer (D) is incorrect because the degree of
the after-tax cost of debt is: financial leverage is calculated by dividing the
 percentage change in net income by the percentage
change in EBIT. Answer (B) is incorrect because, in the pure play
method of project risk assessment, the firm attempts
to estimate beta for a single product company in the
[147] Source: CMA 0690 1-18 same line of business as the project being evaluated.

Answer (A) is incorrect because, although the cost of Answer (C) is correct. The risk of concern to
equity will increase, the weighted average cost of investors who supply capital to a diversified company
is market risk. Beta or market risk is the risk that
capital will decrease. cannot be eliminated by diversification. This type of
risk is defined from the perspective of an investor
Answer (B) is correct. The important consideration is who views the investment as just one part of a
whether the overall cost of capital will be lower for a diversified portfolio. It is the average risk of the firm's
given proposal. According to the Capital Asset investment projects calculated as the weighted
Pricing Model, the change will result in a lower average of project betas.

average cost of capital. For the existing structure, the Answer (D) is incorrect because, in project risk
cost of equity capital is 15.5% [6% + .95 (16% - assessment, the firm attempts to assess the level of
6%)]. Because the company has no debt, the average risk for a given project by considering, for a given
cost of capital is also 15.5%. Under the proposal, the project, either pure play betas or accounting betas
cost of equity capital is 16.5% [6% + 1.05 (16% - (beta values determined from accounting data rather
6%)], and the weighted average cost of capital is than from regression of a company's stock returns on
13.8% [.3(.075) + .7(.165)]. Hence, the proposal of a stock market index). Neither is a sufficient means
30% debt and 70% equity should be accepted. for assessing the overall risk of a diversified firm.

Answer (C) is incorrect because the weighted

average cost of capital will decrease. [150] Source: CMA 0695 1-1

Answer (D) is incorrect because the weighted Answer (A) is incorrect because a firm with higher
average cost of capital will decrease. operating leverage has higher fixed costs and lower

variable costs.
[148] Source: CMA 0688 1-15
Answer (B) is correct. Operating leverage is a
Answer (A) is incorrect because municipal bonds are measure of the degree to which fixed costs are used
rarely considered marketable securities in the in the production process. A company with a higher
accounting sense. They constitute long-term debt. percentage of fixed costs (higher operating leverage)
has greater risk than one in the same industry that
Answer (B) is incorrect because common stock does relies more heavily on variable costs. The DOL
not have as high a priority in company assets as equals the percentage change in net operating income
commercial paper or other debt. divided by the percentage change in sales. Thus,
profits became more sensitive to changes in sales
Answer (C) is incorrect because gold is a volume as the DOL increases.
commodity, not a security. Also, its price fluctuates
for many reasons that do not affect the value of Answer (C) is incorrect because a firm with higher
commercial paper. leverage will be relatively more profitable than a firm
with lower leverage when sales are high. The
Answer (D) is correct. Of the choices given, the opposite is true when sales are low.
commercial paper of a top-rated (most creditworthy)
company has the least risk. Commercial paper is
preferable to stock or stock options because the Answer (D) is incorrect because a firm with higher
latter represent only a residual equity in a leverage is more risky. Its reliance on fixed costs is
corporation. Commercial paper is debt and thus has greater.
priority over shareholders' claims. Also, commercial
paper is a very short-term investment. The maximum
maturity allowed without SEC registration is 270 [151] Source: CMA 0695 1-7
days. However, it can be sold only to sophisticated
investors without registration. Answer (A) is incorrect because 5.5% is the treasury
rate minus 150 bonus points.

[149] Source: CIA 0592 IV-49 Answer (B) is incorrect because 7.0% is the treasury
rate.
Answer (A) is incorrect because, in project risk
assessment, the firm attempts to assess the level of Answer (C) is correct. The current rate for treasury
risk for a given project by considering, for a given bonds is 7%. If the company can issue debt at 150
project, either pure play betas or accounting betas basis points (1.5%) over U.S. treasury bonds, the
(beta values determined from accounting data rather market rate of interest for Martin is 8.5%. Given a
than from regression of a company's stock returns on 40% tax rate, the net cost of debt is 60% of the rate
a stock market index). Neither is a sufficient means actually paid, or 5.1% (60% x 8.5%).
for assessing the overall risk of a diversified firm.
 Answer (D) is incorrect because 8.5% ignores the [155] Source: CMA 1294 1-28
income tax effect.
Answer (A) is incorrect because the growth rate
(10%) is added to the dividend yield (10%).
[152] Source: CMA 0695 1-8
Answer (B) is incorrect because 11.0% equals the
Answer (A) is incorrect because 8.75% equals the growth rate (10%) plus 10% of the current dividend
product of beta and the risk-free rate. yield (10%).

Answer (B) is incorrect because 10.00% fails to add Answer (C) is incorrect because 10.0% is the growth
the risk-free rate to the risk premium. rate.

Answer (C) is incorrect because 15.00% is the Answer (D) is correct. The dividend growth model
expected market return. determines the cost of equity by adding the expected
growth rate to the quotient of the next dividend and
Answer (D) is correct. The CAPM adds the risk-free the current market price. Thus, the cost of equity
rate (determined by government securities) to the capital is 20% [10% + ($3 ・$30)]. This model
product of the beta coefficient (a measure of the assumes that the payout ratio, the retention rate, and
firm's risk) and the difference between the market the earnings per share growth rate are all constant.
return and the risk-free rate. Thus, the current cost of
equity using the CAPM is 17% [7% + 1.25 (15% -
7%)]. [156] Source: CIA 0590 IV-57

Answer (A) is incorrect because a call option is the

[153] Source: CMA 1294 1-29 right to purchase shares at a given price within a
specified period.
Answer (A) is correct. An increase in the corporate
income tax rate might encourage a company to Answer (B) is correct. A put option is the right to sell
borrow because interest on debt is tax deductible, stock at a given price within a certain period. If the
whereas dividends are not. Accordingly, an increase market price falls, the put option may allow the sale
in the tax rate means that the after-tax cost of debt of stock at a price above market, and the profit of the
capital will decrease. option holder will be the difference between the price
stated in the put option and the market price, minus
Answer (B) is incorrect because increased the cost of the option, commissions, and taxes. The
uncertainty encourages equity financing. Dividends do company that issues the stock has nothing to do with
not have to be paid in bad years, but interest on debt put (and call) options.
is a fixed charge.
Answer (C) is incorrect because selling a put option
Answer (C) is incorrect because an increase in could force the company to purchase additional stock
interest rates discourages debt financing. if the option is exercised.

Answer (D) is incorrect because an increase in the Answer (D) is incorrect because a warrant gives the
price-earnings ratio means that the return to holder a right to purchase stock from the issuer at a
shareholders (equity investors) is declining; therefore, given price (it is usually distributed along with debt).
equity capital is a more attractive financing alternative.

[157] Source: CMA 1291 1-13

[154] Source: CMA 1295 1-16
Answer (A) is incorrect because working capital
Answer (A) is incorrect because EPS is maximized at management is short-term asset management.
a higher debt ratio and risk level than allowed for in
the optimal capital structure. Maximizing EPS does Answer (B) is incorrect because return maximization
not maximize the firm's stock price. is more aggressive than maturity matching. It entails
using the lowest cost forms of financing.
Answer (B) is incorrect because the cost of debt
capital must also be considered in estimating optimal Answer (C) is incorrect because financial leverage is
structure. the relationship between debt and equity financing.

Answer (C) is incorrect because the cost of equity Answer (D) is correct. Maturity matching, or
capital must also be considered in estimating optimal equalizing the life of an asset and the debt instrument
structure. used to finance that asset, is a hedging approach. The
basic concept is that the company has the entire life
Answer (D) is correct. Ideally, a firm will have a of the asset to recover the amount invested before
capital structure that minimizes its weighted-average having to pay the lender.
cost of capital. This cost of capital maximizes the
firm's value because it maximizes stock value by
balancing the costs of debt and equity capital and [158] Source: Publisher
their associated risk levels.
Answer (A) is incorrect because, although the call
option is not worth exercising, the value of the
 underlying asset is also less than the exercise price. Answer (D) is incorrect because speculating
increases risk while hedging offsets risk.
Answer (B) is incorrect because, although the value
of the underlying asset is less than the exercise price,
it is also not worth exercising. [162] Source: Publisher

Answer (C) is incorrect because the option does Answer (A) is incorrect because the price of a future
exist; it is just not worth exercising. contract is determined on the day of commitment, not
some time in the future.
Answer (D) is correct. When the value of the asset
underlying a call option is less than the exercise price Answer (B) is incorrect because performance is
of the option, the option is "out-of-money," which deferred in a future contract, and the price of the
means it is not worth exercising. product is not necessarily its present price. The price
can be any price determined on the day of
commitment.
[159] Source: Publisher
Answer (C) is correct. A forward contract is an
Answer (A) is incorrect because a covered option is executory contract in which the parties involved agree
one that is written against stock held in the option to the terms of a purchase and a sale, but
writer's portfolio. performance is deferred. Accordingly, a forward
contract involves a commitment today to purchase a
Answer (B) is incorrect because an unsecured option product on a specific future date at a price
is a nonsense term. determined today.

Answer (C) is correct. A naked option is an option Answer (D) is incorrect because a forward contract
that does not have the backing of stock. is a firm commitment to purchase a product. It is not
based on a contingency. Also, a forward contract
Answer (D) is incorrect because a put option is an does not involve an exercise price (exercise price is in
option that gives the owner the right to sell the an option contract).
underlying asset for a fixed price.

[163] Source: Publisher

[160] Source: Publisher
Answer (A) is incorrect because a short hedge is a
Answer (A) is incorrect because a European option futures contract that is sold to protect against price
is exercisable only at the expiration date. declines. The automobile company wishes to protect
itself against price increases.
Answer (B) is incorrect because a foreign option is a
nonsense term. Answer (B) is correct. A change in prices can be
minimized or avoided by hedging. Hedging is the
Answer (C) is incorrect because, although an option process of using offsetting commitments to minimize
can be exercised in the future, it is not called a future or avoid the impact of adverse price movements. The
option. automobile company desires to stabilize the price of
steel so that its cost to the company will not rise and
Answer (D) is correct. An American option is a cut into profits. Accordingly, the automobile company
contractual arrangement that gives the owner the right uses the futures market to create a long hedge, which
to buy or sell an asset at a fixed price at any moment is a futures contract that is purchased to protect
in time before or on a specified date. against price increases.

Answer (C) is incorrect because the automobile

[161] Source: Publisher company needs to purchase futures in order to
protect itself from loss, not sell futures. Selling futures
Answer (A) is incorrect because hedging decreases protects against price declines.
risk by using offsetting commitments that avoid the
impact of adverse price movements. Answer (D) is incorrect because it is the definition of
a short hedge, which is used for avoiding price
Answer (B) is incorrect because speculation involves declines. The automobile company wants to protect
the assumption of risk in the hope of receiving a gain itself against price increases.
on price movements.

Answer (C) is correct. Derivatives refer to options [164] Source: Publisher

and futures which are contracts between the parties
who contract. They are not claims on business assets Answer (A) is incorrect because the value of the
as are securities. A futures contract is entered into as forward contract will increase when interest rates
either a speculation or a hedge. Speculation involves decrease.
the assumption of risk in the hope of receiving a gain
on price movements. Hedging is the process of using Answer (B) is correct. Interest rate futures contracts
offsetting commitments to minimize or avoid the involve risk-free bonds, such as U.S. Treasury
impact of adverse price movements. bonds. When interest rates decrease over the period
of a forward contract, the value of the bonds and the
 forward contract increase.

Answer (C) is incorrect because the value of the [168] Source: Publisher
forward contract will increase when interest rates
decrease. Answer (A) is correct. Business risk is the risk of
fluctuations in earnings before interest and taxes or in
Answer (D) is incorrect because any decline in operating income when the firm uses no debt. It is the
interest rates increases the value of the bonds. risk inherent in its operations that excludes financial
risk, which is the risk to the shareholders from the use
of financial leverage. Business risk depends on
[165] Source: CIA 1192 IV-57 factors such as demand variability, sales price
variability, input price variability, and amount of
Answer (A) is incorrect because income bonds pay operating leverage.
interest only if interest is earned.
Answer (B) is incorrect because business risk
Answer (B) is incorrect because debentures are depends on such factors as amount of operating
unsecured bonds. leverage.

Answer (C) is incorrect because subordinated Answer (C) is incorrect because business risk
debentures are subordinated to other debt. depends on such factors as demand variability.

Answer (D) is correct. A mortgage bond is secured Answer (D) is incorrect because business risk
with specific fixed assets, usually real property. Thus, depends on such factors as fluctuations in suppliers'
under the rights enumerated in the bond indenture, prices.
creditors will be able to receive payments from
liquidation of the property in case of default. In a
bankruptcy proceeding, these amounts are paid [169] Source: Publisher
before any transfers are made to other creditors,
including those preferences. Hence, mortgage bonds Answer (A) is incorrect because a portfolio is
are less risky than the others listed. efficient if it offers the highest return for a given risk or
the least risk for a given return.

[166] Source: CMA 0691 1-12 Answer (B) is incorrect because the optimal portfolio
is tangent to the investor's highest indifference curve.
Answer (A) is incorrect because negotiable CDs do Thus, it is the efficient portfolio with the highest utility.
have a secondary market (i.e., they are negotiable).
Answer (C) is incorrect because the optimal portfolio
Answer (B) is incorrect because negotiable CDs are is efficient as well as feasible.
regulated.
Answer (D) is correct. An investor wants to
Answer (C) is incorrect because negotiable CDs are maximize expected return and minimize risk when
typically issued in a denomination of $100,000. choosing a portfolio. A feasible portfolio that offers
the highest expected return for a given risk or the
Answer (D) is correct. A certificate of deposit (CD) least risk for a given expected return is an efficient
is a form of savings deposit that cannot be withdrawn portfolio. A portfolio that is selected from the efficient
before maturity without incurring a high penalty. A set of portfolios because it is tangent to the investor's
negotiable CD can be traded. CDs usually have a highest indifference curve is the optimal portfolio.
fairly high rate of return compared with other savings
instruments because they are for fixed, usually
long-term periods. However, their yield is less than [170] Source: Publisher
that of commercial paper and bankers' acceptances
because they are less risky. Answer (A) is incorrect because purchasing-power
risk is the risk that a general rise in the price level will
reduce the quantity of goods that can be purchased
[167] Source: Publisher with a fixed sum of money.

Answer (A) is incorrect because nonmarket risk is Answer (B) is correct. Prices of all stocks, even the
diversifiable and undiversifiable risk. value of portfolios, are correlated to some degree
with broad swings in the stock market. Market risk is
Answer (B) is correct. Total risk is the risk of a single the risk that changes in a stock's price will result from
asset, whereas market risk is its risk if it is held in a changes in the stock market as a whole. Market risk
large portfolio of diversified securities. Total risk is commonly referred to as nondiversifiable risk.
therefore includes diversifiable and undiversifiable
risk. Answer (C) is incorrect because nonmarket risk is
the risk that is influenced by an individual firm's
Answer (C) is incorrect because portfolio risk is policies and decisions. Nonmarket risk is diversifiable
diversifiable and undiversifiable risk. since it is specific to each firm.

Answer (D) is incorrect because market risk is Answer (D) is incorrect because interest-rate risk is
diversifiable and undiversifiable risk. the risk that the value of an asset will fluctuate due to
 changes in the interest rate. Answer (D) is incorrect because price risk is a
component of interest-rate risk.

[171] Source: Publisher

[174] Source: Publisher
Answer (A) is incorrect because an asset with high
risk will have a high expected return to compensate Answer (A) is correct. Business risk is the risk of
for the additional risk. fluctuations in earnings before interest and taxes or in
operating income when the firm uses no debt. It
Answer (B) is incorrect because an asset with high depends on factors such as demand variability, sales
risk will have a higher price than an asset with low price variability, input price variability, and the
risk due to the high expected return. amount of operating leverage. Financial leverage
affects financial risk and is not a factor affecting
Answer (C) is incorrect because an asset with high business risk.
risk will have a constant expected return, not an
increasing expected return. Answer (B) is incorrect because sales price variability
is a factor affecting business risk.
Answer (D) is correct. The greater the standard
deviation of returns, the greater the risk is for an Answer (C) is incorrect because demand variability is
asset. The expected return can vary anywhere a factor affecting business risk.
between the large standard deviation of returns,
creating the risk that the actual return is significantly Answer (D) is incorrect because input price
low in the range of the standard deviation of returns. variability is a factor affecting business risk.

[172] Source: Publisher [175] Source: Publisher

Answer (A) is incorrect because purchasing-power Answer (A) is correct. Investment risk is analyzed in
risk concerns inflation, and default risk concerns terms of the probability that the actual return on an
nonpayment by the debtor. investment will be lower than the expected return.
Comparing a project's expected return with the return
Answer (B) is incorrect because market risk on an asset of similar risk helps determine whether
concerns price changes in the overall securities the project is worth investing in. If the expected
markets. return on a project exceeds the return on an asset of
comparable risk, the project should be pursued.
Answer (C) is incorrect because portfolio risk is the
risk remaining in a portfolio after diversifying Answer (B) is incorrect because a project should be
investments. pursued only if its expected return exceeds the return
on investments of similar risk.

Answer (D) is correct. Interest-rate risk is the risk of Answer (C) is incorrect because a project should be
fluctuations in the value of an asset due to changes in pursued only if its expected return exceeds the return
interest rates. One component of interest-rate risk is on investments of similar risk.
price risk; for example, the value of bonds declines as
interest rates increase. Reinvestment-rate risk is Answer (D) is incorrect because a project should be
another component of interest-rate risk. If interest pursued only if its expected return exceeds the return
rates decline, lower returns will be available for on investments of similar risk.
reinvestment of interest and principal payments
received.
[176] Source: CIA 1187 IV-66

[173] Source: Publisher Answer (A) is incorrect because the coefficient of

variation compares risk with expected return
Answer (A) is incorrect because liquidity risk is the (standard deviation ・expected return).
possibility that an asset cannot be sold on short notice
for its market value. Answer (B) is correct. The required rate of return on
equity capital in the capital asset pricing model is the
Answer (B) is incorrect because business risk is the risk-free rate (determined by government securities),
risk of fluctuations in earnings before interest and plus the product of the market risk premium times the
taxes or in operating income when the firm uses no beta coefficient (beta measures the firm's risk). The
debt. market risk premium is the amount above the
risk-free rate that will induce investment in the
Answer (C) is correct. Exchange-rate risk is the risk market. The beta coefficient of an individual stock is
that a foreign currency transaction will be negatively the correlation between the volatility (price variation)
exposed to fluctuations in exchange rates. Because O of the stock market and that of the price of the
& B Company sells goods to German customers and individual stock. For example, if an individual stock
records accounts receivable denominated in deutsche goes up 15% and the market only 10%, beta is 1.5.
marks, O & B Company is exposed to
exchange-rate risk. Answer (C) is incorrect because standard deviation
 measures dispersion (risk) of project returns.
Answer (C) is incorrect because an income bond
Answer (D) is incorrect because expected return pays interest only if the debtor earns it. Such bonds
does not describe risk. are also more risky than secured debt.

Answer (D) is incorrect because unsecured debt is

[177] Source: CIA 0589 IV-49 riskier than a mortgage bond.

Answer (A) is correct. The general principle is that

risk and return are directly correlated. U.S. Treasury [179] Source: Publisher
securities are backed by the full faith and credit of the
federal government and are therefore the least risky Answer (A) is incorrect because the preferred stock
form of investment. However, their return is dividend is not deductible for tax purposes.
correspondingly lower. Corporate first mortgage
bonds are less risky than income bonds or stock Answer (B) is incorrect because the preferred stock
because they are secured by specific property. In the dividend is not deductible for tax purposes.
event of default, the bondholders can have the
property sold to satisfy their claims. Holders of first Answer (C) is incorrect because the denominator is
mortgages have rights paramount to those of any the market price, not the par value.
other parties, such as holders of second mortgages.
Income bonds pay interest only in the event the Answer (D) is correct. The cost of preferred stock is
corporation earns income. Thus, holders of income the preferred dividend divided by the price. No tax
bonds have less risk than shareholders because adjustment is necessary because dividends are not
meeting the condition makes payment of interest deductible. If the market price is $120 when the
mandatory. Preferred shareholders receive dividends dividend is $15, the cost of preferred capital is
only if they are declared, and the directors usually 12.5% ($15 ・$120).
have complete discretion in this matter. Also,
shareholders have claims junior to those of
debtholders if the enterprise is liquidated. [180] Source: Publisher

Answer (B) is incorrect because the proper listing is Answer (A) is incorrect because an optimal portfolio
mortgage bonds, subordinated debentures, income is a portfolio selected from the efficient set of
bonds, and preferred stock. Debentures are portfolios because it is tangent to the investor's
unsecured debt instruments. Their holders have highest indifference curve.
enforceable claims against the issuer even if no
income is earned or dividends declared. Answer (B) is incorrect because a desirable portfolio
is a nonsense term.
Answer (C) is incorrect because the proper listing is
first mortgage bonds, second mortgage bonds, Answer (C) is correct. A feasible portfolio that offers
income bonds, and common stock. The second the highest expected return for a given risk or the
mortgage bonds are secured, albeit junior, claims. least risk for a given expected return is called an
efficient portfolio.
Answer (D) is incorrect because the proper listing is
mortgage bonds, debentures, preferred stock, and Answer (D) is incorrect because an effective portfolio
common stock. Holders of common stock cannot is a nonsense term.
receive dividends unless the holders of preferred
stock receive the stipulated periodic percentage
return, in addition to any averages if the preferred [181] Source: Publisher
stock is cumulative.
Answer (A) is incorrect because risk avoidance and
loss control do not transfer risk of loss.
[178] Source: CIA 1191 IV-50
Answer (B) is incorrect because an insurable interest
Answer (A) is correct. A mortgage bond is secured is merely a potential for economic loss if an event
with specific fixed assets, usually real property. Thus, occurs.
under the rights enumerated in the bond indenture,
creditors will be able to receive payments from Answer (C) is incorrect because there must be an
liquidation of the property in case of default. In a insurable interest, which is basically potential for loss
bankruptcy proceeding, these amounts are paid if an event occurs. Gambling occurs when only a bet
before any transfers are made to other creditors, is at risk.
including those preferences. Hence, mortgage bonds
are less risky than the others listed. Answer (D) is correct. Insurance is a method of
spreading losses that arise from risks to which many
Answer (B) is incorrect because a debenture is persons are subject. Loss is an unanticipated
long-term debt that is not secured (collateralized) by diminution in economic value as opposed to normal
specific property. Subordinated debentures have a depreciation. Risk is uncertainty about the occurrence
claim on the debtor's assets that may be satisfied only or the amount of loss. For example, buildings are
after senior debt has been paid in full. Debentures of subject to the risk of loss by fire. If the owners all pay
either kind are therefore more risky than mortgage small fees (premiums) for insurance coverage, every
bonds. participant bears part of the loss instead of a few
 bearing all the loss. replace economic benefits lost by a person's death.

Answer (D) is incorrect because, except for term

[182] Source: Publisher policies, life insurance differs from other kinds of
coverage in providing cash value.
Answer (A) is correct. An insurance contract (a
policy) must satisfy the usual requirements: offer and
acceptance, consideration, legality, and capacity of [185] Source: Publisher
the parties. The insured must have an insurable
interest in the subject matter of the contract. Also, the Answer (A) is incorrect because whole life furnishes
subject matter generally must exist at the time of lifetime insurance protection with a cash surrender
contracting. In the contract, the insurer makes a value.
promise to pay a stated amount for loss or injury
incurred as a result of a contingent event. Answer (B) is incorrect because an endowment
policy provides life insurance protection for its
Answer (B) is incorrect because the payee may be a duration. A cash payment is made (the policy
stranger to the contract. A person who insures his/her endows) at the end of the term. Premiums for
own life names a third party as a beneficiary. endowment policies are higher than for whole life
Moreover, not every insurer is an insurance insurance.
company, and the contingent event insured against
must involve a risk. Answer (C) is incorrect because a straight life or
ordinary policy is whole life insurance with level
Answer (C) is incorrect because there is no general premiums payable for life.
requirement that an insurance contract be written.
Answer (D) is correct. Term life insurance provides
Answer (D) is incorrect because the contract may protection for a specified period. Premiums are level
often be oral, and, if the risk is not already in throughout the period. When the term ends, the
existence, the transaction is in essence a wager, not insured receives no payment. Term insurance may be
insurance. renewable (possibly at higher premiums) or
convertible to another form. It is the cheapest kind of
life insurance.
[183] Source: Publisher

Answer (A) is correct. An insurance contract is very [186] Source: Publisher

similar to any other contract. However, an additional
requirement is that the insured must have an insurable Answer (A) is incorrect because a corporation has an
interest. insurable interest only in its key employees, i.e., those
whose death would cause loss to the firm.
Answer (B) is incorrect because there is no general
requirement that an insurance contract be written. Answer (B) is correct. When one person insures the
Oral binders are given every day in the insurance life of another, the policyholder must have an
business. insurable interest in the insured. That interest is found
among persons who have a close family relationship
Answer (C) is incorrect because consideration is or expect to suffer substantial economic loss from the
needed for the initial formation of an insurance death. Business entities are thus permitted to insure
contract. The premium may be paid immediately, or a key people in their organizations whose death might
promise to pay is required. have an adverse effect on profits.

Answer (D) is incorrect because the insurance Answer (C) is incorrect because the required loss
company can also commit a breach by refusing to need not be so great as to cause cessation of
pay the proceeds of the policy upon the occurrence business.
of the event.
Answer (D) is incorrect because one need not be an
owner or an officer to be insurable as a key person.
[184] Source: Publisher

Answer (A) is correct. Life insurance is a contract for [187] Source: Publisher
the payment of a specified amount to the named
beneficiary or to the estate of the insured if the Answer (A) is correct. Fire insurance is the most
insured dies while the policy is in effect. Payment for standardized kind of insurance. Following the lead of
the actual loss is called indemnity. Hence, life New York, almost all states have enacted a standard
insurance is a contract of indemnity. policy either by legislative or administrative action.

Answer (B) is incorrect because life insurance is Answer (B) is incorrect because, given that fire
customarily long-term, if not for life. insurance is usually written for a 1- to 3-year period,
an incontestability clause is not necessary. Such a
Answer (C) is incorrect because, unlike other forms clause bars insurer defenses after a period specified
of insurance, life insurance does not attempt to by law or the policy.
reimburse for the actual amount of a loss since loss of
life is not measurable. Life insurance is intended to Answer (C) is incorrect because a policy may state a
 definite value of the insured property or simply a Answer (B) is incorrect because arson is
maximum amount of coverage that is not conclusive compensable unless intended by the insured.
as to valuation when loss occurs. A policy may thus
be valued or open (unvalued). A pro rata clause is Answer (C) is correct. Arson, fraud, or another
often included (but not required) which requires the intentional act of the insured calculated to cause the
loss to be shared pro rata when there is more than damage insured against will preclude recovery. The
one insurer. parties to an insurance contract have an implied duty
not to bring about the very event that is the subject
Answer (D) is incorrect because the insurable interest matter of the policy.
merely requires the person, e.g., mortgagee, bailee,
etc., to suffer a loss if the event insured against Answer (D) is incorrect because negligence without
occurs. fraud will not prevent recovery by an insured who has
acted in good faith.

[188] Source: Publisher

[191] Source: Publisher
Answer (A) is incorrect because life insurance
policies often do not cover death while the insured is Answer (A) is incorrect because malpractice
in the military. insurance is a special form of liability insurance
protecting professionals from lawsuits by third parties
Answer (B) is incorrect because life insurance for negligence.
policies often do not cover death that results during a
noncommercial air flight. Answer (B) is incorrect because homeowners
insurance generally contains a liability section in the
Answer (C) is incorrect because a lapsed policy may event guests are injured on the premises.
often be reinstated by payment of overdue premiums
plus interest. Answer (C) is incorrect because a primary purpose
of automobile insurance is to protect the owner or
Answer (D) is correct. If a premium is not received driver from liability in the event (s)he is responsible
by the due date, the policyholder has a grace period for injury to another person or damage to property.
under state law, usually a month or 31 days, in which
to pay. After the grace period, the cash surrender Answer (D) is correct. Fire insurance generally
value is not forfeited but can be withdrawn or used to protects the insured from damage to the insured
buy a paid-up policy. property as a result of fire. It does not cover the
insured for causing a fire on someone else's property.

[189] Source: Publisher

[192] Source: Publisher
Answer (A) is incorrect because fire insurance usually
indemnifies for loss caused by hostile, but not Answer (A) is incorrect because, if a policyholder
friendly, fires. does not insure the property for an amount close
enough to its full replacement cost, the policyholder
Answer (B) is correct. Ordinarily, smoke, water, or must bear a proportionate part of any partial loss.
other damage caused by hostile, but not friendly, fires
will be indemnified under a fire insurance policy. Answer (B) is incorrect because the co-insurance
Hostile fires are those ignited in places where they are requirement applies only to partial losses. Total losses
not meant to be. A friendly fire is one that burns result in recovery of the face amount of the policy.
where it is intended to burn, such as a fireplace or
furnace. For example, if a friendly fire is kept within Answer (C) is correct. Co-insurance is a method of
its usual container, damage caused by smoke from it sharing risk between the insurer and the insured. A
will not be reimbursed. co-insurance clause typically provides that, if the
policyholder insures his/her property for at least a
Answer (C) is incorrect because fire insurance usually stated percentage (usually 80%) of its actual cash
indemnifies for loss caused by hostile, but not value, any loss will be paid in full up to the face
friendly, fires. amount of the policy. Thus, a co-insurance clause is
used by many property and casualty insurers to
Answer (D) is incorrect because fire insurance usually encourage policyholders to insure commercial
indemnifies for loss caused by hostile, but not property for an amount that is near to its full
friendly, fires. replacement cost.

Answer (D) is incorrect because a co-insurance

[190] Source: Publisher clause encourages policyholders to insure commercial
property for an amount that is near to its full
Answer (A) is incorrect because agency rules do not replacement cost.
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 [193] Source: CIA 1191 IV-58
actual knowledge or conspiracy of the insured will
not preclude recovery. Answer (A) is incorrect because EPS is not a
function of investor confidence and is not maximized
 by concurrent proportional increases in both debt and
equity. EPS is usually higher if debt is used instead of Answer (D) is incorrect because dividends are based
equity to raise capital, at least initially. on managerial discretion and may rarely change;
interest rates, however, fluctuate daily based upon
Answer (B) is correct. Earnings per share will market conditions.
ordinarily be higher if debt is used to raise capital
instead of equity, provided that the firm is not
over-leveraged. The reason is that the cost of debt is [196] Source: CIA 1195 IV-43
lower than the cost of equity because interest is tax
deductible. However, the prospect of higher EPS is Answer (A) is incorrect because the cost of retained
accompanied by greater risk to the firm resulting from earnings is the rate of return shareholders require on
required interest costs, creditors' liens on the firm's equity capital the firm obtains by retaining earnings.
assets, and the possibility of a proportionately lower The opportunity cost of retained funds will be
EPS if sales volume fails to meet projections. positive.

Answer (C) is incorrect because equity capital is Answer (B) is correct. Newly issued or external
initially more costly than debt. common equity is more costly than retained earnings.
The company incurs issuance costs when raising new,
Answer (D) is incorrect because using only current outside funds.
cash flow to raise capital is usually too conservative
an approach for a growth-oriented firm. Management Answer (C) is incorrect because retained earnings
is expected to be willing to take acceptable risks to will always be less costly than external equity
be competitive and attain an acceptable rate of financing. Earnings retention does not require the
growth. payment of issuance costs.

Answer (D) is incorrect because retained earnings

[194] Source: CMA 0695 1-1 will always be less costly than external equity
financing. Earnings retention does not require the
Answer (A) is incorrect because a firm with higher payment of issuance costs.
operating leverage has higher fixed costs and lower
variable costs.
[197] Source: CFM Sample Q. 7
Answer (B) is correct. Operating leverage is a
measure of the degree to which fixed costs are used Answer (A) is incorrect because 16% ignores the
in the production process. A company with a higher increase in dividends and flotation costs.
percentage of fixed costs (higher operating leverage)
has greater risk than one in the same industry that Answer (B) is incorrect because 16.53% ignores the
relies more heavily on variable costs. The DOL increase in the next dividend.
equals the percentage change in net operating income
divided by the percentage change in sales. Thus, Answer (C) is incorrect because 16.6% ignores the
profits become more sensitive to changes in sales flotation costs.
volume as the DOL increases.
Answer (D) is correct. To determine the cost of new
Answer (C) is incorrect because a firm with higher common stock, the dividend growth model is
leverage will be relatively more profitable than a firm adjusted to include flotation cost as follows:
with lower leverage when sales are high. The
opposite is true when sales are low. D
1 $3.18
Answer (D) is incorrect because a firm with higher R = ----------------- + G = ----------- + .06 = 17.16%
leverage is more risky. Its reliance on fixed costs is P (1 - Flotation) $30.00(.95)
greater. 0

[195] Source: CMA 0690 1-15

Answer (A) is incorrect because the obligation to [199] Source: CFM Sample Q. 9
repay at a specific maturity date reduces the risk to
investors and thus the required return. Answer (A) is incorrect because 5.13% is 5.40%
reduced by the 5% stock flotation costs.
Answer (B) is correct. Providers of equity capital are
exposed to more risk than are lenders because the Answer (B) is incorrect because 5.40% is 60% of
firm is not obligated to pay them a return. Also, in 9%.
case of liquidation, creditors are paid before equity
investors. Thus, equity financing is more expensive Answer (C) is incorrect because 6.27% is 6.60%
than debt because equity investors require a higher reduced by the 5% stock flotation costs.
return to compensate for the greater risk assumed.
Answer (D) is correct. The cost of the bonds equals
Answer (C) is incorrect because the demand for the interest rate times one minus the tax rate, or
equity capital is directly related to its greater cost to 6.60% [11% x (100% - 40%)].
the issuer.
 R is the required rate of return, D is the next dividend, P is
[200] Source: CFM Sample Q. 10 the
1 0
Answer (A) is incorrect because the diversity stock's price, and G is the growth rate in earnings per share.
decreases, not increases, risk. The
equation is also used to determine the stock price.
Answer (B) is incorrect because $50,000,000 is D
minuscule in the debt markets. 1
P = -----
Answer (C) is correct. As a larger proportion of an 0 R-G
entity's capital is provided by debt, the debt becomes
riskier and more expensive. Hence, it requires a
higher interest rate. [203] Source: CIA 0593 IV-49

Answer (D) is incorrect because the combination Answer (A) is incorrect because a higher interest rate
alternative maintains the same debt-equity mixture, raises the required return of investors, which results in
which would not warrant a rate increase in the cost of a lower stock price.
debt or equity.
Answer (B) is correct. The dividend growth model is
used to calculate the price of stock.
[201] Source: CIA 1192 IV-48
D
Answer (A) is correct. The required rate of return on 1
equity capital in the capital asset pricing model is the P = -----
risk-free rate (determined by government securities) 0 R-G
plus the product of the market risk premium times the If:
beta coefficient (beta measures the firm's risk). The P = current price
market risk premium is the amount above the 0
risk-free rate that will induce investment in the D = next dividend
market. The beta coefficient of an individual stock is 1
the correlation between the volatility (price variation) R = required rate of return
of the stock market and that of the price of the G = EPS growth rate
individual stock. Assuming that D and G remain constant, an increase in R
resulting
Answer (B) is incorrect because the coefficient of 1
variation is the standard deviation of an investment's from an increase in the nominal interest rate will cause P to
returns divided by the mean return. decrease.
0
Answer (C) is incorrect because the standard
deviation is a measure of the variability of an Answer (C) is incorrect because a higher interest rate
investment's returns. raises the required return of investors, which results in
a lower stock price.
Answer (D) is incorrect because the beta coefficient
measures the sensitivity of the investment's returns to Answer (D) is incorrect because a higher interest rate
market volatility. raises the required return of investors, which results in
a lower stock price.

[202] Source: CIA 1190 IV-53

[204] Source: CIA 1191 IV-57
Answer (A) is incorrect because the model uses the
growth rate in dividends and the investor's required Answer (A) is correct. In economics, a basic
rate of return. principle is that a firm should increase output until
marginal cost equals marginal revenue. Similarly, the
Answer (B) is incorrect because the model uses the optimal capital budget is determined by calculating
growth rate in dividends and the investor's required the point at which marginal cost of capital (which
rate of return. increases as capital requirements increase) and the
marginal efficiency of investment (which decreases if
Answer (C) is incorrect because the model uses the the most profitable projects are accepted first)
growth rate in dividends and the investor's required intersect.
rate of return.
Answer (B) is incorrect because the intersection of
Answer (D) is correct. The dividend growth model is average marginal cost with average projected rates of
used to calculate the cost of equity. The simplified return when the largest (not most profitable) projects
formula is are accepted first offers no meaningful capital
budgeting conclusion.
D
1 Answer (C) is incorrect because optimal capital
R = -- + G budgeting assumes that the most profitable projects
P will be accepted first and that the marginal cost of
0 capital increases as capital requirements increase.
 Thus, it is possible for the optimal capital budget to the long-term debt. All funding will not be obtained
exclude profitable projects as lower cost capital goes from debt because the firm wants to maintain a
first to projects with higher rates of return. capital structure in which debt represents only 30%
of the total capital.
Answer (D) is incorrect because accepting projects
with rates of return lower than the cost of capital is Answer (C) is correct. Williams' preferred capital
not economically rational business. structure is 50% common stock. However,
$100,000 of retained earnings (50% of the required
$200,000 of capital) will be used before any
[205] Source: CMA 0692 1-1 common stock is issued. Thus, the weighted-average
cost of capital will be determined based on the
Answer (A) is incorrect because the 7.0% figure respective costs of the bonds, preferred stock, and
would be correct only if $100 were received from the retained earnings. The cost of the bonds is given as
sale of the stock. 4.8%, the cost of the preferred stock is 8%, and the
cost of the retained earnings is 7% ($7 dividend ・
Answer (B) is correct. According to the Gordon $100 market price of the common stock). These
growth model, the three elements required to three costs are then weighted by the preferred capital
calculate the cost of equity capital are (1) the structure ratios:
dividends per share, (2) the expected growth rate,
and (3) the market price of the stock. If flotation 30% x 4.8% = 1.44%
costs are incurred when issuing new stock, they are 20% x 8.0% = 1.60%
deducted from the market price to arrive at the 50% x 7.0% = 3.50%
amount of capital the corporation will actually ----------- ------
receive. Accordingly, the $100 selling price is Total 6.54%
reduced by the $3 discount and the $5 flotation costs =========== ======
to arrive at the $92 to be received for the stock. Rounding to the nearest tenth produces the correct
Because the dividend is not expected to increase in answer of 6.5%.
future years, no growth factor is included in the
calculation. Thus, the cost of the common stock is Answer (D) is incorrect because the 6.8% figure can
7.6% ($7 dividend ・$92). only be obtained if new stock is sold. New stock will
not be sold because the retained earnings can be
Answer (C) is incorrect because 7.4% would be used at a lower cost, and there is no need to sell
correct only if the stock could be sold without giving stock when the total capital required is only
a $3 discount. $200,000.

Answer (D) is incorrect because 8.1% would be

correct only if the amount received were about $86 [208] Source: CMA 0692 1-4
or if some growth factor were assumed.
Answer (A) is correct. The cost of the bonds is given
as 4.8%. The cost of the preferred stock is 8% ($8
[206] Source: CMA 0692 1-2 dividend ・$100), the cost of new common stock is
7.6% ($7 dividend ・$92 proceeds), and the cost of
Answer (A) is correct. The three elements required the retained earnings is 7% ($7 dividend ・$100
to calculate the cost of equity capital are (1) the market price). These four costs are then weighted by
dividends per share, (2) the expected growth rate, the preferred capital structure ratios, a process that
and (3) the market price of the stock. Because requires subdividing the common stock portion into
growth is not expected, the calculation is simply to retained earnings of $100,000 (10% of capital) and
divide the dividend of $7 by the $100 market price of new common stock of $400,000 (40% of capital):
the stock to arrive at a cost of equity capital of 7%.
30% x 4.8% = 1.44%
Answer (B) is incorrect because 7.6% would be the 20% x 8.0% = 1.60%
cost of new equity capital from selling stock if the 40% x 7.6% = 3.04%
stock resulted in proceeds of $92 per share. 10% x 7.0% = .70%
----------- -----
Answer (C) is incorrect because 7.4% would be Total 6.78%
correct only if new stock were sold and resulted in =========== =====
proceeds of $95 per share. Rounding to the nearest tenth results in the correct
answer of 6.8%.
Answer (D) is incorrect because dividing the $7
dividend by the $100 market price of the stock Answer (B) is incorrect because 4.8% is the cost of
produces a ratio of 7%, not 8.1%. the long-term debt.

Answer (C) is incorrect because 6.5% would be

[207] Source: CMA 0692 1-3 correct only if the equity capital were obtained totally
from retained earnings. Because only $100,000 of
Answer (A) is incorrect because 19.8% represents retained earnings is available, the remainder of equity
the unweighted sum of each of the three elements of capital must come from sales of new stock.
cost.
Answer (D) is incorrect because 27.4% represents
Answer (B) is incorrect because 4.8% is the cost of the unweighted total of each of the four elements of
 cost. (issuance of fixed income securities, i.e., debt and
preferred stock.

[209] Source: CMA 0692 1-12 Answer (D) is correct. Liquidity risk is the possibility
that an asset cannot be sold on short notice for its
Answer (A) is incorrect because the tax deduction market value. If an asset must be sold at a high
always causes the market yield rate to be higher than discount, it is said to have a substantial amount of
the cost of debt capital. liquidity risk.

Answer (B) is incorrect because additional debt may

or may not be issued more cheaply than earlier debt, [212] Source: CIA 0594 IV-52
depending upon the interest rates in the market place.
Answer (A) is incorrect because the degree of
Answer (C) is incorrect because the cost of debt is financial leverage is a measure of the change in
less than the yield rate given that bond interest is tax earnings available to common stockholders
deductible. associated with a given change in operating earnings.

Answer (B) is correct. The degree of operating

Answer (D) is correct. Because interest is deductible leverage (DOL) is a measure of the change in net
for tax purposes, the actual cost of debt capital is the operating income associated with a given change in
net effect of the interest payment and the offsetting sales volume. For a particular level of output, the
tax deduction. The actual cost of debt equals the following is one possible formula:
interest rate times (1 - the marginal tax rate). Thus, if
a firm with an 8% market rate is in a 40% tax sales revenue - variable costs
bracket, the net cost of the debt capital is 4.8% [8% ------------------------------------------------------
x (1 - .4)]. sales revenue - variable costs - fixed operating costs

Answer (C) is incorrect because the degree of total

[210] Source: Publisher leverage is the multiple of the degree of operating
leverage and the degree of financial leverage. Other
Answer (A) is correct. Following a loss, the owner things being equal, DOL is higher if the degree of
will be able to collect the lesser of (1) the face total leverage is higher.
amount of the policy, (2) the amount of the loss, or
(3) the amount of the co-insurance limitation. The Answer (D) is incorrect because the degree of total
co-insurance limitation is calculated by multiplying the leverage is the multiple of the degree of operating
loss times the following co-insurance formula: [Face leverage and the degree of financial leverage. Other
amount of policy ($120,000) over Co-insurance things being equal, DOL is higher if the degree of
requirement (80% x $200,000 fair value)] = 75%. total leverage is higher.
Thus, 75% of any loss will be covered, up to the face
amount of the policy. The recovery is $112,500
(75% x $150,000 loss). [213] Source: Publisher

Answer (B) is incorrect because the recovery is Answer (A) is incorrect because 4% assumes a 60%
limited to the amount calculated in the co-insurance tax rate.
formula.
Answer (B) is correct. Because the bonds are issued
Answer (C) is incorrect because the recovery is at their face value, the pretax effective rate is 10%.
limited to the amount calculated in the co-insurance However, interest is deductible for tax purposes, so
formula. the government absorbs 40% of the cost, leaving a
6% after-tax cost.
Answer (D) is incorrect because the recovery is
limited to the amount calculated in the co-insurance Answer (C) is incorrect because 10% is the
formula. before-tax rate.

Answer (D) is incorrect because the after-tax cost

[211] Source: CMA 0697 1-11 will be less than the effective before-tax rate.

Answer (A) is incorrect because interest rate risk is

caused by fluctuations in the value of an asset as [214] Source: Publisher
interest rates change. Its components are price risk
and reinvestment-rate risk. Answer (A) is incorrect because 5% is the dividend
yield; the growth rate is ignored.
Answer (B) is incorrect because purchasing power
risk is the risk that a general rise in the price level Answer (B) is incorrect because 9% would be the
(inflation) will reduce what can be purchased with a after-tax cost if dividends were deductible.
fixed sum of money.

Answer (C) is incorrect because financial risk is the Answer (C) is incorrect because 10% is the dividend
risk borne by shareholders, in excess of basic growth rate; it ignores the dividend yield.
business risk, that arises from use of financial leverage
 Answer (D) is correct. The cost of internal equity
capital equals the dividend yield (dividends per share Answer (C) is incorrect because 13.6% assumes the
・market price) plus the dividend growth rate. equity consists solely of new common stock.
Dividing the $3 dividend by the $60 market price
results in a yield of 5%. Adding the 10% dividend Answer (D) is incorrect because 16% is the cost of
growth rate produces a cost of 15% for retained new common stock.
earnings. No adjustment is made for taxes because
dividends are not tax deductible.
[218] Source: Publisher

[215] Source: Publisher Answer (A) is incorrect because 10% is the cost of
debt capital.
Answer (A) is incorrect because 6.25% ignores the
dividend growth rate. Answer (B) is incorrect because 12.74% is the
weighted-average cost of capital calculated for a $7
Answer (B) is incorrect because 15% ignores the million budget.
flotation costs.
Answer (C) is correct. For this calculation, the
Answer (C) is correct. The company will receive only weighted-average cost of capital is based on the 16%
80% of the $60 market price, or $48. Consequently, cost of new common stock and the 10% cost of
the dividend yield is 6.25% ($3 ・$48). Adding the debt. Retained earnings will not be considered
10% growth rate produces a cost of new equity because the amount available has been exhausted.
capital of 16.25%. Thus, the weighted average of any additional capital
required will be 13.6% [(60% x 16% cost of new
Answer (D) is incorrect because 10% is the dividend equity) + (40% x 10% cost of new debt)].
growth rate.
Answer (D) is incorrect because 16% is the cost of
new common stock.
[216] Source: Publisher

Answer (A) is incorrect because $2 million is the [219] Source: CIA 1190 IV-51
amount of debt that must be added to maintain the
optimal structure. Answer (A) is incorrect because default risk is the
risk that a borrower will not pay the interest or
Answer (B) is incorrect because $3 million is the principal on a loan.
amount of earnings retained.
Answer (B) is incorrect because interest-rate risk is
Answer (C) is correct. The current optimal capital the risk to which investors are exposed because of
structure is 40% debt and 60% equity. The $3 million changing interest rates.
to be retained from earnings in the coming year
represents the equity portion of the maximum new Answer (C) is incorrect because purchasing-power
capital outlay. To retain the optimal capital structure, risk is the risk that inflation will reduce the purchasing
$2 million of debt must be added to the $3 million of power of a given sum of money.
retained earnings. Hence, the maximum capital
expansion is $5 million. Answer (D) is correct. An asset is liquid if it can be
converted to cash on short notice. Liquidity
Answer (D) is incorrect because the amount of $5 (marketability) risk is the risk that assets cannot be
million can be calculated. sold at a reasonable price on short notice. If an asset
is not liquid, investors will require a higher return than
for a liquid asset. The difference is the liquidity
[217] Source: Publisher premium.

Answer (A) is incorrect because 11.14% assumes a

tax adjustment for the cost of debt, but the 10% rate [220] Source: CMA 0692 1-13
is an after-tax amount.
Answer (A) is incorrect because the concern is with
Answer (B) is correct. To maintain a capital structure the cost of new funds; the cost of old funds is a sunk
of 40% debt and 60% equity, the $7 million total cost and of no relevance for decision-making
must consist of $2.8 million of debt and $4.2 million purposes.
of equity. The equity will consist of $3 million of
retained earnings and $1.2 million of new stock. The Answer (B) is incorrect because the cost of
weighted-average cost of the three sources of new short-term funds is not usually a concern for
capital is determined as follows: investment purposes.

$3,000,000 ・$7,000,000 x 14% = 6.00%

$1,200,000 ・$7,000,000 x 16% = 2.74% Answer (C) is correct. The theory underlying the cost
$2,800,000 ・$7,000,000 x 10% = 4.00% of capital is based primarily on the cost of long-term
------ funds and the acquisition of new funds. The reason is
12.74% that long-term funds are used to finance long-term
====== investments. For an investment alternative to be
 viable, the return on the investment must be greater
than the cost of the funds used. The objective in
short-term borrowing is different. Short-term loans Answer (A) is incorrect because 2.4 could be
are used to meet working capital needs and not to obtained only by overstating the contribution margin
finance long-term investments. or the fixed costs.

Answer (D) is incorrect because the cost of old funds Answer (B) is incorrect because 1.78 is the degree of
is a sunk cost and of no relevance for operating leverage, not financial leverage.
decision-making purposes. Similarly, short-term
funds are used for working capital or other temporary Answer (C) is correct. The degree of financial
purposes, and there is less concern with the cost of leverage is the percentage change in earnings
capital and the way it compares with the return available to common shareholders that is associated
earned on the assets borrowed. with a given percentage change in net operating
income. Operating income equals earnings before
interest and taxes. The more financial leverage
[221] Source: CMA 0692 1-8 employed, the greater the degree of financial
leverage, and the riskier the firm. Earnings before
Answer (A) is incorrect because 2.4 could be interest and taxes equal $36,000 [$400,000 sales -
obtained only by overstating the contribution margin ($.84 x 400,000 units) VC - $28,000 FC]. Using the
or the fixed costs. given formula, the calculation is as follows:

Answer (B) is correct. Operating leverage is the $36,000 $36,000

percentage change in operating income resulting from --------------------------------------- = --------- = 1.35
a percentage change in sales. It measures how a $36,000 - $6,000 - ($2,000 ・.6) $26,667
change in volume affects profits. Companies with
larger investments and greater fixed costs ordinarily Answer (D) is incorrect because 2.3 is derived by
have higher contribution margins and more operating overstating the $64,000 contribution margin or the
leverage. The degree of operating leverage measures $28,000 of fixed costs.
the extent to which fixed assets are used in the
production process. A company with a high
percentage of fixed costs is more risky than a firm in [224] Source: CMA 0692 1-14
the same industry that relies more on variable costs to
produce. Based on a contribution margin of $.16 per Answer (A) is incorrect because the 4.2% figure can
unit ($1 - $.84 variable cost), the degree of operating be obtained only by incorrectly treating the dividends
leverage is (400,000 x $.16) ・[(400,000 x $.16) - as deductible.
28,000] = 1.78.
Answer (B) is incorrect because the 6.2% figure can
Answer (C) is incorrect because 1.35 includes a be obtained only by treating the dividends as
nonoperating expense (interest) and dividends on deductible.
preferred stock as fixed costs. It is the degree of
financial leverage, not operating leverage. Answer (C) is incorrect because 10% can be
obtained only by basing the calculation on par value
Answer (D) is incorrect because 1.2 is obtained by instead of funds received.
understating the $64,000 contribution margin or
understating the $28,000 of fixed costs. Answer (D) is correct. Because the dividends on
preferred stock are not deductible for tax purposes,
the effect of income taxes is ignored. Thus, the
[222] Source: CMA 0692 1-10 relevant calculation is to divide the $10 annual
dividend by the quantity of funds received at the time
Answer (A) is correct. The degree of total leverage is the stock is issued. In this case, the funds received
equal to the degree of operating leverage times the equal $96 ($101 selling price - $5 underwriting fee).
degree of financial leverage. Thus, a decrease in Thus, the cost of capital is 10.4% ($10 ・$96).
either of these ratios results in a decrease in total
leverage. If the company had no preferred stock, the
DFL and the DTL would be lower because the [225] Source: CMA 0690 1-10
pretax income necessary to pay the preferred
dividends [P ・(1 - T)] is subtracted from the Answer (A) is incorrect because the maximization of
denominator of the DFL. EPS may not always suggest the best capital
structure.
Answer (B) is incorrect because the increases would
not be proportional. Answer (B) is incorrect because the minimization of
debt cost may not be optimal; as long as the firm can
Answer (C) is incorrect because the elimination of earn more on debt capital than it pays in interest, debt
preferred stock would change the equation. financing may be indicated.

Answer (D) is incorrect because the decrease would Answer (C) is correct. Financial structure is the
be proportional. composition of the financing sources of the assets of a
firm. Traditionally, the financial structure consists of
current liabilities, long-term debt, retained earnings,
[223] Source: CMA 0692 1-9 and stock. For most firms, the optimum structure
 includes a combination of debt and equity. Debt is 9.20% [R + ﾟ (R - R ) = .05 + .6(.12 - .05)].
cheaper than equity, but excessive use of debt F M F
increases the firm's risk and drives up the
weighted-average cost of capital. Answer (B) is incorrect because 12.20% equals the
risk-free rate plus 60% of market rate.
Answer (D) is incorrect because minimizing the cost
of equity may signify overly conservative Answer (C) is incorrect because 7.20% results from
management. multiplying both the market rate premium and the
risk-free rate by 60%.

[226] Source: CMA 1294 1-25 Answer (D) is incorrect because 12.00% is the
market rate.
Answer (A) is incorrect because the contract rate is
8% annually.
[229] Source: CPA 0593 L-59
Answer (B) is correct. Proceeds are $14,850,000
[(1.01 x $15,000,000) - (.02 x $15,000,000)]. The Answer (A) is incorrect because, since Pod was in
annual interest is $1.2 million (.08 coupon rate x compliance with the coinsurance requirement,
$15,000,000). Thus, the company is paying $1.2 Owners will pay a proportionate amount of the loss
million annually for the use of $14,850,000, a rate of based on the amount of insurance carried with each
8.08% ($1,200,000 ・$14,850,000). insurer.

Answer (C) is incorrect because 10.00% is the sum Answer (B) is incorrect because, since Pod was in
of the coupon rate and the flotation rate. compliance with the coinsurance requirement,
Owners will pay a proportionate amount of the loss
Answer (D) is incorrect because 7.92% ignores the based on the amount of insurance carried with each
2% flotation costs. insurer.

Answer (C) is correct. A coinsurance clause requires

[227] Source: CMA 1294 1-26 the insured to maintain insurance equal to or greater
than a specified percentage (usually 80%) of the
Answer (A) is correct. The 7% debt cost and the value of the insured property. If the insured has not
12% equity cost should be weighted by the carried the specified percentage and a partial loss
proportions of the total investment represented by occurs, the insurance company is liable for only a
each source of capital. The total project costs $50 proportionate part of the loss. A pro rata clause
million, of which debt is $15 million, or 30% of the generally provides that a person who is insured with
total. Equity capital is the other 70%. Consequently, multiple policies can collect from each insurance
the weighted-average cost of capital is 10.5% company only a proportionate amount of the loss
[(7%)(30%) + (12%)(70%)]. based on the amount of insurance carried with each
insurer. Pod was in compliance with the coinsurance
Answer (B) is incorrect because 8.50% reverses the clause (80% x $250,000 = $200,000). Pod would
weights. recover in full. The pro rata portion Pod would
recover from Owners is $135,000 [($150,000 ・
Answer (C) is incorrect because 9.50% assumes $200,000) x $180,000].
debt and equity are equally weighted.
Answer (D) is incorrect because, since Pod was in
Answer (D) is incorrect because the compliance with the coinsurance requirement,
weighted-average cost cannot be less than any of its Owners will pay a proportionate amount of the loss
components. based on the amount of insurance carried with each
insurer.

[228] Source: CMA 1294 1-27

[230] Source: CPA 0593 L-60
Answer (A) is correct. The market return
Answer (A) is incorrect because a coinsurance clause
(R ), does not apply when the property insured is totally
M destroyed.
given as 12%, minus the risk-free rate
Answer (B) is correct. A coinsurance clause does not
(R ), apply when the property insured is totally destroyed.
F Pod would recover the face amount of the policies.
given as 5%, is the market risk premium. It is the rate
at which investors must be compensated to induce Answer (C) is incorrect because recovery is limited
them to invest in the market. The beta coefficient (ﾟ) to the face amount of the policies.
of an individual stock, given as 60%, is the
correlation between volatility (price variation) of the Answer (D) is incorrect because recovery is limited
stock market and the volatility of the price of the to the face amount of the policies.
individual stock. Consequently, the expected rate of
return is
[231] Source: Publisher
 of the policy.
Answer (A) is incorrect because 5% represents only
half of the return elements (either yield or growth). Answer (C) is incorrect because under no
circumstances would the insurance company pay
Answer (B) is incorrect because the growth rate is more than the face value of the policy.
based on market value, not yield.
Answer (D) is incorrect because under no
Answer (C) is incorrect because the yield and growth circumstances would the insurance company pay
rate are 5% each--a total of 10%. more than the face value of the policy.

Answer (D) is correct. The dividend growth model

estimates the cost of retained earnings using the [234] Source: CPA 1181 L-55
dividends per share, the expected growth rate, and
the market price. The current dividend yield is 5% Answer (A) is correct. Conditions precedent, called
($4 ・$80). Adding the growth rate of 5% to the warranties, are part of the property insurance policy.
yield of 5% results in a required return of 10%. Breach of a warranty precludes recovery and results
in a forfeiture. Since the law disfavors forfeitures,
courts construe questions of interpretation favorably
[232] Source: CPA 1192 L-56 to the insured and against the insurer that drafted the
policy. However, if the parties expressly agree that
Answer (A) is incorrect because partial recovery is certain statements are warranties, then a court would
available when a coinsurance requirement is not recognize them as warranties. Since Jewelry
complied with. warranted never to display more than $10,000 of
jewelry, the breach of warranty prevents recovery.
Answer (B) is incorrect because a coinsurance clause
does not limit recovery when the insured property is a Answer (B) is incorrect because Jewelry will recover
total loss. nothing; it is not entitled to $2,000.

Answer (C) is correct. A coinsurance clause requires Answer (C) is incorrect because the warranty will not
the insured to maintain insurance equal to or greater be construed as a mere representation; the intention
than a specified percentage (usually 80%) of the of the parties clearly was to make it a warranty.
value of the insured property. If the insured has not
carried the specified percentage and a partial loss Answer (D) is incorrect because attachment of the
occurs, the insurance company is liable for only a application to the policy is usually sufficient to make it
proportionate part of the loss. This is to deter people a part thereof. It may also be incorporated into the
from paying for insurance on only a small part of the policy by reference to it.
property's value. However, the coinsurance clause
has no application when an insured building is totally
destroyed. Thus, Hart can recover the $300,000 face [235] Source: CPA 1191 L-60
value of the policy.
Answer (A) is incorrect because part of the loss is
Answer (D) is incorrect because an insured cannot recovered when a coinsurance clause is not complied
collect more from an insurance company than the with.
face value of the policy.
Answer (B) is incorrect because each pays the
amount recoverable times the percentage of the total
[233] Source: CPA 0588 L-59 insurance it agreed to provide.

Answer (A) is incorrect because the coinsurance Answer (C) is correct. Under a coinsurance clause,
percentage is applied to compute the coinsurance the insured agrees to maintain the insurance equal to a
requirement, which in turn is the denominator of the specified percentage of the value of his/her property.
fraction multiplied by the loss. If a loss occurs, the insurer pays only a proportionate
share if the insured has not carried the specified
Answer (B) is correct. Under a standard coinsurance percentage. In this case, the insured agreed to carry
clause, the insured agrees to maintain insurance equal 80%, but in fact carried only 40%; thus, it became a
to a specified percentage of the value of the property. 50% insurer, and the insurance companies' liability
If the insured has not carried the specified percentage was reduced to 50% of any loss. The total combined
and a loss occurs, the insurance company pays only liability of the fire insurance companies in the problem
part of the loss. The coinsurance requirement is is $20,000. Under the standard pro rata clause, a
$750,000 (75% x $1,000,000 FMV at the time of person who is insured with multiple policies can
the loss). Under the formula below, Ritz might collect from each insurance company only a
recover $600,000 of the $900,000 loss. proportionate amount of the loss. Even though Ace
issued a policy for $24,000, it is liable for only
Amount of insurance three-fifths (24,000/40,000) of the recoverable loss
------------------------- x Loss = Recovery after applying the coinsurance formula (3/5 x
Coinsurance requirement $20,000 = $12,000). Likewise, Thrifty is liable for
$500,000 2/5 of $20,000.
--------- x $900,000 = $600,000
$750,000 Answer (D) is incorrect because the insurer pays only
But Ritz may recover no more than the face amount a proportionate share if the insured has not carried
 the specified percentage. 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
[236] Source: CMA 1288 1-5 firm to pay a dividend to shareholders at some time in
the future, once the firm feels it is strong enough to do
Answer (A) is incorrect because the composition of so and still support future operations. After all, it is
the capital structure affects the cost of capital since the primary goal of a firm's management to maximize
the components have different costs. shareholder wealth. Although many factors should be
considered when purchasing a security, the primary
Answer (B) is incorrect because the cost of debt consideration for a value-seeking investor is the future
does not remain constant as financial leverage cash flow stream.
increases. Eventually, that cost also increases.
Answer (C) is incorrect because the beta coefficient
Answer (C) is incorrect because increased leverage is a measure of how volatile the price movements of a
is initially favorable. stock are relative to the market as a benchmark.

Answer (D) is correct. The U-shaped curve indicates Answer (D) is incorrect because standard deviation is
that the cost of capital is quite high when the a measure of risk. While risk is a consideration for
debt-to-equity ratio is quite low. As debt increases, the investor, one of the fundamental concepts in
the cost of capital declines as long as the cost of debt finance is that there is (should be) a trade-off
is less than that of equity. Eventually, the decline in between risk and return, and as long as risk is
the cost of capital levels off because the cost of debt compensated for, it is not a primary consideration.
ultimately rises as more debt is used. Additional
increases in debt (relative to equity) will then increase
the cost of capital. The implication is that some debt
is present in the optimal capital structure because the

cost of capital initially declines when debt is added.

However, a point is reached at which debt becomes
excessive and the cost of capital begins to rise.

[237] Source: Publisher

Answer (A) is incorrect because the 3.5 is multiplied

times the increase in sales.

Answer (B) is incorrect because the 3.5 is multiplied

times the increase in sales.

Answer (C) is correct. The degree of operating

leverage (DOL) is the percentage change in net
operating income associated with a given percentage
of sales. With a DOL of 3.5, it means income will
increase 3.5 times greater than any sales increase.
Thus, multiplying 3.5 times the 6% sales increase
results in a profit increase of 21%.

Answer (D) is incorrect because the DOL is

multiplied by the sales change, not divided into it.

[238] Source: Publisher

Answer (A) is incorrect because book value is a

measure of the stock's worth on a company's
accounting records.

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,