CFA® Level 1 Exam: Correct Statements

Which statement is correct?

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Question

Which of the following statements is correct?

Answers

A. Due to the way the MCC (Marginal Cost of Capital) is constructed, the first break point in the MCC schedule must be associated with using up all available retained earnings and having to issue common stock.

B. Normally, the cost of external equity raised by issuing new common stock is above the cost of retained earnings. Moreover, the higher the growth rate is relative to the dividend yield, the more the cost of external equity will exceed the cost of retained earnings.

C. The lower a company's tax rate, the greater the advantage of using debt in terms of lowering its WACC.

D. Because we often need to make comparisons among firms that are in different income tax brackets, it is best to calculate the WACC (Weighted Average Cost of Capital) on a before-tax basis.

E. If a firm has been suffering accounting losses and is expected to continue suffering such losses, and therefore its tax rate is zero. It is possible that its after-tax component cost of preferred stock as used to calculate the WACC will be less than its after-tax component cost of debt.

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Explanations

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A. B. C. D. E.

Because corporations can exclude dividends for tax purposes, preferred stock often has a market return that is less than the issuing company's cost of debt. Then, if the issuer's tax rate is zero, its component cost of preferred would be less than its cost of debt.

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