CFA® Level 1: CFA® Level 1 Exam Prep

Which Statement is Correct?

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Question

Which of the following statements is correct?

Answers

A. The cost of debt used in calculating the WACC is an average of the after-tax cost of new debt and of outstanding debt.

B. Preferred stock does not involve any adjustment for flotation cost since the dividend and price are fixed.

C. The cost of new common equity includes an adjustment for flotation costs which is expressed as a fixed percentage of the current stock price. The flotation percentage is determined jointly by the current price of the firm's stock and its growth rate.

D. The opportunity cost principle implies that if the firm cannot invest retained earnings and earn at least k(s) (component cost of retained earnings or internal equity), it should pay these funds to its stockholders and let them invest directly in other assets that do provide this return.

E. Capital components are the types of capital used by firms to raise money. All capital comes from one of three types: long-term debt, preferred stock, and equity.

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Explanations

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A. B. C. D. E.

The firm's after-tax earnings belong to its stockholders. All earnings remaining after interest and preferred dividends belong to them, and these earnings serve to compensate stockholders for the use of their capital. The firm may either pay out earnings as dividends or retain them and reinvest them in the firm. If the firm retains earnings, there is an opportunity cost involved - stockholders could have received the earnings as dividends and invested the money in other investments.

Thus, the firm should earn on its retained earnings at least as much as the stockholders themselves could have earned on alternative investments of comparable risk.

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