Question 1:

(2B2-LS16)

Which of the following statements about an option is not correct?

The owner of a put option has the right to sell the underlying asset at
a fixed price.
The buyer of an option contract receives an up-front premium from
the seller of the option contract.
The owner of a call option has the right to buy the underlying asset
from the seller.
The seller (writer) of an option contract receives an up-front premium
from the owner of the option contract.

By definition, a premium is the initial purchase price of an option and it is

usually stated on a per unit basis. The writer (seller) of an option contract
receives an up-front premium from the buyer (owner) of the option
contract. This premium obligates the writer to fulfill the contract (sell or
buy the underlying asset) if the buyer chooses to exercise the option.

Question 2:
(2B2-LS18)

Standard & Poor's downgrades an A-rated bond to a BB rating. What is the

likely impact of this downgrade if the corporation issues future bonds?
The issuer will need to offer higher interest rates.
The principal will yield higher returns.
The issuer will need to offer lower interest rates.
Future returns will be highly speculative.

Credit rating services may adjust ratings up or down during the life of a
bond. A downgraded rating means that future issues will need to offer
higher interest rates to attract buyers.

Question 3:
(2B2-LS11)

What is a primary difference between stock splits and cash dividends?

Stock splits are usually paid quarterly; cash dividends are awarded
annually.
Cash dividends are usually paid quarterly; stock splits are awarded
 annually.

Cash dividends do not result in any taxable gain or loss; stock splits
are taxable.
Stock splits do not result in any taxable gain or loss; cash dividends
are taxable.

A cash dividend is paid in the form of cash, usually a check. Cash

dividends are taxable. Stock splits do not result in any taxable gain or
loss.

Question 4:
(2B2-CQ14)

Following is an excerpt from Albion Corporation's balance sheet.

Albion's bonds are currently trading at $1,083.34, reflecting a yield to

maturity of 8%. The preferred stock is trading at $125 per share. Common
stock is selling at $16 per share, and Albion's treasurer estimates that the
firm's cost of equity is 17%. If Albion's effective income tax rate is 40%,
what is the firm's current cost of capital?

13.9%.
11.9%.
13.1%.
14.1%.

The weighted average cost capital (WACC) is calculated as:

WACC = (weight of long-term debt)(after-tax cost of long-term debt) +

(weight of common stock)(cost of common stock) + (weight of preferred
stock)(cost of preferred stock)

The after-tax cost of debt if calculated as:

After-tax cost of debt = (1 tax rate)(before-tax cost of debt)

After-tax cost of debt = (1 0.4)(0.08) = 0.048, or 4.8%

The cost of preferred stock is calculated as:

Cost of preferred stock = (dividend on preferred stock, per share) / (price

of preferred stock)

Dividend per share on preferred stock = (0.12)(10,000,000 / 100,000) = $12

Cost of preferred stock = ($12) / ($125) = 0.096 or 9.6%

The total of long-term debt, preferred stock, and common stock =

$32,500,200+$12,500,000+$80,000,000=$125,000,200 .
 The weights of each of these components can be calculated as follows:

Weight of long-term debt = $32,500,200 / $125,000,200 = 0.26

Weight of preferred stock = $12,500,000 / $125,000,200 = 0.10

Weight of common stock = $80,000,000 / $125,000,200 = 0.64

The WACC can now be calculated as:

WACC = (0.26)(0.048) + (0.10)(0.096) + (0.64)(0.17) = 0.0125 + 0.0096 +

0.1088 = 0.1309, or 13.1%.

Question 5:
(2B2-AT08)

Debentures are:
bonds backed by the full faith and credit of the issuing firm.
subordinated debt and rank behind convertible bonds.
income bonds that require interest payments only when earnings
permit.
mortgage bonds secured by a lien on specific assets of the firm.

Debentures are unsecured bonds. They are backed by the full faith and
credit of the issuing firm.

Question 6:
(2B2-LS62)

Which of the following methods of calculating the cost of equity reflects a

market value approach?
Weighted average method.
Dividend growth model.
Capital asset pricing model.
Historical rate of return.

The underlying logic of the dividend growth model is that market price of
a stock equals the cash flow of expected future incomes (both dividends
and market price appreciation) discounted to their present value. This
means that when the present value of the future cash flows equals the
market price, the discount rate equals the cost of equity capital. An
underlying assumption is that cash flows will grow at a constant
compound rate.

Question 7:
(2B2-LS55)

Preferred stock may be retired through the use of any one of the following
except a:

*Source: Retired ICMA CMA Exam Questions.

 sinking fund.
call provision.
refunding.
conversion.

Preferred stock may be retired through the use of conversion, call

provision, or sinking fund. Preferred stock is not retired through
refunding.

Question 8:
(2B2-LS60)

Which of the following statements about the cost of debt is incorrect?

Interest costs may be calculated in various ways.
A weighted average of yields-to-maturity should be used to calculate
the cost of debt when one or more types of debt are involved.
The cost of debt should be considered on a before-tax basis.
The market value of debt is generally used when calculating the cost
of capital.

Since the interest payments on corporate debt are a tax-deductible

expense, the cost of debt should be considered on an after-tax basis.

Question 9:
(2B2-LS34)

Which of the following statements describes an option that is in-the-

money?
Payment must be made to the owner if the contract is exercised.
The owner of the contract decides not to sell the underlying asset.
The strike price exceeds the price of the underlying asset.
The owner can exercise the option at any time before maturity.

Different payoffs are possible with options. An option generally referred

to as being in-the-money requires immediate payment to the owner if the
contract is exercised.

Question 10:
(2B2-LS63)

Which of the following statements best describes how a corporation

determines its cost of capital?
The cost is derived only from permanent investments by
shareholders.
The cost is a function of the issuance of interest-bearing instruments.
The cost is derived from determining the cost of each component in a
firm's capital structure.
The cost is a function of temporary (short-term) sources of financing.
 Determining the cost of each component in a firm's capital structure is
the first step in calculating the cost of capital. This involves determining
the cost of debt, the cost of preferred stock, the cost of common equity,
and/or any other methods of financing.

Question 11:
(2B2-CQ12)

An accountant for Stability Inc. must calculate the weighted average cost of
capital (WACC) of the corporation using the following information.

What is the WACC of Stability?

17%.
13.4%.
10.36%.
11.5%.

The WACC is calculated as:

WACC = (weight of long-term debt)(after-tax cost of long-term debt) +

(weight of common stock)(cost of common stock) + (weight of retained
earnings)(cost of retained earnings)

The total of long-term debt, common stock, and retained earnings =

$10,000,000 + $10,000,000 + $5,000,000 = $25,000,000. From this
information, the weight of long-term debt, common stock, and retained
earnings can be determined as:

Weight for long-term debt = ($10,000,000) / ($25,000,000) = 0.4

Weight for common stock = ($10,000,000) / ($25,000,000) = 0.4.
Weight for retained earnings = ($5,000,000 / $25,000,000) = 0.2

WACC = (0.4)(0.08) + (0.4)(0.18) + (0.2)(0.15) = 0.134, or 13.4%

Question 12:
(2B2-LS57)

Which one of the following describes a disadvantage to a firm that issues

preferred stock?

*Source: Retired ICMA CMA Exam Questions.

Preferred stock dividends are legal obligations of the corporation.

Most preferred stock is owned by corporate investors.
 Preferred stock typically has no maturity date.
Preferred stock is usually sold on a higher yield basis than bonds.

A disadvantage of preferred stock is that preferred stock is usually sold on

a higher yield basis than bonds. Preferred stock has a higher seniority risk
than bonds.

Question 13:
(2B2-AT02)

The beta of Wheeling Inc. common stock is greater than 1. This means that:
The Wheeling stock and the market portfolio have the same
systematic risk.
Returns for the Wheeling stock vary more widely than market returns.
The Wheeling stock has the same risk as other stocks with the same
credit rating.
The unsystematic risk for the Wheeling stock varies more widely than
market returns.

The beta for a common stock is the ratio of the variability in its returns to
the variability in the overall stock market. A common stock with a beta of
1 tracks the market. A common stock with a beta greater than 1 has
returns that are more variable than the overall stock market. A common
stock with a beta less than 1 has returns that are less variable than the
overall stock market. Therefore, the returns for the stock of Wheeling, Inc.
will vary more widely than market returns.

Question 14:
(2B2-LS49)

A requirement specified in an indenture agreement which states that a

company cannot acquire or sell major assets without prior creditor
approval is known as a

*Source: Retired ICMA CMA Exam Questions.

put option.
protective covenant.
warrant.
call provision.

Protective covenants set limits (restrictions) on certain actions the

company might be taking during the term of the agreement. They are a
particularly important feature in a bond indenture.

Question 15:
(2B2-LS37)

A common stock referred to as a defensive stock implies that the stock:

seems inexpensive when compared to earnings and other
performance measures.
 is relatively stable and resistant to most economic conditions.
is a solid performer with a good track record and usually generates a
steady income.
has earnings growing faster than the overall economy.

The common stock classification of a defensive stock implies a

conservative stock that is relatively stable and resistant to most
economic conditions (e.g., economic upturns and slowdowns).

Question 16:
(2B2-LS28)

A firm is considering the purchase of a federal agency security. Which of the

following statements is most likely to be true?
The firm has poor liquidity.
Tax exposure is limited.
The securities may be discounted.
The rate is regularly reset.

Federal agency interest-bearing securities have limited tax exposure.

Many are exempt from state and local income taxes but not state
franchise taxes.

Question 17:
(2B2-LS53)

Which one of the following is a debt instrument that generally has a

maturity of ten years or more?

*Source: Retired ICMA CMA Exam Questions.

A financial lease.
A chattel mortgage.
A bond.
A treasury note.

A bond is a promise to pay a specified amount of interest over time and to

repay principal at maturity. These instruments generally have long-term
maturities. Treasury notes have maturities of one to ten years. Treasury
bill maturities are less than one year. A financial lease is a contract.

Question 18:
(2B2-AT09)

All of the following are legal rights of shareholders in U.S. publicly-traded

companies except the right to:
vote on major management changes.
receive annual financial reports.
vote on charter and bylaw changes.
vote on major mergers and acquisitions.
 Changes in management (the CEO and below) are the responsibility of the
board of directors. The board members are elected by the shareholders.
The board is responsible for directing the corporation. Direction
includes planning, organizing, staffing, coordinating, and controlling.

Question 19:
(2B2-AT04)

A pension fund manager utilizes the Capital Asset Pricing Model (CAPM) to
guide the decision process. The manager has been presented with the
following three investment options by the fund advisor, all of which are
large, fully diversified investment funds.

Which one of the following is correct with regard to the returns for these
portfolios?
Portfolio C can be expected to earn the lowest return.
Portfolios A and C can be expected to earn similar returns.
Portfolio B has more risk than Portfolio C and less risk than Portfolio
A.
Portfolio A can be expected to earn the highest return.

Using the CAPM, the required rate of return on a common stock is

calculated by taking the risk-free rate of return and adding to it the
difference between the market rate of return and the risk-free rate of
return times the stock's beta.

Here is the CAPM formula:

Ke = Rf + (Km - Rf)

Where:
Ke = required rate of return
Rf = risk-free rate (such as the return on U.S. T-bill or T-bonds)
= beta coefficient for the company
Km = return on a market portfolio

Since the betas for portfolios A and C are the same, the required rates of
return would be the same.

Question 20:
(2B2-AT16)

DQZ Telecom is considering a project for the coming year that will cost $50
million. DQZ plans to use the following combination of debt and equity to
finance the investment.
 Issue $15 million of 20-year bonds at a price of 101, with a coupon
rate of 8%, and flotation costs of 2% of par.
Use $35 million of funds generated from earnings.

The equity market is expected to earn 12%. U.S. treasury bonds are
currently yielding 5%. The beta coefficient for DQZ is estimated to be .60.
DQZ is subject to an effective corporate income tax rate of 40%.

Assume that the after-tax cost of debt is 7% and the cost of equity is 12%.
Determine the weighted average cost of capital (WACC).
10.5%.
9.5%.
8.5%.
15.8%.

The formula to calculate the WACC is as:

Ka = p1k1+p2k2+ . . . pnkn

Where:

ka = cost of capital (expressed as a percentage)

k = cost of an element in the capital structure
p = proportion that element comprises of the total capital structure
n = different types of financing (each with its own cost and proportion in
the capital structure)

The WACC (Ka) is the weighted average costs of debt, preferred stock,
retained earnings, and common stock sales. The cost of retained earnings
is the cost of internal equity while the cost of common stock is the cost of
external equity.

Ka for DQZ is 10.5%, which is calculated by taking the weighted cost of

debt (2.1%), plus the weighted cost of equity (8.4%).

The 2.1% weighted cost of debt is calculated as:

($15million/$50million)(0.07) = (0.3)(0.07) = 0.021.

The 8.4% weighted cost of equity is calculated by taking the

proportionate weight of equity and dividing it by the cost of equity, as
follows:
($35million/$50million)(0.12) = (0.7)(0.12) = 0.084.

The sum of the weighted average cost of debt and the weighted average
cost of equity is then: 0.021 + 0.084 = 0.105 (10.5%).

Question 21:
(2B2-CQ10)

Angela Company's capital structure consists entirely of long-term debt and

common equity. The cost of capital for each component is shown below.

Angela pays taxes at a rate of 40%. If Angela's weighted average cost of

capital is 10.41%, what proportion of the company's capital structure is in
the form of long-term debt?

55%.
34%.
45%.
66%.

Angela's weighted average cost of capital (WACC) is given at 10.41%. The

formula to calculate the WACC is:

WACC = (weighted cost of debt, or wi)(after-tax cost of debt) + (1 wi)(cost

of common equity)
Where: wi = the company's weighted cost (or portion) of debt

The after-tax cost of debt is calculated as follows:

After-tax cost of debt = (1 tax rate)(% cost of debt)

After-tax cost of debt = (1 0.4)(0.08) = 0.6(0.08) = 0.048, or 4.8%

This amount can then be substituted into the WACC formula and
rearranged to solve for wi as:

10.41% = 4.8%(wi) + (1 wi)(15%)

10.41%= 4.8%(wi) +15% 15%(wi)
4.59% = 10.2%(wi)
wi =4.59% / 10.2% = 45%.

Question 22:
(2B2-LS66)

Joint Products Inc., a corporation with a 40% marginal tax rate, plans to
issue $1,000,000 of 8% preferred stock in exchange for $1,000,000 of its 8%
bonds currently outstanding. The firm's total liabilities and equity are equal
to $10,000,000. The effect of this exchange on the firm's weighted average
cost of capital is likely to be:

*Source: Retired ICMA CMA Exam Questions.

an increase, since a portion of the debt payments are tax deductible.

a decrease, since a portion of the debt payments are tax deductible.
no change, since it involves equal amounts of capital in the exchange
and both instruments have the same rate.
 a decrease, since preferred stock payments do not need to be made
each year, whereas debt payments must be made.

This effect would increase the firm's weighted average cost of capital
since the portion of debt payments are tax deductible. Preferred stock
dividends are not tax deductible.

Question 23:
(2B2-AT20)

Osgood Products has announced that it plans to finance future investments

so that the firm will achieve an optimum capital structure. Which one of the
following corporate objectives is consistent with this announcement?
Minimize the cost of debt.
Maximize earnings per share.
Minimize the cost of equity.
Maximize the net value of the firm.

The goal of the firm is to maximize shareholder wealth. Shareholder

wealth is the value of the firm. It is also the present value of the firm's
future cash flows at the marginal weighted-average cost of capital (Ka).
The smaller Ka is, the higher the present value. The optimal capital
structure for the firm is the one that minimizes Ka, and, therefore,
maximizes the value of the firm.

Question 24:
(2B2-LS59)

What is the weighted average cost of capital (WACC) for a firm given the
information in the chart?

8%.
12%.
9%.
8.8%.

The formula for determining the cost of capital is:

 = 0.30(6%) + 0.35(8%) + 0.35(12%) = 8.8%

Where:

ka = cost of capital (expressed as a percentage)

p = proportional amount of total capital structure
k = cost of an element in the capital structure
n = different types of financing

Question 25:
(2B2-LS27)

Which of the following statements about option payoffs is false? Assume S =

stock price and X = strike price.
S = X, a put option is at-the-money.
S > X, a put option is in-the-money.
S - X > 0, a call option is in-the-money.
S - X = 0, a call option is at-the-money.

A put option is in-the-money if X - S > 0. X - S is the amount of the payoff

from immediate exercise, buying a share for S and selling it in the market
for a great price at X. When the stock's price (S) is greater than the strike
price, a put option is said to be out-of-the-money. If X - S < 0, a put option
is out-of-the-money. The other statements are true.

Question 26:
(2B2-LS65)

Which of the following, when considered individually, would generally have

the effect of increasing a firm's cost of capital?

I. The firm reduces its operating leverage.

II. The corporate tax rate is increased.
III. The firm pays off its only outstanding debt.
IV. The Treasury Bond yield increases.

*Source: Retired ICMA CMA Exam Questions.

I, III and IV.

III and IV.
II and IV.
I and III.

The firm paying off its only outstanding debt and the Treasury Bond yield
increasing would cause the firm's cost of capital to increase. The cost of
capital is the weighted average cost of debt (after-tax), preferred stock,
retained earnings, and common stock. Paying off the debt reduces the
debt portion which has the lowest cost while leaving the more expensive
portions intact. Therefore, the cost of capital would increase.

Question 27:
(2B2-LS03)

A portfolio of diversified international stocks would be most susceptible to:

reinvestment rate risk.
systematic risk.
liquidity risk.
unsystematic risk.

By definition, systematic risk is associated with changes in return based

on the market as a whole. Systematic risk is common to an entire class of
investments because of unavoidable national or global economic
changes or other events that threaten the vast majority of (or all)
businesses and impact large portions of the market.

Question 28:
(2B2-CQ06)

Cox Company has sold 1,000 shares of $100 par, 8% preferred stock at an
issue price of $92 per share. Stock issue costs were $5 per share. Cox pays
taxes at the rate of 40%. What is Cox's cost of preferred stock capital?
8%.
8.7%.
9.2%.
8.25%.

The cost of preferred stock capital is calculated as follows:

Cost of preferred stock capital = (preferred stock dividend per share) /

(net price of the preferred stock)

The dividend per share is calculated as follows:

Dividend per share = (dividend rate)(par value of stock)

Dividend per share = (0.08)($100) = $8 per share

Issue price of preferred stock = $92 per share

Stock issue cost = $5 per share
Net price of preferred stock = $92 $5 = $87

Cost of preferred stock capital = $8 / $87 = 0.09195, which rounds to 9.2%.

Question 29:
(2B2-LS26)

Which of the following best describes the meaning of an effective duration

of 3.5 for a bond?
A 1% change in yield produces an exact change in the price of this
bond of 3.5%.
A 1% change in price produces an approximate change in the yield of
this bond of 3.5%.
 A 1% change in yield produces an approximate change in the price of
this bond of 3.5%.
A 1% change in price produces an exact change in the yield of this
bond of 3.5%.

Effective duration refers to price sensitivity in response to a change in

yield. A 1% change in yield produces an approximate change in the price
of a bond. Duration represent an approximate price-yield relation
because the relation follows a curve, not a straight line. In fact, this curve
is convex (toward the origin).

Question 30:
(2B2-LS20)

The notional amount of a derivative refers to the:

initial purchase price of the contract.
specified quantity of the underlying asset.
fee for exercising the contract before maturity.
fixed price of the contract.

A derivative involves a contract between two parties. A payment (or

multiple payments) is exchanged between the two parties. The notional
amount (or face amount) of the contract may be a predetermined
amount triggered by a specific event or it may be an amount resulting
from the change in value of a specified quantity of the underlying asset.

Question 31:
(2B2-LS25)

What is the after-tax cost of debt for a 6% interest-bearing bond at an

anticipated tax rate of 33%?
4.65%.
6%.
4.02%.
3.3%.

The formula for determining the after-tax cost of debt is:

Where:

kd = interest rate
t = firm's applicable tax rate.
Question 32:
(2B2-LS10)

If interest rates are expected to increase, which of the following bonds is

most attractive to buy on the secondary market when interest rates are
low?
US Treasury bond.
Bond with a rating of Aaa or AAA.
Floating rate bonds.
Zero coupon bonds.

A floating bond interest rate pays an interest rate that varies from time to
time (generally based on some benchmark interest rate). Such a bond is
attractive because the rate should go up and reset at higher levels as
rates rise. That is, bond prices move inversely with changes in interest
rates.

Question 33:
(2B2-LS29)

Viable short-term financing options for a pharmaceutical company include

all of the following except:
issues of preferred stock.
trade credit.
bankers' acceptances.
commercial paper.

By definition, short-term financing refers to the use of debt instruments

that mature in one year or less. Stock is an equity investment instrument.

Question 34:
(2B2-LS17)

A corporate bond trades on the secondary market. The return now required
by investors for this bond exceeds its coupon rate. Thus, the bond will:
pay a lump sum of interest and principal at maturity.
be sold below par value.
pay additional interest at maturity.
be sold above par value

After the initial issue, bonds are bought and sold through brokers in the
secondary market (similar to how stocks are traded). In the secondary
market, a bond's price fluctuates inversely with interest rates. If interest
rates fall, the price will be sold above par value. But in this case, the
interest rates are higher than the bond's stated interest (coupon) rate and
the bond will be sold below par value (at a discount).

Question 35:
(2B2-AT17)

Williams Inc. is interested in measuring its overall cost of capital and has
gathered the following data. Under the terms described below, the
company can sell unlimited amounts of all instruments.

Williams can raise cash by selling $1,000, 8%, 20-year bonds with
annual interest payments. In selling the issue, an average premium of
$30 per bond would be received, and the firm must pay flotation
costs of $30 per bond. The after-tax cost of funds is estimated to be
4.8%.
Williams can sell 8% preferred stock at par value, $105 per share. The
cost of issuing and selling the preferred stock is expected to be $5 per
share.
Williams' common stock is currently selling for $100 per share. The
firm expects to pay cash dividends of $7 per share next year, and the
dividends are expected to remain constant. The stock will have to be
underpriced by $3 per share, and flotation costs are expected to
amount to $5 per share.
Williams expects to have available $100,000 of retained earnings in
the coming year; once these retained earnings are exhausted, the
firm will use new common stock as the form of common stock equity
financing.
Williams preferred capital structure is

The cost of funds from the sale of common stock for Williams Inc. is:
7.4%.
7%.
8.1%.
7.6%.

Using the constant dividend growth model (Gordon's model), the cost of
the sale of common stock (Ke) is calculated by taking the next dividend
payment and dividing it by the net price (price less discount, less flotation
costs) plus the constant dividend growth rate. There is no dividend
growth rate for Williams.

For Williams, Ke= $7/($100-$3-$5) = $7/$92 = .076, or 7.6%.

Question 36:
(2B2-LS31)

What is a fundamental difference between options and forwards?

Both parties are obligated to fulfill an option contract; forward terms
are not binding to either party.
Options have asymmetric payouts; forwards have symmetric payouts.
 Forwards are traded on organized exchanges; options are facilitated
by private contracts.
Options have a specified maturity date; forwards can be sold on or
before the maturity date.

Forwards are fundamentally different than options because neither party

is obligated to perform according to the terms of the contract. One or
both parties can choose not to fulfill the terms of the forward contract.

Question 37:
(2B2-AT14)

Williams Inc. is interested in measuring its overall cost of capital and has
gathered the following data. Under the terms described below, the
company can sell unlimited amounts of all instruments.

Williams can raise cash by selling $1,000, 8%, 20-year bonds with
annual interest payments. In selling the issue, an average premium of
$30 per bond would be received, and the firm must pay flotation
costs of $30 per bond. The after-tax cost of funds is estimated to be
4.8%.
Williams can sell 8 percent preferred stock at par value, $105 per
share. The cost of issuing and selling the preferred stock is expected
to be $5 per share.
Williams' common stock is currently selling for $100 per share. The
firm expects to pay cash dividends of $7 per share next year, and the
dividends are expected to remain constant. The stock will have to be
underpriced by $3 per share, and flotation costs are expected to
amount to $5 per share.
Williams expects to have available $100,000 of retained earnings in
the coming year; once these retained earnings are exhausted, the
firm will use new common stock as the form of common stock equity
financing.
Williams preferred capital structure is

If Williams Inc. needs a total of $1,000,000, the firm's weighted average cost
of capital (WACC) would be:
9.1%.
4.8%.
6.5%.
6.9%.

The WACC (rounded to one decimal place) is 6.9%. The formula to

calculate the WACC is as:
 Ka = p1k1 + p2k2 + . . . pnkn

Where:

ka = cost of capital (expressed as a percentage)

p = proportion that element comprises of the total capital structure
k = cost of an element in the capital structure
n = different types of financing (each with its own cost and proportion in
the capital structure)

The WACC (Ka) is the weighted average costs of debt, preferred stock,
retained earnings, and common stock sales.

The cost of debt is 4.8% and its weight is 0.3 (30%).

The cost of preferred stock is the preferred stock dividend divided by its
net price (price less flotation costs) which is 0.08($105)/($105$5) =
$8.4/$100 = .084 (or 8.4%).
The weight for preferred stock is 0.2(20%).

The cost of retained earnings is the cost of internal equity.

Using the constant dividend growth model (Gordon's model), the cost of
retained earnings (Ke) is calculated by taking the next dividend payment
and dividing it by the price plus the constant dividend growth rate. There
is no dividend growth rate for Williams.
For Williams , Ke (internal) = $7 / $100 = .07 (or 7%).
The weight for internal equity is .10 (or 10%).

The cost of common stock is the cost of external equity.

Using the constant dividend growth model (Gordon's model), the cost of
external equity (Ke) is calculated by taking the next dividend payment
and dividing it by the net price (price less underpricing and flotation
costs) plus the constant dividend growth rate. There is no dividend
growth rate for Williams.

For Williams , Kee (external) = $7 / ($100$3$5) = $7 / $92 = .076 (or

7.6%).
The weight for external equity is .40 (or 40%).

Therefore, Ka = 0.3(0.048) + 0.2(0.084) + 0.1(0.07) + 0.4(0.076) = 0.0144 +

0.0168 + 0.007 + 0.0304 = 0.0686 (or 6.9% rounded).

Question 38:
(2B2-LS15)

An analyst observes a 15-year, 7% option-free bond with semiannual

coupons. The required yield on this bond was 7%, but suddenly it drops to
6.5%. The price of this bond:
will decrease.
cannot be determined without additional information.
 will increase.
will stay the same.

There is an inverse relationship between price and yield. If the required

yield falls, the bond's price will rise, and vice versa.

Question 39:
(2B2-LS12)

A private agreement between two parties to exchange future cash

payments is a(n):
warrant.
convertible security.
option.
swap.

By definition, a swap is a private agreement between two parties to

exchange (or swap) future cash payments. A swap is usually facilitated by
an intermediary. Swaps are characterized by series of forward contracts
and the exchange of payments on specified payment dates.

Question 40:
(2B2-LS09)

Which of the following statements accurately describes bond yields

assuming an upward sloping yield curve?
Higher-quality bonds typically have lower yields than lower-grade
bonds of the same maturity.
Short-term bonds have higher yields than do long-term bonds.
Secured bonds have higher yields than do unsecured bonds.
Fixed interest rate bonds earn more than do zero coupon bonds.

Higher-quality bonds are sold at the lowest rates of interest. Because of

the risk associated with lower-grade, non-investment quality (junk)
bonds, they are typically higher-yield bonds. Junk bonds have a greater
chance of defaulting, but in some circumstances they may also be an
emerging entity or become a star and provide a highly profitable return.

Question 41:
(2B2-LS46)

A company's current dividend is $2 for a share of stock currently selling at

$50. If the company issues new common stock, it expects to pay flotation
costs of 10%. The company's marginal tax rate is 40%. If the company
projects a long-term growth in dividends of 8%, its after-tax cost of new
equity is closest to:
12.32%.
12%.
12.8%.
 7.76%.

The after-tax cost of common stock using the dividend growth model is ke
= D1/P0 + g or [$2.00(1.08)]/$50(1 0.10) + 0.08 = $2.16/$45 + 0.08 = 0.1280
or 12.80%. Common stock dividends are not a tax-deductible expense so
taxes are irrelevant in this computation.

Question 42:
(2B2-LS19)

Which of the following statements concerning bond ratings is correct?

Bond ratings may be adjusted only down (but not up) during the life of
a bond.
U.S. Treasury bonds are rated AAA.
Bond ratings apply to the bond issue and the company.
Bonds rated as junk bonds have a lower-than-average chance of high
yields.

U.S. Treasury bonds are rated AAA since they are backed by the full faith
and credit of the federal government.

Question 43:
(2B2-LS52)

Which one of the following situations would prompt a firm to issue debt, as
opposed to equity, the next time it raises external capital?

*Source: Retired ICMA CMA Exam Questions.

High breakeven point.

Significant percentage of assets under capital lease.
Low fixed-charge coverage.
High effective tax rate.

If a firm is faced with a high effective tax rate, it would prompt a firm to
issue debt, as opposed to equity the next time it raises capital as the cost
of debt is reduced by that effective tax rate.

Question 44:
(2B2-LS67)

In calculating the component costs of long-term funds, the appropriate

cost of retained earnings, ignoring flotation costs, is equal to:

*Source: Retired ICMA CMA Exam Questions.

the same as the cost of preferred stock.

the weighted average cost of capital for the firm.
the cost of common stock.
zero, or no cost.

The appropriate cost of retained earnings, ignoring flotation costs when

 calculating the component costs of long-term funds is equal to the cost of
common stock.

Question 45:
(2B2-LS32)

Which of the following statements accurately describes a put option?

The exercise date is the last day on which the writer can exercise the
underlying asset.
The holder of the put option has lower risk than the option writer.
The holder of an option contract receives an up-front premium from
the seller of the option contract.
The seller of the put option raises money; the holder gains leverage
against adverse changes in market factors.

A put option is a type of option contract giving the holder the right but not
the obligation to sell the underlying asset to the writer. Option holders
have the opportunity for unlimited gain with limited possible losses.
Option writers may experience unlimited potential losses (unless the
contract is covered, which means that the writer already owns the
underlying asset).

Question 46:
(2B2-LS02)

The technique of reducing the risk of an investment by taking an offsetting

position in a second investment instrument is called:
diversification.
arbitrage.
hedging.
speculation.

By definition, hedging is a method of reducing exposure to adverse

fluctuations in prices, interest rates, or foreign exchange rates.
Companies hedge an investment by taking an offsetting position in
another investment.

Question 47:
(2B2-LS01)

A proper way for a US firm to hedge accounts payables denominated in

pesos is through:
call options on pesos.
a forward contract to sell pesos.
any of the other options.
put options on pesos.

Accounts payable will be settled in pesos at a future date, thus the

company has to protect against pesos getting stronger with respect to US
dollars. Because the firm will need to buy pesos to make their payments,
 call options give the right to buy pesos at a specified price. The other
options allow the firm to sell pesos at a specific price.

Question 48:
(2B2-AT12)

The level of safety stock in inventory management depends on all of the

following except the:
cost of running out of inventory.
cost to reorder stock.
level of uncertainty in lead time for stock shipments.
level of uncertainty of the sales forecast.

The purpose of a safety or buffer stock is to minimize the sum of the cost
of stock-outs and the costs of carrying the buffer. Its level is independent
of ordering costs.

Question 49:
(2B2-LS38)

All of the following accurately describe preferred stock except:

Preferred stock dividends are paid before common stock dividends.
Preferred stock dividends paid are based on earnings.
Preferred stock typically has no maturity date.
Preferred stock issues may have a stated call price.

A preferred stock generally offers a fixed dividend. The dividend amount

does not fluctuate based on earnings. The payment is discretionary if the
company does not have sufficient earning to pay. Unpaid dividends for
preferred stock may accumulate.

Question 50:
(2B2-LS35)

Which of the following statements describes a put option that is out-of-the-

money?
The price of the underlying asset exceeds the strike price.
The strike price exceeds the price of the underlying asset.
The owner can exercise the option at any time before maturity.
The owner of the contract decides not to sell the underlying asset.

Different payoffs are possible with options. A put option is referred to as

out-of-the-money if the price of the underlying asset exceeds the strike
price.

Question 51:
(2B2-LS48)

Protective clauses set forth in an indenture are known as:

*Source: Retired ICMA CMA Exam Questions.

requirements.
covenants.
addenda.
provisions.

Protective covenants set limits (restrictions) on certain actions the

company might be taking during the term of the agreement. They are a
particularly important feature in a bond indenture.

Question 52:
(2B2-LS61)

A firm plans to use the historical rate of return to determine the cost of
equity capital. In order to use the historical rate, all of the following
conditions should exist except which of the following?
The firm's performance will hold steady.
Interest rates will not significantly change.
Investor attitude toward risk will not change.
Expected future cash flows will be discounted to present values.

The historical method implies that (1) the firm's performance will not
significantly change in the future, (2) no significant changes in interest
rates will occur, and (3) investor attitude toward risk will not change. The
historical method is relatively easy to calculate, but the limitation is that
the future rarely remains the same as the past.

Question 53:
(2B2-AT10)

Which one of the following statements is correct when comparing bond

financing alternatives?
A call provision is generally considered detrimental to the investor.
A call premium requires the investor to pay an amount greater than
par at the time of purchase.
A convertible bond must be converted to common stock prior to its
maturity.
A bond with a call provision typically has a lower yield to maturity
than a similar bond without a call provision.

A call provision allows the issuer of the bonds to buy back the bonds at a
set price (the call price) after some specified date. Calls are used to
redeem bonds when interest rates drop significantly or to force the
conversion of convertible bonds. When the bonds are called for
redemption, the holder (investor) must sell them back to the issuer. The
holder, however, may want to hold the bonds to earn interest to improve
the conversion gain.
Question 54:
(2B2-LS45)

A company paid a current dividend of $1.50 for a share of stock priced at

$60. The company's current tax rate is 35%. What is the after-tax cost of
equity if the company projects long-term growth in dividends to be 6%?
5.62%.
5.53%.
8.5%.
8.65%.

The after-tax cost of common stock using the dividend growth model is:
ke = D1/P0 + g
or
[$1.50(1.06)]/$60 + 0.06 = $1.59/$60 + 0.06 = 0.0865 or 8.65%.
Common stock dividends are not a tax-deductible expense, so taxes are
irrelevant in this computation.

Question 55:
(2B2-CQ07)

Bull & Bear Investment Banking is working with the management of Clark
Inc. in order to take the company public in an initial public offering.
Selected financial information for Clark is as follows.

If public companies in Clark's industry are trading at twelve times earnings,

what is the estimated value per share of Clark?

$24.00.
$12.00.
$15.00.
$9.00.

The earnings per share (EPS) for Clark is calculated as:

EPS = (net income preferred stock dividends) / (weighted average

number of common stock shares outstanding)

The number of shares outstanding is 3,000,000, which is derived by taking

the $3,000,000 in par value common equity and dividing it by the $1 par
value per share.

EPS = ($3,750,000 $0) / (3,000,000 shares) = $1.25 per share

 The estimated value per share of Clark stock can then be calculated as:

Estimated value per share = 12($1.25) = $15.00 per share.

Question 56:
(2B2-LS21)

A stock undergoes a 3-for-1 stock split. What is the most likely outcome for
a stockholder currently holding 3,000 shares trading at $30 per share?
The holder will have 9,000 shares at $10 per share.
There will be a decrease in total market value of the shares.
The holder will have 1,000 shares at $90 per share.
There will be an increase in total market value of the shares.

In a 3-for-1 stock split, 3,000 shares would receive another 6,000 shares.
At $30 a share, the price should drop down to about $10 a share. The total
market value should remain the same (9,000 shares at $10 a share versus
the original 3,000 shares at $30; both equal $90,000). While the total
market value initially remains the same, stockholders may profit if the
price eventually goes up.

Question 57:
(2B2-LS08)

A company holds as an investment a three-year $1,000,000 note bearing

interest at 8%. If the market rate for a similar investment is 9%, a potential
purchaser of the note will:
get the maker of the note to add a discount equal to the 1%
difference.
get the maker of the note to add a premium equal to the 1%
difference.
add a premium to the amount they pay the seller to make the
effective rate equal to 9%.
discount the amount they pay the seller to make the effective rate
equal to 9%.

The purchaser would receive the principal and interest equal to 8%.
However, since the market rate for such an investment is 9%, the 1%
difference will be deducted as a discount from the amount of cash the
purchaser pays the current owner so that the effective rate of return will
become 9%.

Question 58:
(2B2-AT19)

Williams Inc. is interested in measuring its overall cost of capital and has
gathered the following data. Under the terms described below, the
company can sell unlimited amounts of all instruments.

Williams can raise cash by selling $1,000, 8%, 20-year bonds with
annual interest payments. In selling the issue, an average premium of
 $30 per bond would be received, and the firm must pay flotation
costs of $30 per bond. The after-tax cost of funds is estimated to be
4.8%.
Williams can sell 8% preferred stock at par value, $105 per share. The
cost of issuing and selling the preferred stock is expected to be $5 per
share.
Williams' common stock is currently selling for $100 per share. The
firm expects to pay cash dividends of $7 per share next year, and the
dividends are expected to remain constant. The stock will have to be
underpriced by $3 per share, and flotation costs are expected to
amount to $5 per share.
Williams expects to have available $100,000 of retained earnings in
the coming year; once these retained earnings are exhausted, the
firm will use new common stock as the form of common stock equity
financing.
Williams preferred capital structure is

If Williams Inc. needs a total of $200,000, the firm's weighted average cost
of capital(WACC) would be closest to:
6.6%.
4.8%.
7.3%.
6.8%.

The WACC (rounded to one decimal place) is 6.6%. The formula to

calculate the WACC is:

Ka = p1k1 + p2k2 + . . . pnkn

Where:

ka = cost of capital (expressed as a percentage)

k = cost of an element in the capital structure
p = proportion that element comprises of the total capital structure
n = different types of financing (each with its own cost and proportion in
the capital structure)

The WACC (Ka) is the weighted average costs of debt, preferred stock and
retained earnings.

The cost of debt is 4.8% and its weight is 0.3 (or 30%).

The cost of preferred stock is the preferred stock dividend divided by its
 net price (price less flotation costs) which is [0.08 ($105)] / ($105$5) =
(8.4/100) = .084 (or 8.4%).

The weight for preferred stock is 0.2 (or 20%).

Using the constant dividend growth model (Gordon's model), the cost of
retained earnings (Ke) is calculated by taking the next dividend payment
and dividing it by the price plus the constant dividend growth rate. There
is no dividend growth rate for Williams.

For Williams, Ke = $7/$100 = 0.07 (or 7%).

The weight for retained earnings is 0.5 (or 50%).

Therefore, Ka = 0.3(0.048) + 0.2(0.084) + 0.5(0.07) = 0.0144 + 0.0168 + 0.035

= 0.0662 (6.6% rounded).

Question 59:
(2B2-LS23)

What is the after-tax cost of debt for a 6% interest-bearing bond at an

anticipated tax rate of 38%?
3.72%.
4.4%.
3.8%.
6%.

The formula for determining the after-tax cost of debt is:

After-tax cost of debt = kd(1 t)
After-tax cost of debt = (0.06) (1 0.38) = .0372 = 3.72%.

Question 60:
(2B2-CQ09)

The Hatch Sausage Company is projecting an annual growth rate for the
foreseeable future of 9%. The most recent dividend paid was $3.00 per
share. New common stock can be issued at $36 per share. Using the
constant growth model, what is the approximate cost of capital for retained
earnings?
19.88%.
18.08%.
9.08%.
17.33%.

The cost of capital for retained earnings, using the Constant Dividend
Growth Model (Gordon's Model) is calculated as:

Cost of capital, retained earnings = (next dividend) / (price of common

stock) + (constant growth rate)

In this case, the next dividend is calculated by taking the current dividend
 of $3.00 per share and multiplying it by one plus the constant growth rate,
as:

Value of next dividend = $3(1 + 0.09) = $3.27

Therefore, the cost of capital for retained earnings can be calculated as:

Cost of capital, retained earnings = ($3.27 / $36) + (0.09) = 0.0908 + 0.09 =

0.1808, or 18.08%.

Question 61:
(2B2-LS50)

Dorsy Manufacturing plans to issue mortgage bonds subject to an

indenture. Which of the following restrictions or requirements are likely to
be contained in the indenture?

I. Receiving the trustee's permission prior to selling the property.

II. Maintain the property in good operating condition.
III. Insuring plant and equipment at certain minimum levels.
IV. Including a negative pledge clause.

*Source: Retired ICMA CMA Exam Questions.

I, II, III and IV.

I, III, and IV only.
I and IV only.
II and III only.

Protective covenants set limits (restrictions) on certain actions the

company might be taking during the term of the agreement. They are a
particularly important feature in a bond indenture.

Question 62:
(2B2-LS41)

Legal responsibilities of a bond trustee include all of the following except:

defining sinking fund terms.
ensuring that interest payments are properly paid and applied.
authenticating the bond issue's legality.
administering redemption.

An indenture defines the details of the bond issue, including sinking fund
terms that the borrower pays to a separate custodial account and assures
creditors that adequate funds are available.

Question 63:
(2B2-LS39)

The participating feature for a preferred stock means that preferred

stockholders have the opportunity to:
sell all or part of the shares back to the issuer at pre-specified call
 price.
increase their dividends when common stockholders dividends reach
a certain amount.
convert preferred stock into a specified amount of common stock.
be granted special voting privileges if the corporation is unable to pay
the fixed dividend.

By definition, a participating feature allows preferred stockholders to

participate in increasing dividends when common stockholders'
dividends reach a certain amount. The exact amount of participation
varies and is determined by some predetermined formula that relates
additional preferred stockholder payouts to increases in common
stockholder payouts.

Question 64:
(2B2-LS54)

Which one of the following best describes the record date as it pertains to
common stock?

*Source: Retired ICMA CMA Exam Questions.

Four business days prior to the payment of a dividend.

The 52-week high for a stock published in the Wall Street Journal.
The date that is chosen to determine the ownership of shares.
The date on which a prospectus is declared effective by the Securities
and Exchange Commission.

The date chosen by the issuer of the common stock (which ultimately
determines who the owners of the outstanding shares are on that date).

Question 65:
(2B2-LS56)

All of the following are characteristics of preferred stock except that:

*Source: Retired ICMA CMA Exam Questions.

its dividends are tax deductible to the issuer.

it may be converted into common stock.
it may be callable at the option of the corporation.
it usually has no voting rights.

Preferred stock dividends are not tax deductible to the issuer.

Question 66:
(2B2-AT15)

Hi-Tech Inc. has determined that it can minimize its weighted average cost
of capital (WACC) by using a debt to equity ratio of 2:3. If the firm's cost of
debt is 9% before taxes, the cost of equity is estimated to be 12% before
taxes, and the tax rate is 40%, what is the firm's WACC?
 6.48%.
9.36%.
7.92%.
10.80%.

With a debt to equity ratio of 2 to 3, the company is using 2 parts debt to 3

parts equity when financing asset purchases. As such, debt represents 2/5
and equity represents 3/5 of the financing approach. To determine a
company's WACC, use the following formula:

WACC = wiki + wjkj

Where:
wi = proportion of total permanent capital represented by debt
ki = after-tax cost of debt component
wj = proportion of total permanent capital represented by equity
kj = after-tax cost of equity component

(2 / 5) (9% (1 40%)) + ((3 / 5) 12%) = 9.36%.

Question 67:
(2B2-LS47)

The call provision in some bond indentures allows:

*Source: Retired ICMA CMA Exam Questions.

the bondholder to redeem the bond early by paying a call premium.

the issuer to pay a premium in order to prevent bondholders from
redeeming bonds.
the bondholder to exchange the bond, at no additional cost, for
common shares.
the issuer to exercise an option to redeem the bonds.

A call provision grants the right to buy back (or call) all or part of an issue
at the call price rather than attempting to retire the issue by more
expensive methods.

Question 68:
(2B2-LS30)

Which of the following statements is true about using preferred stock issues
as a source of equity capital?
The cost of preferred stock is a function of the stock's market price
and the firm's tax rate.
Dividends are not tax deductible to the issuer.
A firm can deduct taxes on dividends payments, so the after-tax costs
are reduced when determining taxable income.
The cost of preferred stock is a function of the stock's beta.
 Because preferred stock dividends are not tax deductible, they represent
an outflow of after-tax funds. A preferred stock dividend costs the firm in
after-tax earnings, so the firm must earn additional capital before taxes
for each dividend dollar paid.

Question 69:
(2B2-AT03)

If three stocks are in a portfolio, the expected return on the portfolio is the:
weighted average of the expected returns multiplied by the beta of
each security.
sum of the expected returns multiplied by the variance of each
security.
sum of the expected returns multiplied by the standard deviation of
each security.
weighted average of the expected returns of the three securities.

The expected return on a portfolio is equal to the weighted average of the

expected returns of the securities in the portfolio. This is also the average
return for the portfolio.

Question 70:
(2B2-LS51)

Which one of the following statements concerning debt instruments is

correct?

*Source: Retired ICMA CMA Exam Questions.

The coupon rate and yield of an outstanding long-term bond will

change over time as economic factors change.
A 25-year bond with a coupon rate of 9% and one year to maturity has
more interest rate risk than a 10-year bond with a 9% coupon issued
by the same firm with one year to maturity.
For long-term bonds, price sensitivity to a given change in interest
rates is greater the longer the maturity of the bond.
A bond with one year to maturity would have more interest rate risk
than a bond with 15 years to maturity.

The coupon rate is constant. It is the fixed contractual rate.

Question 71:
(2B2-LS44)

A company's $100, 10% preferred stock is currently selling for $90. If the
company issues new shares, the flotation costs will be 7%. The company's
tax rate is 40%. What is the company's after-tax cost of new preferred
stock?
6%.
11.95%.
 7.17%.
9%.

The after-tax cost of preferred stock including flotation costs is:

kp = Dp/Pnet
or
$10/[($90)(1 0.07)] = $10/$83.70 = 0.1195 or 11.95%.
Dividends are not a tax-deductible expense for preferred stock, so taxes
are irrelevant in the computation.

Question 72:
(2B2-AT13)

A preferred stock is sold for $101 per share, has a face value of $100 per
share, underwriting fees of $5 per share, and annual dividends of $10 per
share. If the tax rate is 40%, the cost of funds (capital) for the preferred
stock is:
5.2%.
6.2%.
10%.
10.4%.

The cost of preferred stock is calculated by taking the preferred stock

dividend and dividing it by its net price (price less flotation costs).

Cost of preferred stock = (preferred stock dividend) / (net price)

Cost of preferred stock = ($10) / ($101 - $5) = $10 / $96 = 0.104, or 10.4%

Question 73:
(2B2-LS40)

A $1,000 bond that costs $500 when issued and pays the full par value at
maturity best describes a:
junk bond.
zero coupon bond.
fixed interest rate bond.
floating rate bond.

Zero coupon bonds have no ongoing interest payments. The bond is sold
at a deep discount and redeemed at full value as compound interest
accrues to par value.

Question 74:
(2B2-AT01)

Stanley Company uses the Capital Asset Pricing Model (CAPM) to estimate
the rate of return demanded by the market on its common stock. If the beta
coefficient is 1.75 for Stanley, the risk-free rate of return in the stock market
is 4.6%, and the current rate of return for the market as measured by an
appropriate index is 7%, what is the market's required rate of return on
Stanley's common stock?
8.05%.
11.2%.
8.8%.
12.25%.

Using the CAPM formula, the required rate of return on a common stock is
calculated as:

Ke = Rf + (Km - Rf)

Where:
Ke = required rate of return
Rf = risk-free rate (such as the return on U.S. T-bill or T-bonds)
= beta coefficient for the company
Km = return on a market portfolio

Therefore, required rate of return on Stanley's common stock is:

Ke = 4.6% + 1.75(7% 4.6%)
Ke = 4.6% + (1.75)(2.4%)
Ke = 4.6% + 4.2% = 8.8% .

Question 75:
(2B2-AT18)

Williams Inc. is interested in measuring its overall cost of capital and has
gathered the following data. Under the terms described below, the
company can sell unlimited amounts of all instruments.

Williams can raise cash by selling $1,000, 8%, 20-year bonds with
annual interest payments. In selling the issue, an average premium of
$30 per bond would be received, and the firm must pay flotation
costs of $30 per bond. The after-tax cost of funds is estimated to be
4.8%.
Williams can sell 8% preferred stock at par value, $105 per share. The
cost of issuing and selling the preferred stock is expected to be $5 per
share.
Williams' common stock is currently selling for $100 per share. The
firm expects to pay cash dividends of $7 per share next year, and the
dividends are expected to remain constant. The stock will have to be
underpriced by $3 per share, and flotation costs are expected to
amount to $5 per share.
Williams expects to have available $100,000 of retained earnings in
the coming year; once these retained earnings are exhausted, the
firm will use new common stock as the form of common stock equity
financing.
Williams preferred capital structure is
The cost of funds from retained earnings for Williams Inc. is:
7.6%.
8.1%.
7%.
7.4%.

Using the constant dividend growth model (Gordon's model), the cost of
retained earnings (Ke) is calculated by taking the next dividend payment
and dividing it by the price plus the constant dividend growth rate. There
is no dividend growth rate for Williams.

For Williams, Ke = $7/$100 = 0.07, or 7.0%.

Question 76:
(2B2-AT11)

If a $1,000 bond sells for $1,125, which of the following statements are
correct?

I. The market rate of interest is greater than the coupon rate on the bond.
II. The coupon rate on the bond is greater than the market rate of interest.
III. The coupon rate and the market rate are equal.
IV. The bond sells at a premium.
V. The bond sells at a discount.
I and V.
II and V.
II and IV.
I and IV.

If the coupon (stated) rate on a bond is greater than the market rate of
interest, the price of the bond will be greater than its maturity value and
the bonds will sell at a premium (price is greater than the maturity value).
The market rate of interest is the rate required by the market. If the
coupon rate is greater than the market rate, the market will bid up the
price to obtain the higher rate (the coupon).

Question 77:
(2B2-LS22)

Which of the following gives minority shareholders more choice in

corporate governance?
Traditional voting.
Cumulative voting.
 Proxy voting.
Preemptive voting.

By definition, a cumulative voting system allows shareholders to cast

different numbers of votes for different candidates. Cumulative voting
attempts to give minority shareholders more voice in corporate
governance by increasing their chances to elect a certain number of
directors.

Question 78:
(2B2-LS04)

Which of the following statements about correlation and return variability

best describes a portfolio with a limited number of stocks representing
different industries?
High correlation and high portfolio return variability.
High correlation and low portfolio return variability.
Low correlation and high portfolio return variability.
Low correlation and low portfolio return variability.

Having fewer stocks in a portfolio representing different industries is

more likely to show low correlation and low portfolio return variability.
The probability that individual stocks in different industries move up and
down in value at the same time or at the same rate is low.

Question 79:
(2B2-LS43)

A company has $50 million in debt outstanding with a coupon rate of 10%.
Currently, the yield to maturity on these bonds is 8%. If the firm's tax rate is
40%, what is the company's after-tax cost of debt?
10%.
6%.
8%.
4.8%.
Time Spent: 8:35 97 Answered Score 21% Restart End
0 Unanswered
The after-tax cost of debt is kd(1 t) = (0.08)(1 0.40) = 0.048 or 4.8%.

Question 80:
(2B2-LS42)

A 15-year, 8% annual-pay bond has a par value of $1,000. What should this
bond be trading for if it were being priced to yield 9% on an annual rate?
1,000.00.
$935.61.
$919.39.
$1085.60.
 The value of the bond should be $919.39. The bond will sell at a discount
because the required rate of return exceeds the coupon rate of the bond.

Using an HP 12C, N = 15; I = 9; FV = 1,000; PMT = 80; PV = $919.39.

Question 81:
(2B2-CQ15)

Thomas Company's capital structure consists of 30% long-term debt, 25%

preferred stock, and 45% common equity. The cost of capital for each
component is shown below.

If Thomas pays taxes at the rate of 40%, what is the company's after-tax
weighted average cost of capital (WACC)?

11.9%.
9.84%.
10.94%.
7.14%.

The WACC is calculated as:

WACC = (weight of long-term debt)(after-tax cost of long-term debt) +

(weight of preferred stock)(cost of preferred stock) + (weight of common
equity)(cost of common equity)

The after-tax cost of debt is calculated as:

After-tax cost of debt = (1 tax rate)(before-tax cost of debt)

After-tax cost of debt = (1 0.4)(0.08) = (0.6)(0.08) = 0.048, or 4.8%

Therefore, WACC = (0.3)(0.048) + (0.25)(0.11) + (0.45)(0.15) = 0.0144 +

0.0275 + 0.0675 = 0.1094, or 10.94%.

Question 82:
(2B2-LS13)

A long-term call option to buy common stock directly from a corporation is

a:
forward contract.
convertible security.
futures contract.
warrant.
 By definition, a warrant is a long-term call option to buy common stock
directly from a corporation. It gives bond or preferred stockholders the
right to purchase shares of common stock at a given price.

Question 83:
(2B2-LS07)

Buying a wheat futures contract to protect against price fluctuation of

wheat would be classified as a:

*Source: Retired ICMA CMA Exam Questions.

cash flow hedge.

foreign currency hedge.
swap.
fair value hedge.

To mitigate the above effects of fluctuations in prices companies

sometimes hedge their exposure through purchase of forward contracts
or options.

Question 84:
(2B2-AT05)

Linda Barnes, treasurer of Cambor Ltd., is a risk-averse investor who

subscribes to modern portfolio theory. She wants to restructure her $10
million portfolio by using the following securities to take advantage of a
prediction that says the overall market will do very well next year.

If Barnes wants to outperform the market next year, while minimizing the
risk, which one of the following portfolios will be the most appropriate
portfolio in this situation?
$5 million in Security II, and $5 million in Security I.
$10 million in Security II.
$7 million in Security I, and $1 million each in Securities II, III, and IV.
$4.5 million in Security I, $2.5 million in Security II, and $1.5 million
each in Securities III and IV.

The expected performance of a portfolio would be measured by its

expected rate of return. The expected rate of return for a portfolio, using
the Capital Asset Pricing Model (CAPM), is calculated by taking the risk-
free rate of return and adding to it the difference between the market rate
of return and the risk-free rate of return times the stock's beta.

Here is the CAPM formula:

 Ke = Rf + (Km - Rf)

Where:
Ke = required rate of return
Rf = risk-free rate (such as the return on U.S. T-bill or T-bonds)
= beta coefficient for the company
Km = return on a market portfolio

Using the CAPM formula, the portfolio with the highest average beta
would have the highest expected rate of return. The beta values of each
portfolio are calculated below.

Option: $10 million in Security II

= 100% 1.00 = 1.00

Option: $5 million in Security II, and $5 million in Security I

= (50% 0.70) + (50% 1.00) = 0.85

Option: $4.5 million in Security I, $2.5 million in Security II, and $1.5
million each in Securities III and IV
= (45% 0.70) + (25% 1.00) + (15% 1.50) + (15% 2.50) = 1.17

Option: $7 million in Security I, and $1 million each in Securities II, III, and
IV
= (70% 0.70) + (10% 1.00) + (10% 1.50) + (10% 2.50) = 0.99

The highest beta value is 1.17. That option should be chosen.

Question 85:
(2B2-LS24)

How does a firm's tax rate influence its after-tax cost of debt?
The higher the tax rate, the greater the after-tax cost of debt.
The sooner the debt is paid off, the lower the tax rate.
The higher the tax rate, the lower the after-tax cost of debt.
The longer the debt is carried, the lower the tax rate.

By definition, the cost of debt represents the interest rate a company pays
on all of its capital debt (e.g., loans and bonds). The stated interest rate is
greater than the after-tax cost of debt because a firm can deduct interest
payments when determining taxable income. The higher the tax rate, the
lower the after-tax cost of debt.

Question 86:
(2B2-AT07)

Which one of the following is not a determinant in valuing a call option?

Exercise price.
Forward contract price.
Expiration date.
Interest rate.
 Exercise price of an option, option expiration date, and time value of
money (interest rate) along with price volatility of the underlying security
are factors affecting option valuation prior to expiration.

Question 87:
(2B2-CQ13)

Kielly Machines Inc. is planning an expansion program estimated to cost

$100 million. Kielly is going to raise funds according to its target capital
structure shown below.

Kielly had net income available to common shareholders of $184 million

last year of which 75% was paid out in dividends. The company has a
marginal tax rate of 40%.

Additional data:

The before-tax cost of debt is estimated to be 11%.

The market yield of preferred stock is estimated to be 12%.
The after-tax cost of retained earnings is estimated to be 16%.

What is Kielly's weighted average cost of capital (WACC)?

14%.
12.22%.
13%.
13.54%.

Kielly had net income available to common shareholders of $184 million

last year, of which 75% was paid out in dividends. That would mean that
the remaining portion of 25% would remain as retained earnings
available for investment.

Retained earnings, available for investment = (0.25)($184,000,000) =

$46,000,000

The $46,000,000 in retained earnings is equal to 46% of the $100,000,000

in investment funds needed. Therefore, no issue of common stock is
needed.

The WACC is calculated as:

WACC = (weight of long-term debt)(after-tax cost of long-term debt) +

(weight of preferred stock)(cost of preferred stock) + (weight of retained
earnings)(cost of retained earnings)
 The after-tax cost of debt if calculated as:

After-tax cost of debt = (1 tax rate)(before-tax cost of debt)

After-tax cost of debt = (1 0.4)(0.11) = 0.066, or 6.6%

Therefore, the WACC can be calculated as follows:

WACC = (0.3)(0.066) + (0.24)(0.12) + (0.46)(0.16)

WACC = .0198 + 0.0288 + 0.0736 = 0.1222, or 12.22%.

Question 88:
(2B2-LS14)

Which of the following statements accurately describes a bond instrument?

A bond is generally considered a conservative equity instrument.
Short-term bonds normally provide higher yields than do long-term
bonds.
Most bonds are sold in multiples of $1,000.
The trustee defines the details of the bond issue.

Although there are many types of bonds, the principal amount of most
bonds is $1,000.

Question 89:
(2B2-LS58)

What is the weighted average cost of capital (WACC) for a firm given the
information in the chart?

29%.
10%.
9.7%.
9%.

The formula for determining the cost of capital is:

Where:

ka = cost of capital (expressed as a percentage)

 p = proportional amount of total capital structure
k = cost of an element in the capital structure
n = different types of financing

Question 90:
(2B2-LS06)

A firm wants to hedge the risk that market value of a corporate bond may
fall. Which of the following actions should the firm take?
Sell a forward contract on a Treasury bond.
Buy a call option on a Treasury bond.
Sell a put option on a Treasury bond.
Buy a forward contract on a Treasury bond.

By definition, a forward contract is an agreement between two parties to

buy or sell a specific amount of an asset at a future date for a set price. Of
the alternatives listed, selling a forward contract on a Treasury bond is
the only one that could lock in a current price and mitigate the risk of a
possible decline in the corporate bond price.

Question 91:
(2B2-LS05)

If a firm's goal is to keep portfolio risk low, the best strategy would be to
include:
diversified investments with low betas.
diversified investments with high betas.
investments with high betas and low correlated returns.
investments with low betas and highly correlated returns.

If the aim is to keep portfolio risk low, diversified investments having low
betas should be included. Diversification reduces portfolio risk as long as
the different investments are unlikely to all move in the same direction
(that they are not perfectly, positively correlated). Relative to beta
measures, the higher the beta above 1.0, the greater the volatility in
relation to market activity.

Question 92:
(2B2-CQ11)

The management of Old Fenske Company (OFC) has been reviewing the
company's financing arrangements. The current financing mix is $750,000
of common stock, $200,000 of preferred stock ($50 par) and $300,000 of
debt. OFC currently pays a common stock cash dividend of $2. The
common stock sells for $38, and dividends have been growing at about 10%
per year. Debt currently provides a yield to maturity to the investor of 12%,
and preferred stock pays a dividend of 9% to yield 11%. Any new issue of
securities will have a flotation cost of approximately 3%. OFC has retained
earnings available for the equity requirement. The company's effective
income tax rate is 40%. Based on this information, the cost of capital for
retained earnings is:
16%.
15.8%.
14.2%.
9.5%.

The cost of capital for retained earnings using the Constant Dividend
Growth Model (Gordon's Model) is calculated as follows:

Cost of capital, retained earnings = (next dividend) / (price of the common

stock) + (constant growth rate)

The next dividend is calculated by taking the current dividend per share
and multiplying it by one plus the constant growth rate.

Next dividend = (current dividend)(1 + constant growth rate)

Next dividend = ($2.00 per share)(1 + 10%) = $2(1.1) = $2.20 per share

The cost of capital for retained earnings can then be calculated:

Cost of capital, retained earnings = ($2.20 / $38) + (0.1) = 0.058 + 0.1 =

0.158, or 15.8%.

Question 93:
(2B2-AT06)

If a bond sells at a premium, the:

stated coupon rate must be more than the required market rate.
nominal rate must be less than the yield rate.
bond purchase price must be more than the fair market value of the
bond.
stated coupon rate must be less than the required market rate.

If a bond sells for more than its face value, it is sold at a premium. Buyers
are willing to pay higher price for the bond expecting higher returns.
Thus, the stated rate must be higher than the market rate.

Question 94:
(2B2-LS64)

Which of the following statements differentiates debt capital from equity

capital?
Debt capital is a function of stock issues; equity capital is a function of
receivables, inventories, and payables.
Debt capital is derived from retained earnings; equity capital is
derived from the issuance of notes, bonds, or loans.
Debt capital is a function of receivables, inventories, and payables;
equity capital is a function of stock issues.
 Debt capital is derived from the issuance of interest-bearing
instruments; equity capital is derived from permanent investments by
shareholders.

Corporations derive capital from essentially two sources: lenders and

shareholders. Debt capital is derived from the issuance of interest-
bearing instruments such as notes, bonds, or loans. Equity capital is
derived from permanent investments by shareholders, either as paid-in
capital or as retained earnings.

Question 95:
(2B2-LS33)

Which of the following statements describes an option that is at-the-

money?
The owner of the contract decides not to sell the underlying asset.
The owner can exercise the option at any time before maturity.
The underlying asset price equals the strike price.
The strike price exceeds the price of the underlying asset.

Different payoffs are possible with options. An option is referred to as

being at-the-money if the underlying asset price equals the strike price.

Question 96:
(2B2-CQ08)

Morton Starley Investment Banking is working with the management of Kell

Inc. in order to take the company public in an initial public offering.
Selected information for the year just ended for Kell is as follows.

If public companies in Kell's industry are trading at a market to book ratio

of 1.5, what is the estimated value per share of Kell?

$16.50.
$27.50.
$13.50.
$21.50.

Book value per share of common stock is calculated by taking the

common stock equity and dividing it by the number of shares of common
stock outstanding.

Book value per share, common stock = (common stock equity) / (number
 of shares of common stock outstanding)

The number of shares outstanding is 3,000,000, which is derived by taking

the $3,000,000 in par value common equity and dividing it by the $1 par
value per share.

Therefore, book value per share of common stock can be calculated as:
Book value per share, common stock = ($3,000,000 + $24,000,000 +
$6,000,000) / (3,000,000 shares)
Book value per share, common stock = ($33,000,000) / (3,000,000 shares)
Book value per share, common stock = $11 per share

The estimated value per share of Kell would then be:

Estimated value per share = $11(1.5) = $16.50 per share.

Question 97:
(2B2-LS36)

All of the following factors influence the theoretical value of an option

except the:
time until expiration of the option.
strike price of the option.
current price of the underlying asset.
net settlement specifications.

To a degree, the price or value of an option depends on the expected

future value of the underlying asset. Several factors influence the
theoretical value of an option. But whether or not the net settlement
must be a cash payment, delivery of an asset that can be easily converted
to cash or another derivative does not change the value.

Back to Top Restart Study Session End Study Session