CFA Practice Question

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CFA Practice Question

Which factors tend to cause companies' D/E ratios to be potentially lower? A country has:

I. Large institutional investors.
II. Active bond and stock markets.
III. Taxes that favor debt.
IV. High inflation.
Correct Answer: I and IV

User Contributed Comments 6

User Comment
giroth Why do large institutional investors favor lower D/E? I understand why high inflation favors low D/E's.
ljamieson Inst'l investors will swallow more equity.
twintigers can somebody explain IV? suppose higher inflation will eat out some interest and principle, which encourage borrow. So why IV is correct.
Thecatz89 because as you said, higher inflation will lower the outflow for the payment of debt interests, thus less bank will be enclined to lend money in the form of debt !

Hope I have helped !
ericczhang Another explanation might be that Debt is carried at book value, whereas Equity in the D/E calculation is from market values of shareholder's equity. In a country with high inflation Debt book values would be misleading on the low side, whereas Equity values would be higher from inflation.
normaj2 When inflation increases interest rates increase. When interest rates increase existing bond values drop. Equity values increase along with inflation so it's better to hold equity in periods of rapid inflation.
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