CFA Practice Question

There are 120 practice questions for this study session.

CFA Practice Question

Supposing there are no taxes, which of the following is true concerning the rates of return earned on shares of a levered firm in terms of the possible range of earnings?

A. The rates are higher than those of an unlevered firm on the upside, but lower on the downside.
B. The rates are unchanged from those of an unlevered firm on the upside, but lower on the downside.
C. The rates are unchanged from those of an unlevered firm on the upside, but higher on the downside.
D. The rates do not differ from those of an unlevered firm.
E. The rates are higher than those of an unlevered firm on the upside, but unchanged on the downside.
Correct Answer: A

User Contributed Comments 12

User Comment
kalps Levered firm greater operating income than unlevered firm on upside and lower on the downside
setmefree leverage increases the risk of firm's equity, so share prices can be more volatile. what if there is tax?
setmefree leverage increases volatility in EPS, which in turn increases equity beta, which is a measure of stock's riskiness. Or, ROE appoximate EPS/share price, so larger variance in EPS, results in larger variance in ROE
setmefree can anyone answer this question, relaxing the "no tax" constraint?
haarlemmer Putting tax into the consideration, we may not arrive the conclucsion as answer A indicates.
sarath what is the meaning of upside or downside ??
sarath This is important concept --- For the levered firms, the debt interest is fixed and at higher operating incomes there is more money to be distributed over less shares so the EPS increases ....

But when hte operating income is low then for the levered firms due to interest expense it still gets reduced , thereby decreasing EPS..
ashpan When operating income high, EPS becomes higher since Net income higher due to less effect of interest expense.
When operating income low, EPS lower since numerator low while denominator (share capital) high.
kolkata7 I duuno y u pple having so much doubts...its a good but simple q...leverage magnifies risk and return of a company...so in case company has high operating or financial leverage it would magnify or deprove its company profitability so the ans is a.I think same will apply even if there is tax constrain becz tax saving from interest is very less then what we pay for financial charge so firm having more financial chage will have high financial leverage but in case of opetating leverage tax is meanigless as such and only fixed cost will matter in that case.
johntan1979 Just need to remember the levered unlevered beta formula. No taxes means higher levered beta, lower unlevered beta. Higher levered beta ==> greater volatility... hence, higher on the upside, lower on the downside.
Teeto Here must be an implicit assumption that a levered firm can produce more than an unlevered one. Otherwise I don't see how there is better return on the upside.
jzty If you gain, you will gain more. If you lose, you will also lose more.
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