CFA Practice Question

There are 151 practice questions for this study session.

CFA Practice Question

Tom owns 100 shares of stock in a firm and his debt/equity ratio is 1.0. He prefers a debt/equity ratio of zero. If the market price per share is $60, what should Tom do?

A. borrow $3,000 and buy 100 new shares
B. sell 100 shares and lend $6,000
C. sell 50 shares and lend $3,000
D. borrow $1,500 and buy 25 new shares
E. borrow $3,000 and buy 50 new shares
Correct Answer: C

User Contributed Comments 7

User Comment
danlan2 Not B?
ehc0791 interesting question: 100 shares are his assets. He has $3,000 own capital and $3,000 debt. Now he sells 50 shares and gets $3,000 to lend which reduces his debt to 0 and equity to be $3,000 still.
creativemny D/E ratio of 1 means 50% debt or 50% borrowed so to reverse this and get to 0% debt, he would sell half of his holding ($3000 or 50shrs)and lend it.
fooshnip can get to answer but its unclear due to the nature of the possible answers. it seems as though you are selling your equity to in turn lend out. if you sell half equity to lend 3k, you still have 6k borrow, 3k lent out. if you lend out 3k of the borrowed 6k, then the answer C makes sense.
ericczhang Before selling, Tom owns:
100 Shares x $60 = $6000 Equity

However, since the D/E Ratio is 1, he owns indirect debt of:
Equity * D/E = Debt
$6000 * 1 = $6000 Debt

In total he owns $6000 Equity directly, $6000 Debt indirectly.

After Selling, tom owns:
50 x $60 = $3000 Equity
$3000 x 1 = $3000 Debt
$3000 Cash from sale of 50 shares

When he lends out his proceeds of $3000, he owns
$3000 Equity
$3000 Debt - $3000 Loan = $0 Debt

Thus getting Debt/Equity of 0/$3000 = 0.
daverco How does that make sense? If he already owns $3K in debt (as implied by the D/E ratio), then buying more debt by selling off shares results in $3K + $3K = $6K in debt. And he'd still have $3K in equity. No? Or is the original $3K in debt what he owes instead of owns? But then the original premise of having a D/E ratio of 1 based on the fact of having 100 shares is not valid. Because he owns the shares, he doesn't owe the equity (as would be the case from a company's B/S perspective).
davidt87 again i think he needs to sell $2,000 and lend it. That way he is short $2,000 in debt, and his remaining $4,000 is long $2,000 in debt and $2,000 in equity. net position in debt is $0
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