CFA Practice Question

There are 534 practice questions for this study session.

CFA Practice Question

Clay Corporation earns a rate of return of 14% on common stockholders' equity. Which of the following will cause the rate of return to increase?

A. Issuing 9% bonds and investing the proceeds to earn 12%.
B. Increasing the size of the cash dividend paid on common stock.
C. An increase in the company's price-earnings ratio.
D. An increase in the market price of the company's stock.
Correct Answer: A

User Contributed Comments 14

User Comment
quincy why?
gopherz1 increased leverage
robbjm30 the funds earn 12% but the interest is only 9% and so the profits are increased relative to equity even with higher interest expense
myanmar leverage effect
Shelton ROCE = (EBIT/Assets - Int/Assets) * (Assets/Equity) * (1-t) - Pref.Div./Equity
thekapila Lets see every choice.
B. Increasing the size of the cash dividend paid on common stock. Its just moving money from income to equity .so no effect.

C. An increase in the company's price-earnings ratio. SO it might be lowering earnings so increasing the ratio.Which might lower ROE.

D. An increase in the market price of the company's stock. it doesn't affect ROE.
chisenga This is nothing but "Du Pont". Answer C and D seems to only increase P/E. Answer B will likely decrease equity, we are left with A which in effect is a piece in the Du Pont formular.
alai2008 if investing all the money in the company supposed an earning of 14% and investing part of the money in financial markets is 12% the result must lower the previous 14%
Sean12211 Bonds are not equity, they are debt. Therefore net income increases and equity remains the same.
aravinda I think simply put, adding debt to the capital structure causes equity to become more risky.. becaue, if the company went bankrupt, they will have to pay the bond holders first and then if there is any money is left then the equity holders will get a proportionate allotment (I think I am right). So due to the added risk for the equity holders, the return on equity must increase.
Nando1 With answer A we are earning 33%, which is more than the 14% threshold so it helps ROE. It has an impact on NI and Leverage.....However, I can also see answer B being correct. If we increase our dividends, our Equity will decrease. Since the denominator in the ROE equation is not smaller, the ROE ratio will be larger.
ddrmax i dont see why B should be incorrect. Maybe because the dividends are only paid out from the retained earnings part of equity. Therefore, it doesn't effect the common equity value?
2014 Free Cash Flow to Equity = Net income + NCC + net borrowing - Fixed Capital expenditure - working capital expenditure.

Net borrowing increases cash available to equity share holders
houstcarr thekapila, increasing/paying dividends is not moving income into equity. it is actually removing equity (and cash on the asset side)
You need to log in first to add your comment.