CFA I
A company's before-tax cost of debt is: A - Difficult to estimate. B - Higher than its cost of equity. C - Equal to the investor's minimum required rate of return on debt.
Answer Explanation: All buyers of the same bond issue receive the same periodic rate of interest, so their required rate of return is the same, and is equal to the company's before-tax cost of debt. Note that taxes reduce the effective cost of debt to the company because interest payments are generally tax-deductible. Choice "a" is incorrect. The sum of all interest payments of a company are generally known with great accuracy. Choice "b" is incorrect. Investors require a higher rate on return on equity than on debt, since cash flows to equity owners are riskier than interest payments on debt.
Which of the following transactions will increase a company's accumulated other comprehensive income account? A - A decrease in the defined benefit pension plan liability. B - A realized gain on an available for sales security. C - An unrealized gain on a trading security.
Answer to Level I Question: A Answer Explanation: A decrease in a company's defined benefit pension plan liability is a gain that is recorded as an increase in accumulated other comprehensive income. Choice "b" is incorrect. Realized gains (and losses) on available for sale securities are reported on the income statement. Realized gains and losses are recorded when securities are sold. Other comprehensive income is impacted by unrealized gains and losses on available for sales securities. Unrealized gains and losses are reported when securities classified as trading or available for sale are adjusted to fair value. Choice "c" is incorrect. Unrealized gains (and losses) on trading securities are reported on the income statement and are not reported in other comprehensive income.
Which of the following common stock-related events does not impact a company's retained earnings? A - A 2 for 1 stock split. B - A stock dividend of 10%. C - A $.30 per share cash dividend declared on common stock.
Answer to Level I Question: A Answer Explanation: A stock split has no impact on retained earnings or any other balance sheet account. Choice "b" is incorrect. In a stock dividend transaction retained earnings is reduced by the value of the stock dividend. For a 10% dividend retained earnings is reduced by the market value of the shares issued. Choice "c" is incorrect. Cash dividends declared reduce the amount of retained earnings reported on the balance sheet.
A company should account for the declaration of an 18% stock dividend by transferring from retained earnings to: A - Contributed capital an amount equal to the market value of the dividend shares. B - Contributed capital any amount greater than the market value of the dividend shares. C - Additional paid-in capital an amount equal to half the market value of the dividend shares with the other half added to the common stock account.
Answer to Level I Question: A Answer Explanation: All stock dividends involve a transfer of value from retained earnings into contributed capital. Any stock dividend which is less than 20% is automatically considered a small stock dividend and is recorded using the market value of the stock. If the stock dividend is greater than 25%, the book (par) value of the shares would be used for the entry. Stock dividends between 20% and 25% may use either par or market value. Note that in any of these situations there is no change to total stockholders' equity, but simply a reclassification from retained earnings to contributed capital. Choice "b" is incorrect. Under no circumstances would you ever use a value more than market value to record a stock dividend. Choice "c" is incorrect. The transfer is not arbitrarily divided 50-50 between the Additional Paid-in Capital and Common Stock accounts. In the case of small stock dividend, the total reduction in retained earnings is based on the market value of the shares. The Common Stock account is credited at par, with the balance being credited to the Additional Paid-In Capital account. Note that both of the accounts credited are part of "contributed capital."
During the three months ended 12/31/2015, Delon Company reported net income of $1,800,000 and paid $360,000 in dividends to common stockholders (which had been declared in the previous period). In addition, Delon declared a cash dividend of $0.22 per share to be paid in the next quarter. The company currently has 1.8 million shares outstanding. What was the increase in stockholders' equity from 9/30/2015 to 12/31/2015? A - $1,440,000 B - $1,404,000 C - $1,044,000
Answer to Level I Question: A Answer Explanation: Any stock dividend which is greater than 25% is automatically considered a large stock dividend and the accounting for the dividend on the financials must use the book value of the stock times the number of shares to record the common stock increase. If the stock dividend is less than 20%, the market value of the shares must be used for the entry. Stock dividends between 20% and 25% may use either book or market value. Choice "c" is incorrect. This transaction merely rearranges the components of stockholders' equity but it has no effect on the total value of stockholders' equity. Choice "b" is incorrect. Retained earnings decrease.
Management: A - Can directly affect the book value of the company. B - Can directly affect the market value of the company. C - Should maximize the difference between market and book value of the company.
Answer to Level I Question: A Answer Explanation: By using accounting techniques that influence earnings and by selling and purchasing shares, management can directly affect the book value of the company. Choice "b" is incorrect. Management can only indirectly affect the market value of the company, since this value reflects the collective and differing expectations of investors concerning the company's future cash flows. Even when management can predict whether the stock will increase or decrease in price as a result of a specific action, the amplitude of the change is impossible to predict. Choice "c" is incorrect. Management can maximize the difference between market and book value by minimizing book value, but this is seldom in the best interest of investors.
When calculating the cost of capital, which component cost is normally the lowest? A - The cost of debt. B - The cost of preferred stock. C - The cost of common equity.
Answer to Level I Question: A Answer Explanation: Debt capital usually has the lowest cost, as a result of the tax deductibility of interest. Choice "b" is incorrect. The cost of preferred stock capital is usually the second lowest cost, as it does not have the tax benefit associated with debt. Choice "c" is incorrect. The cost of common equity is usually the highest cost, because it has the highest risk.
During 20X5, Industrial Machines Inc. purchased the bonds of Service Corporation for $525,000. The purchase price included a $25,000 premium. Industrial Machines has both the intent and the ability to hold the bonds until they mature on January 1, 20X9. At what amount will the bond investment be reported on Industrial Machines' December 31, 20X8 balance sheet? A - Par value of $500,000. B - Purchase price of $525,000. C - Fair value of the bonds on December 31, 20X8.
Answer to Level I Question: A Answer Explanation: Industrial Machines will classify the investment in the Service Corporation bonds as held-to-maturity because the company has both the intent and the ability to hold the bonds until they mature. Held-to-maturity securities are reported at amortized cost. On December 31, 20X8, the bond premium will be fully amortized because the bonds mature on January 1, 20X9. Therefore, the bonds will be reported at their par value (maturity value) of $500,000. Choice "b" is incorrect. The investment in the Service Corporation bonds is a held-to-maturity investment that must be reported at amortized cost. Amortized cost is the par value of the bond plus any unamortized premium or minus any unamortized discount. The $25,000 bond premium will be fully amortized on December 31, 20X8, so the bond investment will not be reported at the purchase price of $525,000. Choice "c" is incorrect. The investment in the Service Corporation bonds is a held-to-maturity investment that must be reported at amortized cost, not at fair value.
Which of the following is MOST LIKELY a characteristic of preferred stock? A - Dividends in arrears are cumulative. B - Senior claim on assets over bond holders. C - Dividends will increase in relation to the increase in price of common stock.
Answer to Level I Question: A Answer Explanation: Preferred stockholders have the right to receive cumulative dividends (in arrears) before common stockholders receive dividends. Choice "b" is incorrect. Bond holders have a priority claim of assets in liquidation over preferred stockholders. However, preferred stockholders receive proceeds before common stockholders. Choice "c" is incorrect. Dividend payouts are typically fixed and do not increase with a rise in price of common stock. Preferred stockholders could potentially profit from a rise in the common stock if they hold convertible preferred stock.
Jerry David owns twelve miniature golf courses along the Atlantic coast, most of which are located in beach towns. Jerry is considering three additional courses, one in New Jersey, one in Delaware, and one in Maryland. Each has a different initial investment requirement, with the New Jersey course requiring the largest investment (and lowest Net Present Value) and the Delaware course requiring the smallest investment (and highest Net Present Value). Jerry will borrow the entire amount for each course, but is confident the funds will be available. Under which of the following conditions should Jerry borrow the full amount for all three courses? A - Only when the marginal cost of capital of the New Jersey course is identical to the required return. B - Only when the required return exceeds the marginal cost of capital for the Delaware course. C - Only when the total amount borrowed exceeds the optimal capital budget.
Answer to Level I Question: A Answer Explanation: Since the New Jersey course has the smallest effect on wealth (lowest NPV), this investment should only be undertaken if the incremental cost of borrowing for that project is equal to (or less than) the required return. As Jerry borrows additional capital for each golf course, the borrowing cost is likely to increase. The profitability of each subsequent course decreases, so Jerry should borrow when the required return is greater than the borrowing cost. Choice "b" is incorrect. The Delaware course has the highest NPV and should be the first investment. The MCC (marginal cost of capital) for this course is likely to be close to the firm's weighted average cost of capital. Choice "c" is incorrect. The optimal capital budget is the point in which the Investment Opportunity Schedule is equal to the marginal cost of capital. There would be no compelling reason to borrow more than the optimal budget amount.
A company with 5,000,000 common shares outstanding ($0.10 par value per share), decides to split its shares 5 for 1. Prior to the split, the shares are selling for $0.60 per share. What is the change in retained earnings for the company as a result of this stock split? A - $0 B - $3,000,000 C - $12,000,000
Answer to Level I Question: A Answer Explanation: Stock splits have no economic or accounting impact on any account of the company, including retained earnings and all other equity accounts. Choice "b" is incorrect. This number represents the market capitalization of the company. Choice "c" is incorrect. This answer is not based on any specific methodology.
The after-tax cost of preferred stock capital is: A - Equal to the before-tax cost of preferred stock capital. B - Equal to the after-tax cost of debt capital. C - Higher than the cost of common equity.
Answer to Level I Question: A Answer Explanation: The after-tax cost of preferred stock capital is equal to the before-tax cost of preferred stock capital, as preferred dividends are not tax deductible for the issuing corporation. Choice "b" is incorrect. Usually, the cost of preferred equity is greater than the after-tax cost of debt capital. Choice "c" is incorrect. Usually, the cost of preferred equity is lower than the cost of common equity.
Ionic Company repurchased 10,000 shares of its common stock for the treasury at $30 per share at the end of 20X2. The par value of the stock is $1 and the shares were originally issued at $10 per share. What is the effect of the repurchase on common stockholders' equity and return on equity for 20X2? A - A decrease of $300,000 and higher return-on-equity. B - A decrease of $300,000 and lower return-on-equity. C - A decrease of $200,000 and lower return-on-equity.
Answer to Level I Question: A Answer Explanation: Treasury stock was recorded at the purchase price (10,000 x $30). Because the balance in the treasury stock account is deducted from common stock, paid-in capital and retained earnings to determine stockholders' equity, this repurchase would reduce equity and increase the return on equity for 20X2. Choice "b" is incorrect. Return on equity will be higher, not lower. Choice "c" is incorrect. The repurchased shares are recorded at the purchase price, not the difference between the purchase price and issue price ($30 - $10 = $20 x 10,000 shares).
Ajax Company purchases treasury shares at year-end. Which of the following BEST DESCRIBES the effect this will have on total stockholders' equity and earnings per share? A - A decrease in stockholders' equity and an increase in earnings per share. B - An increase in stockholders' equity and a decrease in earnings per share. C - A decrease in stockholders' equity and a decrease in earnings per share.
Answer to Level I Question: A Answer Explanation: When treasury stock is purchased by a company, the company spends cash and reduces total stockholders' equity. The reduction in Stockholders' equity occurs by means of a negative (contra) account titled "treasury stock." Earnings per share is calculated based upon total shares outstanding. Because treasury stock is no longer considered to be outstanding once purchased by the company, earnings per share increase. Choice "b" is incorrect. This is the exact opposite of the true effects. Choice "c" is incorrect. Although total stockholders' equity decreases as a result of the treasury stock contra account, the earnings per share would increase because of the lower number of shares outstanding resulting from the repurchase of shares by management.
Which of the following types of dividends must be paid out in the form of cash? A - Stock dividend. B - Regular dividend. C - Dividend from sale of a business.
Answer to Level I Question: B Answer Explanation: A regular dividend must be paid in cash to shareholders of record. Choice "a" is incorrect. Stock dividends are always paid in the form of additional shares of stock in the company. There is no cash involved with this transaction. Choice "c" is incorrect. These one-time special dividends can be paid in cash or other assets of the company.
An executive of Penn William Company came across the following statement: "The before-tax cost of preferred stock may be lower than the before-tax cost of debt, even though preferred stock is riskier than debt." He contacts Amit Patel, CFA to understand the reasoning of the above statement. Patel explains to the executive that this is because: A - Dividends on preferred stock have higher tax deductibility than the tax deductibility of coupon interest on bonds for the issuing firm. B - Preferred stock is generally owned by corporations, which receive 70% exclusion of dividends for tax purpose. C - Preferred stocks have a priority of claim on assets and earnings in the event of liquidation.
Answer to Level I Question: B Answer Explanation: Because preferred dividends receive 70% tax exclusion for the company receiving the dividends, issuing firms are able to issue preferred stock with a dividend rate that is lower than the coupon rate on comparable bond issue. Choice "a" is incorrect. Preferred stock dividends are not tax deductible for the issuing firm. Choice "c" is incorrect. Bonds and not preferred stock have a priority of claim on assets and earnings in the event of liquidation.
On July 1, the Ross Corporation added three new equity positions (Stocks X, Y, and Z) to its portfolio at a total cost of $50,000 each. Stocks X and Y are classified as Trading securities, while Stock Z is classified as Available-For-Sale. Ross sold Stock X on December 15 for $52,500, while Stocks Y and Z remained on the books at year-end with respective values of $57,300 and $40,800. Which of the following best represents the overall impacts of the realized and unrealized gains/losses for these three stocks on the company's financial statements? A - Loss of $1,900 on the balance sheet and a gain of $2,500 on the income statement. B - Loss of $9,200 on the balance sheet and a gain of $9,800 on the income statement. C - Loss of $9,200 on the balance sheet and a gain of $2,500 on the income statement.
Answer to Level I Question: B Answer Explanation: For Trading securities, realized and unrealized gains and losses are reflected on the income statement. For Available-For-Sale securities, realized gains and losses go on the income statement while unrealized gains and losses are reflected on the balance sheet in equity as Other Comprehensive Income. As Stock Z is an Available-For-Sale security, the unrealized loss of $9,200 ($50,000 initial purchase price - $40,800 current market value) is reflected on the balance sheet. Because Stocks X and Y are Trading securities, the realized gain of $2,500 on Stock X ($52,500 sale price - $50,000 purchase price) and the unrealized gain of $7,300 on Stock Y ($57,300 current market value - $50,000 purchase price) are both reflected on the income statement. The total income statement impact is a $9,800 gain ($2,500 + $7,300). Choice "a" is incorrect. While the gain on the sale of Stock X of $2,500 ($52,500 - $50,000) will go on the income statement, this answer assumes that the unrealized gains and losses on Stocks Y and Z both go on the balance sheet. Because Stock Y is classified as a Trading security, the unrealized gain of $7,300 ($57,300 - $50,000) belongs on the income statement. When added to the gain from the sale of Stock X, the total impact on the income statement is $9,800 and therefore, the only impact on the balance sheet will be the unrealized loss on Stock Z of $9,200. Choice "c" is incorrect. This choice fails to account for the unrealized gain of $7,300 on Stock Y ($57,300 - $50,000). As a Trading security, this must be reflected in the income statement and would therefore make the total gain $9,800.
A company's market value is MOST LIKELY to increase because: A - Its book value has gone up. B - Investors expect the future cash flows of the company to be less volatile. C - Management has more confidence in the future prospects of the company.
Answer to Level I Question: B Answer Explanation: Investors value a company based on their collective expectations of its future cash flows. Less volatile, and therefore less risky, cash flows would be discounted at a lower required rate of return and would, therefore, have a higher present value. The amount and timing of expected cash flows also influence market value. Choice "a" is incorrect. Book value can be manipulated by management through accounting techniques or through issuing and purchasing shares. Therefore, an increase in book value is rarely the reason for an increase in market value. Choice "c" is incorrect. Market price is affected by the collective view of investors, not of management, with respect to the future prospects of the company.
Preference shares are generally less risky than common shares because: A - They are not callable. B - Their dividends are known and fixed. C - Their dividends only account for a small portion of the preference shares' total return.
Answer to Level I Question: B Answer Explanation: Known and fixed dividends translate in less uncertain future cash flows and, therefore, lower risk. Choice "a" is incorrect. Preference shares can be callable or putable, similar to common shares. Choice "c" is incorrect. Preference share dividend returns represent a higher portion of the preference shares' total return than in the case of common stock. Common stock returns have not only the current dividend yield component, but also a capital gain component dependent to some extent on expected future dividends.
Which of the following is the LEAST LIKELY reason for a company to access primary equity markets? A - Increase liquidity. B - Lack of access to secondary equity markets. C - Provide an additional currency to make acquisitions.
Answer to Level I Question: B Answer Explanation: Primary and secondary markets serve different purposes and are not substitutes for each other. Primary markets are used to raise capital, whether when first taking a company public through an IPO or when companies issue additional shares through underwriting. Secondary equity markets exist for investors to trade shares between themselves and for companies to repurchase existing shares rather than to raise capital. Choice "a" is incorrect. Raising capital through primary markets increases the liquidity of the company's stock because a larger number of investors can trade the stock, and because trading takes place in an environment of increased transparency. Choice "c" is incorrect. Because of its increased liquidity, the company's publicly traded stock can be used as additional currency in making acquisition or providing stock option-based incentives to employees.
Which of the following will occur after a 2:1 stock split? A - The market price will increase. B - No accounting entry is required. C - Par value per share is unchanged.
Answer to Level I Question: B Answer Explanation: The stock split has no effect on the firm's assets or the value of shareholders' equity. Only the number of shares and par value of the shares are adjusted to reflect the split. Choice "a" is incorrect. The market price of shares in a 2 for 1 stock split is expected to decrease by half because the number of outstanding shares doubles. There may be a "secondary" effect of a slight, short-term rise in share price as the shares become more marketable. Exam questions and answers only focus upon primary affects. Choice "c" is incorrect. As the number of shares outstanding is increased the par value per share is reduced, proportionately. A share of stock with a $1 par value will have a $0.50 par value after a 2 for 1 split.
If an investor invests solely in stocks of companies that are domiciled in the investor's own country, the investor does not have to be concerned with: A - Business risk. B - Financial risk. C - Currency risk.
Answer to Level I Question: C Answer Explanation: Currency risk is the risk that the currency in which the security is denominated may decline relative to the investor's home currency. If investments are only made in domestic companies, then there is no currency risk. Choice "a" is incorrect. The investor should analyze business risk for each firm under consideration, whether it is domiciled in the investor's own country or not. Choice "b" is incorrect. The investor should analyze financial risk for each firm under consideration, whether it is domiciled in the investor's own country or not.
A trucking company is considering hiring ten to fifteen new truck drivers and furnishing each with a new eighteen wheeler. The company is trying to determine its optimal capital budget. Under which of the following conditions would the budget be determined? A - The Investment Opportunity Schedule is greater than the marginal cost of capital. B - The Investment Opportunity Schedule is less than the marginal cost of capital. C - The Investment Opportunity Schedule is equal to the marginal cost of capital.
Answer to Level I Question: C Answer Explanation: Optimal budgets are determined by the relationship between the marginal cost of capital (which increases as more funds are borrowed) and the investment opportunity schedule (which declines as the more profitable investments are chosen first). When these two variables are the same, the optimal budget is determined. Choices "a" and "b" are incorrect. The optimal budget is determined when the Investment Opportunity Schedule is equivalent (not greater than or less than) the marginal cost of capital.
Which of the following components of equity capital (shareholders' equity) represents capital that is internally generated by a firm? A - Treasury stock. B - Common stock. C - Retained earnings.
Answer to Level I Question: C Answer Explanation: Periodic earnings that are internally generated by a company's operations (net income), after the declaration of dividends, are reflected in retained earnings on the balance sheet. Choice "a" is incorrect. This is the amount paid to repurchase a company's own shares. It represents a "contra" equity account because it reduces shareholders' equity. Choice "b" is incorrect. Common stock is external capital supplied by a firm's common shareholders.
A company's return on equity is LEAST LIKELY to decrease as the result of: A - Greater industry competition. B - Increasing capital expenditures. C - Repurchasing shares with excess cash.
Answer to Level I Question: C Answer Explanation: Return on equity using beginning equity will not be affected by share repurchase. Return on equity using average equity will increase as the result of repurchasing shares with excess cash because the denominator of the equation will decrease while net income remains unaffected. Note that net income could decrease if the company uses debt to repurchase shares (due to interest expense); therefore, the direction of ROE change would depend on the relative percentage changes in net income (numerator) and equity (denominator). However, the outcome is still likely to be an ROE increase. Choice "a" is incorrect. When industries become more competitive, profits decline and returns on equity are negatively impacted. Choice "b" is incorrect. Increased capital expenditures result in higher depreciation, which reduces net income and thus return on equity.
Which of the following is the LEAST LIKELY reason for a public company to raise additional equity capital? A - Ensure debt covenants are met. B - Fulfill regulatory requirements. C - Finance a share repurchase.
Answer to Level I Question: C Answer Explanation: Share repurchases reward equity holders by distributing future excess earnings among fewer ownership interests. Thus, share repurchase should be financed with internally generated funds or through debt issuance. Issuing new shares to replace old shares only adds an expense to maintaining the same number of outstanding shares. Choice "a" is incorrect. Capitalizing the company to improve liquidity ratios and meet additional covenants of debt holders is a valid reason for companies to issue additional equity securities. Choice "b" is incorrect. Meeting regulatory requirements can require companies to reach certain capital adequacy ratios and is also a valid reason for companies to access primary equity markets.
Which of the following statements BEST DESCRIBES the impact of a stock split on shareholders' equity accounts? A - Decreases Retained earnings. B - Increases Additional Paid-in capital. C - Decreases par value of Common stock.
Answer to Level I Question: C Answer Explanation: Stock splits have no effect on any balance sheet account of the company. Stock splits only affect the par value of shares. The par value of shares is reduced by the ratio of the stock split. Choice "b" is incorrect. This account is not affected by stock splits. However, it could be affected by stock dividends. Choice "a" is incorrect. This account is not affected by stock splits. However, it is always affected by stock dividends.
The cost of preferred stock equity is: A - Approximately equal to the cost of common equity capital. B - Approximately equal to the Baa corporate bond rate. C - The dividend yield on newly-issued preferred shares.
Answer to Level I Question: C Answer Explanation: The dividend yield on newly-issued preferred shares reflects the market's required rate of return for preferred stock equity, as newly-issued shares typically sell at par. Choice "a" is incorrect. Typically, the cost of common equity capital is greater than the cost of preferred stock equity, because the risk to common shareholders exceeds that of preferred shareholders. Choice "b" is incorrect. This represents a pretax cost of Baa-rated debt.
Which of the following statements MOST ACCURATELY describes the financial statement elements reported on the balance sheet of a company? A - The equity capital reported on a balance sheet represents the fair market value of a company. B - According to the accounting identity, the total assets of a company are equal to its total liabilities. C - The asset and liability values reported on a balance sheet do not necessarily reflect the fair market value of these items.
Answer to Level I Question: C Answer Explanation: The majority of asset and liability items on the balance sheet are carried at historical cost (adjusted for depreciation and amortization) and thus do not necessarily reflect the fair market values of those items, especially when the fair market values have increased. Impairment accounting is used to adjust certain assets to fair market value when that value has declined below the recorded cost. In addition, investments in certain debt and equity securities are marked (up or down) to market and inventory is carried at the lower of cost or market. Choice "a" is incorrect. The fair market value of a company is typically very different than the book value of equity capital reported on the balance sheet. Choice "b" is incorrect. Total assets are equal to total liabilities plus equity rather than just total liabilities alone.
The Hilton Chocolate Company makes several different types of chocolate candy bars. It has a weighted average cost of capital of 7.25%, based on the required return on its outstanding bonds and shares of stock. Hilton is considering investing in a new breath mint product line. Hilton executives are fully aware that breath mints will serve an entirely different target market than its traditional chocolate candy and will require a unique marketing strategy. When determining the net present value of the breath mint product line, which of the following is the MOST LIKELY discount rate to be used? A - 6.75% B - 7.25% C - 7.75%
Answer to Level I Question: C Answer Explanation: The new product line has more risk that the traditional chocolate candy bars. In order to find the NPV of the investment, a higher discount rate should be used to reflect the incremental risk. This excludes both 6.75% and 7.25% as correct answers. Choices "a" and "b" are incorrect. The additional risk incurred from the new product line would dictate that the discount rate be higher than the current 7.25% weighted average cost of capital.
The repurchase of shares of a company's stock for cash is reflected in the financial statements as: A - Short-term asset on the balance sheet. B - Use of cash in the investing activities section of the statement of cash flows. C - Negative (contra) equity account, which reduces total shareholders' equity on the balance sheet.
Answer to Level I Question: C Answer Explanation: The repurchase of shares of stock is represented as treasury stock on the balance sheet. Treasury stock is a negative (contra) equity account. Choice "a" is incorrect. Treasury stock is a contra equity account and although it has a debit balance, it is not an asset. Choice "b" is incorrect. On the statement of cash flows, the repurchase of shares is a financing activity cash outflow, not an investing activity.
Compared to non-callable common shares, callable common shares: A - Trade at a higher price. B - Generally pay a lower dividend. C - Have limited potential future total returns, an additional source of risk.
Answer to Level I Question: C Answer Explanation: The strike price provides a ceiling for the price at which investors can sell their shares; if the stock price rises above the strike price, the company will call the shares and pay the strike price, realizing a profit at the expense of the investor. Because both types of shares can go to zero, and thus have a similar downside, a lower upside translates to an additional source of risk for callable shares. Choice "a" is incorrect. Callable shares can trade at a price below, equal to, or above that of their non-callable counterparts, depending on the difference in dividends and the strike price. Choice "b" is incorrect. To compensate investors for their higher risk, callable shares usually pay a higher dividend.
