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According to the Modigliani-Miller propositions (with taxes), if a company increases its debt level, its market value will most likely:

  1. decrease since the costs of financial distress are increasing.
  2. remain the same since the market value is unaffected by the capital structure.
  3. increase proportionally to the change in debt.
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Explanation:

The Modigliani-Miller (MM) propositions assume perfect capital markets (ie, no arbitrage, no transaction or bankruptcy costs, and symmetric information) and assert that a company's market value equals the present value of its future cash flows. Modigliani and Miller propose that, in the absence of taxes:

  • A company's capital structure does not affect its value (MM I without taxes); and
  • A company's cost of equity (re) is directly proportional to its debt-to-equity ratio (D/E), but WACC remains constant (MM II without taxes).

However, these propositions change when there are corporate taxes:

  • The market value of a levered company is greater than the value of an unlevered but otherwise identical company; tax-exempt interest payments improve the levered company's cash flows, increasing its value. The difference in value is the amount of the debt tax shield (tD), which is the product of a company's tax rate (t) and value of debt (D) (MM I with taxes).
  • A company's re is directly proportional to D/E, adjusted by (1 − t). Greater leverage will increase the cost of equity, but at a slower pace due to taxes. The greater the tax rate (t), the slower the increase in re when D/E increases (MM II with taxes).

Therefore, with taxes, an increase in debt will proportionally increase a company's value and reduce its WACC.

(Choice A) The MM propositions assume no cost of financial distress.

(Choice B) The market value would remain the same in the absence of taxes.

Things to remember:
The Modigliani-Miller (MM) propositions assume perfect capital markets (ie, no arbitrage, no transaction or bankruptcy costs, and symmetric information). When these propositions include corporate taxes, greater leverage will increase a company's market value (MM I) and reduce its WACC (MM II).

If a professional organization has standards of conduct in addition to its code of ethics, the purpose of the standards is most likely to describe:

  1. shared principles.
  2. laws and regulations.
  3. acceptable behaviors.
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Explanation:

Instruments for compliance with professional ethics
Instrument Owner Describes
Code of ethics Professional organization Shared principles
Standards of conduct Professional organization Minimally acceptable behavior
Laws and regulations Government Legal limits of behavior

A code of ethics is a professional organization's statement of shared principles. Standards of conduct provide a guide to practicing the principles outlined in the code of ethics. Standards of conduct also clarify the minimally acceptable behaviors required to conform to the code of ethics. Although not addressed directly in standards of conduct, adherence to civil laws and regulations may be the minimally acceptable behavior in some cases.

Standards of conduct may be principle-based or rule-based. Principle-based standards are universally applicable to members of the profession and are based on the principles outlined in the code of ethics. Rule-based standards, while also relating to the principles in the code of ethics, are usually more narrowly applicable and specific to certain members or scenarios that may arise.

A code of ethics may or may not be accompanied by standards of conduct whereas standards of conduct exist only to enhance their associated code of ethics. CFA Institute has adopted both a code of ethics and standards of conduct (the "Code and Standards"); CFA charterholders and candidates are expected to know and comply with both.

(Choice A) Standards of conduct are used to describe minimally acceptable behaviors or practices, given the shared principles of the code of ethics. The code of ethics describes the shared principles.

(Choice B) Standards of conduct do not describe civil laws and regulations.

Things to remember:
Standards of conduct are used to clarify the minimally acceptable behaviors required to conform to the shared principles stated in a code of ethics; they do not address applicable civil laws and regulations.

At the end of 20X4, a hedge fund had $25 million in assets under management (AUM). The fund has the following fee structure, high-water mark, and 20X5 results:

Selected Data
Management fee (average assets) 1%
Incentive fee (net of management fee) 10%
Soft hurdle rate 6%
High-water mark (millions) $27
Year-end fund assets 20X5 (millions) $30

Assuming no inflows or outflows, the incentive fee (in $) earned by this hedge fund for 20X5 is closest to:

  1. 109,000
  2. 272,500
  3. 300,000
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Explanation:

Hedge funds charge a management fee and an incentive fee. The management fee is calculated as a percentage of the total value of the fund's assets under management (AUM). It is assessed each year regardless of profitability.

The incentive fee is levied against the fund's annual gains, subject to certain conditions. It is calculated either gross or net of the management fee. The net calculation subtracts the management fee from AUM to arrive at an adjusted AUM that is used to calculate the fund's profits.

The high-water mark represents the value of AUM, net of fees, at any time during the fund's existence. To earn an incentive fee, the fund must exceed the high-water mark, the base from which the fee is calculated.

The hurdle rate is the minimum profit that the fund must earn (usually annually) before it receives an incentive fee. The hurdle rate can either be "soft," meaning that the incentive fee is calculated based on the entire profit, or "hard," meaning that the incentive fee is based on only the excess profit above the hurdle rate.

In this scenario, the fund generated net returns in 20X5 of 18.9% ( = (29.725 – 25) / 25 ), above the soft hurdle rate of 6%, and eclipsed the high-water mark of $27 million. Therefore, the fund earned an incentive fee of 10% of profits, net of the management fee on average assets of $27,500,000:

0.10 × (29,725,000 − 27,000,000) = $272,500.

(Choice A) $109,000 is the result of incorrectly assuming a hard hurdle rate is in effect.

(Choice C) $300,000 is the incentive fee if management fees are not deducted.

Things to remember:
Hedge funds charge both a fixed management fee and a variable incentive fee. The incentive fee is contingent on whether the fund earns a profit and may be subject to a high-water mark and hurdle rate.

In the short run, a company maximizing profit in a market with perfect competition produces at a quantity that most likely results in:

  1. economic profits equal to zero.
  2. marginal revenue equal to marginal cost.
  3. market price greater than marginal revenue.
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Explanation:

A firm operating under perfect competition maximizes economic profit by producing and selling at the quantity where marginal revenue (MR) equals marginal cost (MC). Cost in this context includes opportunity costs (eg, the owners' required return from the business). Perfectly competitive firms can earn economic profits in the short run, but even if economic profits are zero or negative, a firm may be earning an accounting profit.

MR, the incremental revenue from selling one additional unit, depends on the firm's demand curve. In the case of perfect competition, the demand curve for any individual firm is a horizontal line at the market equilibrium price, since demand is perfectly elastic. Therefore, market price equals MR at all quantities (Choice C).

MC, the incremental cost to produce one additional unit, depends on the firm's cost structure. Producing at a quantity greater than where MR = MC means that the incremental cost for each unit exceeds the incremental revenue generated by that unit and the firm generates a loss on each additional unit sold. Producing at a lower quantity means that the firm forgoes economic profit (in the short run) since the additional revenue from a unit sold would exceed the cost of the unit.

(Choice A) Perfectly competitive firms can earn economic profits in the short run. However, in the long-run, the positive economic profits will attract new firms, which will increase supply/lower price until economic profit is zero.

Note: Although this question specifically addresses perfect competition, the condition that firms optimally produce when MR = MC applies to all market structures. It is likely that the exam will have questions on this topic.

Things to remember:
Under perfect competition, a firm maximizes short-run economic profit by producing and selling at the quantity where marginal revenue (MR) equals marginal cost (MC). Since there is perfectly elastic demand, price also equals MR for all quantities. Short-run, but not long-run, economic profits are possible. However, a firm may earn an accounting profit even if economic profits are zero or negative.

An analyst observes the following market data for one American put option:

Selected Data
(in CAD)
Stock price 48
Strike price 50
Option premium 4

This option's moneyness is best described as:

  1. in the money.
  2. at the money.
  3. out of the money.
Submit

Explanation:

Moneyness refers to the relationship between an option's strike price and the underlying stock price and is indicative of the option's intrinsic value. An option trading at the money or out of the money has no intrinsic value. An option trading in the money has intrinsic value:

  • For an in-the-money call option, the underlying stock price is greater than the strike price. This gives the call owner the right to buy the stock at a price lower than the market price, which in turn gives the option intrinsic value.
  • For an in-the-money put option, the strike price is greater than the underlying stock price. This gives the put owner the right to sell the stock at a price higher than the market price, which in turn gives the option intrinsic value.

In this scenario, the put option's underlying stock price is less than its strike price. Therefore, the option is trading in the money. Note that the option's premium is irrelevant to determining the option's intrinsic value; it would, however, be relevant to determining the option's profit at exercise.

(Choice B) If the stock price equals the strike price, the option is trading at the money (ATM). At expiration, an ATM option is economically equivalent to owning the underlying asset.

(Choice C) For a call option, if the stock price is less than the strike price, the option is trading out of the money (OTM) and has no intrinsic value. The same is true for a put option if the stock price is greater than the strike price.

Things to remember:
Moneyness refers to the relationship between an option's strike price and the underlying stock price. If the stock price equals the strike price, the option is trading at the money. For a call (put) option, if the stock price is greater (less) than the strike price, the option is trading in the money. For a call (put) option, if the stock price is less (greater) than the strike price, the option is trading out of the money.

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The Level 1 free trial offers access to over 100 practice questions, complete with detailed explanations, step-by-step problem-solving guides, and professionally designed illustrations.
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