CFA Program — Corporate Finance

Question 1

Which source of capital is generally considered to have the lowest cost to the issuing company, due to tax deductibility of interest and seniority in bankruptcy?

• A) Common equity
• B) Preferred equity
• C) Debt
• D) Retained earnings

Question 2

A project has an initial investment of $100,000 and is expected to generate $30,000 per year for 5 years. If the required rate of return is 10%, what is the approximate net present value (NPV)?

• A) -$13,700
• B) $0
• C) $13,700
• D) $50,000

Question 3

A company's weighted average cost of capital (WACC) is used primarily to:

• A) Calculate the company's net income
• B) Discount future cash flows when evaluating investment projects
• C) Determine the company's tax liability
• D) Measure the company's current stock price

Question 4

If a company increases its use of debt financing relative to equity, holding operating income constant, its financial leverage and the volatility of its earnings per share (EPS) will typically:

• A) Decrease
• B) Increase
• C) Remain unchanged
• D) Become negative

Question 5

The internal rate of return (IRR) of a project is the discount rate at which:

• A) The project's NPV equals zero
• B) The project's payback period is minimized
• C) The project's total revenue equals total cost
• D) The project's NPV is maximized

Question 6

A firm's payback period for a capital project measures:

• A) The discounted value of all future cash flows
• B) The time required to recover the initial investment from the project's cash flows
• C) The total profit generated over the project's life
• D) The rate of return earned on the project annually

Question 7

A company is financed with 55% equity and 45% debt. The cost of equity is 12%, the pre-tax cost of debt is 5.5%, and the tax rate is 21%. WACC is closest to:

• A) 8.56%
• B) 7.80%
• C) 9.90%
• D) 6.60%

Question 8

A firm's degree of financial leverage (DFL) measures the sensitivity of:

• A) Sales to a percentage change in production volume.
• B) Operating income to a percentage change in sales.
• C) Stock price to a percentage change in trading volume.
• D) Net income (or earnings per share) to a percentage change in operating income (EBIT), driven by the use of fixed financing costs like interest.

Question 9

According to Modigliani-Miller Proposition II (with taxes), as a firm increases its use of debt financing, its cost of equity will:

• A) Remain completely unaffected by the capital structure.
• B) Always fall to zero once debt exceeds 50% of capital.
• C) Increase, since higher financial leverage increases the risk borne by equity holders.
• D) Decrease, since debt is generally cheaper than equity.

Question 10

A firm's "retention ratio" (plowback ratio) is calculated as:

• A) Net income divided by total revenue.
• B) 1 minus the dividend payout ratio, representing the proportion of net income reinvested in the business rather than paid out as dividends.
• C) Total assets divided by total equity.
• D) Dividends paid divided by total assets.

Question 11

A company evaluates two mutually exclusive projects of different scale. Project A has a higher NPV but a lower IRR than Project B. Assuming the firm's goal is to maximize shareholder wealth, which project should generally be selected?

• A) Project A, since NPV directly measures the dollar increase in firm value, which better aligns with maximizing shareholder wealth than IRR, particularly when project scales differ.
• B) Project B, since a higher IRR is always preferred regardless of scale.
• C) Neither project should ever be accepted if IRRs differ.
• D) Both projects should be accepted simultaneously regardless of mutual exclusivity.

Question 12

A firm's working capital management involves managing which of the following?

• A) Only the firm's long-term debt obligations.
• B) Only the firm's common stock issuances.
• C) Only the firm's long-lived fixed assets.
• D) Current assets and current liabilities, such as inventory, receivables, payables, and cash.

Question 13

A project requires an initial investment of $8,000 and generates $3,000 at the end of each of the next 4 years. Using a discount rate of 10%, the project's NPV is closest to:

• A) $4,000
• B) $1,500
• C) $2,500
• D) $1,510

Question 14

A company's "operating leverage" primarily arises from:

• A) The proportion of fixed costs relative to variable costs in the company's cost structure.
• B) The proportion of debt relative to equity in the capital structure.
• C) The company's dividend payout ratio.
• D) The number of shares outstanding.

Question 15

A firm's "trade credit" from suppliers, if not paid within the discount period offered, effectively represents:

• A) A completely free source of financing under all circumstances.
• B) A form of long-term debt financing.
• C) An asset rather than a liability.
• D) A relatively expensive form of short-term financing, since forgoing an early-payment discount has an implicit annualized cost.

Question 16

Which of the following is a key assumption underlying the Modigliani-Miller capital structure irrelevance theorem (without taxes)?

• A) Perfect capital markets, including no taxes, no bankruptcy costs, and symmetric information among all market participants.
• B) Corporate tax rates must exceed 30%.
• C) All companies must have identical dividend policies.
• D) Interest rates must always be negative.

Question 17

A company's payback period for a project is 3.5 years, while its required payback threshold is 4 years. Based on the payback period rule alone, the firm should:

• A) Accept the project only if the IRR is negative.
• B) Accept the project, since it recovers the initial investment within the required threshold.
• C) Reject the project, since 3.5 years is too short.
• D) The payback period rule provides no basis for an accept/reject decision.

Question 18

Which of the following best describes "financial risk" as distinguished from "business risk"?

• A) Financial risk applies only to companies with no debt whatsoever.
• B) Business risk is determined solely by a company's dividend policy.
• C) Financial risk arises from a company's use of fixed financing costs, such as debt, while business risk arises from the inherent uncertainty of the company's operations and industry.
• D) Financial risk and business risk are identical concepts with no meaningful distinction.

Question 19

A project has a required return of 12%. Its IRR is 15% and NPV is $200,000. The firm should:

• A) Reject the project because the IRR could be misleading
• B) Accept the project because IRR > required return and NPV > 0
• C) Reject the project because IRR < required return
• D) Require additional analysis before deciding

Question 20

According to the Modigliani-Miller theorem with no taxes, the value of a levered firm equals:

• A) The value of an unlevered firm plus the tax shield on debt
• B) The value of an unlevered firm
• C) The present value of its future free cash flows
• D) The value of an unlevered firm minus financial distress costs

Question 21

A firm's WACC is 10%. Its before-tax cost of debt is 6% and the tax rate is 30%. If the debt-to-equity ratio is 0.5, the cost of equity is closest to:

• A) 12.17%
• B) 13.00%
• C) 11.80%
• D) 14.20%

Question 22

Which dividend policy theory argues that investors are indifferent between dividends and capital gains because they can create 'homemade dividends'?

• A) Bird-in-hand theory
• B) Tax preference theory
• C) Dividend irrelevance theory
• D) Signaling theory

Question 23

The payback period method of capital budgeting ignores:

• A) The initial investment amount
• B) The time value of money and cash flows beyond the payback period
• C) Cash flows during the payback period
• D) The project's required rate of return

Question 24

Which of the following best describes the agency conflict between shareholders and bondholders?

• A) Shareholders prefer low-risk projects; bondholders prefer high-risk projects
• B) Shareholders may prefer high-risk projects that transfer wealth from bondholders
• C) Both groups always prefer the same investment policies
• D) Bondholders bear all the firm's operating risk

Question 25

A company is financed with 60% equity and 40% debt. The cost of equity is 11%, the pre-tax cost of debt is 6%, and the tax rate is 25%. The company's WACC is closest to:

• A) 8.40%
• B) 8.60%
• C) 10.20%
• D) 7.20%

Question 26

A company's degree of operating leverage (DOL) measures the sensitivity of:

• A) Net income to a percentage change in interest rates only.
• B) Sales to a percentage change in the number of employees.
• C) Stock price to a percentage change in trading volume.
• D) Operating income (EBIT) to a percentage change in sales, driven by the proportion of fixed operating costs.

Question 27

According to the Modigliani-Miller Proposition I (without taxes), a firm's capital structure decision:

• A) Always maximizes firm value by using 100% equity financing.
• B) Has a large, predictable effect on firm value in every real-world scenario.
• C) Does not affect the overall value of the firm, under the stated assumptions (no taxes, no bankruptcy costs, efficient markets).
• D) Always maximizes firm value by using 100% debt financing.

Question 28

A company's payback period for a capital project is calculated as the length of time required for:

• A) The project's IRR to exceed its NPV.
• B) The cumulative cash flows from the project to equal the initial investment.
• C) The project to generate its first dollar of any cash flow.
• D) The company's stock price to double.

Question 29

Which of the following is generally considered a limitation of the payback period method for evaluating capital projects?

• A) It ignores the time value of money and cash flows occurring after the payback point.
• B) It always produces the same ranking as NPV for any set of projects.
• C) It requires advanced statistical software to calculate.
• D) It cannot be calculated for any project with positive cash flows.

Question 30

A firm's current ratio and quick ratio are both important measures of:

• A) Long-term solvency exclusively.
• B) Profitability margins.
• C) Market valuation multiples.
• D) Short-term liquidity -- the firm's ability to meet its near-term obligations.

Question 31

A company's preferred stock pays an annual dividend of $4.50 per share and currently trades at $60 per share, with no flotation costs assumed. The cost of preferred stock is closest to:

• A) 7.5%
• B) 6.0%
• C) 9.0%
• D) 5.0%

Question 32

A company follows a strict residual dividend policy. Under this approach, the company will:

• A) Pay a fixed dollar dividend every year regardless of earnings or investment needs.
• B) First fund all acceptable capital investment projects from available earnings (consistent with its target capital structure), and distribute only the leftover (residual) earnings as dividends.
• C) Always distribute 100% of net income as dividends regardless of investment opportunities.
• D) Set dividends based solely on matching the dividends paid by direct competitors.

Question 33

A company's pre-tax cost of debt is 7.0%, and its marginal tax rate is 30%. The company's after-tax cost of debt is closest to:

• A) 4.9%
• B) 7.0%
• C) 2.1%
• D) 6.3%

Question 34

A project requires an initial investment of $1,000,000 and has a present value of future cash flows of $1,250,000. The project's profitability index is closest to:

• A) 0.80
• B) 1.00
• C) 0.25
• D) 1.25

Question 35

A company has fixed operating costs of $360,000 per year. Each unit sells for $60 and has a variable cost of $36 per unit. The breakeven quantity of units the company must sell to cover its fixed costs is closest to:

• A) 6,000 units
• B) 10,000 units
• C) 15,000 units
• D) 20,000 units

Question 36

A company's sales increased from $1,000,000 to $1,150,000 (a 15% increase), while its EBIT increased from $200,000 to $260,000 (a 30% increase) over the same period. The company's degree of operating leverage (DOL), measured over this period, is closest to:

• A) 1.5x
• B) 2.0x
• C) 0.5x
• D) 3.0x