ACA Business Finance 3 — Questions and Answers
Question 1: The pecking order theory of capital structure suggests companies prefer:
- Debt over equity at all times
- Retained earnings first, then debt, then equity as a last resort (Correct answer)
- Equity before debt due to lower risk
- An equal mix of debt and equity
Correct answer: Retained earnings first, then debt, then equity as a last resort
Pecking order theory (Myers & Majluf) suggests firms prefer internal financing (retained earnings), then external debt, and finally new equity, due to asymmetric information and signalling effects.
Question 2: A company with a quick ratio of less than 1 indicates:
- Excellent short-term liquidity
- Its current liquid assets cannot cover current liabilities (Correct answer)
- It has excessive inventory levels
- It is insolvent
Correct answer: Its current liquid assets cannot cover current liabilities
A quick ratio below 1 means liquid current assets (excluding inventory) are less than current liabilities, suggesting potential short-term liquidity pressure.
Question 3: Duration in bond analysis measures:
- The coupon rate of the bond
- The weighted average time to receive cash flows, reflecting price sensitivity to interest rate changes (Correct answer)
- The credit quality of the bond issuer
- The bond's yield to maturity
Correct answer: The weighted average time to receive cash flows, reflecting price sensitivity to interest rate changes
Duration measures the weighted average time to receive a bond's cash flows and also approximates the percentage price change for a given change in interest rates (interest rate sensitivity).
Question 4: Which of the following is a non-cash item that is added back to profit when calculating operating cash flow?
- Increase in receivables
- Depreciation (Correct answer)
- Tax paid
- Interest paid
Correct answer: Depreciation
Depreciation is a non-cash charge that reduces profit but does not involve a cash outflow; it is therefore added back to profit when calculating operating cash flows under the indirect method.
Question 5: Enterprise value (EV) is typically calculated as:
- Market capitalisation only
- Market capitalisation plus net debt (debt minus cash) (Correct answer)
- Total assets minus current liabilities
- Book value of equity
Correct answer: Market capitalisation plus net debt (debt minus cash)
Enterprise value represents the total value of the business to all capital providers: EV = market capitalisation + total debt − cash and cash equivalents.
Question 6: The Modigliani-Miller theorem with tax implies:
- Capital structure is irrelevant
- Firm value increases with debt due to the tax shield on interest (Correct answer)
- Firms should avoid all debt
- Equity is always cheaper than debt
Correct answer: Firm value increases with debt due to the tax shield on interest
With corporate tax, MM shows that interest tax shields increase firm value; therefore, 100% debt would theoretically maximise value — but in practice, financial distress costs limit optimal gearing.
ACA Business Finance 3
The pecking order theory of capital structure suggests companies prefer: