CA Corporate Finance & Investment 2 — Questions and Answers
Question 1: A firm's weighted average cost of capital (WACC) is best described as:
- The cost of equity capital only
- The minimum return a firm must earn to satisfy all capital providers (Correct answer)
- The after-tax cost of debt only
- The risk-free rate plus a market risk premium
Correct answer: The minimum return a firm must earn to satisfy all capital providers
WACC represents the blended required return across all capital sources, weighted by their proportions in the capital structure.
Question 2: Under the Modigliani-Miller theorem with taxes, a firm's value increases as it takes on more debt because:
- Debt reduces operating risk
- Interest payments shield income from corporate taxes (Correct answer)
- Equity holders demand lower returns when leverage is higher
- Debt eliminates agency costs between managers and shareholders
Correct answer: Interest payments shield income from corporate taxes
The tax shield on interest payments increases firm value by reducing the effective cost of debt financing.
Question 3: Which capital budgeting technique explicitly accounts for the time value of money AND provides a dollar-amount measure of value created?
- Payback period
- Accounting rate of return
- Net present value (NPV) (Correct answer)
- Profitability index
Correct answer: Net present value (NPV)
NPV discounts all cash flows at the required rate and shows the absolute dollar amount of value added above the investment cost.
Question 4: A project has an IRR of 14% and the firm's WACC is 11%. Which statement is correct?
- The project destroys shareholder value and should be rejected
- The project should be accepted because IRR exceeds WACC (Correct answer)
- The project is marginal and requires further analysis
- WACC must be recalculated before a decision can be made
Correct answer: The project should be accepted because IRR exceeds WACC
When IRR exceeds the cost of capital (WACC), the project generates returns above the hurdle rate and should be accepted.
Question 5: The Capital Asset Pricing Model (CAPM) states that the expected return on a security equals:
- Risk-free rate + Beta × (Market return − Risk-free rate) (Correct answer)
- Beta × Market return
- Risk-free rate + Standard deviation × Market premium
- Dividend yield + Capital gains yield
Correct answer: Risk-free rate + Beta × (Market return − Risk-free rate)
CAPM: E(R) = Rf + β(Rm − Rf), where the equity risk premium is scaled by beta to reflect systematic risk.
Question 6: Which of the following is NOT a form of market efficiency?
- Weak-form efficiency
- Semi-strong form efficiency
- Strong-form efficiency
- Absolute-form efficiency (Correct answer)
Correct answer: Absolute-form efficiency
The Efficient Market Hypothesis recognizes only three forms: weak, semi-strong, and strong; 'absolute-form' is not a recognized category.
Question 7: A company repurchases its own shares on the open market. What is the primary effect on earnings per share (EPS)?
- EPS decreases because total equity rises
- EPS is unaffected because net income does not change
- EPS increases because fewer shares are outstanding (Correct answer)
- EPS decreases because interest expense increases
Correct answer: EPS increases because fewer shares are outstanding
Share buybacks reduce the share count, so the same net income is spread over fewer shares, mechanically increasing EPS.
CA Corporate Finance & Investment 2
A firm's weighted average cost of capital (WACC) is best described as: