CA Corporate Finance & Investment 3 — Questions and Answers
Question 1: In a leveraged buyout (LBO), the primary source of equity returns typically comes from:
- Paying high dividends during the holding period
- Debt paydown, EBITDA growth, and multiple expansion (Correct answer)
- Issuing new equity to fund operations
- Reducing working capital to zero
Correct answer: Debt paydown, EBITDA growth, and multiple expansion
LBO returns are driven by three value levers: using operating cash flows to repay debt, growing EBITDA, and exiting at a higher valuation multiple.
Question 2: The dividend discount model (DDM) values a stock as the present value of:
- Future earnings discounted at the cost of equity
- Future dividends discounted at the cost of equity (Correct answer)
- Future free cash flows discounted at WACC
- Book value plus goodwill
Correct answer: Future dividends discounted at the cost of equity
The DDM discounts expected future dividends at the required rate of return on equity to determine intrinsic stock value.
Question 3: Which of the following best describes 'operating leverage'?
- The proportion of debt in the capital structure
- The sensitivity of net income to changes in interest rates
- The degree to which fixed operating costs magnify changes in revenue into larger changes in EBIT (Correct answer)
- The use of derivatives to hedge commodity price risk
Correct answer: The degree to which fixed operating costs magnify changes in revenue into larger changes in EBIT
Operating leverage reflects how a firm's fixed cost base causes operating income to move proportionally more than revenue.
Question 4: A company issues convertible bonds at a coupon rate below its straight-debt rate. The compensation to bondholders for accepting the lower coupon is:
- A higher par value at maturity
- Priority in bankruptcy above senior debt
- The option to convert bonds into equity shares (Correct answer)
- Tax-exempt interest payments
Correct answer: The option to convert bonds into equity shares
The conversion feature grants bondholders an embedded call option on equity, which compensates them for accepting a below-market coupon.
Question 5: In merger analysis, the 'accretion/dilution test' evaluates whether a deal:
- Increases or decreases the acquirer's post-deal EPS (Correct answer)
- Creates or destroys book value
- Reduces or increases target leverage
- Improves or worsens the combined firm's credit rating
Correct answer: Increases or decreases the acquirer's post-deal EPS
An accretive deal raises the acquirer's pro forma EPS above its standalone EPS; a dilutive deal lowers it.
Question 6: Which risk measure captures only the systematic (non-diversifiable) component of a security's total risk?
- Standard deviation
- Variance
- Beta (Correct answer)
- Semi-variance
Correct answer: Beta
Beta measures a security's sensitivity to market-wide movements, capturing only systematic risk that cannot be eliminated through diversification.
Question 7: A zero-coupon bond is issued at $600 and matures at $1,000 in five years. What best describes its yield?
- It has no yield because it pays no coupons
- Its yield equals the coupon rate divided by par value
- Its yield is the discount rate that equates $600 today to $1,000 in five years (Correct answer)
- Its yield equals the coupon rate minus the inflation rate
Correct answer: Its yield is the discount rate that equates $600 today to $1,000 in five years
A zero-coupon bond's yield (YTM) is the rate that makes the present value of the single maturity payment equal to the current price.
CA Corporate Finance & Investment 3
In a leveraged buyout (LBO), the primary source of equity returns typically comes from: