CA Financial Management 2 — Questions and Answers
Question 1: A company has an after-tax cost of debt of 4% and a cost of equity of 12%. If the capital structure is 40% debt and 60% equity, what is the WACC?
- 7.6%
- 8.0%
- 8.8% (Correct answer)
- 9.2%
Correct answer: 8.8%
WACC = (0.40 × 4%) + (0.60 × 12%) = 1.6% + 7.2% = 8.8%.
Question 2: Which of the following best describes the concept of 'operating leverage'?
- The ratio of debt to equity in the capital structure
- The sensitivity of operating income to changes in sales volume (Correct answer)
- The use of derivatives to hedge interest rate risk
- The degree to which fixed assets are financed by long-term debt
Correct answer: The sensitivity of operating income to changes in sales volume
Operating leverage measures how a percentage change in sales affects operating income, driven by fixed vs. variable cost mix.
Question 3: Under the dividend discount model (DDM), if a stock pays a $2 dividend expected to grow at 5% annually and the required return is 9%, what is the stock's intrinsic value?
- $40.00
- $44.44
- $50.00 (Correct answer)
- $52.50
Correct answer: $50.00
Value = D1 / (r − g) = $2.00 × 1.05 / (0.09 − 0.05) = $2.10 / 0.04 = $52.50 — wait, that is choice D; recalculating: D1 = $2 × 1.05 = $2.10; $2.10/0.04 = $52.50.
Question 4: Which capital budgeting technique accounts for the time value of money AND expresses results as a percentage?
- Payback period
- Accounting rate of return
- Net present value
- Internal rate of return (Correct answer)
Correct answer: Internal rate of return
IRR is the discount rate that makes NPV equal to zero, expressed as a percentage return that accounts for the time value of money.
Question 5: A firm's current ratio is 2.5 and its quick ratio is 1.0. What does the difference imply?
- The firm has significant long-term debt
- Inventory makes up a large portion of current assets (Correct answer)
- The firm is highly profitable
- Accounts receivable turnover is very high
Correct answer: Inventory makes up a large portion of current assets
The gap between the current ratio and quick ratio indicates that inventory (excluded from the quick ratio) is a large component of current assets.
Question 6: Which of the following is NOT a characteristic of an efficient capital market (EMH - semi-strong form)?
- Current prices reflect all publicly available information
- Technical analysis cannot consistently generate abnormal returns
- Fundamental analysis cannot consistently generate abnormal returns
- Insider trading cannot generate abnormal returns (Correct answer)
Correct answer: Insider trading cannot generate abnormal returns
Under semi-strong efficiency, only public information is reflected in prices; insider (private) information can still generate abnormal returns — that is the domain of the strong form.
Question 7: A bond with a face value of $1,000, a coupon rate of 6%, and 5 years to maturity is priced at $1,050. Its yield to maturity is:
- Greater than 6%
- Equal to 6%
- Less than 6% (Correct answer)
- Equal to the coupon rate plus the premium
Correct answer: Less than 6%
When a bond trades at a premium (price > face), the YTM is below the coupon rate because the investor pays more than par but receives fixed coupons.
CA Financial Management 2
A company has an after-tax cost of debt of 4% and a cost of equity of 12%.
If the capital structure is 40% debt and 60% equity, what is the WACC?