CA Financial Management 3 — Questions and Answers
Question 1: Which of the following best describes 'financial risk' in the context of a firm's capital structure?
- Risk of losing market share to competitors
- Additional risk borne by equity holders due to the use of debt financing (Correct answer)
- Risk that operating costs will exceed revenues
- Uncertainty about future interest rates in the economy
Correct answer: Additional risk borne by equity holders due to the use of debt financing
Financial risk is the additional variability in equity returns that arises because fixed interest obligations must be met before equity holders receive any return.
Question 2: A project costs $500,000 and generates net cash inflows of $125,000 per year. What is the payback period?
- 3 years
- 4 years (Correct answer)
- 5 years
- 6 years
Correct answer: 4 years
Payback period = Initial investment / Annual cash inflow = $500,000 / $125,000 = 4 years.
Question 3: Which of the following working capital strategies is considered the MOST aggressive?
- Financing all current assets with long-term debt
- Financing permanent current assets with short-term debt (Correct answer)
- Maintaining large cash reserves and low short-term borrowing
- Using retained earnings exclusively for working capital needs
Correct answer: Financing permanent current assets with short-term debt
Financing permanent (non-seasonal) current assets with short-term debt is aggressive because it exposes the firm to rollover risk and interest rate fluctuations.
Question 4: The Modigliani-Miller theorem, WITHOUT taxes, states that:
- Capital structure affects firm value through the tax shield on debt
- A firm's value is independent of its capital structure (Correct answer)
- Optimal leverage maximizes the present value of tax shields
- Dividend policy determines equity value in perfect markets
Correct answer: A firm's value is independent of its capital structure
In a perfect capital market with no taxes, M&M Proposition I holds that firm value is unaffected by how it is financed.
Question 5: Which ratio directly measures how effectively a firm collects its receivables?
- Current ratio
- Debt-to-equity ratio
- Receivables turnover ratio (Correct answer)
- Gross profit margin
Correct answer: Receivables turnover ratio
Receivables turnover = Net credit sales / Average accounts receivable, showing how many times receivables are collected in a period.
Question 6: If a company's degree of combined leverage (DCL) is 4, what does this mean?
- A 1% increase in sales leads to a 4% increase in EPS (Correct answer)
- The firm has $4 of debt for every $1 of equity
- A 4% change in EBIT causes a 1% change in EPS
- The firm's assets turn over 4 times per year
Correct answer: A 1% increase in sales leads to a 4% increase in EPS
DCL = DOL × DFL, and it measures the percentage change in EPS for a 1% change in sales; a DCL of 4 means EPS rises 4% for every 1% sales increase.
Question 7: Which of the following is an example of a 'spontaneous' source of financing?
- Long-term bond issuance
- Accounts payable (Correct answer)
- Common stock offering
- Term bank loan
Correct answer: Accounts payable
Accounts payable arise automatically (spontaneously) from normal business operations as goods and services are purchased on credit.
CA Financial Management 3
Which of the following best describes 'financial risk' in the context of a firm's capital structure?