CAT Corporate Finance & Investment 2 — Questions and Answers
Question 1: A company has an after-tax cost of debt of 4%, a cost of equity of 10%, and a debt-to-equity ratio of 1:1. What is the WACC?
- 5%
- 6%
- 7% (Correct answer)
- 8%
Correct answer: 7%
With equal proportions (50% each), WACC = 0.5×4% + 0.5×10% = 7%.
Question 2: Which of the following best describes the 'pecking order theory' of capital structure?
- Firms prefer debt over equity at all times
- Firms prefer internal financing first, then debt, then equity as a last resort (Correct answer)
- Firms target a fixed debt-to-equity ratio
- Firms issue equity before taking on any debt
Correct answer: Firms prefer internal financing first, then debt, then equity as a last resort
The pecking order theory states firms favor retained earnings, then debt, and issue new equity only as a last resort due to information asymmetry costs.
Question 3: A bond with a face value of $1,000, a coupon rate of 6%, and 5 years to maturity is trading at $950. Is the yield to maturity (YTM) higher or lower than 6%?
- Lower than 6%
- Equal to 6%
- Higher than 6% (Correct answer)
- Cannot be determined without market rate
Correct answer: Higher than 6%
When a bond trades below par (at a discount), the YTM is higher than the coupon rate.
Question 4: Which investment appraisal technique explicitly accounts for the time value of money by discounting future cash flows?
- Accounting Rate of Return (ARR)
- Payback Period
- Net Present Value (NPV) (Correct answer)
- Return on Capital Employed (ROCE)
Correct answer: Net Present Value (NPV)
NPV discounts all future cash flows back to their present value using the cost of capital.
Question 5: A project has an NPV of $0 at a discount rate of 12%. What does this imply?
- The project makes no profit
- The project's IRR equals 12% (Correct answer)
- The project should be rejected
- The project returns less than the cost of capital
Correct answer: The project's IRR equals 12%
The IRR is the discount rate at which NPV equals zero, so IRR = 12% in this case.
Question 6: Under the dividend growth model (Gordon Growth Model), if a share pays a dividend of $2, the required return is 8%, and dividends grow at 4%, what is the share's intrinsic value?
- $25
- $50 (Correct answer)
- $40
- $33
Correct answer: $50
Value = D1 / (r − g) = $2 / (0.08 − 0.04) = $2 / 0.04 = $50.
Question 7: Which of the following is a NON-CASH item that reduces taxable profit but does not affect operating cash flow directly?
- Interest payments
- Depreciation (Correct answer)
- Dividends paid
- Tax paid
Correct answer: Depreciation
Depreciation reduces accounting profit but is added back in cash flow statements as it involves no cash outflow.
CAT Corporate Finance & Investment 2
A company has an after-tax cost of debt of 4%, a cost of equity of 10%, and a debt-to-equity ratio of 1:1.
What is the WACC?