CAT Corporate Finance & Investment 3 — Questions and Answers
Question 1: A company is evaluating two mutually exclusive projects with the same initial investment but different lifespans. Which method is most appropriate to compare them?
- Compare their NPVs directly
- Use the Equivalent Annual Annuity (EAA) method (Correct answer)
- Choose the project with the higher IRR
- Choose the project with the shorter payback period
Correct answer: Use the Equivalent Annual Annuity (EAA) method
The Equivalent Annual Annuity (EAA) converts NPVs into comparable annual cash flows, making projects with different lives directly comparable.
Question 2: What does a high 'interest coverage ratio' indicate about a company?
- The company has high financial leverage
- The company can comfortably meet its interest obligations from operating profit (Correct answer)
- The company's interest payments exceed its earnings
- The company relies heavily on debt financing
Correct answer: The company can comfortably meet its interest obligations from operating profit
A high interest coverage ratio (EBIT / Interest) means the company generates sufficient operating profit to cover interest payments multiple times.
Question 3: In the context of capital investment appraisal, what is 'sensitivity analysis' used for?
- To calculate the exact NPV of a project
- To assess how changes in key variables affect the project's NPV or IRR (Correct answer)
- To determine the optimal capital structure
- To measure the payback period under best-case assumptions
Correct answer: To assess how changes in key variables affect the project's NPV or IRR
Sensitivity analysis tests how sensitive the NPV is to changes in individual variables such as sales volume, price, or cost, one at a time.
Question 4: Which of the following represents systematic (market) risk?
- A factory fire destroying production capacity
- A key executive unexpectedly resigning
- An economic recession reducing demand across all industries (Correct answer)
- A product recall affecting one company
Correct answer: An economic recession reducing demand across all industries
Systematic risk affects the entire market and cannot be eliminated through diversification; a recession is a classic example.
Question 5: A rights issue is offered at a 20% discount to the current market price of $10. What is the theoretical ex-rights price if the ratio is 1 new share for every 4 existing shares?
- $8.00
- $8.40
- $9.60 (Correct answer)
- $9.20
Correct answer: $9.60
Rights price = $10 × 0.80 = $8. TERP = [(4 × $10) + (1 × $8)] / 5 = $48 / 5 = $9.60.
Question 6: What is the primary purpose of a company's 'dividend policy'?
- To minimize the tax paid on profits
- To determine how much profit is retained versus distributed to shareholders (Correct answer)
- To ensure the share price always increases
- To reduce the company's debt obligations
Correct answer: To determine how much profit is retained versus distributed to shareholders
Dividend policy governs the proportion of earnings paid out as dividends versus retained for reinvestment in the business.
Question 7: According to Modigliani and Miller's (MM) theory with no taxes, what happens to a firm's value when it increases financial leverage?
- Firm value increases due to cheaper debt
- Firm value decreases due to higher risk
- Firm value is unchanged (Correct answer)
- Firm value depends entirely on dividend policy
Correct answer: Firm value is unchanged
MM's theory without taxes states that capital structure is irrelevant — firm value depends on operating cash flows, not how it is financed.
CAT Corporate Finance & Investment 3
A company is evaluating two mutually exclusive projects with the same initial investment but different lifespans.
Which method is most appropriate to compare them?