CCA CCA Corporate Finance & Capital Structure 2 — Questions and Answers
Question 1: What is the difference between systematic risk and unsystematic risk?
- Systematic risk can be diversified away; unsystematic risk cannot
- Unsystematic risk affects the entire market; systematic risk affects individual firms
- Systematic risk affects the entire market and cannot be diversified away; unsystematic risk is firm-specific and can be diversified (Correct answer)
- Both types can be eliminated through portfolio diversification
Correct answer: Systematic risk affects the entire market and cannot be diversified away; unsystematic risk is firm-specific and can be diversified
Systematic (market) risk affects all securities and cannot be diversified away, while unsystematic (firm-specific) risk can be reduced by holding a diversified portfolio.
Question 2: Which metric measures the sensitivity of a stock's returns to movements in the overall market?
- Alpha
- Beta (Correct answer)
- Standard deviation
- Sharpe ratio
Correct answer: Beta
Beta measures how much a stock's returns move relative to the market; a beta of 1 means the stock moves in line with the market.
Question 3: A company repurchases its own shares. What is the most likely immediate effect on earnings per share (EPS)?
- EPS decreases because equity capital is reduced
- EPS increases because the same earnings are spread over fewer shares (Correct answer)
- EPS is unchanged because repurchases don't affect net income
- EPS decreases because cash dividends are eliminated
Correct answer: EPS increases because the same earnings are spread over fewer shares
Share repurchases reduce the number of shares outstanding, so the same net income is divided over fewer shares, increasing EPS.
Question 4: What is the primary purpose of a rights offering?
- To allow existing shareholders to purchase additional shares at a discount before new investors (Correct answer)
- To grant employees stock options at market price
- To buy back shares from institutional investors
- To convert debt into equity at the company's discretion
Correct answer: To allow existing shareholders to purchase additional shares at a discount before new investors
A rights offering gives existing shareholders the preemptive right to buy new shares at a discount, protecting them from dilution.
Question 5: Which of the following best describes a leveraged buyout (LBO)?
- An acquisition funded primarily with retained earnings of the acquiring firm
- A takeover financed mostly with debt, using the target's assets as collateral (Correct answer)
- A merger between two equal-sized companies using stock-for-stock exchange
- A minority stake purchase by a venture capital fund
Correct answer: A takeover financed mostly with debt, using the target's assets as collateral
In an LBO, a buyer (often private equity) acquires a company using substantial debt financing secured against the target's assets and cash flows.
Question 6: The Capital Asset Pricing Model (CAPM) estimates the required return on a stock as:
- Risk-free rate + Beta × (Market return – Risk-free rate) (Correct answer)
- Dividend yield + Capital gains yield
- Earnings per share ÷ Stock price
- Risk-free rate × Beta
Correct answer: Risk-free rate + Beta × (Market return – Risk-free rate)
CAPM states: Required return = Risk-free rate + Beta × Equity risk premium, where the equity risk premium is the market return minus the risk-free rate.
CCA CCA Corporate Finance & Capital Structure 2
What is the difference between systematic risk and unsystematic risk?