Certified Management Accountant Corporate Finance 2 — Questions and Answers
Question 1: The weighted average cost of capital (WACC) is primarily used to:
- Calculate reported accounting profit for financial statements
- Measure the cost of individual financing components in isolation
- Discount project cash flows to determine whether they create shareholder value (Correct answer)
- Assess a firm's short-term liquidity position
Correct answer: Discount project cash flows to determine whether they create shareholder value
WACC represents the blended cost of all financing sources and serves as the discount rate (hurdle rate) for evaluating capital investment projects.
Question 2: The cost of retained earnings is best estimated using:
- The coupon rate on the firm's existing bonds
- The Capital Asset Pricing Model (CAPM) using the stock's beta (Correct answer)
- The dividend yield on the firm's preferred stock
- The firm's current short-term borrowing rate
Correct answer: The Capital Asset Pricing Model (CAPM) using the stock's beta
The CAPM estimates the required return on equity as the risk-free rate plus beta multiplied by the market risk premium, representing the opportunity cost of retained earnings.
Question 3: Why is the cost of debt adjusted for taxes when calculating WACC?
- Debt is inherently riskier than equity financing
- Interest expense is tax-deductible, reducing the net cost to the firm (Correct answer)
- Debt holders have legal priority over equity holders
- Debt must be repaid before equity dividends can be declared
Correct answer: Interest expense is tax-deductible, reducing the net cost to the firm
Because interest payments are tax-deductible, the after-tax cost of debt equals the pre-tax rate multiplied by (1 minus the tax rate).
Question 4: A firm has 40% debt at a 6% pre-tax cost (tax rate 25%) and 60% equity at a 12% cost. What is the WACC?
- 8.4%
- 9.0% (Correct answer)
- 9.6%
- 10.2%
Correct answer: 9.0%
WACC = (0.40 × 6% × 0.75) + (0.60 × 12%) = 1.8% + 7.2% = 9.0%.
Question 5: In the CAPM, beta represents:
- The total risk (systematic + unsystematic) of a stock
- The stock's systematic risk relative to the overall market (Correct answer)
- The firm-specific unsystematic risk that can be diversified away
- The annual dividend yield of the stock
Correct answer: The stock's systematic risk relative to the overall market
Beta measures a stock's sensitivity to broad market movements, capturing only the non-diversifiable systematic risk priced by the market.
Question 6: The marginal cost of capital (MCC) increases as a firm raises progressively more capital because:
- Fixed costs decline as financing scale increases
- Lower-cost financing sources are exhausted first, forcing the firm to use more expensive capital (Correct answer)
- Tax rates automatically rise as profitability increases
- Investors demand lower returns for larger, more stable firms
Correct answer: Lower-cost financing sources are exhausted first, forcing the firm to use more expensive capital
A firm accesses its cheapest financing first; as total capital raised grows, it must tap progressively more expensive sources, raising the marginal cost.
Certified Management Accountant Corporate Finance 2
The weighted average cost of capital (WACC) is primarily used to: