Certified Management Accountant Corporate Finance 1 — Questions and Answers
Question 1: According to the Modigliani-Miller theorem with corporate taxes, firm value increases with debt because:
- Debt reduces agency costs between managers and shareholders
- Interest payments are tax-deductible, creating a valuable tax shield (Correct answer)
- Debt holders have legal priority over equity holders in liquidation
- Debt reduces the required return on equity
Correct answer: Interest payments are tax-deductible, creating a valuable tax shield
The interest tax shield reduces the firm's tax liability, and this tax benefit increases firm value as more debt is used.
Question 2: The optimal capital structure for a firm minimizes:
- Total assets on the balance sheet
- Weighted average cost of capital (WACC) (Correct answer)
- Earnings per share volatility
- Book value of equity
Correct answer: Weighted average cost of capital (WACC)
The optimal capital structure is the specific debt-equity mix that minimizes WACC, thereby maximizing the present value of the firm.
Question 3: Financial leverage amplifies:
- Only positive returns to equity holders when performance is good
- Only negative returns to equity holders when performance is poor
- Both positive and negative returns to equity holders (Correct answer)
- The tax benefits of debt financing regardless of performance
Correct answer: Both positive and negative returns to equity holders
Financial leverage magnifies both gains and losses for equity holders because fixed interest obligations remain regardless of operating performance levels.
Question 4: Which capital structure theory suggests firms prefer internal financing first, then debt, and equity only as a last resort?
- Trade-off theory
- Agency theory
- Pecking order theory (Correct answer)
- Market timing theory
Correct answer: Pecking order theory
The pecking order theory (Myers and Majluf) argues firms rank financing sources to minimize information asymmetry costs, preferring retained earnings, then debt, then new equity.
Question 5: The degree of financial leverage (DFL) measures:
- The ratio of total debt to total equity
- The sensitivity of earnings per share (EPS) to a change in EBIT (Correct answer)
- The absolute dollar cost of debt financing
- The percentage of total assets financed by debt
Correct answer: The sensitivity of earnings per share (EPS) to a change in EBIT
DFL measures how a given percentage change in EBIT translates into a percentage change in EPS, reflecting the impact of fixed financial charges on equity earnings.
Question 6: A firm's debt-to-equity ratio increases from 0.5 to 1.0. All else equal, this change will most likely:
- Decrease the firm's financial risk
- Increase the firm's financial risk (Correct answer)
- Have no effect on the firm's cost of equity
- Reduce the firm's annual tax liability
Correct answer: Increase the firm's financial risk
A higher debt-to-equity ratio increases financial risk because greater fixed interest obligations raise the probability of financial distress.
Certified Management Accountant Corporate Finance 1
According to the Modigliani-Miller theorem with corporate taxes, firm value increases with debt because: