CFA Corporate Finance & Governance 2 — Questions and Answers
Question 1: A company's WACC is 10% and it is evaluating a project with an IRR of 12%. According to the NPV rule, the firm should:
- Reject the project because IRR exceeds WACC
- Accept the project because IRR exceeds WACC (Correct answer)
- Reject the project because NPV will be negative
- Accept the project only if the payback period is under 3 years
Correct answer: Accept the project because IRR exceeds WACC
When a project's IRR exceeds the WACC (cost of capital), the project has a positive NPV and should be accepted.
Question 2: Which of the following best describes the agency problem in corporate governance?
- Conflicts between creditors and the government
- Conflicts between managers and shareholders due to misaligned interests (Correct answer)
- Disputes between domestic and foreign shareholders
- Disagreements between auditors and management over accounting standards
Correct answer: Conflicts between managers and shareholders due to misaligned interests
The agency problem arises when managers (agents) act in their own self-interest rather than in the best interest of shareholders (principals).
Question 3: A firm has net income of $500,000, depreciation of $100,000, and a decrease in net working capital of $50,000. What is the firm's approximate operating cash flow?
- $350,000
- $500,000
- $550,000
- $650,000 (Correct answer)
Correct answer: $650,000
Operating cash flow = Net income + Depreciation + Decrease in NWC = $500,000 + $100,000 + $50,000 = $650,000.
Question 4: Which capital structure theory suggests that firms have an optimal debt ratio that balances tax benefits of debt against financial distress costs?
- Modigliani-Miller Theorem (with no taxes)
- Pecking Order Theory
- Market Timing Theory
- Static Trade-Off Theory (Correct answer)
Correct answer: Static Trade-Off Theory
The Static Trade-Off Theory holds that the optimal capital structure balances the tax shield benefit of debt against the costs of financial distress.
Question 5: Which of the following is a primary duty of the board of directors?
- Executing day-to-day operational decisions
- Setting product pricing strategies
- Overseeing management and protecting shareholder interests (Correct answer)
- Preparing financial statements for external auditors
Correct answer: Overseeing management and protecting shareholder interests
The board of directors is responsible for overseeing management and acting as a fiduciary to protect the interests of shareholders.
Question 6: A project requires an initial investment of $1,000,000 and generates annual after-tax cash flows of $250,000 for 6 years. The payback period is:
- 2.5 years
- 3.0 years
- 4.0 years (Correct answer)
- 6.0 years
Correct answer: 4.0 years
Payback period = Initial investment / Annual cash flow = $1,000,000 / $250,000 = 4 years.
Question 7: Under the Modigliani-Miller proposition with corporate taxes, the value of a levered firm equals:
- The value of an unlevered firm minus the present value of the tax shield
- The value of an unlevered firm plus the present value of the tax shield (Correct answer)
- The value of an unlevered firm regardless of leverage
- The market value of equity minus total debt
Correct answer: The value of an unlevered firm plus the present value of the tax shield
With corporate taxes, MM shows that the value of a levered firm = unlevered firm value + PV of tax shield, since interest is tax-deductible.
CFA Corporate Finance & Governance 2
A company's WACC is 10% and it is evaluating a project with an IRR of 12%.
According to the NPV rule, the firm should: