CFM CFM Corporate Finance & Valuation 1 — Questions and Answers
Question 1: The Weighted Average Cost of Capital (WACC) is used as the discount rate when:
- Evaluating the creditworthiness of suppliers
- Discounting a firm's expected free cash flows to determine enterprise value (Correct answer)
- Setting credit terms for customers
- Calculating accounts payable turnover
Correct answer: Discounting a firm's expected free cash flows to determine enterprise value
WACC represents the blended cost of all capital sources and is used as the discount rate in discounted cash flow (DCF) analysis to determine enterprise value.
Question 2: Which capital budgeting method calculates the discount rate at which NPV equals zero?
- Net Present Value (NPV)
- Internal Rate of Return (IRR) (Correct answer)
- Payback Period
- Profitability Index
Correct answer: Internal Rate of Return (IRR)
IRR is the discount rate that makes the NPV of a project's cash flows equal to zero; if IRR exceeds the cost of capital, the project adds value.
Question 3: What does the Modigliani-Miller theorem suggest about capital structure in a world without taxes?
- Firms should maximize debt to minimize cost of capital
- Capital structure is irrelevant and does not affect firm value (Correct answer)
- Equity financing is always cheaper than debt financing
- Optimal leverage ratio is 50% debt and 50% equity
Correct answer: Capital structure is irrelevant and does not affect firm value
M&M Proposition I states that in perfect markets without taxes, firm value is unaffected by capital structure because investors can replicate any leverage ratio themselves.
Question 4: Enterprise Value (EV) is calculated as:
- Market capitalization + Cash - Debt
- Market capitalization + Debt - Cash (Correct answer)
- Net income × P/E ratio
- Total assets - Total liabilities
Correct answer: Market capitalization + Debt - Cash
EV = Market Cap + Total Debt - Cash and equivalents, representing the total cost to acquire a business including assumption of debt net of available cash.
Question 5: What is the primary advantage of using the Payback Period method for capital budgeting?
- It accounts for the time value of money
- It is simple, easy to calculate, and emphasizes liquidity and speed of recovery (Correct answer)
- It considers all cash flows over the asset's full life
- It maximizes shareholder wealth by focusing on NPV
Correct answer: It is simple, easy to calculate, and emphasizes liquidity and speed of recovery
The payback period is straightforward to calculate and highlights how quickly an investment recovers its cost, making it useful for liquidity-constrained firms.
Question 6: Which valuation multiple compares enterprise value to a company's operating earnings before non-cash charges?
- P/E ratio
- EV/EBITDA (Correct answer)
- Price/Book
- EV/Revenue
Correct answer: EV/EBITDA
EV/EBITDA compares total enterprise value to EBITDA, making it useful for comparing companies with different capital structures and depreciation policies.
CFM CFM Corporate Finance & Valuation 1
The Weighted Average Cost of Capital (WACC) is used as the discount rate when: