CFM Corporate Finance & Valuation 2 — Questions and Answers
Question 1: What is the net present value (NPV) decision rule for capital projects?
- Accept if NPV is greater than IRR
- Accept if NPV is positive; reject if NPV is negative (Correct answer)
- Accept if NPV equals WACC
- Accept if NPV is greater than payback period
Correct answer: Accept if NPV is positive; reject if NPV is negative
A positive NPV indicates a project creates value by generating returns exceeding the cost of capital, so it should be accepted.
Question 2: When comparing NPV and IRR, which method is theoretically superior for evaluating mutually exclusive projects?
- IRR, because it provides a percentage return
- NPV, because it measures absolute value creation in dollars (Correct answer)
- Payback period, because it measures liquidity risk
- Profitability index, because it accounts for project size
Correct answer: NPV, because it measures absolute value creation in dollars
NPV is theoretically superior for mutually exclusive projects because it directly measures dollar value added, while IRR can give misleading rankings when project scales differ.
Question 3: What is the Modigliani-Miller theorem (without taxes) about capital structure?
- Firms should maximize debt to increase returns to equity
- In perfect markets, a firm's value is independent of its capital structure (Correct answer)
- Equity is always cheaper than debt financing
- Optimal capital structure minimizes the cost of equity
Correct answer: In perfect markets, a firm's value is independent of its capital structure
M&M Proposition I (without taxes) states that in a perfect market, capital structure is irrelevant — firm value depends only on its operating cash flows.
Question 4: What is a leveraged buyout (LBO)?
- An acquisition financed primarily with equity from the acquirer
- A purchase of a company funded mostly with debt, using the target's assets as collateral (Correct answer)
- A stock buyback program financed by operating cash flow
- A cross-border acquisition involving currency hedging
Correct answer: A purchase of a company funded mostly with debt, using the target's assets as collateral
An LBO uses significant debt to fund the acquisition, with the acquired company's cash flows and assets servicing and securing the debt.
Question 5: What does 'dilution' mean in the context of an acquisition using stock as currency?
- The target company's earnings per share decrease post-merger
- The acquirer's earnings per share decrease after issuing new shares for the deal (Correct answer)
- The combined entity's revenues decline
- The acquirer's credit rating is downgraded
Correct answer: The acquirer's earnings per share decrease after issuing new shares for the deal
Dilution occurs when an acquirer issues new shares to fund an acquisition, increasing share count and potentially decreasing earnings per share for existing shareholders.
Question 6: Which approach to valuation uses financial metrics of comparable publicly traded companies to derive valuation multiples?
- DCF analysis
- Precedent transaction analysis
- Comparable company analysis (comps) (Correct answer)
- Asset replacement value method
Correct answer: Comparable company analysis (comps)
Comparable company analysis derives market-based valuation multiples (like P/E or EV/EBITDA) from similar public companies and applies them to the target.
CFM Corporate Finance & Valuation 2
What is the net present value (NPV) decision rule for capital projects?