CIC Economic & Financial Analysis 3 — Questions and Answers
Question 1: The monetary transmission mechanism describes how:
- Fiscal policy changes affect the money supply
- Central bank policy rate changes propagate through the economy to affect output and inflation (Correct answer)
- Banks transmit customer deposits into loans
- Currency exchange rates are set by central banks
Correct answer: Central bank policy rate changes propagate through the economy to affect output and inflation
The monetary transmission mechanism refers to the channels through which changes in the central bank's policy rate affect spending, investment, and ultimately inflation and output.
Question 2: A company's EBITDA margin is 20% and its revenue is $500 million. Its capital expenditures are $30 million and depreciation is $20 million. What is its approximate Free Cash Flow to the Firm (FCFF) before working capital changes?
- $100 million
- $70 million
- $90 million (Correct answer)
- $50 million
Correct answer: $90 million
EBITDA = $100M; EBIT = $80M; after-tax (assume 0 for simplicity here the question asks approximate FCFF as EBITDA - CapEx = $100M - $30M = $70M, but FCFF = EBIT(1-t) + D&A - CapEx; since no tax given, approximate = $80M + $20M - $30M = $70M... The closest match to EBITDA - CapEx + D&A approach: $100M - $30M = $70M.
Question 3: Purchasing Power Parity (PPP) theory suggests that in the long run:
- Interest rate differentials determine exchange rates
- Exchange rates adjust so that identical goods cost the same across countries (Correct answer)
- Countries with higher growth rates attract more foreign capital
- Central banks can permanently maintain fixed exchange rates
Correct answer: Exchange rates adjust so that identical goods cost the same across countries
PPP holds that exchange rates should adjust to equalize the price of identical goods across countries, eliminating arbitrage opportunities.
Question 4: Which of the following best describes the concept of 'crowding out' in economics?
- Private investment declines because government borrowing raises interest rates (Correct answer)
- Central bank open market purchases reduce bank reserves
- Import growth displaces domestic manufacturing employment
- Inflation erodes the real value of fixed-income returns
Correct answer: Private investment declines because government borrowing raises interest rates
Crowding out occurs when increased government borrowing raises interest rates, reducing the funds available for and the attractiveness of private investment.
Question 5: An analyst notices a stock's P/E ratio is significantly below its 5-year historical average and below industry peers. Which consideration is MOST important before concluding the stock is undervalued?
- The stock's recent price momentum
- Whether earnings quality and business fundamentals justify a higher multiple (Correct answer)
- The company's dividend payout history
- The stock's beta relative to the market
Correct answer: Whether earnings quality and business fundamentals justify a higher multiple
A low P/E could reflect a 'value trap' if earnings are deteriorating or of poor quality; fundamental analysis must support the case for multiple expansion.
Question 6: The Fisher Effect states that the nominal interest rate equals:
- The real interest rate minus expected inflation
- The real interest rate plus expected inflation (Correct answer)
- The real interest rate divided by expected inflation
- The risk-free rate plus the default risk premium
Correct answer: The real interest rate plus expected inflation
The Fisher Effect: nominal rate ≈ real interest rate + expected inflation, meaning lenders demand compensation for expected loss of purchasing power.
Question 7: In fundamental equity analysis, which measure is LEAST affected by a company's choice of capital structure?
- Earnings per share (EPS)
- Return on equity (ROE)
- Return on invested capital (ROIC) (Correct answer)
- Net profit margin
Correct answer: Return on invested capital (ROIC)
ROIC measures returns relative to total invested capital (debt + equity), making it independent of whether a company finances with debt or equity.
CIC Economic & Financial Analysis 3
The monetary transmission mechanism describes how: