CIC Economic & Financial Analysis 4 — Questions and Answers
Question 1: Which of the following is an example of automatic fiscal stabilizers?
- A government stimulus package passed during a recession
- Progressive income taxes and unemployment insurance payments (Correct answer)
- Central bank asset purchase programs (QE)
- Infrastructure spending bills approved by Congress
Correct answer: Progressive income taxes and unemployment insurance payments
Automatic stabilizers like progressive taxes (which fall automatically in recessions) and unemployment benefits expand/contract without legislative action to smooth the business cycle.
Question 2: When a central bank engages in quantitative easing (QE), it primarily:
- Raises reserve requirements for commercial banks
- Purchases securities to inject liquidity and lower long-term interest rates (Correct answer)
- Issues new government bonds to finance budget deficits
- Sets a ceiling on short-term interbank lending rates
Correct answer: Purchases securities to inject liquidity and lower long-term interest rates
QE involves the central bank buying longer-term securities (typically government bonds and MBS) to increase money supply and push down long-term yields.
Question 3: A company reports operating cash flow of $80M, capital expenditures of $25M, and dividends paid of $10M. What is its Free Cash Flow to Equity (FCFE) if net borrowing was $5M?
- $55M
- $50M (Correct answer)
- $45M
- $60M
Correct answer: $50M
FCFE = Operating Cash Flow − CapEx + Net Borrowing = $80M − $25M + $5M = $60M; subtracting dividends is not part of the FCFE formula, so FCFE = $60M. However FCFE = CFO - CapEx + net borrowing = $80 - $25 + $5 = $60M.
Question 4: The concept of 'mean reversion' in financial analysis suggests that:
- Asset prices trend indefinitely in the same direction once momentum is established
- Variables like profit margins and P/E ratios tend to return to long-run averages over time (Correct answer)
- Interest rates converge to zero in the long run
- Diversification eliminates all portfolio risk over long horizons
Correct answer: Variables like profit margins and P/E ratios tend to return to long-run averages over time
Mean reversion implies that extreme values in metrics like profit margins, valuation multiples, or returns tend to drift back toward their long-term historical averages.
Question 5: A firm's operating leverage is HIGH when:
- Variable costs represent a large proportion of total costs
- Fixed costs represent a large proportion of total costs (Correct answer)
- The firm uses significant financial (debt) leverage
- The firm's earnings are highly correlated with interest rates
Correct answer: Fixed costs represent a large proportion of total costs
High operating leverage means a large share of costs are fixed, so a small change in revenue produces a magnified change in operating income (EBIT).
Question 6: Which economic theory argues that markets are efficient and that fiscal stimulus is ineffective because consumers anticipate future tax increases?
- Keynesian economics
- Ricardian equivalence (Correct answer)
- Monetarism
- Supply-side economics
Correct answer: Ricardian equivalence
Ricardian equivalence holds that rational consumers save stimulus payments to pay future taxes needed to service government debt, neutralizing fiscal multiplier effects.
Question 7: The Gordon Growth Model (Dividend Discount Model) values a stock as:
- Next year's dividend divided by (required return minus dividend growth rate) (Correct answer)
- Current dividend divided by required return
- Earnings per share divided by (required return minus growth rate)
- Book value per share multiplied by return on equity
Correct answer: Next year's dividend divided by (required return minus dividend growth rate)
The Gordon Growth Model: P = D₁ / (r − g), where D₁ is the next expected dividend, r is the required return, and g is the constant dividend growth rate.
CIC Economic & Financial Analysis 4
Which of the following is an example of automatic fiscal stabilizers?