CPA CFE Finance 2 ā Questions and Answers
Question 1: What is the primary purpose of financial leverage?
- To reduce the company's total debt
- To amplify returns to equity holders by using debt financing, which increases both the potential upside and downside (Correct answer)
- To eliminate all financial risk
- To avoid paying interest on borrowed funds
Correct answer: To amplify returns to equity holders by using debt financing, which increases both the potential upside and downside
Financial leverage uses debt to magnify returns to equity holders. When the return on assets exceeds the cost of debt, leverage increases ROE. However, it also amplifies losses when returns fall below the cost of debt, increasing the financial risk borne by equity holders.
Question 2: What is the internal rate of return (IRR) of a project?
- The project's profit margin
- The discount rate that makes the net present value of the project's cash flows equal to zero (Correct answer)
- The project's accounting rate of return
- The cost of capital used to evaluate the project
Correct answer: The discount rate that makes the net present value of the project's cash flows equal to zero
The IRR is the discount rate at which the present value of a project's expected cash inflows equals the present value of its cash outflows (NPV = 0). A project is acceptable if its IRR exceeds the required rate of return (hurdle rate or cost of capital).
Question 3: In portfolio theory, what does diversification achieve?
- It eliminates all investment risk
- It reduces unsystematic (company-specific) risk but cannot eliminate systematic (market) risk (Correct answer)
- It increases the expected return without changing risk
- It guarantees a minimum return on the portfolio
Correct answer: It reduces unsystematic (company-specific) risk but cannot eliminate systematic (market) risk
Diversification reduces unsystematic risk (specific to individual companies) by combining assets whose returns are not perfectly correlated. However, systematic risk (market-wide factors like interest rates, recessions) cannot be diversified away and remains in any portfolio.
Question 4: What is the dividend discount model (DDM) used for?
- Calculating the tax on dividend income
- Estimating the intrinsic value of a stock based on the present value of expected future dividends (Correct answer)
- Determining the company's dividend payout ratio
- Setting the company's dividend policy
Correct answer: Estimating the intrinsic value of a stock based on the present value of expected future dividends
The DDM values a stock as the present value of all expected future dividends. The constant growth version (Gordon Growth Model) is: P = Dā/(r-g), where Dā is the expected dividend, r is the required return, and g is the constant growth rate in dividends.
Question 5: Under the pecking order theory of capital structure, what is the preferred order of financing?
- External equity first, then debt, then internal funds
- Internal funds (retained earnings) first, then debt, then external equity as a last resort (Correct answer)
- Debt first, then internal funds, then equity
- All sources of financing are equally preferred
Correct answer: Internal funds (retained earnings) first, then debt, then external equity as a last resort
The pecking order theory suggests that firms prefer internal financing first (least information asymmetry), then debt (moderate information asymmetry), and finally external equity (greatest information asymmetry and adverse selection). This minimizes the costs associated with information asymmetry.
Question 6: What is the payback period method of capital budgeting, and what is its main limitation?
- It calculates NPV; its limitation is complexity
- It measures the time to recover the initial investment; its main limitation is that it ignores the time value of money and cash flows after the payback period (Correct answer)
- It measures the accounting rate of return; it has no limitations
- It calculates IRR; its limitation is multiple solutions
Correct answer: It measures the time to recover the initial investment; its main limitation is that it ignores the time value of money and cash flows after the payback period
The payback period measures how long it takes for a project's cash inflows to recover the initial investment. While simple and intuitive, it ignores the time value of money, ignores cash flows occurring after the payback period, and uses an arbitrary cutoff rather than a value-based criterion.
CPA CFE Finance 2
What is the primary purpose of financial leverage?