CPA CFE Finance 3 — Questions and Answers
Question 1: What is the efficient market hypothesis (EMH) and what are its forms?
- The theory that all markets operate without transaction costs
- The hypothesis that security prices fully reflect available information; weak form (past prices), semi-strong form (all public information), strong form (all information including private) (Correct answer)
- The theory that only large companies have efficient markets
- The hypothesis that markets always overvalue securities
Correct answer: The hypothesis that security prices fully reflect available information; weak form (past prices), semi-strong form (all public information), strong form (all information including private)
EMH states that security prices reflect available information. Weak form: prices reflect past trading data. Semi-strong form: prices reflect all publicly available information. Strong form: prices reflect all information, including private/insider information. Each form has implications for whether investors can earn abnormal returns.
Question 2: What is the purpose of a sensitivity analysis in capital budgeting?
- To determine the exact NPV of a project
- To examine how changes in individual input variables (revenue, costs, discount rate) affect the project's NPV or IRR, identifying which variables have the greatest impact (Correct answer)
- To calculate the project's payback period
- To ensure the project's IRR exceeds the WACC
Correct answer: To examine how changes in individual input variables (revenue, costs, discount rate) affect the project's NPV or IRR, identifying which variables have the greatest impact
Sensitivity analysis tests how the project's outcome (NPV or IRR) changes when one input variable is varied while others are held constant. This identifies the key value drivers and the variables that create the most risk, helping management focus attention and risk mitigation efforts.
Question 3: What is the difference between systematic risk and unsystematic risk?
- Systematic risk can be diversified away; unsystematic cannot
- Systematic risk affects the entire market and cannot be diversified away; unsystematic risk is specific to an individual company and can be eliminated through diversification (Correct answer)
- Both types of risk can be completely eliminated
- Unsystematic risk affects the entire market
Correct answer: Systematic risk affects the entire market and cannot be diversified away; unsystematic risk is specific to an individual company and can be eliminated through diversification
Systematic risk (market risk) arises from factors affecting the entire economy (interest rates, inflation, recessions) and cannot be diversified away. Unsystematic risk (specific risk) is unique to a particular company or industry and can be eliminated by holding a diversified portfolio.
Question 4: In option pricing, what factors affect the value of a call option?
- Only the current stock price
- Stock price, exercise price, time to expiration, volatility, risk-free rate, and dividends (Correct answer)
- Only the exercise price and expiration date
- Only the volatility of the underlying stock
Correct answer: Stock price, exercise price, time to expiration, volatility, risk-free rate, and dividends
Call option value increases with higher stock price, lower exercise price, longer time to expiration, higher volatility, higher risk-free rate, and lower expected dividends. These six factors are the inputs to option pricing models like Black-Scholes.
Question 5: What is the purpose of the DuPont analysis?
- To calculate the company's share price
- To decompose return on equity (ROE) into its component parts — profit margin, asset turnover, and equity multiplier — to identify drivers of performance (Correct answer)
- To determine the optimal capital budget
- To evaluate bond credit ratings
Correct answer: To decompose return on equity (ROE) into its component parts — profit margin, asset turnover, and equity multiplier — to identify drivers of performance
DuPont analysis breaks ROE into three components: net profit margin (profitability), total asset turnover (efficiency), and equity multiplier (leverage). This decomposition reveals whether ROE is driven by operational efficiency, effective asset use, or financial leverage.
Question 6: What is the trade-off theory of capital structure?
- Companies should use no debt at all
- Companies balance the tax benefits of debt against the costs of financial distress to find an optimal capital structure (Correct answer)
- Companies should use 100% debt financing
- Capital structure has no effect on firm value
Correct answer: Companies balance the tax benefits of debt against the costs of financial distress to find an optimal capital structure
The trade-off theory suggests that firms choose their capital structure by balancing the tax shield benefit of debt (interest is tax-deductible) against the increasing costs of financial distress (bankruptcy costs, agency costs) as leverage increases. The optimal structure maximizes firm value.
CPA CFE Finance 3
What is the efficient market hypothesis (EMH) and what are its forms?