CPA CFE Finance 1 — Questions and Answers
Question 1: What does the weighted average cost of capital (WACC) represent for a company?
- The cost of the company's most expensive source of financing
- The blended cost of all sources of capital (debt and equity), weighted by their proportion in the company's target capital structure (Correct answer)
- The interest rate on the company's bank loans
- The required return on the company's common shares only
Correct answer: The blended cost of all sources of capital (debt and equity), weighted by their proportion in the company's target capital structure
WACC represents the minimum rate of return a company must earn on its existing assets to satisfy its creditors, owners, and other providers of capital. It is calculated by weighting the after-tax cost of each source of financing by its proportion in the capital structure.
Question 2: According to the Capital Asset Pricing Model (CAPM), what determines the expected return on a security?
- Only the risk-free rate
- The risk-free rate plus a premium for the security's systematic risk (beta multiplied by the market risk premium) (Correct answer)
- The security's total risk including both systematic and unsystematic components
- The company's dividend yield only
Correct answer: The risk-free rate plus a premium for the security's systematic risk (beta multiplied by the market risk premium)
CAPM states that E(R) = Rf + β(Rm - Rf), where the expected return equals the risk-free rate plus a risk premium. Beta measures the security's systematic (non-diversifiable) risk relative to the market. Unsystematic risk is not rewarded because it can be diversified away.
Question 3: What is the net present value (NPV) rule for capital budgeting decisions?
- Accept projects with NPV equal to zero
- Accept projects with a positive NPV, as they are expected to add value to the firm (Correct answer)
- Accept projects with the shortest payback period
- Accept all projects regardless of NPV
Correct answer: Accept projects with a positive NPV, as they are expected to add value to the firm
The NPV rule states that a project should be accepted if its NPV is positive, meaning the present value of expected future cash flows exceeds the initial investment. A positive NPV indicates the project earns more than the required rate of return and increases shareholder wealth.
Question 4: What is the relationship between bond prices and interest rates?
- Bond prices and interest rates move in the same direction
- Bond prices and interest rates have an inverse relationship: when interest rates rise, bond prices fall, and vice versa (Correct answer)
- Bond prices are not affected by interest rate changes
- Only zero-coupon bond prices are affected by interest rates
Correct answer: Bond prices and interest rates have an inverse relationship: when interest rates rise, bond prices fall, and vice versa
Bond prices and interest rates have an inverse relationship because when market interest rates rise, existing bonds with lower coupon rates become less attractive, so their prices fall to offer comparable yields. Conversely, when rates fall, existing bonds become more valuable.
Question 5: In working capital management, what is the cash conversion cycle?
- The total time from paying cash for raw materials to receiving cash from customers
- Days inventory outstanding plus days sales outstanding minus days payables outstanding (Correct answer)
- The number of days it takes to collect accounts receivable only
- The average payment period to suppliers
Correct answer: Days inventory outstanding plus days sales outstanding minus days payables outstanding
The cash conversion cycle (CCC) measures the time between cash outflow for materials and cash inflow from sales: CCC = DIO + DSO - DPO. A shorter cycle means the company converts its investments in inventory and other resources into cash flows from sales more quickly.
Question 6: What does the Modigliani-Miller theorem (without taxes) state about capital structure?
- Debt always reduces the value of a firm
- In a perfect market, the value of a firm is independent of its capital structure (Correct answer)
- Companies should use 100% equity financing
- Capital structure is the most important determinant of firm value
Correct answer: In a perfect market, the value of a firm is independent of its capital structure
The M&M theorem (Proposition I, no taxes) states that in a perfect capital market (no taxes, no bankruptcy costs, no agency costs, symmetric information), the value of a firm is unaffected by how it is financed. The overall cost of capital remains constant regardless of the debt-equity mix.
CPA CFE Finance 1
What does the weighted average cost of capital (WACC) represent for a company?