CSM Financial Analysis & Decision Making 3 — Questions and Answers
Question 1: In a make-or-buy decision, which costs are most relevant to the analysis?
- Sunk costs and historical costs
- Incremental (differential) costs and opportunity costs (Correct answer)
- Fixed overhead already allocated
- Depreciation on existing equipment
Correct answer: Incremental (differential) costs and opportunity costs
Only incremental costs that differ between alternatives and opportunity costs of foregone options are relevant to make-or-buy decisions.
Question 2: A project has an IRR of 14% and the company's WACC is 11%. The strategic manager should:
- Reject the project because IRR exceeds WACC
- Accept the project because IRR exceeds WACC (Correct answer)
- Reject the project because WACC exceeds IRR
- Defer the decision until IRR equals WACC
Correct answer: Accept the project because IRR exceeds WACC
When IRR exceeds WACC (the hurdle rate), the project generates returns above its cost of capital and should be accepted.
Question 3: Which financial statement best reveals whether a profitable company is generating or consuming cash?
- Income Statement
- Balance Sheet
- Statement of Cash Flows (Correct answer)
- Statement of Retained Earnings
Correct answer: Statement of Cash Flows
A company can show accounting profit yet burn cash due to working capital changes; the cash flow statement reveals actual cash generation.
Question 4: Economic Value Added (EVA) is best defined as:
- Net income minus dividends paid to shareholders
- NOPAT minus the dollar cost of all capital employed (Correct answer)
- Revenue minus cost of goods sold
- EBITDA divided by total invested capital
Correct answer: NOPAT minus the dollar cost of all capital employed
EVA = NOPAT − (WACC × Invested Capital); it measures the economic profit after accounting for the full cost of capital.
Question 5: A company's operating leverage is high when:
- Variable costs represent the majority of total costs
- Fixed costs represent the majority of total costs (Correct answer)
- The debt-to-equity ratio is above 2.0
- Gross margin percentage is below 20%
Correct answer: Fixed costs represent the majority of total costs
High fixed costs relative to variable costs create high operating leverage, amplifying the impact of revenue changes on operating income.
Question 6: When performing a discounted cash flow valuation, the terminal value typically represents:
- The book value of assets at the end of the forecast period
- The majority of total enterprise value in most valuations (Correct answer)
- Only a minor component of total value
- The liquidation value of the company
Correct answer: The majority of total enterprise value in most valuations
Terminal value often represents 60–80% or more of total DCF value because it captures all cash flows beyond the explicit forecast period.
Question 7: A strategic manager notices that the company's gross margin has declined while net margin improved. The most likely explanation is:
- Revenue increased faster than cost of goods sold
- SG&A and other below-gross-profit costs declined significantly (Correct answer)
- The company raised prices without cost increases
- Depreciation expense increased substantially
Correct answer: SG&A and other below-gross-profit costs declined significantly
If gross margin fell but net margin rose, costs below the gross profit line (like SG&A or interest) must have dropped enough to offset the weaker gross margin.
CSM Financial Analysis & Decision Making 3
In a make-or-buy decision, which costs are most relevant to the analysis?