FAC Corporate Finance & Investment 2 — Questions and Answers
Question 1: A firm has a debt-to-equity ratio of 1.5 and an equity beta of 1.8. Using the Hamada equation, what is the asset (unlevered) beta if the tax rate is 30%?
- 0.86 (Correct answer)
- 1.05
- 1.22
- 1.44
Correct answer: 0.86
Asset beta = Equity beta / [1 + (1 - tax rate) × D/E] = 1.8 / [1 + 0.70 × 1.5] = 1.8 / 2.05 ≈ 0.88, closest to 0.86.
Question 2: Which of the following best describes the concept of economic value added (EVA)?
- Net income minus preferred dividends
- NOPAT minus the dollar cost of all capital employed (Correct answer)
- EBITDA minus capital expenditures
- Operating cash flow divided by total assets
Correct answer: NOPAT minus the dollar cost of all capital employed
EVA = NOPAT − (WACC × Invested Capital), measuring whether a firm earns above its cost of capital.
Question 3: A company is evaluating a project with an initial outlay of $500,000 and uneven cash flows. The IRR is 14% while WACC is 12%. The modified IRR (MIRR) is 11%. Which decision rule should be followed?
- Accept because IRR > WACC
- Reject because MIRR < WACC (Correct answer)
- Accept because MIRR > 0
- Reject because IRR > MIRR
Correct answer: Reject because MIRR < WACC
MIRR is the more reliable measure; since MIRR (11%) < WACC (12%), the project destroys value and should be rejected.
Question 4: Under the pecking order theory of capital structure, firms prefer financing in which sequence?
- Equity → Debt → Internal funds
- Internal funds → Debt → Equity (Correct answer)
- Debt → Equity → Internal funds
- Equity → Internal funds → Debt
Correct answer: Internal funds → Debt → Equity
Pecking order theory holds that firms use retained earnings first, then debt, and issue equity only as a last resort to minimize adverse selection costs.
Question 5: A callable bond is trading at a premium. How does the call feature most likely affect the bond's duration compared to an otherwise identical non-callable bond?
- Duration is longer because cash flows extend if called
- Duration is shorter because the call caps price appreciation and shortens expected maturity (Correct answer)
- Duration is the same since coupons are unchanged
- Duration is longer because investors demand higher yields
Correct answer: Duration is shorter because the call caps price appreciation and shortens expected maturity
Callable bonds exhibit negative convexity at premium prices; the call option caps price gains and effectively shortens duration.
Question 6: Which capital budgeting technique is most appropriate when comparing two mutually exclusive projects with significantly different useful lives?
- Net present value (NPV)
- Payback period
- Equivalent annual annuity (EAA) (Correct answer)
- Internal rate of return (IRR)
Correct answer: Equivalent annual annuity (EAA)
EAA converts each project's NPV into an annual equivalent, enabling a fair comparison across projects with unequal lives.
Question 7: A firm repurchases 10% of its shares outstanding. Assuming EPS increases proportionally and P/E remains constant, what is the most likely effect on share price?
- Share price decreases by 10%
- Share price increases by approximately 11% (Correct answer)
- Share price is unchanged because total earnings are the same
- Share price falls because cash is reduced
Correct answer: Share price increases by approximately 11%
With 10% fewer shares, EPS rises by 1/0.90 − 1 ≈ 11.1%; at a constant P/E, price rises by the same proportion.
FAC Corporate Finance & Investment 2
A firm has a debt-to-equity ratio of 1.5 and an equity beta of 1.8.
Using the Hamada equation, what is the asset (unlevered) beta if the tax rate is 30%?