FCCA Strategic Financial Management 1 — Questions and Answers
Question 1: Which capital budgeting technique calculates the discount rate at which the net present value of a project equals zero?
- Net Present Value (NPV)
- Internal Rate of Return (IRR) (Correct answer)
- Payback Period
- Accounting Rate of Return (ARR)
Correct answer: Internal Rate of Return (IRR)
The IRR is defined as the discount rate that makes the NPV of all cash flows from a project equal to zero.
Question 2: Under the Modigliani-Miller theorem (without taxes), what is the effect of changing a firm's capital structure on its overall value?
- It increases firm value by reducing the cost of equity
- It decreases firm value by increasing financial risk
- It has no effect on the overall firm value (Correct answer)
- It always maximizes value when debt is maximized
Correct answer: It has no effect on the overall firm value
Modigliani-Miller (without taxes) states that in perfect capital markets, firm value is independent of its capital structure.
Question 3: Which of the following best describes the Weighted Average Cost of Capital (WACC)?
- The cost of the most recently issued debt
- The average return required by all providers of finance, weighted by their proportion of total capital (Correct answer)
- The risk-free rate plus a market risk premium
- The cost of equity minus the tax shield on debt
Correct answer: The average return required by all providers of finance, weighted by their proportion of total capital
WACC blends the required returns of equity holders and debt holders, each weighted by their share of total capital, to reflect the firm's overall financing cost.
Question 4: In the Capital Asset Pricing Model (CAPM), what does a beta (β) greater than 1 indicate?
- The asset is less volatile than the market
- The asset moves independently of the market
- The asset is more volatile than the market (Correct answer)
- The asset has no systematic risk
Correct answer: The asset is more volatile than the market
A beta greater than 1 means the asset amplifies market movements, indicating higher systematic risk than the overall market.
Question 5: Which working capital strategy involves maintaining minimal inventory and tight credit policies to reduce current assets?
- Conservative working capital strategy
- Aggressive working capital strategy (Correct answer)
- Matching working capital strategy
- Hedging working capital strategy
Correct answer: Aggressive working capital strategy
An aggressive strategy minimizes current assets (low inventory, tight receivables) to reduce financing costs, accepting higher liquidity risk.
Question 6: A company has a current ratio of 1.8 and a quick ratio of 0.9. What does this most likely indicate?
- The company holds no short-term debt
- A significant portion of current assets is tied up in inventory (Correct answer)
- The company has excessive cash holdings
- The company's receivables are very high relative to payables
Correct answer: A significant portion of current assets is tied up in inventory
The large gap between the current ratio and quick ratio (which excludes inventory) indicates that inventory makes up a substantial part of current assets.
Question 7: Which dividend policy theory argues that investors are indifferent between dividends and capital gains because they can create 'homemade dividends'?
- Bird-in-the-hand theory
- Signalling theory
- Clientele effect theory
- Modigliani-Miller dividend irrelevance theory (Correct answer)
Correct answer: Modigliani-Miller dividend irrelevance theory
Modigliani and Miller argued that in perfect markets, dividend policy is irrelevant because shareholders can replicate any dividend stream by selling shares.
FCCA Strategic Financial Management 1
Which capital budgeting technique calculates the discount rate at which the net present value of a project equals zero?