FIA Corporate Finance Fundamentals 5 — Questions and Answers
Question 1: Which of the following scenarios would most likely lead to financial distress?
- High operating cash flows with low debt levels
- Strong equity base with minimal leverage
- High fixed debt obligations with declining revenues (Correct answer)
- Rising gross margins with stable interest rates
Correct answer: High fixed debt obligations with declining revenues
Financial distress typically arises when a firm's cash flows are insufficient to meet its fixed debt obligations, especially if revenues decline.
Question 2: A project has an NPV of $0 when discounted at 12%. This means the project's IRR is:
- Less than 12%
- Greater than 12%
- Equal to 12% (Correct answer)
- Cannot be determined from this information
Correct answer: Equal to 12%
By definition, the IRR is the discount rate at which NPV equals zero, so if NPV = $0 at 12%, then IRR = 12%.
Question 3: In the context of capital budgeting, what does the profitability index (PI) measure?
- Ratio of total cash inflows to total cash outflows
- Present value of future cash flows per dollar of initial investment (Correct answer)
- Internal rate of return adjusted for project size
- Payback period expressed as a percentage of project life
Correct answer: Present value of future cash flows per dollar of initial investment
PI = PV of future cash flows ÷ Initial investment, indicating value created per dollar invested and useful for ranking projects under capital rationing.
Question 4: A rights offering allows existing shareholders to:
- Sell their shares at a premium before a merger
- Purchase additional shares at a discount before the public offering (Correct answer)
- Vote on executive compensation proposals
- Receive preferred dividends before common shareholders
Correct answer: Purchase additional shares at a discount before the public offering
A rights offering gives current shareholders the right to buy new shares at a below-market subscription price, helping them maintain their ownership percentage.
Question 5: Which of the following best explains why the weighted average cost of capital (WACC) is used as the discount rate in DCF analysis?
- It represents the risk-free return available in the market
- It reflects the blended required return of all capital providers (Correct answer)
- It equals the company's historical stock return
- It is always lower than the cost of equity
Correct answer: It reflects the blended required return of all capital providers
WACC weights the cost of each capital component (debt and equity) by its proportion in the firm's capital structure, representing the minimum return required by all investors.
Question 6: A company repurchases 5% of its outstanding shares. All else equal, this will most likely:
- Decrease earnings per share
- Increase the number of shares outstanding
- Increase earnings per share (Correct answer)
- Decrease return on equity
Correct answer: Increase earnings per share
A share repurchase reduces the share count; if net income is unchanged, EPS rises because the same earnings are spread over fewer shares.
Question 7: Which of the following is a characteristic of preferred stock that distinguishes it from common stock?
- Preferred stockholders have voting rights at annual meetings
- Preferred dividends must be paid before common dividends (Correct answer)
- Preferred stock always converts to common stock at maturity
- Preferred stockholders bear residual risk in liquidation
Correct answer: Preferred dividends must be paid before common dividends
Preferred stockholders have a senior claim on dividends and assets over common stockholders, though they typically lack voting rights.
FIA Corporate Finance Fundamentals 5
Which of the following scenarios would most likely lead to financial distress?