IFA IFA Business Finance & Investment 2 — Questions and Answers
Question 1: What is the difference between systematic and unsystematic risk?
- Systematic risk is unique to a company; unsystematic risk affects all companies
- Systematic risk affects the entire market and cannot be diversified away; unsystematic risk is company-specific and can be diversified (Correct answer)
- Systematic risk is always higher than unsystematic risk
- There is no practical difference in portfolio management
Correct answer: Systematic risk affects the entire market and cannot be diversified away; unsystematic risk is company-specific and can be diversified
Systematic (market) risk cannot be eliminated through diversification as it affects all securities, while unsystematic (specific) risk can be reduced by holding a diversified portfolio.
Question 2: What does portfolio diversification achieve for an investor?
- Guarantees a minimum return
- Reduces unsystematic risk by combining assets whose returns are not perfectly correlated (Correct answer)
- Eliminates all investment risk
- Maximizes return by concentrating in the best-performing asset
Correct answer: Reduces unsystematic risk by combining assets whose returns are not perfectly correlated
Diversification reduces unsystematic risk because when some assets perform poorly, others may perform well, smoothing overall portfolio returns.
Question 3: What is a rights issue in corporate finance?
- The legal right of management to veto shareholder decisions
- An offer of new shares to existing shareholders in proportion to their current holdings (Correct answer)
- A share buyback program
- A dividend paid in additional shares
Correct answer: An offer of new shares to existing shareholders in proportion to their current holdings
A rights issue allows existing shareholders to purchase new shares at a discount, typically in proportion to their current holding, giving them the 'right' to maintain their ownership percentage.
Question 4: What does the term 'cost of debt' refer to in capital structure analysis?
- The total loan balance owed by the company
- The effective after-tax interest rate the company pays on its borrowings (Correct answer)
- The bank fees charged for setting up a loan
- The market price of outstanding bonds
Correct answer: The effective after-tax interest rate the company pays on its borrowings
The cost of debt is the effective interest rate a company pays on its debt, typically calculated on an after-tax basis because interest payments are tax-deductible.
Question 5: What is the capital asset pricing model (CAPM) used for?
- Calculating depreciation on fixed assets
- Estimating the expected return on an investment based on its systematic risk (beta) (Correct answer)
- Valuing inventory under FIFO or LIFO
- Forecasting future sales revenue
Correct answer: Estimating the expected return on an investment based on its systematic risk (beta)
CAPM calculates the expected return of an asset as the risk-free rate plus a risk premium based on beta, which measures sensitivity to market movements.
Question 6: Which capital budgeting technique accounts for the time value of money?
- Payback period
- Accounting rate of return (ARR)
- Net present value (NPV) (Correct answer)
- Return on investment (ROI) based on average profits
Correct answer: Net present value (NPV)
NPV discounts all future cash flows back to present value using a required rate of return, directly incorporating the time value of money into the investment decision.
IFA IFA Business Finance & Investment 2
What is the difference between systematic and unsystematic risk?