ACA Business Finance 1 — Questions and Answers
Question 1: The weighted average cost of capital (WACC) is used in capital budgeting to:
- Maximise the tax shield of debt
- Discount future cash flows when the project has the same risk as the company (Correct answer)
- Calculate the payback period
- Measure the return on equity
Correct answer: Discount future cash flows when the project has the same risk as the company
WACC represents the average cost of all financing sources, weighted by their market value proportions. It is appropriate as a discount rate when the project mirrors the company's existing risk profile.
Question 2: Which of the following is a feature of debt finance compared to equity finance?
- Dividends are tax-deductible
- Interest is tax-deductible (Correct answer)
- Debt holders have voting rights
- Debt does not increase financial risk
Correct answer: Interest is tax-deductible
Interest payments on debt are tax-deductible, creating a tax shield that reduces the effective cost of debt. Dividends on equity are not tax-deductible.
Question 3: The internal rate of return (IRR) of a project is the discount rate at which:
- Net present value equals the initial investment
- Net present value equals zero (Correct answer)
- Payback period is shortest
- Return on investment is maximised
Correct answer: Net present value equals zero
IRR is the discount rate that makes the NPV of a project's cash flows equal to zero. A project is acceptable if its IRR exceeds the cost of capital.
Question 4: Which capital structure theory suggests that an optimal capital structure exists that maximises firm value by balancing tax benefits of debt against financial distress costs?
- Modigliani-Miller (no tax) theorem
- Trade-off theory (Correct answer)
- Pecking order theory
- Market timing theory
Correct answer: Trade-off theory
Trade-off theory posits that firms balance the tax shield benefits of debt against the costs of financial distress; the optimal capital structure occurs where marginal benefit equals marginal cost.
Question 5: A rights issue involves:
- Issuing new shares to the public at market price
- Offering existing shareholders the right to buy new shares at a discount (Correct answer)
- Repurchasing shares from existing shareholders
- Issuing bonus shares from retained earnings
Correct answer: Offering existing shareholders the right to buy new shares at a discount
A rights issue offers existing shareholders the right (but not obligation) to purchase additional shares at a discounted price, typically in proportion to their existing holdings.
Question 6: Which of the following best describes working capital management?
- Managing long-term capital investment decisions
- Managing the company's short-term assets and liabilities to maintain liquidity (Correct answer)
- Setting the dividend policy of the company
- Arranging long-term debt financing
Correct answer: Managing the company's short-term assets and liabilities to maintain liquidity
Working capital management involves managing current assets (inventory, receivables, cash) and current liabilities (payables) to ensure the company has sufficient liquidity to meet short-term obligations.
ACA Business Finance 1
The weighted average cost of capital (WACC) is used in capital budgeting to: