BEC Financial Management and Capital Budgeting 1 — Questions and Answers
Question 1: The weighted average cost of capital (WACC) represents:
- The average rate a company must earn to satisfy all capital providers (Correct answer)
- The interest rate on the company's long-term debt
- The return required by common equity shareholders only
- The company's effective tax rate on earnings
Correct answer: The average rate a company must earn to satisfy all capital providers
WACC is the blended required rate of return weighted by the proportions of debt and equity in the capital structure, representing the minimum return the firm must earn on its assets.
Question 2: Net Present Value (NPV) of a project is calculated as:
- Present value of future cash inflows minus the initial investment (Correct answer)
- Total undiscounted cash inflows minus total cash outflows
- Future value of cash inflows divided by the cost of capital
- Annual operating income divided by total assets
Correct answer: Present value of future cash inflows minus the initial investment
NPV equals the sum of discounted future cash inflows less the initial investment; a positive NPV indicates the project creates shareholder value.
Question 3: A company's Internal Rate of Return (IRR) decision rule states: accept a project if:
- IRR exceeds the required rate of return (hurdle rate) (Correct answer)
- IRR is less than the cost of debt
- IRR equals zero
- IRR is less than the NPV
Correct answer: IRR exceeds the required rate of return (hurdle rate)
The IRR decision rule holds that a project should be accepted when its IRR exceeds the company's required rate of return, indicating the project earns more than its cost of capital.
Question 4: Working capital is defined as:
- Current assets minus current liabilities (Correct answer)
- Total assets minus total liabilities
- Cash and cash equivalents only
- Long-term assets minus long-term debt
Correct answer: Current assets minus current liabilities
Working capital is the difference between current assets and current liabilities, measuring a company's short-term liquidity and operational efficiency.
Question 5: The payback period method evaluates a project based on:
- How long it takes to recover the initial investment from cash flows (Correct answer)
- The present value of all future cash flows
- The project's average accounting return on investment
- The difference between IRR and WACC
Correct answer: How long it takes to recover the initial investment from cash flows
The payback period measures the time required for a project's cumulative cash inflows to equal its initial cost, favoring projects that recoup investment quickly.
Question 6: Financial leverage refers to the use of:
- Debt financing to amplify returns on equity (Correct answer)
- Short-term borrowing to fund current operations
- Accounts receivable to secure a line of credit
- Retained earnings to fund capital expenditures
Correct answer: Debt financing to amplify returns on equity
Financial leverage involves using borrowed funds to magnify potential returns to equity holders, though it also amplifies losses and increases financial risk.
BEC Financial Management and Capital Budgeting 1
The weighted average cost of capital (WACC) represents: