CAA Business Finance & Economics 2 — Questions and Answers
Question 1: According to the Net Present Value (NPV) rule, a capital project should be accepted when:
- NPV equals zero exactly
- NPV is negative
- NPV is positive (Correct answer)
- The internal rate of return equals the risk-free rate
Correct answer: NPV is positive
A positive NPV means the project is expected to generate returns exceeding the cost of capital, thereby creating value for shareholders.
Question 2: The Weighted Average Cost of Capital (WACC) represents:
- The cost of equity financing only
- The average return required by all capital providers, weighted by their proportions in the capital structure (Correct answer)
- The risk-free rate plus an equity risk premium
- The after-tax cost of debt financing only
Correct answer: The average return required by all capital providers, weighted by their proportions in the capital structure
WACC blends the costs of debt and equity, each weighted by their respective share of total capital, and represents the minimum return a firm must earn to satisfy all its capital providers.
Question 3: Financial leverage in corporate finance refers to:
- Using equity to conservatively finance all assets
- Using debt financing to amplify potential returns, while also magnifying potential losses (Correct answer)
- Diversifying investments across multiple industry sectors
- Hedging against changes in interest rates through derivatives
Correct answer: Using debt financing to amplify potential returns, while also magnifying potential losses
Financial leverage involves using borrowed capital to increase the potential return on equity, but it also amplifies losses, thereby increasing financial risk.
Question 4: In the Capital Asset Pricing Model (CAPM), beta (β) measures:
- The total risk of a security, including all sources
- The unsystematic risk unique to a specific company
- A security's sensitivity to systematic (market-wide) risk (Correct answer)
- The expected return of the market portfolio itself
Correct answer: A security's sensitivity to systematic (market-wide) risk
Beta measures the degree to which a security's returns move in relation to the overall market; a beta greater than 1 indicates higher volatility than the market.
Question 5: Which capital budgeting method fails to account for the time value of money?
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
- Payback Period (Correct answer)
- Modified Internal Rate of Return (MIRR)
Correct answer: Payback Period
The payback period simply totals undiscounted cash flows until the initial investment is recovered, completely ignoring the time value of money.
Question 6: The Gordon Growth Model (Dividend Discount Model) values a stock as:
- The book value of the firm's net assets
- The present value of all expected future dividends (Correct answer)
- A multiple of the firm's current earnings per share
- The market price-to-earnings ratio multiplied by book value
Correct answer: The present value of all expected future dividends
The DDM values a stock by discounting all expected future dividends at the investor's required rate of return, treating dividends as the fundamental cash flows to equity holders.
Question 7: Systematic risk in a portfolio context is best described as:
- Risk that can be fully eliminated through diversification
- Company-specific risk arising from internal business decisions
- Market-wide risk that cannot be eliminated through diversification (Correct answer)
- Risk arising solely from poor management decisions
Correct answer: Market-wide risk that cannot be eliminated through diversification
Systematic risk, also called market risk, affects the entire economy or market and cannot be diversified away; only unsystematic (firm-specific) risk can be reduced through diversification.
CAA Business Finance & Economics 2
According to the Net Present Value (NPV) rule, a capital project should be accepted when: