CCA CCA Corporate Finance & Capital Structure 1 — Questions and Answers
Question 1: What is the Weighted Average Cost of Capital (WACC) used for in corporate finance?
- To calculate dividend payments to shareholders
- To measure liquidity ratios
- As a discount rate to evaluate investment projects and determine firm value (Correct answer)
- To set credit terms for customers
Correct answer: As a discount rate to evaluate investment projects and determine firm value
WACC represents the minimum return a company must earn on its assets to satisfy all capital providers, and it is used as the discount rate in NPV analysis.
Question 2: According to the Modigliani-Miller theorem (with taxes), what happens to firm value as debt increases?
- Firm value decreases due to financial risk
- Firm value is unaffected by capital structure
- Firm value increases due to the tax shield on interest (Correct answer)
- Firm value decreases due to higher WACC
Correct answer: Firm value increases due to the tax shield on interest
In the MM framework with corporate taxes, interest is tax-deductible, creating a tax shield that increases firm value as leverage rises.
Question 3: Which capital budgeting method accounts for the time value of money AND expresses the return as a percentage?
- Payback period
- Accounting rate of return (ARR)
- Internal rate of return (IRR) (Correct answer)
- Net present value (NPV)
Correct answer: Internal rate of return (IRR)
IRR is the discount rate at which NPV equals zero; it considers the time value of money and expresses investment returns as a percentage.
Question 4: A project has a positive NPV. What does this indicate?
- The project's payback period is less than one year
- The project earns exactly the required rate of return
- The project creates value by earning more than the required rate of return (Correct answer)
- The project has no financial risk
Correct answer: The project creates value by earning more than the required rate of return
A positive NPV means the present value of cash inflows exceeds the present value of outflows, indicating the project generates returns above the cost of capital.
Question 5: What is financial leverage, and what is its primary effect on earnings?
- Using equity financing to amplify returns; it stabilizes earnings
- Using debt financing to amplify returns; it magnifies both gains and losses (Correct answer)
- Using retained earnings to fund operations; it reduces volatility
- Hedging currency risk; it protects earnings
Correct answer: Using debt financing to amplify returns; it magnifies both gains and losses
Financial leverage uses debt to fund assets; because interest is a fixed cost, leverage amplifies EPS changes relative to operating income changes.
Question 6: Which of the following best describes the pecking order theory of capital structure?
- Firms target an optimal debt-to-equity ratio and adjust toward it over time
- Firms prefer internal financing first, then debt, and issue equity only as a last resort (Correct answer)
- Firms always choose the capital source with the lowest after-tax cost
- Firms balance tax benefits of debt against bankruptcy costs
Correct answer: Firms prefer internal financing first, then debt, and issue equity only as a last resort
The pecking order theory holds that firms minimize information asymmetry costs by preferring retained earnings, then debt, and finally equity issuance.
CCA CCA Corporate Finance & Capital Structure 1
What is the Weighted Average Cost of Capital (WACC) used for in corporate finance?