CFM CFM Corporate Finance & Valuation 2 — Questions and Answers
Question 1: In a leveraged buyout (LBO), the primary source of returns for the private equity buyer is:
- Dividend income from portfolio company
- Debt paydown, operational improvements, and multiple expansion (Correct answer)
- Interest income from loans to management
- Currency appreciation on foreign assets
Correct answer: Debt paydown, operational improvements, and multiple expansion
LBO returns come from three main drivers: paying down acquisition debt with operating cash flow, improving EBITDA through operational changes, and selling at a higher valuation multiple.
Question 2: What does the term 'beta' measure in the context of the Capital Asset Pricing Model (CAPM)?
- A company's total risk
- A stock's sensitivity to market-wide movements (Correct answer)
- The risk-free rate of return
- The premium investors demand for holding equity
Correct answer: A stock's sensitivity to market-wide movements
Beta measures systematic (market) risk, indicating how much a stock's returns move relative to the overall market; a beta of 1.5 means the stock is 50% more volatile than the market.
Question 3: Which of the following best describes a company's 'cost of equity' under CAPM?
- The dividend yield on preferred stock
- Risk-free rate + beta × equity risk premium (Correct answer)
- Coupon rate on the most recent bond issuance
- After-tax cost of long-term debt
Correct answer: Risk-free rate + beta × equity risk premium
CAPM: Cost of Equity = Rf + β × (Rm - Rf), where Rf is the risk-free rate and (Rm - Rf) is the equity risk premium, compensating investors for taking on equity risk.
Question 4: What is a 'terminal value' in discounted cash flow analysis?
- The book value of assets at the end of a project
- The present value of all cash flows beyond the explicit forecast period, assuming perpetual growth (Correct answer)
- The liquidation value of the company
- The final year's free cash flow without discounting
Correct answer: The present value of all cash flows beyond the explicit forecast period, assuming perpetual growth
Terminal value captures the value of cash flows beyond the projection horizon, often calculated using the Gordon Growth Model (FCF × (1+g) / (WACC - g)).
Question 5: In a merger, what does the term 'accretion/dilution analysis' assess?
- Whether the merger improves the acquirer's credit rating
- The impact of the transaction on the acquirer's earnings per share (EPS) (Correct answer)
- The effect on the target's book value
- Environmental regulatory approval likelihood
Correct answer: The impact of the transaction on the acquirer's earnings per share (EPS)
Accretion/dilution analysis determines if the acquisition increases (accretive) or decreases (dilutive) the acquirer's post-deal EPS, informing the deal's attractiveness.
Question 6: Which financial concept describes the additional return investors demand for investing in equity over a risk-free asset?
- Credit spread
- Equity risk premium (ERP) (Correct answer)
- Dividend yield premium
- WACC spread
Correct answer: Equity risk premium (ERP)
The equity risk premium (ERP) is the excess return above the risk-free rate that investors require to hold stocks, reflecting the higher risk of equity versus government bonds.
CFM CFM Corporate Finance & Valuation 2
In a leveraged buyout (LBO), the primary source of returns for the private equity buyer is: