US CMA Part 2 · Chapter 3
Corporate finance: risk and return, long-term financing and cost of capital MCQs with Answers
15 multiple-choice questions on Corporate finance: risk and return, long-term financing and cost of capital for US CMA Part 2 Strategic Financial Management. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
An analyst estimates the following one-year returns for Westbrook Corp. stock: Strong economy (probability 0.30): 18% Normal economy (probability 0.50): 10% Recession (probability 0.20): -4% What is the expected return?
- A) 9.6%
- B) 11.2%
- C) 8.0%
- D) 10.4%
Show answer & explanation
Answer: A) 9.6%
Expected return = sum of (probability x return) = (0.30 x 18%) + (0.50 x 10%) + (0.20 x -4%) = 5.4% + 5.0% - 0.8% = 9.6%. A simple average of the three outcomes (8.0%) ignores the probabilities, and treating the recession return as +4% gives 11.2%.
Question 2
Using the same three scenarios for Westbrook Corp. (probabilities 0.30, 0.50 and 0.20; returns 18%, 10% and -4%; expected return 9.6%), what is the standard deviation of returns?
- A) 58.24%
- B) 9.09%
- C) 7.63%
- D) 5.82%
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Answer: C) 7.63%
Deviations from the expected return of 9.6% are 8.4%, 0.4% and -13.6%. Variance = 0.30(8.4)^2 + 0.50(0.4)^2 + 0.20(-13.6)^2 = 21.168 + 0.080 + 36.992 = 58.24 (in %-squared). Standard deviation = square root of 58.24 = 7.63% (rounded to two decimals). 58.24% is the variance mis-stated as a percentage, not the standard deviation.
Question 3
Investment A has an expected return of 12% and a standard deviation of 9%. Investment B has an expected return of 8% and a standard deviation of 5%. Using the coefficient of variation, which statement is correct?
- A) A and B have the same risk per unit of expected return
- B) B has less risk per unit of expected return (CV 0.625 versus 0.75 for A)
- C) B has less risk per unit of expected return (CV 1.60 versus 1.33 for A)
- D) A has less risk per unit of expected return (CV 0.75 versus 0.625 for B)
Show answer & explanation
Answer: B) B has less risk per unit of expected return (CV 0.625 versus 0.75 for A)
Coefficient of variation = standard deviation / expected return. A: 9% / 12% = 0.75. B: 5% / 8% = 0.625. The lower CV means B carries less risk per unit of expected return. The ratio must be standard deviation divided by expected return, not the inverse.
Question 4
The risk-free rate is 3%, the expected return on the market is 9% and Yarrow Inc. has a beta of 1.3. Using the capital asset pricing model, what is Yarrow's required rate of return?
- A) 11.7%
- B) 14.7%
- C) 16.8%
- D) 10.8%
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Answer: D) 10.8%
CAPM: required return = risk-free rate + beta x (market return - risk-free rate) = 3% + 1.3 x (9% - 3%) = 3% + 7.8% = 10.8%. A common error is to multiply beta by the full market return instead of the market risk premium.
Question 5
A portfolio is invested 40% in a stock with a beta of 0.8, 35% in a stock with a beta of 1.2 and 25% in a stock with a beta of 1.6. What is the portfolio beta?
- A) 1.14
- B) 1.26
- C) 1.03
- D) 1.20
Show answer & explanation
Answer: A) 1.14
Portfolio beta is the weighted average of the individual betas: (0.40 x 0.8) + (0.35 x 1.2) + (0.25 x 1.6) = 0.32 + 0.42 + 0.40 = 1.14. A simple average (1.20) ignores the portfolio weights.
Question 6
Which type of risk can be substantially eliminated by holding a well-diversified portfolio of securities?
- A) Purchasing power (inflation) risk affecting the whole economy
- B) Systematic (market) risk
- C) Unsystematic (company-specific) risk
- D) Interest rate risk affecting all bonds
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Answer: C) Unsystematic (company-specific) risk
Diversification eliminates unsystematic risk, which arises from events specific to an individual company or industry and tends to offset across many holdings. Systematic risk, including economy-wide interest rate and inflation risk, affects all securities and cannot be diversified away; it is measured by beta and is the only risk rewarded under CAPM.
Question 7
A $1,000 face value bond pays a 6% annual coupon and matures in 5 years. If the market yield on similar bonds is 8%, what is the bond's price (rounded to the nearest dollar)?
- A) $981
- B) $1,000
- C) $933
- D) $920
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Answer: D) $920
Price = PV of coupons + PV of face value. Annual coupon = 6% x $1,000 = $60. PV of coupons = $60 x 3.9927 (5-year annuity factor at 8%) = $239.56. PV of face = $1,000 x 0.6806 = $680.58. Price = $920.15, or about $920. The bond sells at a discount because its coupon rate is below the market yield.
Question 8
A corporate bond has a coupon rate of 5%. Market interest rates for bonds of similar risk and maturity rise to 7%. Which statement is correct?
- A) The bond's coupon payments will increase to 7%
- B) The bond will trade at a discount to its face value
- C) The bond will continue to trade at face value until maturity
- D) The bond will trade at a premium to its face value
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Answer: B) The bond will trade at a discount to its face value
Bond prices move inversely with market yields. When the market rate rises above the fixed coupon rate, investors will pay less than face value so that their yield to maturity equals the market rate; the bond therefore trades at a discount. The coupon on a fixed-rate bond does not change.
Question 9
Zephyr Utilities' preferred stock pays a fixed annual dividend of $4.50 per share and has no maturity. If investors require a 9% return, what is the value of one preferred share?
- A) $54.50
- B) $45.00
- C) $25.00
- D) $50.00
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Answer: D) $50.00
Preferred stock with a fixed dividend and no maturity is valued as a perpetuity: value = dividend / required return = $4.50 / 9% = $50.00.
Question 10
Ashford Brewing just paid a dividend of $2.00 per share. Dividends are expected to grow at 4% per year indefinitely, and investors require a 10% return. Using the constant growth (Gordon) model, what is the value of one share?
- A) $20.80
- B) $14.86
- C) $33.33
- D) $34.67
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Answer: D) $34.67
Next year's dividend D1 = $2.00 x 1.04 = $2.08. Value = D1 / (k - g) = $2.08 / (10% - 4%) = $2.08 / 0.06 = $34.67. Using the dividend just paid (D0) instead of D1 gives $33.33, which understates value.
Question 11
Bexley Corp. can issue new bonds at a pre-tax yield of 7%. Its marginal income tax rate is 25%. What is its after-tax cost of debt?
- A) 5.25%
- B) 7.00%
- C) 9.33%
- D) 1.75%
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Answer: A) 5.25%
Interest is tax-deductible, so after-tax cost of debt = pre-tax yield x (1 - tax rate) = 7% x (1 - 25%) = 5.25%. Dividing by (1 - t) (9.33%) grosses up the cost instead of reducing it.
Question 12
Carrow Media plans to issue new common stock at $40.00 per share. Flotation costs are 6% of the issue price. The next dividend is expected to be $1.80 and dividends are expected to grow at 5% per year. What is the cost of new common equity (rounded to two decimals)?
- A) 9.50%
- B) 9.79%
- C) 15.50%
- D) 4.79%
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Answer: B) 9.79%
Net proceeds per share = $40.00 x (1 - 6%) = $37.60. Cost of new equity = D1 / net proceeds + g = $1.80 / $37.60 + 5% = 4.79% + 5.00% = 9.79%. Ignoring flotation costs gives 9.50%, which is the cost of retained earnings rather than new stock.
Question 13
Dalton Freight's target capital structure is 40% debt, 10% preferred stock and 50% common equity. Its before-tax cost of debt is 7%, tax rate 25%, cost of preferred stock 8% and cost of common equity 12%. What is its weighted average cost of capital?
- A) 8.70%
- B) 9.00%
- C) 8.90%
- D) 9.60%
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Answer: C) 8.90%
After-tax cost of debt = 7% x (1 - 0.25) = 5.25%. WACC = (0.40 x 5.25%) + (0.10 x 8%) + (0.50 x 12%) = 2.10% + 0.80% + 6.00% = 8.90%. Using the pre-tax debt cost gives 9.60%. Preferred dividends are not tax-deductible, so the cost of preferred stock is not adjusted for tax.
Question 14
Ellery Corp. expects to generate $1,200,000 of retained earnings next year. Its target capital structure is 60% common equity and 40% debt. At what level of total new capital will the weighted marginal cost of capital increase because the company must start issuing new common stock?
- A) $2,000,000
- B) $1,200,000
- C) $720,000
- D) $3,000,000
Show answer & explanation
Answer: A) $2,000,000
The retained earnings break point = available retained earnings / equity proportion = $1,200,000 / 60% = $2,000,000. Up to this level of total financing, the equity portion can be met from cheaper retained earnings; beyond it, more expensive new stock (with flotation costs) is required, so the marginal cost of capital rises.
Question 15
Which of the following is an advantage of long-term debt financing compared with issuing common stock?
- A) Bondholders have no legal claim if interest is not paid
- B) Interest payments are tax-deductible and existing shareholders' control is not diluted
- C) Debt has no fixed repayment obligation
- D) Debt reduces the company's financial leverage
Show answer & explanation
Answer: B) Interest payments are tax-deductible and existing shareholders' control is not diluted
Interest is a tax-deductible expense, which lowers the effective cost of debt, and bondholders do not vote, so owners retain control. Debt does, however, create fixed interest and principal obligations, increases financial leverage and gives bondholders legal remedies on default, so the other statements are incorrect.