CORPORATE FINANCE CFA LEVEL I
QUESTIONS AND ANSWERS UPDATED
Q. The acceptance of which of the following capital budgeting projects is most likely to expose a
company to the highest level of uncertainty?
Replacement of worn out equipment
Expansion projects
Newly launched product or services ANS -C is correct. Investments related to new products or services
expose the company to even more uncertainties than expansion projects. These decisions are more
complex and will involve more people in the decision-making process.
A is incorrect because replacement of worn out equipment is simply an improvement to the existing
project with recurring revenues.
Q. Proponents of dual-class voting structures believe that the benefits to public shareholders most likely
include:
reducing conflicts of interest between management and those with economic interests.
trading values that are typically at a slight premium to single-class peers.
promoting company stability by insulating management from short-term investor pressures. ANS -C is
correct. Proponents of dual-class structures argue that management is better able to make long-term
strategic investments that may have negative short-term implications when control is wielded by a small
group of shareholders with superior voting rights.
A is incorrect because of their reduced ability to influence management, shareholders with economic
but not voting interest are more likely to view management's interests in conflict with their own.
B is incorrect because entities with multiple voting structures tend to trade at a discount to their peers,
not a premium.
Q. Which of the following is the least appropriate method for an external analyst to use to estimate a
company's target capital structure for determining the weighted average cost of capital (WACC)?
,Using the company's current capital structure at book value weights
Using averages of comparable companies' capital structure
Using statements made by the company's management regarding capital structure policy ANS -A is
correct. An external analyst does not know a company's actual target capital structure. Consequently,
the analyst should rely on market value (not book value) weights for the components of the company's
current capital structure. B and C are incorrect because this is an accepted method for an external
analyst to estimate a company's target capital structure.
Q. Given two mutually exclusive projects with normal cash flows, the point at which their net present
value profiles intersect the horizontal axis is most likely the projects':
weighted average cost of capital.
crossover rate.
internal rate of return. ANS -C is correct. For a project with normal cash flows, the NPV profile
intersects the horizontal axis at the point where the discount rate equals the IRR. The crossover rate is
the discount rate at which the NPVs of the projects are equal. Although it is possible that the crossover
rate is equal to each project's IRR, it is not a likely event. It is also possible that the IRR is equal to the
WACC, but that scenario is not the most likely one.
B is incorrect because the crossover rate is the discount rate at which the NPVs of the projects are equal.
While it is possible that the crossover rate is equal to each project's IRR, it is not a likely event.
A is incorrect because the project's net present value (NPV) occurs when the NPV profile intersects the
vertical axis or when the discount rate = 0.
Q. Under the stakeholder theory, corporate governance is most consistent with a system of:
internal controls and procedures by which individual companies are managed.
defined roles for management and the majority shareowner(s).
checks and balances to minimize the conflicting interests among shareowners. ANS -A is correct.
Corporate governance is the system of internal controls and procedures by which individual companies
are managed.
, B is incorrect because the majority shareholder doesn't necessarily have a specific role that is defined
through corporate governance. Instead, the majority shareholder exercises influence and/or control
through voting mechanisms tied to their shareholdings.
C is incorrect because Corporate governance is primarily aimed at managing the conflicting interests
between management and external shareholders, not amongst shareholders.
Q. Which of the following statements describes the most appropriate treatment of cash flows in capital
budgeting?
Interest costs are included in the project's cash flows to reflect financing costs.
A project is evaluated using its incremental cash flows on an after-tax basis.
Sunk costs and externalities should not be included in the cash flow estimates. ANS -B is correct. All of
the incremental cash flows arising from a project should be analyzed on an after-tax basis.
C is incorrect because only sunk costs should be ignored in a project's cash flow estimation, but not any
externalities. Sunk costs cannot be recovered once they have been incurred. Externalities (both positive
and negative ones) are the effects of an investment decision on other things beside the investment
itself; they should therefore be included in the cash flow estimation.
A is incorrect because financing costs like interest costs are excluded from calculations of operating cash
flows. The financing costs are reflected in the required rate of return for an investment project. If
financing costs are included, we would be double-counting these costs.
Q. Based on good corporate governance practices, it is most appropriate for a company's compensation
committee to:
develop director remuneration policies.
recommend remuneration for the external auditors.
include some external directors. ANS -A is correct. Under good corporate governance practices the
compensation committee develops remuneration policies for directors as well as key executives. The
audit committee, not the compensation committee, would be involved in the remuneration of the
external auditors.
QUESTIONS AND ANSWERS UPDATED
Q. The acceptance of which of the following capital budgeting projects is most likely to expose a
company to the highest level of uncertainty?
Replacement of worn out equipment
Expansion projects
Newly launched product or services ANS -C is correct. Investments related to new products or services
expose the company to even more uncertainties than expansion projects. These decisions are more
complex and will involve more people in the decision-making process.
A is incorrect because replacement of worn out equipment is simply an improvement to the existing
project with recurring revenues.
Q. Proponents of dual-class voting structures believe that the benefits to public shareholders most likely
include:
reducing conflicts of interest between management and those with economic interests.
trading values that are typically at a slight premium to single-class peers.
promoting company stability by insulating management from short-term investor pressures. ANS -C is
correct. Proponents of dual-class structures argue that management is better able to make long-term
strategic investments that may have negative short-term implications when control is wielded by a small
group of shareholders with superior voting rights.
A is incorrect because of their reduced ability to influence management, shareholders with economic
but not voting interest are more likely to view management's interests in conflict with their own.
B is incorrect because entities with multiple voting structures tend to trade at a discount to their peers,
not a premium.
Q. Which of the following is the least appropriate method for an external analyst to use to estimate a
company's target capital structure for determining the weighted average cost of capital (WACC)?
,Using the company's current capital structure at book value weights
Using averages of comparable companies' capital structure
Using statements made by the company's management regarding capital structure policy ANS -A is
correct. An external analyst does not know a company's actual target capital structure. Consequently,
the analyst should rely on market value (not book value) weights for the components of the company's
current capital structure. B and C are incorrect because this is an accepted method for an external
analyst to estimate a company's target capital structure.
Q. Given two mutually exclusive projects with normal cash flows, the point at which their net present
value profiles intersect the horizontal axis is most likely the projects':
weighted average cost of capital.
crossover rate.
internal rate of return. ANS -C is correct. For a project with normal cash flows, the NPV profile
intersects the horizontal axis at the point where the discount rate equals the IRR. The crossover rate is
the discount rate at which the NPVs of the projects are equal. Although it is possible that the crossover
rate is equal to each project's IRR, it is not a likely event. It is also possible that the IRR is equal to the
WACC, but that scenario is not the most likely one.
B is incorrect because the crossover rate is the discount rate at which the NPVs of the projects are equal.
While it is possible that the crossover rate is equal to each project's IRR, it is not a likely event.
A is incorrect because the project's net present value (NPV) occurs when the NPV profile intersects the
vertical axis or when the discount rate = 0.
Q. Under the stakeholder theory, corporate governance is most consistent with a system of:
internal controls and procedures by which individual companies are managed.
defined roles for management and the majority shareowner(s).
checks and balances to minimize the conflicting interests among shareowners. ANS -A is correct.
Corporate governance is the system of internal controls and procedures by which individual companies
are managed.
, B is incorrect because the majority shareholder doesn't necessarily have a specific role that is defined
through corporate governance. Instead, the majority shareholder exercises influence and/or control
through voting mechanisms tied to their shareholdings.
C is incorrect because Corporate governance is primarily aimed at managing the conflicting interests
between management and external shareholders, not amongst shareholders.
Q. Which of the following statements describes the most appropriate treatment of cash flows in capital
budgeting?
Interest costs are included in the project's cash flows to reflect financing costs.
A project is evaluated using its incremental cash flows on an after-tax basis.
Sunk costs and externalities should not be included in the cash flow estimates. ANS -B is correct. All of
the incremental cash flows arising from a project should be analyzed on an after-tax basis.
C is incorrect because only sunk costs should be ignored in a project's cash flow estimation, but not any
externalities. Sunk costs cannot be recovered once they have been incurred. Externalities (both positive
and negative ones) are the effects of an investment decision on other things beside the investment
itself; they should therefore be included in the cash flow estimation.
A is incorrect because financing costs like interest costs are excluded from calculations of operating cash
flows. The financing costs are reflected in the required rate of return for an investment project. If
financing costs are included, we would be double-counting these costs.
Q. Based on good corporate governance practices, it is most appropriate for a company's compensation
committee to:
develop director remuneration policies.
recommend remuneration for the external auditors.
include some external directors. ANS -A is correct. Under good corporate governance practices the
compensation committee develops remuneration policies for directors as well as key executives. The
audit committee, not the compensation committee, would be involved in the remuneration of the
external auditors.
