Chartered Financial Analyst · Level I
CFA L1 Corporate Finance: practice questions with answers
6 free exam-style questions on Corporate Finance for CFA L1 Level I. Try each one, then open the answer to read the explanation. Fincora has 52 original questions on this syllabus area.
Question 1
Three investors form Halden Ventures as a limited partnership. Oren Vale is the general partner, and Ruth Kade and Simon Futh are limited partners. Which statement about this structure is most accurate?
- A All three partners have unlimited personal liability for the partnership's debts.
- B Vale manages the business and has unlimited liability, while Kade's and Futh's liability is limited to the amounts they invested.
- C Kade and Futh make the day-to-day management decisions in exchange for limiting their liability.
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Answer: B. A limited partnership has at least one general partner and one or more limited partners. The general partner manages the business and has unlimited liability for its obligations. Limited partners contribute capital, share in profits, and have liability limited to their investment, but they typically have no role in day-to-day management. A general partnership, by contrast, gives all partners management rights and unlimited liability.
Question 2
Under Modigliani and Miller's propositions with corporate taxes, an all-equity company has a cost of capital (r0) of 10%. It recapitalizes to a debt-to-equity ratio of 0.5 with a pre-tax cost of debt of 6%. The corporate tax rate is 25%. The company's cost of equity after the recapitalization is closest to:
- A 11.0%
- B 11.5%
- C 12.0%
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Answer: B. MM Proposition II with taxes: re = r0 + (r0 - rd) x (1 - t) x D/E.
re = 10% + (10% - 6%) x (1 - 0.25) x 0.5 = 10% + 4% x 0.75 x 0.5 = 10% + 1.5% = 11.5%.
The cost of equity rises less steeply than without taxes (where it would be 12.0%) because the debt tax shield reduces shareholders' risk-adjusted cost of leverage.
Question 3
Drevon Foods' CEO is paid a large annual cash bonus based on revenue growth. Over three years she has made several acquisitions that increased revenue but earned returns below the company's cost of capital. Which change to her compensation would most likely reduce this agency problem?
- A Raise her fixed salary so that her pay no longer depends on company performance.
- B Increase the bonus paid for each percentage point of revenue growth.
- C Replace the revenue-based bonus with share awards that vest over several years and depend on returns on invested capital exceeding the cost of capital.
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Answer: C. The conflict here is between managers and shareholders: the bonus rewards size (revenue growth), so the CEO has an incentive to make acquisitions that grow the company even when they earn less than the cost of capital and destroy shareholder value (empire building).
Compensation is one of the main governance mechanisms for aligning interests. Pay that is (1) tied to measures of value creation, such as ROIC relative to the cost of capital or total shareholder return, and (2) paid in equity that vests over several years encourages the CEO to pursue only projects that create long-term value.
Question 4
At Mernick Industries, divisional managers rank proposed projects mainly by their expected effect on reported earnings per share (EPS) over the next two years. Projects with a positive net present value (NPV) that would reduce EPS in the early years are routinely rejected. This practice is best described as:
- A an appropriate approach, because near-term EPS growth is the main driver of shareholder value.
- B a capital allocation pitfall: relying on accounting measures rather than on the project's economic value.
- C a capital allocation pitfall: anchoring each year's capital budget on the previous year's budget.
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Answer: B. Common pitfalls in capital allocation include: inertia (anchoring budgets on last year's levels), pet projects of senior managers, basing decisions on accounting results such as EPS, net income or ROE, failing to consider alternatives, and inconsistent assumptions or costs of capital.
A positive-NPV project adds value for shareholders even if its accounting effect on EPS is negative in the early years (for example because of start-up costs or depreciation). Rejecting such projects because of their short-term EPS effect destroys value. The correct criterion is NPV, based on cash flows discounted at the project's cost of capital.
Question 5
Notara offers a note-taking app. The basic version is free and has no advertising. Users who want extra storage, collaboration tools and offline access pay a monthly fee for a premium version; about 4% of users choose to pay. Notara's pricing approach is best described as:
- A bundling.
- B freemium pricing.
- C a hidden revenue model.
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Answer: B. Notara uses freemium pricing: the core product is free, which builds a large user base at low marginal cost, and revenue comes from the small share of users who pay for premium features. Its success depends on the conversion rate from free to paid users and on keeping the cost of serving free users low.
In a hidden revenue model (for example many social media and search services) users do not pay and revenue comes from third parties such as advertisers. Bundling sells several products together for one price.
Question 6
Dunmere Retail finances all of its current assets, including the permanent level of inventory and receivables it always carries, and part of its fixed assets with short-term bank loans that it rolls over every few months. Dunmere's approach to financing working capital is best described as:
- A conservative, with higher financing costs but lower refinancing risk.
- B matching, because short-term assets are financed with short-term liabilities.
- C aggressive, with lower expected financing costs but higher refinancing risk.
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Answer: C. Working capital financing approaches:
- Conservative: long-term financing covers fixed assets, permanent current assets and part of fluctuating current assets. Lower refinancing risk, higher cost.
- Matching (moderate): long-term financing for fixed assets and permanent current assets; short-term financing for fluctuating current assets.
- Aggressive: short-term financing covers fluctuating current assets and some or all of permanent current assets (and possibly fixed assets). Typically lower cost because short-term rates are usually lower, but higher risk that funding cannot be renewed, or only at higher rates, when it matures.
Dunmere uses rolling short-term loans for permanent assets, so its approach is aggressive.
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