CMA P2 Corporate Finance: practice questions with answers

Question 1

The risk-free rate is 4%, the expected return on the market portfolio is 10%, and Norland Corp.'s stock has a beta of 1.3. Using the capital asset pricing model, what is Norland's required rate of return?

1. A 17.0%
2. B 11.8%
3. C 13.0%
4. D 7.8%

Show the answer

Answer: B. Market risk premium = 10% − 4% = 6%.
Required return = rf + β × (Rm − rf) = 4% + 1.3 × 6% = 4% + 7.8% = 11.8%.

Question 2

Brennan Co. needs $8,000,000 for expansion. Under Plan A it would issue new common stock, bringing total shares outstanding to 1,000,000. Under Plan B it would issue $8,000,000 of 8% bonds and have 600,000 shares outstanding. The tax rate is 25%. At what level of EBIT would earnings per share be the same under both plans?

1. A $960,000
2. B $640,000
3. C $853,333
4. D $1,600,000

Show the answer

Answer: D. Interest under Plan B = 8% × 8,000,000 = $640,000.
Set EPS equal: (EBIT)(1 − t) / 1,000,000 = (EBIT − 640,000)(1 − t) / 600,000.
600,000 EBIT = 1,000,000 EBIT − 640,000,000,000 → 400,000 EBIT = 640,000,000,000 → EBIT = $1,600,000.
Check: Plan A EPS = 1,600,000 × 0.75 / 1,000,000 = $1.20; Plan B EPS = 960,000 × 0.75 / 600,000 = $1.20.
Above $1,600,000 of EBIT, the debt plan gives higher EPS.

Question 3

A supplier offers Brookline Co. terms of 2/10, net 40. Brookline currently forgoes the discount and pays on day 40. Using a 365-day year, what is the nominal (simple) annual cost of not taking the discount?

1. A 18.62%
2. B 24.33%
3. C 24.83%
4. D 74.49%

Show the answer

Answer: C. By paying on day 40 instead of day 10, Brookline keeps $98 for 30 more days at a cost of $2.
Nominal annual cost = [discount / (100% − discount)] × [365 / (credit period − discount period)] = (2 / 98) × (365 / 30) = 0.020408 × 12.1667 = 24.83%.

Question 4

A portfolio is invested 60% in Fund X and 40% in Fund Y. Fund X has a standard deviation of returns of 20%, Fund Y has a standard deviation of 30%, and the correlation between their returns is 0.25. What is the portfolio's standard deviation?

1. A 24.00%
2. B 16.97%
3. C 18.00%
4. D 18.97%

Show the answer

Answer: D. σp² = wX²σX² + wY²σY² + 2wXwYρσXσY
= (0.6²)(20²) + (0.4²)(30²) + 2(0.6)(0.4)(0.25)(20)(30)
= 144 + 144 + 72 = 360 (%²).
σp = √360 = 18.97%.

Because the correlation is below +1, the portfolio's risk is less than the 24% weighted average of the two funds' risks: this is the benefit of diversification.

Question 5

Tolland Mining is raising equity through a rights offering. Each existing share receives one right, and 5 rights plus $30 in cash buy one new share. The stock currently trades rights-on at $40 per share. What is the theoretical value of one right?

1. A $8.33
2. B $10.00
3. C $2.00
4. D $1.67

Show the answer

Answer: D. Value of one right (rights-on) = (P − S) / (N + 1) = ($40 − $30) / (5 + 1) = $1.67.

Check with the theoretical ex-rights price: (5 × $40 + $30) / 6 = $38.33, so each right is worth $40 − $38.33 = $1.67, or ($38.33 − $30) / 5 = $1.67.
Shareholders who sell or exercise their rights are not made worse off by the issue price being below market.

Question 6

Garland Medical has a $5,000,000 revolving credit agreement with its bank. It pays 7% interest on amounts borrowed and a commitment fee of 0.5% a year on the unused portion of the line. Garland expects to borrow an average of $3,000,000 during the year. What is the effective annual cost of the funds borrowed?

1. A 4.40%
2. B 7.83%
3. C 7.50%
4. D 7.33%

Show the answer

Answer: D. Interest = 7% × $3,000,000 = $210,000.
Commitment fee = 0.5% × ($5,000,000 − $3,000,000) = $10,000.
Effective annual cost = ($210,000 + $10,000) / $3,000,000 = 7.33%.

The commitment fee pays the bank for guaranteeing that funds will be available; it raises the effective cost of the amount actually used.