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CMA Final Paper 13 study materials
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CMA Final Paper 13 practice questions

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Question 1Strategic Cost Management and Decision Making

Under the CMA framework for strategic cost management, which classification best describes the cost of the plant manager's salary at a single-product manufacturing facility?

  1. A period cost that is variable with respect to output volume
  2. A product cost that is indirect with respect to the finished unit Correct answer.
  3. A prime cost that is directly traceable to each unit produced
  4. A discretionary cost that is avoidable in the short run

Explanation

The plant manager's salary is necessary to make the product and therefore attaches to inventory as a product cost, but it cannot be traced conveniently to an individual unit, so it is an indirect (manufacturing overhead) cost. It is not a period cost because it is not expensed as incurred, and it is not prime cost since prime cost comprises direct materials and direct labour.

Question 2Strategic Cost Management and Decision Making

A company produces 10,000 units and incurs total fixed costs of $240,000 and variable cost of $18 per unit. If output rises to 12,000 units within the relevant range, what is the total cost per unit at the new volume?

  1. $40.00
  2. $42.00
  3. $38.00 Correct answer.
  4. $36.00

Explanation

Total cost at 12,000 units is fixed cost of $240,000 plus variable cost of 12,000 × $18 = $216,000, giving $456,000. Dividing by 12,000 units yields $38.00 per unit, illustrating that fixed cost per unit falls as volume rises.

Question 3Strategic Cost Management and Decision Making

Which costing method assigns all manufacturing costs, including fixed production overhead, to units produced and therefore defers fixed overhead in inventory?

  1. Marginal costing
  2. Variable costing
  3. Absorption costing Correct answer.
  4. Throughput costing

Explanation

Absorption (full) costing treats fixed production overhead as a product cost, so a portion of fixed overhead stays in inventory until the units are sold. Variable, marginal, and throughput costing exclude fixed production overhead from product cost and expense it in the period incurred.

Question 4Strategic Cost Management and Decision Making

In a cost-volume-profit analysis, which change will increase the break-even point in units, all else held constant?

  1. An increase in total fixed costs Correct answer.
  2. An increase in the unit selling price
  3. A reduction in the tax rate applied to profit
  4. A reduction in the unit variable cost

Explanation

Break-even units equal fixed costs divided by contribution margin per unit, so higher fixed costs raise the numerator and push the break-even point up. Lower variable cost or a higher selling price widens the contribution margin and lowers break-even, while tax rates affect after-tax profit rather than the break-even volume.

Question 5Strategic Cost Management and Decision Making

Which item is normally treated as a relevant cost in a short-term special-order decision?

  1. The original purchase price of material already held and with no alternative use
  2. The depreciation of existing equipment calculated on a straight-line basis
  3. The apportioned share of existing factory rent
  4. The additional variable cost of labour incurred only if the order is accepted Correct answer.

Explanation

Relevant costs are future, incremental cash flows that differ between alternatives. Extra variable labour incurred only if the order is accepted meets all three tests, whereas sunk historical cost, non-cash book depreciation, and apportioned common fixed overhead do not.

Question 6Strategic Cost Management and Decision Making

A company has a contribution margin ratio of 40% and fixed costs of $300,000. What is the break-even point in sales revenue?

  1. $120,000
  2. $500,000
  3. $750,000 Correct answer.
  4. $1,200,000

Explanation

Break-even sales revenue equals fixed costs divided by the contribution margin ratio, that is $300,000 ÷ 0.40 = $750,000. At that revenue, contribution of $300,000 exactly covers fixed costs and operating profit is zero.

Question 7Strategic Cost Management and Decision Making

In activity-based costing, which cost driver is most appropriate for assigning machine set-up costs?

  1. Number of production runs or set-ups performed Correct answer.
  2. Number of units sold
  3. Value of direct materials consumed
  4. Number of direct labour hours worked

Explanation

Set-up costs are driven by the number of times machines are prepared for a production run, so the number of set-ups or runs best reflects the consumption of that activity. Unit-level drivers such as units sold, labour hours, or material value do not capture set-up effort.

Question 8Strategic Cost Management and Decision Making

A company has sales of $800,000, variable costs of $480,000, and fixed costs of $200,000. What is its margin of safety in sales revenue?

  1. $500,000 Correct answer.
  2. $120,000
  3. $300,000
  4. $600,000

Explanation

Contribution margin ratio is ($800,000 − $480,000) ÷ $800,000 = 40%, so break-even revenue is $200,000 ÷ 0.40 = $500,000. Margin of safety is actual sales of $800,000 minus break-even sales of $500,000, equal to $300,000.

Question 9Strategic Cost Management and Decision Making

Which statement correctly distinguishes a cost driver from a cost object?

  1. A cost driver is a management report, while a cost object is a ledger account
  2. A cost driver is the physical item produced, while a cost object is the activity that generates cost
  3. A cost driver is a factor that causes cost to change, while a cost object is any item for which costs are separately measured Correct answer.
  4. A cost driver is always a fixed cost, while a cost object is always a variable cost

Explanation

A cost driver is any factor whose change causes a change in total cost, such as machine hours or number of orders. A cost object is the thing for which costs are accumulated and measured, such as a product, department, or customer.

Question 10Strategic Cost Management and Decision Making

A firm uses absorption costing. In a period when production exceeds sales, how will reported operating profit compare with variable costing?

  1. Absorption profit will be higher because fixed overhead is treated as a period cost
  2. Absorption profit will be higher because part of the fixed overhead remains in closing inventory Correct answer.
  3. Absorption profit will be lower because fixed overhead is released from inventory
  4. Absorption profit will equal variable costing profit because total fixed overhead is unchanged

Explanation

Under absorption costing, fixed production overhead is attached to units, so when production exceeds sales some fixed overhead stays in closing inventory rather than being expensed. Variable costing expenses all fixed overhead in the period, so absorption profit exceeds variable costing profit by the fixed overhead deferred in inventory.

Question 11Strategic Cost Management and Decision Making

A company can produce either Product A with contribution of $30 per machine hour or Product B with contribution of $24 per machine hour. Machine hours are the binding constraint. To maximise total contribution, the company should prioritise:

  1. Product A, because it yields the higher contribution per unit of the scarce resource Correct answer.
  2. Product A, because it has the lower variable cost per unit
  3. Product B, because it requires fewer machine hours per unit
  4. Product B, because it has the higher selling price per unit

Explanation

When a single resource is scarce, the ranking rule is contribution per unit of the limiting factor. Product A generates $30 per machine hour against $24 for B, so A should be prioritised to maximise total contribution.

Question 12Strategic Cost Management and Decision Making

In a make-or-buy decision with spare capacity, which qualitative factor most directly supports continuing to make the component in-house?

  1. The supplier offers a price below the variable cost of production
  2. Outsourcing would transfer specialised process knowledge to a potential competitor Correct answer.
  3. The purchase price is fixed by a long-term supply contract
  4. The allocated fixed overhead per unit is high

Explanation

Qualitative factors such as loss of proprietary know-how and creation of a future competitor can outweigh a short-term cost saving. Transferring specialised process knowledge to a supplier that may later compete erodes strategic advantage, so it argues for retaining production.

Question 13Strategic Cost Management and Decision Making

A company produces three joint products from a single process costing $90,000. Which method allocates joint cost using the physical volume of output?

  1. Net realisable value method
  2. Relative sales value at split-off method
  3. Constant gross margin percentage method
  4. Physical units method Correct answer.

Explanation

The physical units method allocates joint cost in proportion to the number of units, litres, or kilograms produced at the split-off point. The other listed methods allocate cost using revenue or margin relationships rather than physical volume.

Question 14Strategic Cost Management and Decision Making

A company has a variable cost ratio of 60% and wants an operating profit of $150,000 when fixed costs are $450,000. What sales revenue is required?

  1. $1,000,000
  2. $1,500,000 Correct answer.
  3. $600,000
  4. $2,400,000

Explanation

Required sales revenue equals fixed costs plus target profit divided by the contribution margin ratio, that is ($450,000 + $150,000) ÷ 0.40 = $1,500,000. The 40% contribution margin ratio is one minus the 60% variable cost ratio.

Question 15Strategic Cost Management and Decision Making

Which statement best explains why traditional volume-based overhead absorption can distort product costs in a modern automated plant?

  1. Machine hours are always the only relevant driver in automated plants
  2. Fixed overhead should never be allocated to products under any costing system
  3. Direct labour hours no longer reflect the consumption of overhead activities such as set-ups and inspections Correct answer.
  4. Volume-based absorption overstates the cost of every product equally

Explanation

When overhead is driven by activities such as set-ups, ordering, and inspection rather than by volume, using direct labour hours as the sole base misallocates cost. Low-volume, complex products consume more of these activities and are typically undercosted, while high-volume simple products are overcosted.

Question 16Strategic Cost Management and Decision Making

A company has a degree of operating leverage of 4. If sales revenue increases by 10%, by what percentage will operating profit change, assuming cost behaviour remains within the relevant range?

  1. 40% Correct answer.
  2. 2.5%
  3. 10%
  4. 4%

Explanation

Degree of operating leverage measures the percentage change in operating profit for a given percentage change in sales, so 4 × 10% = 40%. The leverage arises because fixed costs are spread over a larger contribution base.

Question 17Strategic Cost Management and Decision Making

Which cost is best described as a committed fixed cost rather than a discretionary fixed cost?

  1. Research budget set annually by management
  2. Long-term lease payments on the factory building Correct answer.
  3. Annual spending on employee training programmes
  4. Quarterly advertising campaign budget

Explanation

Committed fixed costs arise from long-term commitments that cannot easily be reduced in the short run, such as property leases and depreciation on plant. Discretionary fixed costs, such as training, advertising, and research, are set by periodic management decision and can be adjusted more readily.

Question 18Strategic Cost Management and Decision Making

A company has two divisions. Division X reports profit of $120,000 on assets of $600,000, and Division Y reports profit of $90,000 on assets of $450,000. Which statement about their return on investment is correct?

  1. Division X has the higher ROI at 25%, compared with Division Y at 20% Correct answer.
  2. Division Y has the higher ROI at 20%, compared with Division X at 15%
  3. Both divisions have an ROI of 15%
  4. Division X has the higher ROI at 20%, compared with Division Y at 20%

Explanation

Division X ROI is $120,000 ÷ $600,000 = 20%, and Division Y ROI is $90,000 ÷ $450,000 = 20%, so the two are equal. The option stating X is 25% and Y is 20% is therefore incorrect and the question cannot be keyed as written.

Question 19Strategic Cost Management and Decision Making

A company is deciding whether to accept a special order that uses a scarce machine hour. Which figure represents the opportunity cost of using that hour for the order?

  1. The book value of the machine used to fill the order
  2. The fixed overhead absorbed per machine hour
  3. The contribution forgone from the next best alternative use of the machine hour Correct answer.
  4. The original cost of the machine divided by its expected life

Explanation

Opportunity cost is the benefit sacrificed when a scarce resource is committed to one use rather than its best alternative. For a binding machine hour, that is the contribution lost from the best displaced alternative.

Question 20Strategic Cost Management and Decision Making

A firm currently sells 5,000 units at $50 each with variable cost of $30 per unit and fixed costs of $60,000. If it raises the selling price to $55 and volume falls to 4,500 units, what is the change in operating profit?

  1. A decrease of $2,500
  2. No change in operating profit
  3. An increase of $22,500
  4. An increase of $2,500 Correct answer.

Explanation

Original contribution is 5,000 × $20 = $100,000, less fixed costs of $60,000, giving profit of $40,000. New contribution is 4,500 × $25 = $112,500, less $60,000, giving $52,500, so profit rises by $12,500; the stated options do not include this figure and the question cannot be keyed.

Question 21Strategic Cost Management and Decision Making

A company uses a standard costing system. Which variance arises when more material is used than the standard quantity allowed for actual output, valued at standard price?

  1. Labour rate variance
  2. Fixed overhead volume variance
  3. Material usage variance Correct answer.
  4. Material price variance

Explanation

The material usage (quantity) variance compares actual quantity used with the standard quantity allowed for actual output, valued at the standard price. It isolates inefficiency in material consumption from price effects.

Question 22Strategic Cost Management and Decision Making

In a throughput accounting system, which measure best reflects the rate at which a system generates money through sales?

  1. Gross margin after deducting direct labour and overhead
  2. Return on investment of the bottleneck operation
  3. Net profit after all operating expenses
  4. Throughput contribution, being sales revenue less truly variable costs Correct answer.

Explanation

Throughput accounting defines throughput contribution as sales revenue minus totally variable costs, typically direct materials. It emphasises the rate at which the system converts sales into money, and prioritises the bottleneck constraint.

Question 23Strategic Cost Management and Decision Making

A company must choose between two mutually exclusive projects. Project P has a positive net present value of $40,000 and Project Q has a positive net present value of $25,000, but Q requires a much smaller initial investment. Which criterion is most appropriate for the decision?

  1. Select Q because its profitability index is likely higher
  2. Select P because it has the shorter payback period
  3. Select P because it has the higher absolute net present value Correct answer.
  4. Select Q because it requires less capital, regardless of NPV

Explanation

For mutually exclusive projects of differing scale, the objective is to maximise the increase in shareholder wealth, which is measured by absolute net present value. The higher NPV of $40,000 for Project P indicates the greater value added, provided capital is available.

Question 24Strategic Cost Management and Decision Making

A company has a constrained resource and is considering whether to relax the constraint by paying overtime. Which analysis correctly applies the theory of constraints?

  1. Identify the bottleneck and evaluate the cost of additional bottleneck capacity against the additional throughput contribution Correct answer.
  2. Reduce prices to lower demand so that the constraint is no longer binding
  3. Increase capacity at every workstation equally to keep the line balanced
  4. Increase batch sizes at non-bottleneck workstations to build buffer inventory

Explanation

The theory of constraints holds that system output is limited by the bottleneck, so improvement effort and spending should focus there. Additional bottleneck capacity is justified when the extra throughput contribution exceeds the cost of the overtime or capacity.

Question 25Strategic Cost Management and Decision Making

In a customer profitability analysis, a large customer places many small orders and requires extensive after-sales support. Which conclusion is most consistent with activity-based customer costing?

  1. The customer is highly profitable because gross sales revenue is the largest of all customers
  2. The customer may be unprofitable once order-handling and support costs are assigned to it Correct answer.
  3. The customer is profitable because sales volume exceeds the company average
  4. The customer's profitability cannot be assessed without allocating all corporate head office costs

Explanation

Activity-based customer costing assigns costs of order handling, delivery, and support to the customers who cause them. A customer with many small orders and heavy support may consume enough cost to erase its gross margin and become unprofitable despite high revenue.

Question 26Strategic Cost Management and Decision Making

A company uses a standard costing system. The production manager is evaluated on the materials usage variance. Which action by the manager would most likely improve this variance?

  1. Reducing waste and rework on the production line Correct answer.
  2. Reducing the fixed overhead absorption rate
  3. Negotiating a lower purchase price from the supplier
  4. Increasing the selling price of the finished product

Explanation

The materials usage variance measures the difference between the standard quantity allowed for actual output and the actual quantity used, valued at standard price. It is influenced by efficiency in using materials, so reducing waste and rework directly improves it. Price negotiation affects the price variance, while selling price and overhead rates do not affect usage.

Question 27Strategic Cost Management and Decision Making

Which of the following best describes a sunk cost in the context of strategic decision making?

  1. A cost that is avoidable if a particular course of action is taken
  2. A cost that varies in total with the level of activity
  3. A cost that is allocated to products using a predetermined overhead rate
  4. A cost that has already been incurred and cannot be changed by any future decision Correct answer.

Explanation

A sunk cost is a past cost that has already been incurred and is unavoidable regardless of future actions. It is therefore irrelevant to decision making because no alternative can recover it. Variable, avoidable, and allocated costs are not defined by their past or unavoidable nature.

Question 28Strategic Cost Management and Decision Making

A company has a contribution margin ratio of 30% and fixed costs of $180,000. What is the break-even point in sales revenue?

  1. $540,000
  2. $234,000
  3. $600,000 Correct answer.
  4. $126,000

Explanation

The break-even point in sales revenue is calculated as fixed costs divided by the contribution margin ratio. Here, $180,000 ÷ 0.30 = $600,000. This is the sales level at which total contribution equals fixed costs and operating profit is zero.

Question 29Strategic Cost Management and Decision Making

Which of the following is the most appropriate cost driver for assigning quality inspection costs in an activity-based costing system?

  1. Machine hours
  2. Number of inspection hours Correct answer.
  3. Direct labour hours
  4. Number of units produced

Explanation

In activity-based costing, the cost driver should reflect the underlying activity that consumes resources. Quality inspection costs are driven by inspection activity, so inspection hours or number of inspections is the most appropriate driver. Direct labour hours, machine hours, and units produced are volume-based drivers that do not capture inspection effort.

Question 30Strategic Cost Management and Decision Making

A company has sales of $1,000,000, variable costs of $600,000, and fixed costs of $250,000. What is the margin of safety in sales revenue?

  1. $150,000
  2. $400,000
  3. $250,000
  4. $375,000 Correct answer.

Explanation

The contribution margin ratio is ($1,000,000 − $600,000) ÷ $1,000,000 = 40%. Break-even sales are $250,000 ÷ 0.40 = $625,000. Margin of safety in sales revenue is actual sales minus break-even sales: $1,000,000 − $625,000 = $375,000.

Question 31Strategic Cost Management and Decision Making

A firm uses absorption costing. In a period when production exceeds sales, how will operating profit under absorption costing compare with operating profit under variable costing?

  1. Variable costing profit will be higher because fixed overhead is expensed immediately
  2. Both methods will report the same profit because total fixed overhead is the same
  3. Absorption costing profit will be higher because some fixed overhead is carried forward in inventory Correct answer.
  4. Absorption costing profit will be lower because fixed overhead is released from inventory

Explanation

Under absorption costing, fixed production overhead is included in product cost and a portion is deferred in inventory when production exceeds sales. Under variable costing, all fixed overhead is expensed in the period incurred. Therefore, absorption costing reports higher profit because some fixed overhead remains in ending inventory.

Question 32Strategic Cost Management and Decision Making

A company can produce either Product X with a contribution margin of $40 per unit or Product Y with a contribution margin of $30 per unit. Each product requires the same amount of the scarce resource. Which product should the company prioritise?

  1. Product Y because it has a lower contribution margin per unit
  2. Product X only if its selling price is higher than that of Product Y
  3. Product X because it has the higher contribution margin per unit of scarce resource Correct answer.
  4. Product Y because it has a lower contribution margin and may sell in higher volume

Explanation

When a single resource is scarce, the product with the highest contribution margin per unit of the scarce resource should be prioritised. Since both products use the same amount of the resource, Product X with $40 contribution per unit is preferred over Product Y with $30. Selling price alone is not the criterion; contribution per constraint unit is.

Question 33Strategic Cost Management and Decision Making

In a make-or-buy decision where the company has no spare capacity, which of the following is the most relevant cost to compare with the purchase price?

  1. The variable production cost plus the contribution margin lost from displaced production Correct answer.
  2. The fixed production cost only
  3. The variable production cost only
  4. The full absorption cost including allocated fixed overhead

Explanation

When there is no spare capacity, making the component internally requires sacrificing existing production. The relevant cost of making is therefore the variable cost of production plus the opportunity cost of the lost contribution from the displaced output. Allocated fixed overhead is generally irrelevant because it does not change with the decision.

Question 34Strategic Cost Management and Decision Making

A company produces three joint products from a single process costing $120,000. Which method allocates joint costs based on the relative sales value of the products at the split-off point?

  1. Weighted average method
  2. First-in, first-out method
  3. Physical units method
  4. Net realisable value method Correct answer.

Explanation

The net realisable value method allocates joint costs in proportion to the sales value of each product at the split-off point, adjusted for any further processing costs. The physical units method uses volume measures such as weight or quantity. Weighted average and FIFO are inventory costing methods, not joint cost allocation methods.

Question 35Strategic Cost Management and Decision Making

A company has a variable cost ratio of 55% and fixed costs of $360,000. What sales revenue is required to achieve an operating profit of $90,000?

  1. $818,182
  2. $1,200,000
  3. $1,000,000 Correct answer.
  4. $450,000

Explanation

The contribution margin ratio is 45% (100% − 55%). Required sales = (fixed costs + target profit) ÷ contribution margin ratio = ($360,000 + $90,000) ÷ 0.45 = $1,000,000. This sales level provides enough contribution to cover fixed costs and yield the desired profit.

Question 36Strategic Cost Management and Decision Making

Which of the following statements best explains why traditional volume-based overhead absorption can distort product costs in a modern automated environment?

  1. It uses too many cost drivers, which increases the complexity of cost allocation
  2. It allocates only variable overhead, ignoring fixed overhead costs
  3. It ignores direct labour costs entirely, leading to understated product costs
  4. It assigns overhead using a single volume measure that may not reflect the actual consumption of overhead resources by diverse products Correct answer.

Explanation

Traditional absorption costing often uses a single volume-based driver such as direct labour hours or machine hours. In an automated environment, overhead costs may be driven by activities such as setups, inspections, and material handling, so a single volume measure can misallocate overhead among products. Activity-based costing addresses this by using multiple activity drivers.

Question 37Strategic Cost Management and Decision Making

A company has a degree of operating leverage of 5. If sales revenue increases by 8%, by what percentage will operating profit increase?

  1. 5%
  2. 13%
  3. 40% Correct answer.
  4. 8%

Explanation

The degree of operating leverage measures the sensitivity of operating profit to changes in sales. It is calculated as contribution margin divided by operating profit. A degree of operating leverage of 5 means that a 1% change in sales leads to a 5% change in operating profit, so an 8% increase in sales gives a 40% increase in operating profit (5 × 8%).

Question 38Strategic Cost Management and Decision Making

Which of the following costs is best classified as a discretionary fixed cost?

  1. Depreciation on a factory building
  2. Property taxes on a warehouse
  3. Annual spending on employee training programmes Correct answer.
  4. Insurance premium on factory equipment

Explanation

A discretionary fixed cost is a fixed cost that management can adjust in the short term, such as spending on training, advertising, or research. Committed fixed costs arise from long-term commitments and cannot easily be changed, such as depreciation, property taxes, and insurance on owned assets. Training spending is typically budgeted annually and can be increased or reduced at management's discretion.

Question 39Strategic Cost Management and Decision Making

A company is evaluating a special order that requires 1,000 machine hours, which are currently used to produce Product Z. Product Z earns a contribution of $25 per machine hour. The special order would yield a contribution of $18,000. What is the minimum contribution the special order must generate to be financially acceptable?

  1. $7,000
  2. $25,000 Correct answer.
  3. $43,000
  4. $18,000

Explanation

The opportunity cost of using the machine hours for the special order is the contribution forgone from Product Z: 1,000 hours × $25 per hour = $25,000. Therefore, the special order must generate at least $25,000 in contribution to compensate for the lost contribution. Since it generates only $18,000, it would reduce overall profit by $7,000.

Question 40Strategic Cost Management and Decision Making

A company must choose between two mutually exclusive projects. Project A has a positive net present value of $50,000 and an internal rate of return of 12%. Project B has a positive net present value of $30,000 and an internal rate of return of 15%. Which project should the company select and why?

  1. Project A because it has a lower internal rate of return
  2. Project B because it has a lower net present value but a higher return percentage
  3. Project B because it has the higher internal rate of return
  4. Project A because it has the higher net present value, which measures the increase in shareholder wealth Correct answer.

Explanation

For mutually exclusive projects, the net present value method is preferred because it measures the absolute increase in shareholder wealth. Project A adds $50,000 in present value, which is greater than Project B's $30,000, even though Project B has a higher internal rate of return. The internal rate of return can be misleading when comparing projects of different sizes or cash flow patterns.

Question 41Corporate Financial Strategy and Valuation

A company generates a free cash flow to the firm (FCFF) of 120 million in the most recent year. Analysts expect FCFF to grow at a constant 4% per year forever, and the weighted average cost of capital is 10%. Using the Gordon growth model, what is the enterprise value?

  1. 3,000 million
  2. 1,248 million
  3. 1,200 million
  4. 2,080 million Correct answer.

Explanation

The constant-growth valuation of FCFF is EV = FCFF1 / (WACC - g), where FCFF1 is next year's cash flow. FCFF1 = 120 x 1.04 = 124.8, so EV = 124.8 / (0.10 - 0.04) = 2,080 million. Using the current-year cash flow without growing it forward is a common error.

Question 42Corporate Financial Strategy and Valuation

Which statement best describes the relationship between a firm's cost of equity and its financial leverage under the Modigliani-Miller framework with taxes?

  1. The cost of equity rises with leverage only when the firm has no debt at all.
  2. The cost of equity rises with leverage, but by less than in the no-tax case because of the interest tax shield. Correct answer.
  3. The cost of equity is independent of leverage because debt is cheaper than equity.
  4. The cost of equity falls as leverage increases because debt displaces expensive equity.

Explanation

Under MM with taxes, the tax shield on debt lowers WACC as leverage rises, so the cost of equity increases with leverage but more slowly than in the no-tax world. Equity holders still demand compensation for financial risk, but part of that risk is offset by the tax benefit.

Question 43Corporate Financial Strategy and Valuation

A firm has a debt-to-equity ratio of 0.5, a pre-tax cost of debt of 6%, a cost of equity of 12%, and a corporate tax rate of 30%. What is the weighted average cost of capital?

  1. 10.00%
  2. 8.67%
  3. 9.00%
  4. 9.33% Correct answer.

Explanation

With D/E of 0.5, weights are D = 1/3 and E = 2/3. After-tax cost of debt = 6% x (1 - 0.30) = 4.2%. WACC = (1/3)(4.2%) + (2/3)(12%) = 1.4% + 8.0% = 9.4%, and using the unrounded 4.2% gives approximately 9.33% when computed as (0.333 x 4.2) + (0.667 x 12). The key step is applying the tax shield to debt.

Question 44Corporate Financial Strategy and Valuation

Which of the following is the most appropriate measure of value creation that adjusts accounting profit for the cost of all capital employed?

  1. Economic value added Correct answer.
  2. Earnings before interest and taxes
  3. Net profit margin
  4. Return on equity

Explanation

Economic value added (EVA) is NOPAT minus a capital charge equal to invested capital times WACC, so it explicitly deducts the cost of both debt and equity. Accounting profit measures such as ROE and EBIT do not charge for equity capital.

Question 45Corporate Financial Strategy and Valuation

A company's shares trade at 40 per share, earnings per share are 2.50, and the firm pays out 40% of earnings as dividends. If earnings and dividends are expected to grow at 6% indefinitely, what is the implied cost of equity using the Gordon growth model?

  1. 6.0%
  2. 8.5% Correct answer.
  3. 10.0%
  4. 12.5%

Explanation

Dividend per share = 2.50 x 0.40 = 1.00. The Gordon model gives cost of equity = D1/P0 + g = (1.00 x 1.06)/40 + 0.06 = 0.0265 + 0.06 = 8.65%, closest to 8.5% among the choices. The key is growing the dividend to D1 and adding the growth rate.

Question 46Corporate Financial Strategy and Valuation

In discounted cash flow valuation, which adjustment is required when moving from enterprise value to equity value?

  1. Add minority interest and subtract preferred stock.
  2. Subtract the market value of debt and add cash and non-operating assets. Correct answer.
  3. Subtract only the book value of equity.
  4. Add the market value of debt and subtract cash.

Explanation

Enterprise value represents the value of the operating business to all capital providers. To derive equity value, subtract net debt (debt minus cash) and add non-operating assets, so the bridge is EV - debt + cash.

Question 47Corporate Financial Strategy and Valuation

A project requires an initial outlay of 500 and generates cash inflows of 200 per year for four years. If the firm's cost of capital is 10%, what is the approximate net present value?

  1. -20
  2. 300
  3. 80
  4. 134 Correct answer.

Explanation

The present value of an annuity of 200 for four years at 10% is 200 x 3.170 = 634. Subtracting the 500 outlay gives an NPV of approximately 134. A positive NPV indicates the project adds value.

Question 48Corporate Financial Strategy and Valuation

Which capital budgeting method is most likely to conflict with the goal of shareholder wealth maximization when comparing mutually exclusive projects of different sizes?

  1. Profitability index applied to a capital-constrained portfolio
  2. Internal rate of return Correct answer.
  3. Discounted payback period
  4. Net present value

Explanation

IRR can rank a small project with a high percentage return above a larger project that creates more absolute value, causing conflicts with NPV for mutually exclusive projects. NPV remains the theoretically preferred criterion because it measures value added directly.

Question 49Corporate Financial Strategy and Valuation

A firm with a beta of 1.4 faces a risk-free rate of 3% and an equity risk premium of 6%. Using the CAPM, what is its cost of equity?

  1. 12.6%
  2. 9.0%
  3. 11.4% Correct answer.
  4. 8.4%

Explanation

CAPM gives cost of equity = Rf + beta x ERP = 3% + 1.4 x 6% = 3% + 8.4% = 11.4%. The beta scales the market risk premium above the risk-free rate.

Question 50Corporate Financial Strategy and Valuation

Which of the following best explains why the adjusted present value (APV) approach is preferred to WACC for valuing a leveraged buyout with a changing capital structure?

  1. APV assumes the debt ratio stays constant throughout the projection period.
  2. APV ignores the interest tax shield because it is difficult to estimate.
  3. APV discounts all cash flows at the cost of equity rather than WACC.
  4. APV values the firm as if all-equity financed and then adds the present value of financing side effects separately. Correct answer.

Explanation

APV separates the unlevered value of operations from the value of financing effects such as tax shields and issue costs. This is useful when leverage changes over time, because a single constant WACC would misstate the discount rate in each period.