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CMA Sri Lanka SL2 Financial Strategy & Valuation Exam study materials
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CMA Sri Lanka SL2 Financial Strategy & Valuation Exam practice questions

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Question 1Financial Strategy, Corporate Objectives and Stakeholder Value

In corporate financial strategy, the primary objective of a listed company is most commonly defined as:

  1. minimising the weighted average cost of capital
  2. maximising annual accounting profit after tax
  3. maximising the long-term market value of its ordinary shares Correct answer.
  4. maximising sales revenue growth

Explanation

Shareholder wealth maximisation treats the market value of ordinary shares as the primary measure of long-term value creation. Accounting profit can be increased by taking excessive risk or under-investing, and revenue growth may destroy value if returns fall below the cost of capital. Minimising WACC is a financing decision that supports value creation rather than the ultimate corporate objective.

Question 2Financial Strategy, Corporate Objectives and Stakeholder Value

Which governance mechanism most directly reduces the agency conflict between shareholders and executive managers?

  1. Reducing the frequency of external audit
  2. Linking a significant portion of executive pay to long-term share price performance Correct answer.
  3. Increasing the proportion of executive directors on the board
  4. Allowing managers unrestricted discretion over corporate donations

Explanation

Agency conflict arises because managers act as agents for shareholders and may pursue their own interests. Remuneration tied to long-term share price performance aligns managerial rewards with shareholder wealth creation. Strengthening insider control or weakening monitoring typically increases agency costs rather than reducing them.

Question 3Financial Strategy, Corporate Objectives and Stakeholder Value

Under Mendelow's stakeholder power-interest matrix, a stakeholder with high power and high interest should be managed as:

  1. key player, managed closely Correct answer.
  2. keep informed
  3. minimal effort
  4. keep satisfied

Explanation

Mendelow's matrix classifies stakeholders by their power to affect the organisation and their interest in its activities. High power combined with high interest identifies key players who must be managed closely and involved in major decisions. Keep satisfied applies to high-power, low-interest stakeholders, while keep informed applies to low-power, high-interest stakeholders.

Question 4Financial Strategy, Corporate Objectives and Stakeholder Value

The triple bottom line approach to corporate performance evaluates the firm against which three dimensions?

  1. Revenue growth, cost control and asset utilisation
  2. Shareholder value, customer satisfaction and employee morale
  3. Economic, social and environmental performance Correct answer.
  4. Profit, cash flow and liquidity

Explanation

The triple bottom line, associated with Elkington, broadens corporate performance beyond financial profit to include social and environmental outcomes. It is often summarised as people, planet and profit. The other options describe financial or managerial performance measures rather than the three triple bottom line dimensions.

Question 5Financial Strategy, Corporate Objectives and Stakeholder Value

A retail bank measures the average time taken to approve a customer loan application. Under Kaplan and Norton's balanced scorecard, this measure belongs to which perspective?

  1. Internal business process Correct answer.
  2. Customer
  3. Learning and growth
  4. Financial

Explanation

Process cycle time is a measure of how efficiently an internal operating process performs. The internal business process perspective focuses on the critical processes at which the organisation must excel. Customer perspective measures would include satisfaction or retention, while learning and growth covers employee skills and information systems.

Question 6Financial Strategy, Corporate Objectives and Stakeholder Value

A criticism of using profit maximisation as the sole corporate objective is that it:

  1. ignores the need to generate cash flows
  2. does not account for the timing and risk of future returns Correct answer.
  3. is prohibited under all corporate governance codes
  4. always leads to lower share prices than revenue maximisation

Explanation

Profit maximisation is an accounting-based objective and does not explicitly consider when returns arise or the risk attached to them. Financial strategy instead focuses on value creation, which requires comparing expected returns with the cost of capital and timing. Cash flow is related to profit, and no universal governance prohibition or automatic share price ranking exists.

Question 7Financial Strategy, Corporate Objectives and Stakeholder Value

Under stakeholder theory, corporate strategy should primarily aim to:

  1. minimise the number of stakeholder groups consulted
  2. maximise short-term distributable profit for shareholders
  3. prioritise management remuneration over other claims
  4. balance the legitimate interests of groups affected by the firm's activities Correct answer.

Explanation

Stakeholder theory holds that a company should consider the legitimate interests of employees, customers, suppliers, communities and shareholders rather than shareholders alone. Strategy therefore seeks a balanced approach to the claims of affected groups. Short-term profit and management remuneration do not represent the central stakeholder principle.

Question 8Financial Strategy, Corporate Objectives and Stakeholder Value

Which statement best describes the relationship between a company's mission and its financial objectives?

  1. Financial objectives are formulated independently of the mission
  2. Financial objectives replace the mission once the company lists its shares
  3. Financial objectives should translate the mission into measurable performance targets Correct answer.
  4. The mission is a short-term budget target set by the finance function

Explanation

A mission expresses the organisation's overarching purpose and strategic direction. Financial objectives convert that purpose into specific, measurable targets such as return on capital employed or earnings growth. They should therefore be consistent with, rather than independent of, the mission.

Question 9Financial Strategy, Corporate Objectives and Stakeholder Value

In agency theory, which item is classified as a residual loss?

  1. The reduction in shareholder value that remains after monitoring and bonding costs have been incurred Correct answer.
  2. The fee paid to an external auditor for certifying the financial statements
  3. The cost of installing a whistleblowing hotline
  4. The discount offered to customers for early payment

Explanation

Agency costs comprise monitoring costs, bonding costs and residual loss. Residual loss is the remaining reduction in value caused by the divergence between agent and principal interests even after monitoring and bonding arrangements have been put in place. Audit fees and whistleblowing systems are examples of monitoring costs, not residual loss.

Question 10Financial Strategy, Corporate Objectives and Stakeholder Value

A public-sector hospital treats 12% more patients with the same budget and staffing levels. In value-for-money terms, this improvement is best described as:

  1. efficiency Correct answer.
  2. economy
  3. effectiveness
  4. equity

Explanation

Efficiency measures the relationship between outputs and the inputs used to produce them. Treating more patients with the same budget and staffing means more output is achieved for the same input. Economy refers to the cost of inputs, while effectiveness refers to the achievement of intended outcomes.

Question 11Financial Strategy, Corporate Objectives and Stakeholder Value

A company's board is reviewing its strategic financial management framework. Which set of decisions forms the core of that framework?

  1. Investment, financing and dividend decisions Correct answer.
  2. Procurement, production and distribution decisions
  3. Audit, compliance and internal control decisions
  4. Operating, marketing and human resource decisions

Explanation

Strategic financial management centres on the investment decision (which assets to acquire), the financing decision (how to fund them) and the dividend decision (how much cash to return). Operating, audit and supply-chain choices support the strategy but are not the three core financial decisions.

Question 12Financial Strategy, Corporate Objectives and Stakeholder Value

A district health authority buys the same volume and quality of medical gloves from a new supplier at a unit price 8% lower than before. Which value-for-money element has improved?

  1. Economy Correct answer.
  2. Effectiveness
  3. Equity
  4. Efficiency

Explanation

Economy concerns acquiring inputs of the required quality at the lowest cost, so a lower unit price for identical gloves is a straightforward economy gain. Efficiency concerns the ratio of outputs to inputs, and effectiveness concerns whether outcomes or targets are achieved.

Question 13Financial Strategy, Corporate Objectives and Stakeholder Value

Under a 'comply or explain' corporate governance code, a listed company that chooses not to follow a provision must:

  1. explain the departure and its rationale to shareholders Correct answer.
  2. obtain prior written approval from every shareholder before departing
  3. suspend its listing until it returns to full compliance with the code
  4. apply the provision only to its overseas subsidiaries and joint ventures

Explanation

Comply or explain allows flexibility: the company may depart from a provision, but must state that it has done so and explain why, allowing shareholders to judge the explanation. It does not require unanimous shareholder approval, delisting or selective application.

Question 14Financial Strategy, Corporate Objectives and Stakeholder Value

A residents' association has a legitimate claim on a factory's noise levels and regards the issue as urgent, but it has little ability to influence the company. Under Mitchell, Agle and Wood's stakeholder salience model, the association is best classified as:

  1. a dependent stakeholder Correct answer.
  2. a definitive stakeholder
  3. a dormant stakeholder
  4. a discretionary stakeholder

Explanation

Salience depends on power, legitimacy and urgency. The association has legitimacy and urgency but lacks power, which makes it dependent; it becomes definitive only when all three attributes are present. Dormant stakeholders possess power alone, while discretionary stakeholders possess legitimacy alone.

Question 15Financial Strategy, Corporate Objectives and Stakeholder Value

A division reports return on capital employed of 13%, while the board's risk-adjusted weighted average cost of capital for that division is 15%. On a shareholder value basis, the division is:

  1. value-neutral because ROCE and WACC measure different things and cannot be compared
  2. destroying value, as its return is below its cost of capital Correct answer.
  3. creating value because ROCE exceeds the rate of inflation and the growth target
  4. creating value because it reports a positive accounting return on capital

Explanation

Shareholder value is created only when the return on invested capital exceeds the opportunity cost of that capital. A 13% return against a 15% cost of capital means the division earns less than investors require, so it destroys value even though the accounting return is positive.

Question 16Financial Strategy, Corporate Objectives and Stakeholder Value

Which executive reward design is most likely to align a chief executive's behaviour with long-term shareholder value?

  1. Restricted shares vesting over years with clawback for restatements Correct answer.
  2. A large annual cash bonus tied solely to current-year reported profit
  3. A fixed salary increase agreed at the start of each financial year
  4. Share options with a one-year vesting period and no performance condition

Explanation

Multi-year vesting and clawback extend the executive's decision horizon and expose remuneration to later evidence about performance quality, discouraging short-term earnings manipulation. Annual profit bonuses and short-vesting options reward near-term outcomes, while a fixed salary is largely insensitive to performance.

Question 17Financial Strategy, Corporate Objectives and Stakeholder Value

In a listed company where a single family controls 55% of the votes, the most prominent agency conflict is between:

  1. controlling and minority shareholders Correct answer.
  2. the company and the stock exchange regulator
  3. senior managers and the company's trade creditors
  4. the board of directors and the external auditor

Explanation

Where ownership is concentrated, the classic manager–shareholder conflict is overshadowed by a principal–principal conflict: the controlling owner can influence related-party transactions, dividend policy and board appointments in ways that disadvantage minority investors. Auditor, creditor and regulator relationships are governed by separate accountability mechanisms.

Question 18Financial Strategy, Corporate Objectives and Stakeholder Value

A publicly funded museum receives a fixed annual grant. Which objective is most appropriate for evaluating its financial strategy?

  1. Maximise visitor numbers regardless of the cost per visitor
  2. Deliver agreed visitor and education outcomes within the grant Correct answer.
  3. Maximise the surplus generated from ticket sales each year
  4. Minimise total operating expenditure regardless of visitor numbers

Explanation

A grant-funded entity is expected to deliver specified service outcomes while living within its budget, so performance should be judged on outcomes achieved per unit of funding. Profit maximisation, indiscriminate cost cutting and volume at any cost all ignore the balance between mission delivery and financial constraint.

Question 19Financial Strategy, Corporate Objectives and Stakeholder Value

Which statement best describes the 'enlightened shareholder value' approach to corporate governance?

  1. Directors must treat every stakeholder group as having an equal claim on the company's residual income and reserves
  2. Directors' duties are owed exclusively to the creditors whenever the company reports a profit
  3. Directors pursue long-term shareholder value while considering employees, suppliers, customers and communities Correct answer.
  4. Directors may prioritise any stakeholder group provided that the annual dividend is maintained at its stated level

Explanation

Enlightened shareholder value retains shareholder value as the ultimate objective but requires directors to consider the long-term consequences of decisions for a range of stakeholders. It is therefore distinct from a stakeholder-equality model and from a narrow duty owed only to creditors.

Question 20Financial Strategy, Corporate Objectives and Stakeholder Value

A conglomerate with no operational links between its divisions consistently trades at a market value below the sum of its parts. Which explanation is most consistent with financial strategy theory?

  1. The discount proves that the divisions should be merged into a single reporting segment for investors
  2. Diversification always raises value because it reduces unsystematic risk for shareholders and lowers the cost of debt
  3. Investors can diversify unsystematic risk themselves, so unrelated diversification may destroy value Correct answer.
  4. The conglomerate is capturing synergies that the stock market has failed to recognise in its valuation

Explanation

Shareholders can hold diversified portfolios cheaply, so a firm does not add value merely by spreading across unrelated industries. A persistent conglomerate discount is often attributed to agency-driven empire building, cross-subsidisation of weak divisions and inefficient internal capital allocation.

Question 21Financial Strategy, Corporate Objectives and Stakeholder Value

A board is deciding whether to fund a new factory using retained earnings, a bank loan or an equity issue. In corporate financial strategy, this choice is best classified as:

  1. a financing decision, because it sets the long-term capital mix Correct answer.
  2. a working capital decision, because it changes cash balances
  3. an investment decision, because it selects a long-term asset
  4. a dividend decision, because it changes distributable reserves

Explanation

Financing decisions concern how long-term funds are raised and structured, including the balance between debt, equity and retained earnings. The selection of the factory itself would be an investment decision, but the choice among funding sources is a financing decision that shapes capital structure.

Question 22Financial Strategy, Corporate Objectives and Stakeholder Value

In a listed company applying good corporate governance, which task is most appropriate for the audit committee rather than the full board?

  1. Setting the annual dividend per share for shareholders
  2. Selecting the company's next chief executive officer
  3. Overseeing the external audit and auditor appointment Correct answer.
  4. Approving the chief executive's long-term incentive plan

Explanation

The audit committee typically oversees financial reporting, internal control and the external audit relationship, including recommending or approving auditor appointment. Dividend policy, executive remuneration and CEO succession belong with the board or other specialised committees such as remuneration and nomination committees.

Question 23Financial Strategy, Corporate Objectives and Stakeholder Value

Division A reports net operating profit after tax of Rs. 50 million and invested capital of Rs. 400 million. The company's after-tax weighted average cost of capital is 10%. What is the division's economic value added?

  1. Rs. 50 million
  2. Rs. 40 million
  3. Rs. 10 million Correct answer.
  4. Rs. 90 million

Explanation

Economic value added equals NOPAT minus a charge for invested capital at the WACC. The capital charge is 10% × Rs. 400 million = Rs. 40 million, so EVA is Rs. 50 million − Rs. 40 million = Rs. 10 million.

Question 24Financial Strategy, Corporate Objectives and Stakeholder Value

Which statement best captures instrumental stakeholder theory?

  1. Treating stakeholders well is a means to superior long-term financial performance Correct answer.
  2. Stakeholders have intrinsic rights that override shareholder returns in every case
  3. Corporate objectives should be set solely by reference to the largest shareholder's preferences
  4. Only stakeholders with formal contracts have a legitimate claim on the company

Explanation

Instrumental stakeholder theory treats stakeholder management as a strategy for building trust and sustaining long-term value creation. It differs from normative stakeholder theory, which justifies stakeholder claims on intrinsic ethical grounds rather than purely as a means to financial ends.

Question 25Financial Strategy, Corporate Objectives and Stakeholder Value

Which item is best classified as an agency monitoring cost incurred by shareholders?

  1. A bonus paid to a divisional manager for exceeding sales targets
  2. The external audit fee and the cost of independent board oversight Correct answer.
  3. The loss in value when managers purchase and use excessive corporate jets
  4. The interest premium charged by lenders to compensate for default risk

Explanation

Monitoring costs are incurred by principals to observe and constrain agent behaviour, such as paying for an independent audit and independent board oversight. These costs aim to reduce information asymmetry and managerial opportunism.

Question 26Financial Strategy, Corporate Objectives and Stakeholder Value

Under the concept of double materiality in sustainability reporting, a company should report:

  1. Only the company's negative impacts on society and the environment
  2. Both how sustainability affects enterprise value and how the company affects society Correct answer.
  3. Sustainability matters that are material to either the company or its stakeholders, but not both
  4. Only sustainability matters that are financially material to the company

Explanation

Double materiality combines financial materiality, meaning sustainability issues that affect the company's value, with impact materiality, meaning the company's effects on society and the environment. Reporting under this concept therefore covers both directions of influence.

Question 27Financial Strategy, Corporate Objectives and Stakeholder Value

A company with a stable dividend policy unexpectedly increases its dividend per share. Under dividend signalling theory, the market is most likely to interpret this as:

  1. A guarantee that future dividends will never be reduced by the board
  2. Management's confidence that future cash flows can sustain the payout Correct answer.
  3. Evidence that the company lacks profitable investment projects for the cash
  4. A signal that the company's cost of equity has fallen

Explanation

Dividend signalling theory suggests that dividend changes convey management's private information about future earnings and cash flow. An unexpected increase is generally read as confidence that the higher payout can be sustained, not as a binding guarantee.

Question 28Financial Strategy, Corporate Objectives and Stakeholder Value

After a company has issued a large amount of debt, its shareholders encourage management to switch from low-risk to high-risk projects. This behaviour is best described as:

  1. Asset substitution, a shareholder–bondholder agency conflict Correct answer.
  2. A monitoring cost arising from the separation of ownership and control
  3. Signalling by managers to reduce information asymmetry with lenders
  4. A residual loss caused by managerial shirking

Explanation

Asset substitution occurs when shareholders favour riskier projects after debt is issued because they capture the upside while bondholders bear much of the downside. It is a classic agency conflict between shareholders and lenders.

Question 29Financial Strategy, Corporate Objectives and Stakeholder Value

A creditor has a legal right to accelerate repayment, the loan covenant breach is imminent, and the creditor can enforce security. Under the stakeholder salience model, this creditor is best classified as:

  1. Discretionary, because it has legitimacy but no power or urgency
  2. Dormant, because it has power but no legitimacy or urgency
  3. Dependent, because it has urgency and legitimacy but lacks power
  4. Definitive, because it possesses power, legitimacy and urgency Correct answer.

Explanation

The stakeholder salience model classifies stakeholders as definitive when they possess power, legitimacy and urgency simultaneously. This creditor can enforce repayment, has a legal claim, and faces an imminent breach, so all three attributes are present.

Question 30Financial Strategy, Corporate Objectives and Stakeholder Value

A company reports a rising return on equity driven mainly by increased borrowing rather than improved operating performance. Why is this ROE trend a weak indicator of shareholder value creation?

  1. Leverage can raise ROE while increasing financial risk, not economic profit Correct answer.
  2. ROE excludes interest payments, so it overstates the cost of debt
  3. ROE is calculated after tax, while shareholder value is always measured before tax
  4. ROE ignores the book value of equity and therefore cannot be compared across years

Explanation

ROE equals net income divided by equity, so greater borrowing can shrink the equity base and lift the ratio even without better operations. The higher financial risk borne by shareholders means the improvement may not represent genuine economic value creation.

Question 31Capital Structure, Cost of Capital and Gearing Decisions

A listed Sri Lankan manufacturer is computing its weighted average cost of capital. Under standard WACC convention, how should the cost of debt be incorporated when the company is taxed at 30%?

  1. The coupon rate on the most recent bond issue, used unchanged
  2. The pre-tax cost of debt used unchanged in the weighting
  3. The after-tax cost of debt grossed up by the tax rate
  4. The pre-tax cost of debt multiplied by (1 − tax rate) Correct answer.

Explanation

Interest is a deductible expense, so each rupee of interest reduces the tax charge by the tax rate and the effective burden on shareholders is the pre-tax rate times (1 − tax rate). Because WACC measures the after-tax return required by all providers of capital, the debt component must be adjusted for this interest tax shield, unlike the cost of equity which is already an after-tax figure.

Question 32Capital Structure, Cost of Capital and Gearing Decisions

Under the Modigliani-Miller propositions in a world with no corporate taxes, no bankruptcy costs and perfect capital markets, which statement about capital structure holds?

  1. Firm value is independent of the debt-equity mix, so financing choices do not create value Correct answer.
  2. The cost of equity remains constant as gearing rises because shareholders diversify away firm-specific risk
  3. Firm value is maximised at a capital structure of 100% debt
  4. Increasing gearing lowers WACC because interest is deductible against profits

Explanation

Without taxes, the tax shield disappears and any saving from cheaper debt is exactly offset by the higher return equity investors demand for bearing greater financial risk. Total firm value is therefore determined by operating cash flows and asset risk alone, not by how those assets are financed.

Question 33Capital Structure, Cost of Capital and Gearing Decisions

A trading company reports a degree of operating leverage of 3.0 at its current level of sales. What does this figure indicate about the company's exposure?

  1. A 1% change in EBIT produces roughly a 3% change in sales revenue
  2. Interest expense is three times the annual tax charge on operating profit
  3. The company's debt-to-equity ratio is three times the industry average
  4. A 1% change in sales produces roughly a 3% change in EBIT Correct answer.

Explanation

Degree of operating leverage measures the sensitivity of operating profit to sales, driven by the proportion of fixed versus variable costs in the cost base. A value of 3.0 means each 1% movement in sales magnifies into roughly a 3% movement in EBIT, in either direction.

Question 34Capital Structure, Cost of Capital and Gearing Decisions

A Sri Lankan conglomerate has a beta of 1.4. The risk-free rate is 9.0% and the expected market risk premium is 6.0%. Using the CAPM, what is the company's cost of equity?

  1. 15.0%
  2. 14.4%
  3. 17.4% Correct answer.
  4. 21.0%

Explanation

The CAPM sets the cost of equity as the risk-free rate plus beta multiplied by the market risk premium. Here 9.0% + (1.4 × 6.0%) = 9.0% + 8.4% = 17.4%, which is the return shareholders require given the company's systematic risk.

Question 35Capital Structure, Cost of Capital and Gearing Decisions

A company funds its operations 60% with equity and 40% with debt. The cost of equity is 18%, the pre-tax cost of debt is 12% and the corporate tax rate is 30%. What is the weighted average cost of capital?

  1. 15.60%
  2. 13.20%
  3. 14.16% Correct answer.
  4. 12.00%

Explanation

The debt component must be adjusted for the tax shield before weighting: 12% × (1 − 0.30) = 8.4%. WACC is then (0.60 × 18%) + (0.40 × 8.4%) = 10.8% + 3.36% = 14.16%, which is the hurdle rate for projects of average business risk.

Question 36Capital Structure, Cost of Capital and Gearing Decisions

An all-equity firm has a market value of LKR 500 million. It plans to issue LKR 200 million of perpetual debt and use the proceeds to repurchase shares. The corporate tax rate is 30% and capital markets are perfect apart from taxes. Under the Modigliani-Miller model with taxes, what is the value of the firm after the recapitalisation?

  1. LKR 700 million
  2. LKR 560 million Correct answer.
  3. LKR 500 million
  4. LKR 640 million

Explanation

With taxes, leverage adds the present value of the interest tax shield, equal to the tax rate multiplied by the debt amount. Value rises to 500 + (0.30 × 200) = LKR 560 million, so the gain accrues to shareholders through the debt-for-equity swap.

Question 37Capital Structure, Cost of Capital and Gearing Decisions

A company needs LKR 100 million for expansion and currently has 2 million shares in issue at a market price of LKR 25. Plan A raises the whole amount through a rights issue at LKR 25 per share. Plan B raises LKR 50 million of equity at LKR 25 and LKR 50 million of debt at 12% interest. The tax rate is 30%. At what EBIT do the two plans produce the same earnings per share?

  1. LKR 36 million
  2. LKR 18 million Correct answer.
  3. LKR 12 million
  4. LKR 6 million

Explanation

Plan A issues 4 million new shares for 6 million in total and carries no interest; Plan B issues 2 million new shares for 4 million in total and incurs LKR 6 million of interest. Setting 0.7 × EBIT / 6 = 0.7 × (EBIT − 6) / 4 gives 4 × EBIT = 6 × EBIT − 36, so EBIT = LKR 18 million.

Question 38Capital Structure, Cost of Capital and Gearing Decisions

A profitable Sri Lankan company needs external finance and its managers believe the market undervalues its shares. According to the pecking order theory, what is the preferred sequence of funding sources?

  1. New equity, then debt, then retained earnings
  2. Debt, then retained earnings, then new equity
  3. New equity, then retained earnings, then debt
  4. Retained earnings, then debt, then new equity Correct answer.

Explanation

Pecking order theory stems from asymmetric information and adverse selection: internal funds avoid issuing securities at all, debt suffers less from information asymmetry than equity, and new equity is a last resort because investors read an equity issue as a signal that shares are overvalued.

Question 39Capital Structure, Cost of Capital and Gearing Decisions

A comparable pure-play firm in the same industry has an unlevered (asset) beta of 0.90. A company being valued has a target debt-to-equity ratio of 1.0, a corporate tax rate of 30% and risk-free debt. Using the Hamada relationship, what levered equity beta should be applied in the CAPM?

  1. 1.17
  2. 1.80
  3. 0.90
  4. 1.53 Correct answer.

Explanation

The Hamada formula relevers the asset beta for financial risk: βL = βU × [1 + (1 − t) × D/E]. Substituting gives 0.90 × [1 + (0.70 × 1.0)] = 0.90 × 1.70 = 1.53, which reflects the extra systematic risk borne by shareholders of the geared company.

Question 40Capital Structure, Cost of Capital and Gearing Decisions

Two Sri Lankan firms operate in the same industry and face a 30% tax rate. Firm K has long-term contracted revenue that is highly stable, while Firm L's revenue swings sharply with the economic cycle. Both have the same asset base. According to trade-off theory, which target capital structure is most defensible?

  1. Firm K should target lower gearing because stable cash flows reduce its need for an interest tax shield
  2. Firm L should target lower gearing because volatile cash flows raise the expected cost of financial distress Correct answer.
  3. Both firms should target identical gearing because their tax shields per rupee of debt are the same
  4. Firm L should target higher gearing because fixed interest commitments offset the volatility of its earnings

Explanation

Trade-off theory balances the present value of the interest tax shield against the expected costs of financial distress, which include direct administration costs and the loss of customers, suppliers and key staff. A firm with highly cyclical earnings has a greater probability of hitting financial distress at any given debt level, so it should carry less debt than a firm with contracted, stable cash flows.

Question 41Capital Structure, Cost of Capital and Gearing Decisions

Which risk is increased specifically by adding debt to a company's capital structure?

  1. Financial risk
  2. Operating risk
  3. Business risk Correct answer.
  4. Systematic market risk

Explanation

Financial risk arises from fixed financing obligations, such as interest and principal repayments, that a company must meet regardless of operating performance. Business and operating risk stem from the firm's operations and are not created by the financing mix.

Question 42Capital Structure, Cost of Capital and Gearing Decisions

For a company with publicly traded debt and equity, which weights are preferred when computing WACC?

  1. Current market values Correct answer.
  2. Par value of outstanding debt
  3. Historical book values
  4. Original issue proceeds

Explanation

WACC should use market value weights because investors require returns based on the current market prices of the securities they hold. Book values, par values and original proceeds reflect past accounting or issuance amounts and may differ materially from current market values.

Question 43Capital Structure, Cost of Capital and Gearing Decisions

A company has perpetual debt with a market value of LKR 50 million and faces a 30% corporate tax rate. What is the present value of the interest tax shield?

  1. LKR 10.5 million
  2. LKR 15.0 million Correct answer.
  3. LKR 3.5 million
  4. LKR 50.0 million

Explanation

For perpetual debt, the present value of the interest tax shield equals the corporate tax rate multiplied by the market value of debt. Thus LKR 50 million × 30% = LKR 15.0 million.

Question 44Capital Structure, Cost of Capital and Gearing Decisions

A company reports EBIT of LKR 120 million and annual interest expense of LKR 20 million. What is its degree of financial leverage?

  1. 1.00
  2. 1.50 Correct answer.
  3. 1.20
  4. 0.83

Explanation

The degree of financial leverage is EBIT divided by EBIT minus interest, so LKR 120 million ÷ LKR 100 million = 1.20. This means a 1% change in EBIT produces approximately a 1.2% change in earnings per share.

Question 45Capital Structure, Cost of Capital and Gearing Decisions

Above the EBIT-EPS indifference point, why does higher gearing tend to raise earnings per share?

  1. Fixed interest magnifies EPS growth as EBIT rises Correct answer.
  2. Debt repayment improves operating cash flow
  3. Interest payments reduce the corporate tax rate
  4. Equity holders demand a lower return when gearing rises

Explanation

Above the indifference point, the fixed interest cost remains constant while additional EBIT is spread over a smaller equity base, so EPS rises faster. The tax deductibility of interest reinforces this effect, but the key driver is operating profit exceeding the fixed financing charge.

Question 46Capital Structure, Cost of Capital and Gearing Decisions

Under trade-off theory, where does the optimal capital structure lie?

  1. Where the dividend payout ratio is at its highest
  2. Where marginal tax shield equals marginal distress cost Correct answer.
  3. At the point where the interest tax benefit of debt is greatest
  4. At a capital structure that carries no long-term debt

Explanation

Trade-off theory balances the present value of interest tax shields against the present value of financial distress costs. The optimum occurs where the marginal benefit of additional debt equals its marginal distress cost, not where either is simply maximised in isolation.

Question 47Capital Structure, Cost of Capital and Gearing Decisions

A company has a pre-tax cost of debt of 10% and faces a 25% corporate tax rate. What is its after-tax cost of debt for WACC purposes?

  1. 13.3%
  2. 10.0% Correct answer.
  3. 7.5%
  4. 5.0%

Explanation

The after-tax cost of debt is the pre-tax rate multiplied by one minus the tax rate, because interest is tax deductible. Hence 10% × (1 − 0.25) = 7.5%.

Question 48Capital Structure, Cost of Capital and Gearing Decisions

Which item is best classified as an indirect cost of financial distress?

  1. Court filing and administrative charges
  2. Audit fees for statutory reporting
  3. Loss of key customers and supplier support Correct answer.
  4. Legal fees paid to advisers on a restructuring

Explanation

Indirect distress costs arise from stakeholder responses, such as customers deferring orders, suppliers tightening credit terms and employees leaving. Legal fees, court charges and audit fees are direct, out-of-pocket costs of the distress process.

Question 49Capital Structure, Cost of Capital and Gearing Decisions

A comparable firm has an unlevered beta of 0.80. The subject company targets a debt-to-equity ratio of 0.60 and faces a 30% tax rate. Using the Hamada equation, what is its levered beta?

  1. 1.36
  2. 1.14 Correct answer.
  3. 0.80
  4. 1.28

Explanation

The Hamada equation relevers beta as βL = βU × [1 + (1 − T) × D/E]. Here 0.80 × [1 + 0.70 × 0.60] = 0.80 × 1.42 = 1.136, which rounds to 1.14.

Question 50Capital Structure, Cost of Capital and Gearing Decisions

In a Modigliani-Miller world with corporate taxes, a firm has an unlevered cost of equity of 14%, debt cost of 8%, a debt-to-equity ratio of 1.0 and a 30% tax rate. What is its levered cost of equity?

  1. 15.4%
  2. 20.0%
  3. 22.0%
  4. 18.2% Correct answer.

Explanation

With taxes, the levered cost of equity is rE = r0 + (D/E) × (1 − Tc) × (r0 − rD). Substituting gives 14% + 1.0 × 0.70 × 6% = 18.2%.