MCQ Quiz

<h3>First Principles Thinking: Weighted Average Cost of Capital</h3><p><strong>B is correct.</strong> WACC blends the after-tax costs of debt and equity, weighted by their proportions in the capital structure: WACC = [Weight_Debt × Cost_Debt × (1 - Tax Rate)] + [Weight_Equity × Cost_Equity]. First, calculate after-tax cost of debt: 5% × (1 - 0.20) = 5% × 0.80 = 4%. Then: WACC = (0.40 × 4%) + (0.60 × 10%) = 1.6% + 6.0% = 7.6%. The mechanism: WACC represents the firm's overall required return on invested capital, reflecting the blended cost of all financing sources. The tax shield lowers the effective debt cost from 5% to 4%, making the overall WACC lower than a simple weighted average of 5% and 10% (which would be 7%). Edge case: if debt were 0%, WACC = 10% (all-equity); if equity were 0%, WACC approaches the after-tax debt cost. WACC is the hurdle rate for capital investments: projects must earn returns exceeding WACC to create value.</p><p>A is wrong because 7.2% likely results from using an incorrect debt weight or miscalculating the after-tax debt cost. Possibly calculated 0.40 × 3% + 0.60 × 10% = 7.2%, implying after-tax debt cost of 3% (incorrect for a 20% tax rate).</p><p>C is wrong because 8.0% results from ignoring the tax shield, calculating WACC = 0.40 × 5% + 0.60 × 10% = 2% + 6% = 8%. This treats interest as non-deductible, overstating the true WACC by 40 basis points.</p>

<h3>First Principles Thinking: Return on Assets</h3><p><strong>C is correct.</strong> Return on assets (ROA) measures the firm's operating profitability independent of capital structure, defined as Operating Income / Total Assets. Operating Income = Revenue - Operating Expenses = 100 - 70 = 30. Total Assets = Debt + Equity = 75 + 25 = 100 (by the balance sheet identity). ROA = 30 / 100 = 0.30 or 30%. The mechanism: ROA reflects the firm's efficiency in generating profits from its asset base before considering financing costs. It is independent of leverage. The firm's interest rate on debt is 15 / 75 = 20%. Since ROA (30%) exceeds the cost of debt (20%), the firm generates a positive spread of 10% on its 75 of debt, which accrues to equity holders and creates positive leverage. Edge case: if ROA fell below 20%, leverage would destroy shareholder value. This relationship between ROA and the cost of debt determines whether leverage is value-enhancing or value-destroying.</p><p>A is wrong because 15% likely confuses net income with operating income, calculating 15 / 100 = 15%. ROA uses operating income (30), not net income (15), to isolate operating performance from financing decisions.</p><p>B is wrong because 20% is the interest rate on debt (15 / 75 = 20%), not the return on assets. This confuses the cost of one financing source with the return on the entire asset base.</p>

<h3>First Principles Thinking: Credit Risk and Collections</h3><p><strong>B is correct.</strong> Extending credit to lower-creditworthiness customers creates multiple liquidity drags: (1) increased payment delinquencies (customers missing due dates), (2) higher uncollectible accounts (customers never paying), (3) longer DSO as collection efforts extend, (4) higher monitoring and collection costs. The mechanism: lower-quality customers have higher default rates; the company receives less cash than expected from these sales, creating a cash inflow shortfall (drag on liquidity). Additionally, accounts receivable on the balance sheet bloat with potentially uncollectible amounts, reducing the quality of liquid assets. Bad debt expenses reduce net income, further straining financial resources. Edge case: aggressive credit extensions can boost reported sales initially but deteriorate underlying cash generation and working capital quality.</p><p>A is wrong because while increased sales may occur, liquidity is determined by cash collections, not sales volume. If lower-creditworthiness customers don't pay as reliably, sales don't translate to cash inflows. Higher revenue with lower collections actually worsens liquidity despite higher top-line growth.</p><p>C is wrong because credit policy fundamentally affects collection timing and delinquencies, directly impacting cash inflows and DSO. Sales volume and timing are heavily influenced by credit terms—extending credit to weaker customers changes both volume and, critically, collection certainty. Claiming no effect misses the essential relationship between credit quality and liquidity.</p>

<h3>First Principles Thinking: Duration Matching Principle</h3><p><strong>B is correct.</strong> A matched (moderate) working capital approach aligns the duration of financing with the duration of asset needs. Key principles include: (1) permanent current assets (baseline inventory and receivables needed year-round) are financed with long-term debt and equity, (2) variable current assets (seasonal increases, growth-related needs) are financed with short-term debt and credit lines. The mechanism: matching maturities reduces risk—long-term assets financed with long-term liabilities avoid refinancing pressure; short-term variable needs use flexible short-term sources. This balanced strategy offers: lower costs than conservative (some short-term financing), greater flexibility than aggressive (long-term base), and moderate refinancing risk. Edge case: matched approaches require accurate forecasting of permanent versus variable needs; misclassification can create timing mismatches.</p><p>A is wrong because using all short-term debt represents an aggressive approach, not matched. Aggressive approaches minimize long-term financing; matched approaches use long-term financing for permanent needs. This answer describes the opposite strategy.</p><p>C is wrong because funding all needs with long-term debt represents a conservative approach, not matched. Conservative approaches maximize long-term financing for stability; matched approaches use a blend—long-term for permanent and short-term for variable. This answer describes the opposite strategy of a matched approach.</p>

<h3>First Principles Thinking: Cash Outflow Acceleration</h3><p><strong>B is correct.</strong> A pull on liquidity involves acceleration of cash outflows or restriction of credit availability, forcing earlier or increased payments. Reducing the company's credit line by the bank represents a pull because: (1) the company loses access to a financing source, (2) existing credit must be repaid sooner or at higher interest rates, (3) the company must find alternative (possibly more expensive) financing or use cash reserves to cover obligations. The mechanism: a reduced credit line eliminates a secondary liquidity source and may force the company to draw down cash or negotiate with suppliers—both acceleration of cash outflows or reduction in financing flexibility. Edge case: credit line reductions during economic stress can trigger financial distress if the company lacks alternative funding.</p><p>A is wrong because this represents a drag on liquidity, not a pull. Delayed customer payments slow cash inflows (a drag). Drags reduce inflows; pulls accelerate outflows. While both harm liquidity, they are distinct categories. Customer payment delays are specifically categorized as drags in the curriculum.</p><p>C is wrong because slow-moving inventory represents a drag on liquidity, not a pull. Unsold inventory delays conversion to cash (an inflow problem), whereas a pull on liquidity involves acceleration of outflows or reduced credit. Inventory turnover problems are classified as drags affecting the cash conversion cycle and inflows.</p>

<h3>First Principles Thinking: Receivables Impact</h3><p><strong>B is correct.</strong> Extending the net payment period from 30 to 40 days (net 40) increases days sales outstanding (DSO), the time before customers pay. Since the cash conversion cycle includes DSO as a component (CCC = DOH + DSO - DPO), an increase in DSO lengthens the cash conversion cycle. The mechanism: customers now have 40 days instead of 30 to pay, so the company waits 10 additional days for cash receipts. This 10-day increase in DSO directly increases the CCC by 10 days. Longer cash conversion cycles require more working capital financing and reduce liquidity. Note: the discount terms (2/10) remain unchanged, so only the net payment period changes. Edge case: companies extend credit terms to boost sales, accepting longer cash collection periods as a trade-off.</p><p>A is wrong because the change lengthens, not shortens, the cash conversion cycle. Extending payment terms makes it take longer for customers to pay, increasing DSO and CCC. Shortening the cycle would require faster customer payments or reduced inventory holding, neither of which occurs here.</p><p>C is wrong because the change does affect the cash conversion cycle. Modifying credit terms directly impacts DSO, a component of the CCC formula. Since DSO increases from implied 30 to 40 days, the CCC must increase. Claiming no effect misses the fundamental relationship between credit terms and the operating timeline.</p>

<h3>First Principles Thinking: Full Operating Timeline</h3><p><strong>C is correct.</strong> The operating cycle is the total time from when a company receives inventory from suppliers to when it collects cash from customers. The formula is: Operating Cycle = Days of Inventory on Hand + Days Sales Outstanding. From the data: Operating Cycle = 30 + 40 = 70 days. The mechanism: inventory is received at day 0, held for 30 days, then sold to customers who pay 40 days later (at day 70 from the initial purchase). The operating cycle is different from the cash conversion cycle, which also accounts for the time a company takes to pay suppliers (DPO). The CCC is shorter than the OC by the amount of DPO. Edge case: a company with a 70-day operating cycle needs financing for that entire period unless customers prepay or it maintains significant cash reserves.</p><p>A is wrong because 10 days results from subtracting instead of adding: 40 - 30 = 10. The operating cycle measures total time from inventory receipt to cash collection, requiring addition, not subtraction. This fundamental misunderstanding of the definition produces an incorrect answer.</p><p>B is wrong because 40 days is just one component (DSO) of the operating cycle, ignoring the inventory holding period. The operating cycle encompasses both the time inventory is held (DOH) and the time to collect after sale (DSO), totaling 70 days, not just 40.</p>

<h3>First Principles Thinking: Supplier Payment Timing</h3><p><strong>A is correct.</strong> Days payable outstanding measures the average number of days a company takes to pay suppliers. The calculation is: DPO = (Average Accounts Payable / COGS) × 365 days. From the data: DPO = (50,000 / 400,000) × 365 = 0.125 × 365 = 45.625 days, which rounds to 46 days (though 45 is the closest option). The mechanism: daily COGS is approximately $1,096 ($400,000 / 365). Accounts payable of $50,000 represents 45.625 days of this daily amount. Longer DPO preserves cash (company delays payments), reducing need for working capital financing, but may forfeit early-payment discounts. Shorter DPO indicates aggressive payment but consumes cash faster. Edge case: companies may strategically delay payments to maximize cash position, but excessive delays damage supplier relationships and may trigger payment acceleration clauses.</p><p>B is wrong because while 46 days is closer to the precise calculation (45.625), if the question requires selecting from the given options, 45 is the closest match. Using 46 would imply accounts payable of $50,411 ($400,000 × 46/365), which is slightly different from given data.</p><p>C is wrong because 50 days results from treating accounts payable ($50,000) as if it equals the daily COGS ($400,000 / 365 = $1,096 per day) directly, or from other calculation errors. 50 days implies DPO = 50/365 = 0.137, suggesting accounts payable of $54,795 ($400,000 × 50/365), not $50,000.</p>

<h3>First Principles Thinking: Inventory Holding Period</h3><p><strong>C is correct.</strong> Days of inventory on hand measures the average number of days inventory is held before being sold. The calculation is: DOH = (Average Inventory / COGS) × 365 days. From the data: DOH = (120,000 / 600,000) × 365 = 0.20 × 365 = 73 days. The mechanism: COGS of $600,000 translates to daily inventory usage of approximately $1,644 ($600,000 / 365). Average inventory of $120,000 represents 73 days of this daily usage. Longer DOH ties up more capital and increases obsolescence risk; shorter DOH improves liquidity and reduces holding costs. Industries differ: fashion retail has low DOH (fast turnover), while spirits and pharmaceuticals have high DOH (aging/regulatory requirements). Edge case: just-in-time inventory systems minimize DOH but increase supply chain risk.</p><p>A is wrong because 60 days results from using incorrect numerator or denominator. If DOH were 60 days with the given COGS, average inventory would be $98,630 ($600,000 × 60/365), not $120,000. This calculation error understates the actual inventory holding period.</p><p>B is wrong because 65 days doesn't match the precise calculation. Using 65 days implies average inventory of $106,575 ($600,000 × 65/365) or COGS of $673,846 ($120,000 × 365/65). Neither matches given data, indicating a misapplication of the formula or arithmetic error.</p>

<h3>First Principles Thinking: Anti-Takeover Mechanisms</h3><p><strong>B is correct.</strong> A shareholder rights plan (poison pill) is an anti-takeover defense that deters hostile takeovers by making acquisition economically unattractive. Mechanism: if an external shareholder purchases a certain threshold of shares (e.g., 15%), existing shareholders are granted the right to buy additional shares at a discount. This dilutes the acquirer's ownership stake and substantially increases acquisition cost. Example: if acquirer owns 20% of company and all other shareholders exercise discounted purchase rights, the acquirer's stake might dilute to 10%, requiring acquisition of additional shares at inflated prices to gain control. Purpose: protects shareholders from undervalued hostile bids by making takeover prohibitively expensive, forcing acquirers to negotiate with the board or abandon attempts. Edge case: poison pills can entrench management by preventing removal, especially if combined with staggered boards.</p><p>A is wrong because poison pills don't enable dividend votes or shareholder decisions on acquisitions. Pills automatically activate upon crossing an ownership threshold; shareholders don't vote to trigger them. The mechanism is automatic dilution/share purchase rights, not shareholder voting on dividends.</p><p>C is wrong because poison pills don't guarantee minority control of the board. Pills prevent hostile takeovers but don't ensure minority governance rights in the post-takeover scenario. A successful hostile takeover (if completed despite the pill) would typically result in acquirer-controlled board. Pills are prevention mechanisms, not control guarantees for minorities.</p>

<h3>First Principles Thinking: Audit Committee Independence and Expertise</h3><p><strong>B is correct.</strong> Audit committees are the most widely required and established board committees. Best practices and regulations mandate: (1) composition solely of independent directors (no material relationships with company, no employment, no family ties); (2) inclusion of at least one director with accounting or financial management expertise. The rationale: independence ensures auditors and management cannot unduly influence oversight; financial expertise enables intelligent evaluation of accounting policies, internal controls, and audit quality. Mechanism: an independent, expert committee monitors financial reporting integrity, selects external auditors, reviews their work, and proposes remedial actions. This structure minimizes conflicts where management-friendly insiders might shield accounting issues. Edge case: some jurisdictions require audit committees in financial services (banks, insurers); others mandate them for all public companies.</p><p>A is wrong because best practices require exclusively independent directors, not a mix of inside and outside directors. Inside directors (current/former executives) have material relationships with management and cannot provide objective oversight of financial reporting by those same executives. This creates the conflict the independence requirement addresses.</p><p>C is wrong because it incorrectly asserts all committee members must have accounting credentials and excludes experienced directors. Best practices require at least one accounting expert, not all members. Experienced independent directors (without accounting backgrounds) add valuable governance perspective. Over-specializing to accountants only reduces board diversity and misses broader governance expertise.</p>

<h3>First Principles Thinking: Ownership Structure Classifications</h3><p><strong>B is correct.</strong> Corporate ownership structures are classified by control distribution. Dispersed ownership involves many shareholders, none of whom can exercise control over the corporation (e.g., public companies with millions of shares). Concentrated ownership reflects an individual shareholder or group (controlling shareholders—family, another company, government) with sufficient shares/votes to exercise control. The mechanism: in dispersed structures, no single shareholder has enough power to dictate board elections or strategic decisions, requiring coalition-building or proxy contests for change. In concentrated structures, controlling shareholders possess decision-making authority. Example: KLD Marine Ltd. with one large owner versus a public company with dispersed retail shareholders. Edge case: voting structures like dual-class shares can create concentrated control even with minority economic ownership.</p><p>A is wrong because it assumes dispersed ownership means equal voting power, which is inaccurate. Shareholders may have equal votes per share, but dispersed ownership is defined by the inability of any one shareholder to control the firm, not by equality of voting rights. Concentrated ownership doesn't require majority voting; controlling shareholders may have 30% with fragmented opposition.</p><p>C is wrong because it asserts dispersed ownership eliminates agency costs. In reality, dispersed ownership creates principal-agent conflicts between dispersed shareholders and management because shareholders lack sufficient individual power to monitor effectively. Concentrated ownership may reduce shareholder-management conflicts but creates controlling-minority shareholder conflicts. Both structures face agency costs, just different types.</p>

<h3>First Principles Thinking: Agency Cost Types</h3><p><strong>B is correct.</strong> Agency costs result from conflicts of interest between principal (shareholder) and agent (management) and can be classified as direct or indirect. Direct agency costs are explicit, out-of-pocket expenses incurred to monitor or align agent behavior. Hiring independent external auditors represents a direct cost: shareholders bear audit fees to mitigate the risk that financial reports are materially misstated or deviate from GAAP. This is a preventive/monitoring cost borne by shareholders (via reduced dividends) to protect their interests. The mechanism: the audit fee is a concrete expenditure reducing shareholder value to lower agency risk. Edge case: audit costs are justified if the reduction in information asymmetry exceeds the audit fee.</p><p>A is wrong because foregone profits from missed opportunities are an indirect agency cost. Indirect costs are opportunity costs or economic losses, not explicit expenditures. A missed acquisition due to management risk aversion reflects the cost of misaligned incentives (management too conservative), not a direct expense. This is an economic loss, not a billable service.</p><p>C is wrong because stock price volatility is a market consequence of management behavior, not an agency cost per se. Volatility reflects changed risk perception by investors but is not a direct cost paid by the corporation to mitigate agency problems. This confuses market impacts with actual agency expenditures.</p>

<h3>First Principles Thinking: Income-Only Return</h3><p><strong>B is correct.</strong> Current yield measures only the annual coupon income relative to price, ignoring capital gains and reinvestment. Annual coupon = par × coupon rate = $1,000 × 6% = $60. Current yield = annual coupon / price = $60 / $802.07 = 0.0748 or 7.48%. Because the bond trades at a discount (below par), current yield exceeds the coupon rate—you receive the same dollar coupon on a smaller investment. Current yield is the same for annual-pay and semiannual-pay bonds with identical coupon rates and prices, as it uses total annual coupon payments.</p><p>A is incorrect: 6% is the stated coupon rate, not the current yield. This error treats coupon rate and current yield as equivalent, ignoring that current yield must be calculated relative to the actual market price, not par value.</p><p>C is incorrect: 7.66% appears to miscalculate the coupon payment or price relationship. This may result from incorrectly using the semiannual coupon ($30) instead of the full annual amount, or a computational error in the division.</p>

<h3>First Principles Thinking: YTM as IRR</h3><p><strong>B is correct.</strong> YTM is the discount rate that equates the present value of all future cash flows to the current bond price. For this annual-pay bond, we have 5 annual coupon payments of 7 plus a par value of 100 at maturity. Setting PV = -102.078, we solve: 102.078 = 7/(1+r) + 7/(1+r)² + 7/(1+r)³ + 7/(1+r)⁴ + 107/(1+r)⁵. Using a financial calculator: N=5, PMT=7, FV=100, PV=-102.078, CPT I/Y = 6.5%. The bond trades at a premium (price > 100), so YTM must be below the coupon rate of 7%, which confirms our answer.</p><p>A is incorrect: 5.50% would produce a bond price significantly higher than 102.078, as the discount rate would be too low. This misconception arises from underestimating the premium's impact on yield.</p><p>C is incorrect: 7.50% would result in a bond price below par (discount bond), not the premium price of 102.078. This error confuses the relationship between coupon rate, YTM, and price—when price exceeds par, YTM must be less than the coupon rate.</p>

<h3>First Principles Thinking: Liquidity Stress vs. Efficiency</h3><p><strong>B is correct.</strong> While a negative Cash Conversion Cycle (CCC) is generally viewed as favorable (indicating the firm is financed by suppliers), the driver of the negative number determines the signal. In the National Datacomputer (NDC) case, the negative CCC was driven by a spike in accounts payable (delaying payments due to cash shortages) and a drop in inventory to zero (inability to purchase new stock). From a first-principles perspective, if the 'financing' (payables) grows only because the firm <em>cannot</em> pay, and the 'asset' (inventory) shrinks because the firm <em>cannot</em> buy, the negative cycle signals a liquidity crisis rather than leverage or efficiency. </p><p>A is incorrect: Just-in-time manufacturing reduces DOH, but it does not typically lead to a complete disappearance of inventory due to credit freezes, nor is it characterized by an inability to pay suppliers (spiking payables) as a primary feature.</p><p>C is incorrect: This describes the Apple scenario, where the firm <em>has</em> cash but chooses to use supplier credit. The NDC case is defined by a lack of cash.</p>

<h3>First Principles Thinking: Scaling by a Single Base</h3><p><strong>A is correct.</strong> Start from the idea that an income statement mixes big and small firms: EUR 10 million of advertising is huge for a tiny firm and trivial for a giant. By dividing every line by a common basenet revenueeach item becomes a percentage of sales. Now the structure of the business, not its sheer size, is visible. This is exactly how the reading defines common-size income statements: every income and expense line expressed as a percentage of net revenues. Hook: "divide by sales to compare business models, not balance sheets." </p><p>B is incorrect: common-size analysis keeps the original accounting numbers; it does not remeasure them at current market prices. It simply rescales them into percentages using a single denominator.</p><p>C is incorrect: neither international nor United States standards require statements to be presented in common-size form. It is an analytical tool used by investors and analysts, not a mandatory reporting format.</p>

<h3>First Principles Thinking: Scaling by a Single Base</h3><p><strong>A is correct.</strong> Start from the idea that an income statement mixes big and small firms: EUR 10 million of advertising is huge for a tiny firm and trivial for a giant. By dividing every line by a common basenet revenueeach item becomes a percentage of sales. Now the structure of the business, not its sheer size, is visible. This is exactly how the reading defines common-size income statements: every income and expense line expressed as a percentage of net revenues. Hook: "divide by sales to compare business models, not balance sheets." </p><p>B is incorrect: common-size analysis keeps the original accounting numbers; it does not remeasure them at current market prices. It simply rescales them into percentages using a single denominator.</p><p>C is incorrect: neither international nor United States standards require statements to be presented in common-size form. It is an analytical tool used by investors and analysts, not a mandatory reporting format.</p>