CFA Level I Corporate Issuers Practice Questions

Correct answer: B. A director who has no material business, financial, or family relationship with the company or its management beyond board service

Independence is defined by the absence of material relationships that could compromise objective judgment — not by share ownership. A is wrong because owning equity does not itself create a disqualifying conflict, but the question tests whether candidates conflate 'aligned interests' with 'independent judgment.' C is wrong because a recent executive role (typically within a multi-year look-back period) creates exactly the kind of relationship independence rules are designed to exclude. D is wrong because informally reporting to management destroys the arm's-length relationship independence requires.

• A. A significant equity stake doesn't define independence; the defining test is the absence of other material relationships with the company or management, not equity ownership.
• B. Independence means no material business, financial, or family ties to the company or management beyond the board role itself, ensuring the director's judgment isn't compromised by other relationships.
• C. A recent former executive is generally not considered independent, since recent employment (typically within a defined look-back period) creates the very ties independence rules are meant to exclude.
• D. A director who reports informally to and serves at management's invitation lacks the arm's-length relationship required for independence — that's a management-affiliated, not independent, director.

Correct answer: C. Cost of debt

Interest payments on debt are tax-deductible to the issuing company, so the after-tax cost of debt used in WACC is Kd × (1 − tax rate). Preferred and common dividends are paid from after-tax income and are not deductible, so their costs are not tax-adjusted.

• A. Incorrect — cost of common equity isn't tax-deductible to the firm, since dividends aren't a deductible expense, so it receives no tax adjustment in WACC.
• B. Incorrect — preferred dividends aren't tax-deductible either, so the cost of preferred stock is used pre-tax in WACC, unlike debt.
• C. Correct — interest payments on debt are tax-deductible, so the cost of debt is multiplied by (1 − tax rate) to reflect the tax shield in the WACC calculation.
• D. Incorrect — cost of retained earnings, a component of equity cost, isn't tax-adjusted, since equity distributions aren't a deductible expense for the firm.

Correct answer: C. 6.0%

After-tax cost of debt = before-tax cost of debt × (1 − marginal tax rate) = 8% × (1 − 0.25) = 8% × 0.75 = 6.0%.

• A. Incorrect. This is only the tax shield amount (8% × 0.25), not the after-tax cost of debt itself.
• B. Incorrect. This is the pretax cost of debt, ignoring the tax shield entirely.
• C. Correct. 8% × (1 − 0.25) = 6.0%.
• D. Incorrect. This results from applying a 20% tax rate instead of the 25% rate given in the problem.

Correct answer: B. A network effect

A network effect exists when the value of a product or service to each user rises as the total number of users increases — common in platform business models like ride-sharing, marketplaces, and social media. Economies of scale instead refers to declining average cost per unit as production volume rises, a supply-side, not demand-side, phenomenon.

• A. Economies of scale refer to per-unit cost declining as production volume increases, a supply-side cost phenomenon, not a demand-side effect of user base size on value.
• B. A network effect describes value to each user rising as the total user base grows — exactly the ride-sharing dynamic described, where more drivers attract more riders and vice versa.
• C. Vertical integration refers to a firm owning multiple stages of its supply chain, unrelated to how a growing user base affects platform value.
• D. Operating leverage describes how fixed costs magnify the sensitivity of profits to revenue changes, not the value users derive from a growing network.