CPA Canada Core 2: Finance

Use this page to isolate Finance before returning to mixed CPA Canada Core 2 practice.

Topic snapshot

Sample questions

These questions are original Finance Prep practice items aligned to this topic area. They are designed for self-assessment and are not official exam questions.

Question 1

Topic: Finance

Prairie Foods Ltd., a profitable private company, needs $600,000 within one month to buy inventory for confirmed seasonal orders. The cash shortfall is expected to last four months until receivables are collected, and the owner-managers want to preserve control. The company’s lending covenant allows up to $800,000 of additional secured borrowing; interest and financing fees are deductible, but dividends are not. Management is considering these offers:

Which recommendation best fits the company’s financing needs?

• A. Use the private equity because it avoids debt service and reduces covenant risk.
• B. Use the term loan because its 6% stated interest rate is lower than the operating line’s 7% rate.
• C. Use the supplier deferral because it is available immediately and requires no security.
• D. Use the operating line because it matches the short-term cash need, preserves control, and charges deductible interest only while funds are drawn.

Best answer: D

What this tests: Finance

Explanation: Short-term seasonal working capital is usually best financed with a flexible short-term source that can be repaid when receivables are collected. The operating line is available within the one-month deadline, is within the borrowing covenant, preserves ownership control, and charges deductible interest only for the period funds are used. Its approximate four-month before-tax cost is 7% × 4/12 = 2.3%, which is lower than the supplier’s 4% fee for the same period. The term loan has a lower stated annual rate, but it creates a five-year commitment and prepayment cost for a four-month need. Equity avoids debt, but it gives up voting shares and a board seat, and expected dividends are not deductible.

• The term loan’s lower stated rate ignores the five-year commitment and prepayment penalty.
• Private equity reduces debt pressure but conflicts with the owners’ control objective and lacks an interest tax shield.
• Supplier deferral solves timing immediately, but immediate funding is not required and the four-month fee is more costly than the operating line.

The operating line meets the timing need, fits the four-month working capital cycle, avoids dilution, and has a lower effective cost than the supplier deferral.

Question 2

Topic: Finance

Alyssa is reviewing a three-month cash forecast for Calder Parts Inc. Cash on April 1 is CAD 45,000, and management requires a minimum cash balance of CAD 30,000 at each month-end. The operating line of credit has CAD 100,000 available and can be drawn or repaid at any time. Forecast net operating cash flows before financing are:

Assume no interest and no other cash flows. What should Alyssa recommend?

• A. Replace the operating line with long-term debt of CAD 125,000 because the peak draw exceeds monthly operating cash inflows.
• B. Use the operating line and arrange at least CAD 25,000 of additional short-term financing or cash deferrals before May.
• C. Wait until May actual results are known before requesting financing because the April draw is within the line limit.
• D. Rely on the operating line only because the June inflow will reduce borrowings by quarter-end.

Best answer: B

What this tests: Finance

Explanation: Cash flow monitoring should focus on timing and peak funding requirements, not only the final cash position. Starting with CAD 45,000, April’s CAD 60,000 outflow would require a CAD 45,000 draw to keep CAD 30,000 cash on hand. May’s CAD 80,000 outflow would require another CAD 80,000, bringing the peak financing need to CAD 125,000. Since only CAD 100,000 is available on the operating line, management has a CAD 25,000 shortfall before considering June’s recovery. The best response is to arrange temporary financing, defer discretionary cash outflows, or accelerate collections before the May shortage occurs.

• Relying only on the line ignores the May peak funding requirement, which exceeds available credit.
• Waiting until May is not proactive cash monitoring; the forecast already identifies the liquidity gap.
• Long-term debt is not the best fit for a temporary working-capital shortfall when most of the need is covered by the operating line.

The forecast shows a peak financing need of CAD 125,000 to maintain the minimum cash balance, which is CAD 25,000 more than the available line.

Question 3

Topic: Finance

A maintenance manager at a Canadian manufacturer is evaluating a machine replacement. Initial cash outflow at time 0 is CAD 300,000. Expected after-tax cash inflows at the end of years 1 to 4 are CAD 90,000, CAD 100,000, CAD 110,000, and CAD 80,000, with no residual value. The company requires a 10% return and accepts projects only if NPV is positive; it also uses a maximum 3.0-year payback as a secondary liquidity screen. Present value factors at 10% for years 1 to 4 are 0.909, 0.826, 0.751, and 0.683. What should management do?

• A. Accept the project based only on the 3.0-year payback because meeting the payback screen overrides the NPV benchmark.
• B. Reject the project because undiscounted total inflows of CAD 380,000 do not provide a 10% return for each of the four years.
• C. Reject the project because the fourth-year cash flow occurs after the payback benchmark and should be excluded from the NPV analysis.
• D. Accept the project because its NPV is about CAD 1,660 and the 3.0-year payback meets the liquidity screen.

Best answer: D

What this tests: Finance

Explanation: NPV is a discounted cash flow method that compares the present value of all relevant project cash flows with the initial investment using the required return. Here, the present value of inflows is CAD 301,660, so NPV is CAD 1,660 positive. The payback period is based on undiscounted cash flows: CAD 90,000 + CAD 100,000 + CAD 110,000 = CAD 300,000, so the project pays back exactly at the end of year 3. Since the company’s primary NPV benchmark is met and the secondary payback screen is also met, management should accept the project.

• Excluding year 4 from NPV confuses the payback screen with the NPV calculation; NPV includes all relevant cash flows.
• Payback alone is not enough because it ignores time value of money and cash flows after recovery.
• Applying the 10% return as a simple annual total is not a valid capital budgeting method.

The discounted inflows total CAD 301,660, giving a positive NPV, and cumulative undiscounted inflows recover the initial cost at the end of year 3.

Question 4

Topic: Finance

Great Lakes Meals Inc. is a privately owned Canadian online meal-kit company with annual revenue of 18 million. It is in its third year, operates one leased distribution centre, outsources delivery, and has a strategy of rapid subscriber growth funded by a recent equity raise. An analyst compared its EBITDA margin and current ratio with a published benchmark for mature national grocery retailers with physical stores and revenue above 500 million. Great Lakes shows a lower EBITDA margin and lower current ratio. The CFO asks whether these variances justify reducing customer acquisition spending immediately. What should the analyst do next?

• A. Recommend reducing customer acquisition spending until the EBITDA margin matches mature grocery retailers.
• B. Replace the benchmark analysis with Great Lakes’ prior-year ratios because internal trends avoid industry differences.
• C. Assess benchmark comparability and obtain or adjust benchmarks for similar online, growth-stage subscription food businesses before drawing conclusions.
• D. Use the published benchmark as the primary target because it is based on a larger sample of food retailers.

Best answer: C

What this tests: Finance

Explanation: Industry benchmarks are useful only when the comparison group is relevant to the entity’s context. Great Lakes is an early-stage, online subscription business pursuing growth, while the benchmark group consists of mature, large, physical-store grocery retailers. Differences in lifecycle, scale, strategy, delivery model, and working-capital structure can make EBITDA margin and current ratio comparisons misleading. The analyst should first test comparability and either find a more relevant peer group or adjust the benchmark interpretation. Only after that step should management consider whether the variances indicate poor performance, expected growth investment, or financing risk.

• Reducing customer acquisition spending is premature because the variance may reflect a deliberate growth strategy rather than underperformance.
• Relying on the published benchmark just because the sample is larger ignores whether the sample is comparable.
• Internal trend analysis can be useful, but it does not replace the need to evaluate whether external benchmarks are relevant.

The next step is to determine whether the benchmark reflects Great Lakes’ size, lifecycle, strategy, and operating model before using it to support a decision.

Question 5

Topic: Finance

Riverside Components Inc. is considering a 20% sales-growth plan for next year that would require additional inventory purchases early in the year. The bank operating line limit is $800,000. Management says the plan is low risk because the current ratio is above benchmark.

Which conclusion is most useful for management and board decision making?

• A. Reduce prices immediately because the main problem is revenue growth below industry expectations.
• B. Replace long-term financing with the operating line because current assets exceed current liabilities.
• C. Approve the growth plan because the gross margin and current ratio both exceed benchmark.
• D. Condition the growth plan on improving collections and inventory turnover and confirming short-term financing capacity.

Best answer: D

What this tests: Finance

Explanation: The most decision-useful conclusion looks beyond one favourable ratio. Although revenue and gross margin improved and the current ratio is above benchmark, liquidity quality has weakened. The quick ratio is below benchmark, receivables and inventory are turning much more slowly, operating cash flow is negative, and the operating line is almost fully used. A sales-growth plan requiring more inventory would likely increase the working-capital strain unless collections, inventory management, and financing capacity are addressed first. The board should therefore focus on whether management can fund and control growth, not simply whether accounting current assets exceed current liabilities.

• Relying on the current ratio ignores that much of the current asset base is tied up in slower receivables and inventory.
• Reducing prices is not supported because gross margin is above benchmark and liquidity, not demand, is the visible constraint.
• Using the operating line for broader financing is inappropriate because the line is already close to its limit and should support short-term working capital.

The exhibit shows profitable growth but deteriorating liquidity, negative operating cash flow, slow receivables and inventory, and an operating line close to its limit.

Question 6

Topic: Finance

Evergreen Home Supplies is preparing for its annual bank renewal. Management reports that sales and net income improved, but the controller is concerned about the company’s financial state over the next quarter. Which analysis tool should be prioritized based on the exhibit?

• A. Prepare a short-term cash-flow forecast with working-capital schedules for receivables, inventory, payables, and line-of-credit use.
• B. Benchmark the net income margin against industry averages to assess pricing performance.
• C. Compare sales revenue to the annual budget and analyze the sales volume variance.
• D. Calculate a five-year debt-to-equity trend to assess long-term capital structure.

Best answer: A

What this tests: Finance

Explanation: The most relevant tool depends on the financial issue shown by the data. Here, sales and net income are improving, but cash has nearly disappeared, the line of credit is almost fully drawn, receivable and inventory days have worsened, payable days have stretched, and the current ratio is below the bank covenant. These facts point to an immediate liquidity and working-capital problem, not primarily a profitability or sales-performance problem. A short-term cash-flow forecast linked to collections, inventory purchases, supplier payments, and line-of-credit usage would best show whether the company can operate through the next quarter and what financing action is needed.

• Net income margin benchmarking may help assess pricing, but it does not address the near-term cash shortage and covenant pressure.
• A debt-to-equity trend focuses on solvency and capital structure, not the immediate operating cash cycle concern.
• Sales variance analysis explains revenue performance, but sales growth is not the key issue when collections, inventory, and financing capacity are deteriorating.

The exhibit shows liquidity and working-capital pressure despite positive earnings, so cash-flow analysis is the most relevant tool.

Question 7

Topic: Finance

North Shore Components Inc. is considering a financing plan to fund automated equipment that supports its strategy of diversifying from one major customer into smaller higher-margin contracts. The CFO’s draft plan is to borrow CAD 4.8 million using a five-year variable-rate term loan secured by all assets, including internally developed process technology. Board-approved financing parameters are to maintain debt-to-EBITDA at or below 2.0, maintain a debt service coverage ratio of at least 1.40 under a realistic downside case, and avoid security over strategic technology unless no reasonable alternative exists. The CFO’s base-case forecast shows debt-to-EBITDA of 1.9 and a debt service coverage ratio of 1.55, but assumes immediate new contract volume and no increase in interest rates. What should the CPA do next before recommending whether the financing plan aligns with the entity’s strategic objectives and risk tolerance?

• A. Ask the operations team to finalize the equipment’s depreciation schedule before assessing the loan terms.
• B. Stress-test the forecast for delayed contract volume and interest-rate increases, then compare the covenant results and security over technology with the board’s financing parameters.
• C. Select the variable-rate loan because it funds the strategic equipment at the lowest quoted interest rate.
• D. Recommend approval because the base-case ratios are within the board-approved limits.

Best answer: B

What this tests: Finance

Explanation: The next step is not to approve or reject the financing based only on the base case. The board’s risk tolerance specifically requires covenant capacity under a realistic downside case, and the draft plan contains two key risks: variable interest exposure and security over strategic technology. A Core 2 financing recommendation should assess whether the plan supports the strategy while remaining within stated risk limits. Stress-testing delayed contract volume and higher interest rates will show whether debt service and leverage remain acceptable. The CPA should also assess whether pledging strategic technology is consistent with the board’s parameters or whether alternative financing should be considered.

• Approval based only on base-case ratios ignores the required downside test and the concern over strategic technology security.
• Choosing the lowest quoted rate ignores variable-rate risk, covenant risk, and strategic alignment.
• Finalizing depreciation may support accounting or budgeting, but it does not address financing risk tolerance or cash-flow capacity.

This directly tests whether the plan remains acceptable under the board’s stated downside, leverage, covenant, and strategic-asset risk limits.

Question 8

Topic: Finance

Prairie Tooling Ltd. is evaluating a four-year equipment purchase. Management uses NPV and accepts projects only when NPV is positive. All tax effects occur in the same year as the related cash flow, and all amounts are before financing costs.

Any disposal proceeds above UCC are taxable recapture in year 4. What should management conclude?

• A. Reject the project; the NPV is approximately $(22,503).
• B. Accept the project; the NPV is approximately $58,450.
• C. Accept the project; the NPV is approximately $25,045.
• D. Accept the project; the NPV is approximately $26,753.

Best answer: C

What this tests: Finance

Explanation: Annual after-tax operating cash flow is $100,000 × 75% + $60,000 × 25% = $90,000. The year 4 recapture tax is ($70,000 − $60,000) × 25% = $2,500, so after-tax disposal proceeds are $67,500. Year 4 also includes the $20,000 working capital recovery. The present value of years 1–3 operating cash flows is $90,000 × (0.9091 + 0.8264 + 0.7513) = $223,812. The present value of the year 4 cash flow is ($90,000 + $67,500 + $20,000) × 0.6830 = $121,233. Total PV is $345,045, less the initial outlay of $320,000, giving a positive NPV of about $25,045.

• Using approximately $26,753 ignores the tax on recapture when disposal proceeds exceed UCC.
• Using approximately $58,450 treats the operating cash flows and disposal proceeds as if there were no income tax effects.
• Rejecting at approximately $(22,503) omits the CCA tax shield, which is a relevant tax cash-flow benefit.

The NPV is positive after applying income tax to operating cash flows, the CCA tax shield, recapture tax on disposal, and working-capital recovery.

Question 9

Topic: Finance

Maple Components Inc. is choosing how to finance a 6.0 million expansion. Project cash flows are expected to be identical under each alternative. Management uses the lowest WACC, within board-approved risk limits, as the indicator of shareholder value maximization. The board’s risk tolerance requires a debt-to-equity ratio of no more than 0.80 and forecast interest coverage of at least 4.0 times. Use debt-to-equity = interest-bearing debt / shareholders’ equity.

Forecast after expansion and financing, amounts in millions of dollars:

Which recommendation is best supported by the exhibit?

• A. Finance with 50% debt and 50% equity because it has the lowest WACC among alternatives that meet both risk limits.
• B. Delay the expansion because no financing alternative satisfies the board’s risk tolerance.
• C. Finance entirely with equity because it produces the lowest debt-to-equity ratio.
• D. Finance entirely with debt because it has the lowest WACC and still meets the interest-coverage limit.

Best answer: A

What this tests: Finance

Explanation: Value maximization must be evaluated within the entity’s stated risk tolerance. The debt-only option has the lowest WACC at 8.9%, but its debt-to-equity ratio is 14.0 / 16.0 = 0.88, which exceeds the board’s maximum of 0.80. Its interest coverage is acceptable at 3.90 / 0.96 = 4.1 times, but breaching one risk limit is enough to reject it. The equity-only option is low risk, with a debt-to-equity ratio of 0.36 and strong coverage, but it has the highest WACC. The 50% debt / 50% equity option has a debt-to-equity ratio of 0.58 and coverage of 5.4 times, so it meets both risk limits and has the lowest WACC among acceptable alternatives.

• Debt-only financing overweights the lowest WACC and ignores the debt-to-equity breach.
• Equity-only financing is conservative but does not maximize value when a lower-WACC acceptable structure exists.
• Delaying is not supported because both equity-only and mixed financing satisfy the board’s stated risk tolerance.

This option meets the debt-to-equity and interest-coverage limits while providing a lower WACC than the equity-only alternative.

Question 10

Topic: Finance

Cascade Components Inc. is evaluating a new project with business risk similar to its existing operations. Management concluded that the appropriate discount rate is approximately 9.6%, based on the company’s weighted average cost of capital. Which schedule best supports this conclusion?

• A. A financing history schedule using the average coupon rate on existing debt of 5%, the prior-year return on equity of 8%, and the current book-value debt-to-equity ratio, giving a WACC of 6.50%.
• B. A WACC schedule using book-value weights of 50% debt and 50% common equity, a 7% pre-tax borrowing cost, a 25% corporate tax rate, and a 12% cost of equity, giving a WACC of 8.63%.
• C. A WACC schedule using target market-value weights of 35% debt and 65% common equity, a current pre-tax borrowing cost of 7%, a 25% corporate tax rate, and a 12% cost of equity, giving a WACC of 9.64%.
• D. A WACC schedule using target market-value weights of 35% debt and 65% common equity, a 7% pre-tax borrowing cost without tax adjustment, and a 12% cost of equity, giving a WACC of 10.25%.

Best answer: C

What this tests: Finance

Explanation: The best support for a WACC conclusion is a schedule that uses the relevant component costs, target capital structure weights, and the after-tax cost of debt. Because interest is tax-deductible, the debt component should be multiplied by \(1 - \text{tax rate}\). For a project with the same risk as existing operations, the company’s target market-value capital structure is usually more relevant than historical book values. The correct schedule calculates WACC as 35% debt × 7% × 75% plus 65% equity × 12%, which equals 9.64%, or approximately 9.6%.

• Book-value weights may not reflect the intended financing mix or current investor-required returns.
• Using the pre-tax cost of debt overstates WACC because it ignores the tax shield from interest deductibility.
• Historical coupon rates and prior-year returns are backward-looking and do not provide the relevant current component costs.

This schedule applies the correct WACC inputs and uses the after-tax cost of debt: 35% × 7% × (1 − 25%) + 65% × 12% = 9.64%.

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• CPA Canada Core 2: Financial Reporting
• CPA Canada Core 2: Strategy and Governance
• CPA Canada Core 2: Management Accounting

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