Sample Questions and Answers
A higher dividend payout ratio generally indicates:
a) The firm has less growth potential
b) The firm has more debt
c) The firm is reinvesting all of its profits
d) The firm has a low risk of bankruptcy
Answer: a) The firm has less growth potential
Explanation: A higher payout ratio may signal that the firm is distributing more of its profits to shareholders rather than reinvesting them for growth, possibly indicating lower growth potential.
Dividend irrelevance theory argues that:
a) Dividend policy does not affect a firm’s value in perfect markets
b) Dividends are crucial for investor satisfaction
c) Firms should always increase dividends to attract investors
d) The value of a firm is determined solely by its dividend policy
Answer: a) Dividend policy does not affect a firm’s value in perfect markets
Explanation: The dividend irrelevance theory posits that, under ideal conditions, a firm’s dividend policy does not impact its market value because investors can create their own dividend-equivalent portfolios.
Time Value of Money & Capital Budgeting
The payback period measures:
a) The time it takes to recover the initial investment
b) The time it takes to earn a return equal to the cost of capital
c) The time it takes to reach the project’s break-even point
d) The time it takes to achieve a positive net present value
Answer: a) The time it takes to recover the initial investment
Explanation: The payback period is the time it takes for a project to repay its initial investment from its cash inflows, without considering the time value of money.
The internal rate of return (IRR) is the discount rate that:
a) Maximizes a firm’s NPV
b) Makes the NPV of a project equal to zero
c) Equals the project’s cost of equity
d) Maximizes the firm’s return on equity
Answer: b) Makes the NPV of a project equal to zero
Explanation: The IRR is the discount rate that makes the net present value (NPV) of a project equal to zero, indicating the rate of return the project is expected to generate.
Capital budgeting is the process of:
a) Determining how to allocate profits between dividends and reinvestment
b) Deciding on the optimal capital structure for a firm
c) Identifying and evaluating potential long-term investments
d) Deciding on the timing of dividend payments
Answer: c) Identifying and evaluating potential long-term investments
Explanation: Capital budgeting involves analyzing and selecting investments in long-term assets, such as projects, based on expected cash flows and profitability.
The modified internal rate of return (MIRR) addresses a problem with the traditional IRR by:
a) Considering the initial investment in its calculation
b) Assuming reinvestment at the project’s IRR
c) Reinvesting cash flows at the firm’s cost of capital
d) Ignoring non-cash expenses in the calculation
Answer: c) Reinvesting cash flows at the firm’s cost of capital
Explanation: The MIRR addresses the IRR’s reinvestment assumption by assuming cash flows are reinvested at the firm’s cost of capital instead of the IRR.
If a project has a negative NPV, it means:
a) The project will add value to the firm
b) The project is expected to break even
c) The project is expected to destroy value for the firm
d) The project is highly risky
Answer: c) The project is expected to destroy value for the firm
Explanation: A negative NPV means the project is expected to return less than its cost of capital, indicating that it would destroy value for the firm.
Risk & Return
The beta coefficient of a stock measures:
a) The stock’s risk relative to the market
b) The risk of a company’s earnings volatility
c) The dividend yield of a stock
d) The potential return of a stock based on historical performance
Answer: a) The stock’s risk relative to the market
Explanation: Beta measures the volatility or systematic risk of a stock in relation to the overall market. A beta of 1 indicates the stock moves with the market.
The security market line (SML) is used to:
a) Calculate the required rate of return for an asset
b) Determine the market risk premium
c) Identify underpriced stocks
d) Calculate the company’s cost of equity
Answer: a) Calculate the required rate of return for an asset
Explanation: The SML represents the relationship between the risk (beta) and the expected return of an asset, allowing the calculation of the required rate of return for that asset.
Diversification reduces:
a) Both systematic and unsystematic risk
b) Systematic risk only
c) Unsystematic risk only
d) Total risk
Answer: c) Unsystematic risk only
Explanation: Diversification reduces unsystematic risk (company-specific risk), but it cannot eliminate systematic risk (market-wide risk).
If a stock has a beta of 1.5 and the market return is 10%, the expected return of the stock (assuming a risk-free rate of 3%) is:
a) 10%
b) 13.5%
c) 18%
d) 15%
Answer: b) 13.5%
Explanation: Using the CAPM formula: E(R)=Rf+β(Rm−Rf)=3%+1.5(10%−3%)=13.5%E(R) = R_f + \beta (R_m – R_f) = 3\% + 1.5(10\% – 3\%) = 13.5\%E(R)=Rf+β(Rm−Rf)=3%+1.5(10%−3%)=13.5%.
A stock with a beta of 0.5 is considered:
a) More volatile than the market
b) Less volatile than the market
c) Unaffected by market movements
d) Highly correlated with the market
Answer: b) Less volatile than the market
Explanation: A beta of 0.5 indicates that the stock is less volatile than the market, moving half as much as the market’s movements.
Capital Structure & Corporate Financing
The optimal capital structure is the mix of debt and equity that:
a) Minimizes a firm’s tax liabilities
b) Maximizes the firm’s value by balancing the benefits and costs of debt
c) Ensures a firm has no debt
d) Maximizes dividends
Answer: b) Maximizes the firm’s value by balancing the benefits and costs of debt
Explanation: The optimal capital structure maximizes the firm’s value by balancing the benefits of debt (e.g., tax shields) and the potential costs (e.g., bankruptcy risk).
Agency costs arise from:
a) The risk of the firm’s cash flows
b) The conflict of interest between management and shareholders
c) The decision to issue new equity
d) The costs associated with issuing bonds
Answer: b) The conflict of interest between management and shareholders
Explanation: Agency costs are incurred due to the conflict of interest between managers (agents) and shareholders (principals), which can result in inefficiencies and costs.
Debt financing is generally cheaper than equity financing because:
a) Debt holders have a higher risk than equity holders
b) Interest payments on debt are tax-deductible
c) Debt holders have a lower priority than equity holders in bankruptcy
d) Debt financing is not subject to market fluctuations
Answer: b) Interest payments on debt are tax-deductible
Explanation: Interest payments on debt are tax-deductible, reducing the effective cost of debt, which makes it generally cheaper than equity financing.
The trade-off theory of capital structure suggests that firms:
a) Should always use as much debt as possible
b) Should balance the benefits of debt with the costs of financial distress
c) Should minimize equity financing
d) Should avoid debt financing entirely
Answer: b) Should balance the benefits of debt with the costs of financial distress
Explanation: The trade-off theory suggests that firms balance the tax benefits of debt with the costs of financial distress or bankruptcy.
A firm is said to have a high degree of financial leverage if it:
a) Has a large proportion of debt in its capital structure
b) Relies entirely on equity financing
c) Is highly liquid
d) Has a low cost of capital
Answer: a) Has a large proportion of debt in its capital structure
Explanation: Financial leverage refers to the use of debt in a firm’s capital structure. A high degree of financial leverage means the firm relies more heavily on debt.
Dividend Policy & Corporate Governance
The residual dividend policy suggests that dividends should be paid:
a) Based on a fixed percentage of earnings
b) After all profitable investment opportunities have been funded
c) In proportion to the number of shares outstanding
d) Based on historical payout levels
Answer: b) After all profitable investment opportunities have been funded
Explanation: Under the residual dividend policy, dividends are paid after funding all profitable investment opportunities, ensuring that the firm retains enough capital for growth.
The dividend payout ratio is calculated by:
a) Dividing total dividends by total equity
b) Dividing net income by total dividends paid
c) Dividing dividends paid by net income
d) Dividing earnings before interest and taxes by net income
Answer: c) Dividing dividends paid by net income
Explanation: The dividend payout ratio is the proportion of a company’s earnings that is paid out as dividends to shareholders.
A dividend reinvestment plan (DRIP) allows shareholders to:
a) Receive dividends in the form of additional shares instead of cash
b) Automatically reinvest their dividends in other stocks
c) Receive dividends in cash without taxes
d) Reduce their tax liability on dividends
Answer: a) Receive dividends in the form of additional shares instead of cash
Explanation: A DRIP allows shareholders to reinvest their dividends by purchasing additional shares, often at a discounted price.
A stock split typically:
a) Increases the value of shares
b) Decreases the number of shares outstanding
c) Increases the number of shares outstanding but does not affect the total value of the investment
d) Is taxable for the shareholder
Answer: c) Increases the number of shares outstanding but does not affect the total value of the investment
Explanation: A stock split increases the number of shares outstanding but reduces the price per share, leaving the total value of the investment unchanged.
The clientele effect suggests that:
a) Dividend policies attract certain types of investors based on their preferences
b) Investors prefer companies that reinvest all earnings
c) Investors dislike dividends due to taxes
d) Firms should avoid paying dividends
Answer: a) Dividend policies attract certain types of investors based on their preferences
Explanation: The clientele effect suggests that a company’s dividend policy will attract investors with preferences that align with the firm’s payout practices.
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