Sample questions and answers
In terms of capital budgeting, the WACC is used as:
A) The discount rate for evaluating investment projects
B) The return expected on equity financing
C) The rate of return for debt investors
D) The minimum required return for equity investors
Answer: A
The Capital Asset Pricing Model (CAPM) uses the risk-free rate, beta, and market risk premium to calculate:
A) The required return on equity
B) The required return on debt
C) The WACC
D) The cost of capital for a project
Answer: A
If the expected return on a project is higher than the company’s WACC, the project will:
A) Increase the company’s overall value
B) Decrease the company’s overall value
C) Have no effect on the company’s value
D) Increase the company’s tax liability
Answer: A
The effect of the tax shield on debt financing is that it:
A) Decreases the cost of debt
B) Increases the firm’s risk
C) Increases the WACC
D) Decreases the WACC
Answer: D
Which of the following is true about the risk-free rate?
A) It is the return on debt with no risk of default
B) It is always equal to the cost of equity
C) It is determined by the company’s capital structure
D) It reflects the return expected on high-risk investments
Answer: A
The cost of capital for a project should be based on:
A) The company’s historical cost of capital
B) The market risk premium
C) The required rate of return for the project’s specific risk
D) The company’s average cost of debt
Answer: C
If a company decides to increase its debt financing, it is likely to:
A) Increase its cost of equity
B) Decrease its overall cost of capital
C) Keep its WACC unchanged
D) Decrease its cost of debt
Answer: B
A firm with high business risk will likely have a:
A) Lower cost of equity
B) Higher cost of equity
C) Lower cost of debt
D) Lower WACC
Answer: B
Which of the following is a key factor in determining the cost of equity using the Dividend Discount Model (DDM)?
A) The company’s cost of debt
B) The company’s expected future dividends
C) The company’s tax rate
D) The market risk premium
Answer: B
The cost of preferred stock is calculated as:
A) The dividend yield on the preferred stock
B) The coupon rate of the company’s debt
C) The market risk premium plus the risk-free rate
D) The return required by equity investors
Answer: A
The cost of debt is usually lower than the cost of equity because:
A) Debt holders have a higher claim on assets in case of liquidation
B) Debt financing has no risk
C) Debt financing is not affected by changes in interest rates
D) Debt financing does not require equity compensation
Answer: A
Which of the following describes the relationship between the cost of debt and the tax rate?
A) The cost of debt increases as the tax rate increases
B) The cost of debt decreases as the tax rate increases
C) The tax rate has no effect on the cost of debt
D) The cost of debt remains constant regardless of tax rate changes
Answer: B
A company’s cost of equity capital is:
A) The same as the cost of debt
B) Always higher than the cost of debt
C) Less sensitive to changes in market conditions than the cost of debt
D) Equal to the dividend yield on the company’s stock
Answer: B
In the WACC formula, which of the following represents the cost of debt?
A) The return on equity
B) The coupon rate of bonds
C) The after-tax return on debt
D) The weighted average dividend yield
Answer: C
A company’s debt ratio impacts its WACC because:
A) A higher debt ratio typically reduces the cost of equity
B) A higher debt ratio increases the cost of equity
C) A higher debt ratio reduces the firm’s overall risk
D) A higher debt ratio always reduces the WACC
Answer: B
The formula for the cost of equity using the Capital Asset Pricing Model (CAPM) is:
A) Risk-free rate + Beta × Market risk premium
B) Risk-free rate + Debt × Market risk premium
C) Beta × Risk-free rate + Equity
D) Risk-free rate + Cost of debt × Equity
Answer: A
Which of the following best defines financial leverage?
A) The use of debt to increase the return on equity
B) The use of equity to reduce the return on debt
C) The use of short-term debt to finance long-term projects
D) The use of retained earnings to reduce capital costs
Answer: A
The concept of the optimal capital structure suggests that:
A) The more debt a company uses, the higher its cost of capital
B) The optimal capital structure minimizes the company’s cost of capital
C) A company should have no debt to minimize risk
D) There is no relationship between capital structure and cost of capital
Answer: B
If the cost of debt increases, the WACC will likely:
A) Increase
B) Decrease
C) Remain unchanged
D) Become negative
Answer: A
If a company uses a high percentage of debt financing, it will:
A) Likely have a lower cost of equity
B) Likely have a higher cost of equity
C) Have no impact on the cost of equity
D) Likely have a higher WACC
Answer: B
The Modigliani-Miller theory of capital structure states that:
A) The cost of capital is irrelevant in determining the value of the firm
B) Debt financing increases a firm’s cost of capital
C) A company should finance all its projects with equity
D) The optimal capital structure involves using no debt
Answer: A
The market risk premium is the:
A) Return on equity minus the risk-free rate
B) Difference between the return on the market and the risk-free rate
C) Return on debt minus the equity return
D) Return on government bonds
Answer: B
When a company’s debt-to-equity ratio increases, its WACC will generally:
A) Stay the same
B) Decrease
C) Increase
D) Become less predictable
Answer: C
A company with a lower business risk will typically have:
A) A higher cost of equity
B) A lower cost of equity
C) A higher WACC
D) A higher debt ratio
Answer: B
The cost of debt can be lower than the cost of equity because:
A) Debt is more volatile than equity
B) Debt holders have senior claims in case of liquidation
C) Debt is less risky than equity
D) Debt provides no tax benefits
Answer: B
In a company’s WACC calculation, the weight assigned to equity represents:
A) The percentage of debt financing
B) The percentage of total capital funded by shareholders’ equity
C) The percentage of total capital funded by preferred stock
D) The total cost of equity divided by the total capital
Answer: B
A firm’s WACC is most useful when evaluating:
A) The profitability of specific products
B) The risk-free rate for debt investment
C) Investment projects that are similar to the firm’s existing operations
D) The firm’s debt-to-equity ratio
Answer: C
Which of the following is a disadvantage of using debt financing in capital structure?
A) Debt increases the cost of capital
B) Debt does not offer tax benefits
C) Debt increases the firm’s financial risk
D) Debt reduces the overall leverage of the firm
Answer: C
Which of the following is NOT a factor that affects the cost of capital?
A) The tax rate
B) The company’s size
C) The market risk premium
D) The firm’s capital structure
Answer: B
In the weighted average cost of capital formula, the weight of debt is:
A) The market value of debt divided by total market value of the company
B) The book value of debt divided by total book value of the company
C) The total debt divided by total capital
D) The total capital divided by total debt
Answer: A
If the risk-free rate decreases, the cost of equity will:
A) Increase
B) Decrease
C) Stay the same
D) Become negative
Answer: B
If a company’s cost of debt is 5%, and its tax rate is 30%, what is the after-tax cost of debt?
A) 5%
B) 3.5%
C) 6.5%
D) 7%
Answer: B
The cost of equity is generally higher than the cost of debt because:
A) Equity holders are paid before debt holders in case of liquidation
B) Debt has no associated risk
C) Equity investors require a higher return to compensate for higher risk
D) Debt financing is cheaper due to the tax shield
Answer: C
Which of the following best describes the relationship between the cost of equity and the firm’s beta?
A) The cost of equity increases as beta decreases
B) The cost of equity decreases as beta decreases
C) The cost of equity is unaffected by changes in beta
D) Beta and cost of equity are not related
Answer: B
The weighted average cost of capital (WACC) can be used to evaluate:
A) Only equity investments
B) Investment projects with risks similar to the firm’s overall risk
C) Projects that are unrelated to the firm’s core business
D) The firm’s tax liability
Answer: B
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