WorksheetsFinal Exam – Review Questions
Total questions: 100
Worksheet time: 1hrs 13mins
The weighted average cost of capital (WACC) is:
The return expected by equity investors.
The required return on a portfolio of all the firm’s securities.
The rate of return required by bondholders only.
Always equal to the firm's cost of equity.
The cost of equity can be estimated using:
The CAPM.
The dividend growth model.
Both A and B.
Neither A nor B.
In the WACC formula, the weights are based on:
Book values of debt and equity.
Market values of debt and equity.
Face value of bonds and par value of stock.
Historical cost of the firm’s capital.
Which of the following is tax-deductible for the firm?
Dividends.
Interest payments.
Retained earnings.
Flotation costs.
The formula for the cost of debt is usually expressed as:
Coupon rate on outstanding bonds.
Yield to maturity on existing debt.
Face value of bonds issued.
Prime lending rate.
The cost of preferred stock is calculated as:
Dividend divided by the market price of the preferred stock.
Dividend divided by the par value.
Market price divided by the dividend.
Coupon rate on preferred stock.
A company’s WACC will decrease if:
The risk-free rate rises.
The company issues more equity.
What is the primary reason that debt financing is cheaper than equity financing?
Debt holders have voting rights.
Dividends are tax-deductible.
Interest payments are tax-deductible.
Debt is riskier than equity.
When calculating WACC, flotation costs are:
Ignored entirely.
Added to the cost of debt only.
Included in the initial cost of raising new equity or debt.
Considered as operating expenses.
Which of the following is true regarding the firm's cost of capital?
It is the minimum rate of return the firm must earn on its investments.
It is always equal to the risk-free rate.
It applies only to equity-financed projects.
It ignores the firm's capital structure.
If a firm increases its debt-equity ratio, its equity becomes:
Less risky.
More risky.
Unchanged in risk.
Risk-free.
The after-tax cost of debt equals:
Coupon rate × (1 – Tax rate).
Coupon rate × Tax rate.
Yield to maturity × (1 + Tax rate).
Yield to maturity × (1 – Tax rate).
The WACC reflects the risk of:
The firm's existing assets.
The firm's new project only.
The firm's debt obligations.
The firm’s stock price.
Which of the following best describes the marginal cost of capital?
The cost of the last dollar of new capital raised.
The average cost of all past capital.
What happens to the WACC if a firm issues new equity with significant flotation costs?
WACC decreases.
WACC remains unchanged.
WACC increases.
Cannot be determined.
The CAPM formula for the cost of equity is:
Risk-free rate + Beta × (Market risk premium).
Risk-free rate × Beta + (Market risk premium).
Risk-free rate + (Market return × Beta).
Market return + Risk-free rate × Beta.
What is the key assumption when using the firm's current WACC to evaluate a new project?
The project is riskier than the firm.
The project is of similar risk to the firm’s overall risk.
The project will be financed entirely with equity.
The project has no flotation costs.
If a firm uses more debt in its capital structure, initially:
WACC increases due to more risk.
WACC decreases because debt is cheaper.
WACC stays the same.
Equity cost falls, reducing WACC.
When a firm has multiple divisions with different risk levels, the WACC used for a project in a risky division should be:
The firm’s overall WACC.
The WACC adjusted upward for the division’s risk.
The same as the firm’s debt cost.
The same as the risk-free rate.
A firm's cost of retained earnings is:
Zero.
Equal to the cost of equity.
Equal to the cost of debt.
Always lower than the cost of equity.
Which of the following is NOT part of the firm's capital structure?
Preferred stock.
Retained earnings.
Short-term debt used for working capital.
Common stock.
The "pure play" approach in project evaluation involves:
Using a company's internal rate of return.
Using the beta of a firm that specializes in the same project type.
Using the historical WACC of the firm.
Applying the risk-free rate.
If the firm’s WACC is 10%, and it accepts a project with a 9% return, this will:
Increase firm value.
Decrease firm value.
Leave firm value unchanged.
Be a neutral investment.
Which of the following is true about the dividend growth model for estimating the cost of equity?
It requires knowledge of the firm’s beta.
It assumes dividends grow at a constant rate forever.
It does not require market data.
It is best suited for non-dividend-paying firms.
When using the WACC, one should NOT:
Use book values for the capital structure weights.
Use after-tax cost of debt.
Use market values for equity and debt.
Account for flotation costs in new equity.
Which of the following best defines operating leverage?
The degree to which a firm relies on debt.
The degree to which a firm relies on fixed costs in its operations.
The extent to which dividends are paid.
The use of preferred stock in capital structure.
Financial leverage is concerned with:
The use of fixed operating costs.
The use of variable costs.
The use of debt financing.
The use of common equity.
Which of the following is NOT an effect of financial leverage?
It magnifies both gains and losses to shareholders.
It increases the firm's beta.
It reduces the firm's tax liability.
It eliminates business risk.
The break-even point is the sales level at which:
EBIT equals net income.
EBIT equals zero.
Net income equals zero.
Fixed costs are zero.
The Modigliani-Miller (MM) Proposition I (without taxes) states:
Firm value increases with leverage.
Firm value is independent of its capital structure.
Debt is cheaper than equity.
Taxes have no effect on firm value.
According to MM Proposition II (without taxes), as leverage increases:
The cost of equity remains unchanged.
The cost of equity decreases.
The cost of equity increases.
The WACC decreases.
The main benefit of debt financing is:
Increased flexibility.
Tax shield from interest payments.
Higher dividend payouts.
Lower financial risk.
The optimal capital structure is the one that:
Maximizes the firm's stock price.
Minimizes the firm's tax liability.
Maximizes the firm's WACC.
Minimizes operating leverage.
Which of the following increases as financial leverage increases?
Business risk.
Financial risk.
Operating leverage.
Sales volume.
The static theory of capital structure suggests that firms should:
Use no debt to avoid financial risk.
Use as much debt as possible.
Balance the tax benefits of debt with the costs of financial distress.
Ignore the cost of debt.
A firm with high operating leverage is more sensitive to:
Changes in variable costs.
Changes in sales.
Changes in tax rates.
Changes in dividend payouts.
The pecking-order theory of capital structure suggests firms prefer to finance new projects in which order?
Equity, then debt.
Debt, then equity.
Internal financing, then debt, then equity.
Equity only.
Which of the following best describes the concept of business risk?
Risk associated with a firm’s capital structure.
Risk inherent in the firm's operations.
Risk of bankruptcy due to debt financing.
Risk of interest rate changes.
As per MM Proposition I with corporate taxes, firm value:
Decreases with leverage.
Increases with leverage due to the tax shield.
Is unrelated to leverage.
Is maximized at zero leverage.
Financial distress costs are:
Always zero for large firms.
Costs that only occur after bankruptcy.
Costs associated with the possibility of bankruptcy.
Included in operating expenses.
Which of the following is a direct cost of financial distress?
Lost sales due to worried customers.
Legal and administrative costs in bankruptcy.
Loss of employee morale.
Increased cost of capital.
Which of the following is true regarding MM’s assumptions in their propositions (without taxes)?
Firms can go bankrupt.
No taxes and no bankruptcy costs.
There are flotation costs.
Investors cannot borrow or lend at the risk-free rate.
The degree of operating leverage (DOL) is calculated as:
% change in EBIT / % change in sales.
% change in EPS / % change in EBIT.
EBIT / Sales.
Sales / EBIT.
The degree of financial leverage (DFL) is calculated as:
% change in EBIT / % change in sales.
% change in EPS / % change in EBIT.
EBIT / Sales.
Sales / EBIT.
Which firm is most likely to benefit from high leverage?
A firm with highly uncertain and volatile cash flows.
A firm with stable and predictable cash flows.
A start-up with minimal revenues.
A firm with mostly variable costs.
The firm's total risk is a combination of:
Financial risk only.
Business risk only.
Business and financial risk.
Market risk only.
Under the trade-off theory, firms with high profitability:
Should use less debt because they don’t need a tax shield.
Should use more debt to shield profits from taxes.
Should avoid both debt and equity financing.
Should rely only on internal equity.
Which of the following is NOT a factor influencing a firm's capital structure decision?
Tax rate.
Asset structure.
CEO's personal risk preference.
Market conditions.
What does the "irrelevance proposition" suggest?
Dividend policy is irrelevant to firm value.
Capital structure does not affect firm value under perfect market assumptions.
Debt always increases firm value.
Equity always reduces firm value.
What typically happens to the firm's weighted average cost of capital (WACC) when financial distress costs are included?
WACC decreases indefinitely with more debt.
WACC first decreases, then increases after a certain debt level.
WACC is unaffected by distress costs.
WACC increases as more debt is used.
Which of the following is a measure of total risk?
Beta.
Expected return.
Standard deviation.
Risk-free rate.
The risk that cannot be diversified away is called:
Unsystematic risk.
Diversifiable risk.
Systematic risk.
Firm-specific risk.
The Capital Asset Pricing Model (CAPM) describes the relationship between:
Expected return and unsystematic risk.
Expected return and standard deviation.
Expected return and beta.
Expected return and total risk.
According to CAPM, the expected return on a security is equal to:
The risk-free rate plus the market risk premium.
Beta times the risk-free rate.
Risk-free rate + Beta × (Market return - Risk-free rate).
Market return plus the risk-free rate.
Which of the following is a correct interpretation of beta?
The standard deviation of the stock’s returns.
The stock’s sensitivity to market movements.
Diversification is most effective when:
Securities have high positive correlation.
Securities have low or negative correlation.
Securities have beta equal to 1.
All securities are from the same industry.
The slope of the Security Market Line (SML) is:
The market risk premium.
The risk-free rate.
Beta.
The standard deviation of the market.
Which of the following is NOT a characteristic of systematic risk?
A) It affects a large number of assets.
B) It is also called market risk.
C) It can be eliminated through diversification.
D) It includes risks like inflation and interest rate changes.
Unsystematic risk can best be described as:
Market-wide risk.
Firm-specific risk.
Non-diversifiable risk.
Beta risk.
If a portfolio has a beta of 1.0, it:
Is risk-free.
Is expected to have the same risk as the market.
Has no systematic risk.
Will have zero return.
The expected return of a portfolio is:
The weighted average of the expected returns of the assets in the portfolio.
The sum of the individual standard deviations.
The geometric mean of asset returns.
Always equal to the risk-free rate.
Which of the following best explains why unsystematic risk disappears in a well-diversified portfolio?
It is correlated across all firms.
It can be eliminated through diversification.
It is a market-wide risk.
It is related to inflation and interest rates.
Which of the following statements is TRUE?
Beta measures total risk.
Total risk equals systematic risk plus unsystematic risk.
Standard deviation measures only unsystematic risk.
The risk-free rate has a beta of 1.
The reward-to-risk ratio of a security is equal to:
(Market return - Risk-free rate) / Beta.
(Expected return - Risk-free rate) / Beta.
Beta × Market risk premium.
(Expected return + Beta) / Risk-free rate.
In CAPM, what is the expected return of a security with zero beta?
Market return.
Zero.
Risk-free rate.
Beta × Market return.
An efficient portfolio is one that:
Has the lowest possible beta.
Offers the highest return for a given level of risk.
Holds only market risk.
Eliminates all systematic risk.
Which of the following represents a risk-free asset?
Corporate bonds.
Common stock.
Treasury bills.
Preferred stock.
When adding a risky asset to a risk-free asset, the resulting portfolio’s risk:
Increases linearly with the asset’s beta.
Decreases to zero.
Remains unchanged.
Always equals the risky asset’s standard deviation.
The variance of a two-asset portfolio depends on:
Which of the following assets has a beta of zero?
A stock that moves exactly with the market.
Treasury bills.
A high-risk corporate bond.
The market portfolio.
The market risk premium is defined as:
Beta × Expected return of the market.
Expected return of the market minus the risk-free rate.
Standard deviation of the market.
Expected return of the market.
The main idea of the risk-return tradeoff is:
Higher risk always results in lower returns.
Investors are only rewarded for unsystematic risk.
Investors require a higher return for taking more risk.
Diversification eliminates systematic risk.
What does the Security Market Line (SML) show?
The relationship between expected return and total risk.
The relationship between expected return and systematic risk.
The efficient frontier of portfolios.
The minimum variance portfolio.
The total return on an investment is made up of:
Risk-free rate and market risk premium.
Expected return and capital gains.
Capital gains and dividend yield.
Beta and alpha.
If two assets have a correlation coefficient of +1, combining them:
Reduces total risk to zero.
Does not change the portfolio’s risk.
Results in the same risk as a weighted average of the two.
Increases diversification benefits.
What is the required return on a portfolio of all the firm’s securities?
The cost of equity
The required return on a portfolio of all the firm’s securities
The cost of debt
The cost of equity can be estimated using which of the following?
CAPM (risk-based approach)
Dividend growth model
Both A and B
WACC weights are based on which of the following?
Book values of debt and equity
Market values of debt and equity
Historical values of debt and equity
Which of the following is tax-deductible?
Dividend payments
Interest payments
Both A and B
What is a better reflection of the current cost of debt than the coupon rate?
Book value
Yield to maturity on existing debt
Market value
How is the cost of preferred stock calculated?
Dividend divided by the market price of the preferred stock
Dividend divided by the book value of the preferred stock
Dividend divided by the par value of the preferred stock
What happens when the company issues more debt (up to a point)?
WACC increases
WACC remains unchanged
The company issues more debt (up to a point)
Why is debt cheaper than equity?
Dividends are tax-deductible
Equity is riskier
Interest payments are tax-deductible
How are flotation costs treated?
Ignored in the cost of capital
Included in the ongoing cost of debt
Included in the initial cost of raising new equity or debt
What is the minimum rate of return the firm must earn on its investments?
It is the minimum rate of return the firm must earn on its investments
It is the average rate of return on all projects
It is the maximum rate of return the firm can earn
As debt increases, what happens to financial leverage?
Less risky
More risky
No change
Yield to maturity × (1 – Tax rate).
WACC reflects the risk of which of the following?
What is the cost of the last dollar of new capital raised?
What happens to WACC when high flotation costs increase the cost of new equity?
WACC decreases.
WACC remains the same.
WACC increases.
What is the CAPM formula?
WACC is appropriate only if the new project is of similar risk to which of the following?
What happens to WACC when more debt is added and debt is cheaper?
WACC increases because debt is more expensive.
WACC decreases because debt is cheaper.
How should the WACC be adjusted for the division’s risk?
The cost of retained earnings is:
What is short-term debt typically used for in capital structure?
A) Long-term investments
B) Asset acquisition
C) Short-term debt used for working capital.
D) Equity financing
The pure play approach estimates project risk by using:
What happens to firm value if a project returns less than WACC?
Decrease firm value.
Increase firm value.
The dividend growth model relies on which of the following assumptions?
Dividends grow at a variable rate
Dividends grow at a constant rate forever
Dividends do not grow
Dividends decrease over time
In WACC calculations, which values should be used for the capital structure weights?
Book values
Market values
Historical values
Projected values
