TRAINING SESSION - PRACTICE MCQS Flashcards
(25 cards)
In a world with taxes, which of the following is the rate we should use to evaluate an all-equity financed project with the same risk as the firm?
A) The weighted-average cost of capital
B) The pre-tax WACC
C) The cost of equity
D) The cost of debt
B
Which of the following statements is FALSE?
A) With no debt, the WACC is equal to the unlevered equity cost of capital.
B) With perfect capital markets, a firm’s WACC is dependent on its capital structure
and is equal to its equity cost of capital only if the firm is levered.
C) As the firm borrows at the low cost of capital for debt, its equity cost of capital
rises, but the net effect is that the firm’s WACC is unchanged.
D) Although debt has a lower cost of capital than equity, leverage does not lower a
firm’s WACC.
B
Explanation: With perfect capital markets, a firm’s WACC is independent of its
capital structure and is equal to its equity cost of capital only if the firm is unlevered.
3) Which of the following statements is FALSE?
A) Firms with steady, reliable cash flows, such as utility companies, are able to use
high levels of debt and still have a very low probability of default.
B) If there were no costs of financial distress, the value of the firm would continue to
increase with increasing debt until the interest on the debt exceeds the firm’s
earnings before interest and taxes and the tax shield is exhausted.
C) The costs of financial distress reduce the value of the levered firm, VL. The
amount of the reduction decreases with the probability of default, which in turn
increases with the level of the debt D.
D) The tradeoff theory states that firms should increase their leverage until it reaches
the level D* for which VL is maximized.
C
Explanation: The costs of financial distress reduce the value of the levered firm, VL.
The amount of the reduction increases with the probability of default, which in turn
increases with the level of the debt D.
4) Which of the following statements is FALSE?
A) The optimal level of debt D* balances the costs and benefits of leverage.
B) As the debt level increases, the firm benefits from the interest tax shield (which
has present value τ*D).
C) If the debt level is too large, firm value is reduced due to the loss of tax benefits
(when interest exceeds EBIT), financial distress costs, and the agency costs of
leverage.
D) As the debt level increases, the firm faces decreased incentives for management,
which increase wasteful investment and perks.
Answer: D
Explanation: As the debt level increases, the firm faces improved incentives for
management, which reduce wasteful investment and perks.
5) Which of the following statements is FALSE?
A) While firms do still pay dividends, substantial evidence shows that many firms
have recognized their tax disadvantage.
B) The fact that firms continue to issue dividends despite their tax disadvantage is
often referred to as the dividend puzzle.
C) At the end of the 1990s, dividend payments exceeded the value of repurchases
for U.S. industrial firms.
D) While evidence is indicative of the growing importance of share repurchases as a
part of firms’ payout policies, it also shows that dividends remain a key form of
payouts to shareholders.
Answer: C
Explanation: At the end of the 1990s, value of repurchases exceeded dividend
payments the for U.S. industrial firms.
6) Which of the following statements is FALSE?
A) If firms smooth dividends, the firm’s dividend choice will contain information
regarding management’s expectations of future earnings.
B) Because of the increasing popularity of repurchases, firms cut dividends much
more frequently than they increase them.
C) Announcing a share repurchase today does not necessarily represent a long-term
commitment to repurchase shares.
D) While cutting the dividend is costly for managers in terms of their reputation and
the reaction of investors, it is by no means as costly as failing to make debt
payments.
Answer: B
Explanation: Despite the increasing popularity of repurchases, firms increase
dividends much more frequently than they cut them.
7) Which of the following statements is FALSE?
A) An option holder would not exercise an in-the-money option.
B) The option seller, also called the option writer, sells (or writes) the option and has
a short position in the contract.
C) Because the long side of an option contract has the option to exercise, the short
side has an obligation to fulfill the contract.
D) When the exercise price of an option is equal to the current price of the stock, the
option is said to be at-the-money.
Answer: A
8) Which of the following statements is FALSE?
A) Options allow investors to speculate, or place a bet on the direction in which they
believe the market is likely to move.
B) Options where the strike price and the stock price are very far apart are referred
to as deep in-the-money or deep out-of-the-money.
C) Call options with strike prices above the current stock price are in-the-money, as
are put options with strike prices below the current stock price.
D) European options allow their holders to exercise the option only on the expiration
date—holders cannot exercise before the expiration date.
Answer: C
9) Which of the following is NOT a real option?
A) A stock option
B) An abandonment option
C) An investment timing option
D) An expansion option
Answer: A
10) Which of the following statements is NOT true regarding Angel Investors?
A) They are typically arranged as limited partnerships.
B) For many start-ups, the first round of outside private equity financing is often
obtained from them.
C) Because their capital investment is often large relative to the amount of capital
already in place at the firm, they typically receive a sizeable equity share in the
business in return for their funds.
D) These investors are frequently friends or acquaintances of the entrepreneur.
Answer: A
Explanation: Venture capital firms are typically arranged as limited partnerships.
11) In M&M Proposition 1, conservation of value implies that:
A) the mix of common stock and the preferred stock does not affect the risk of the
firm’s assets.
B) the cash flows generated by the firm’s assets do not affect the value of the firm’s
assets.
C) all the provided answer choices are correct.
D) the mix of senior and subordinated debt does not affect the value of the firm’s
assets.
Answer: D
12) The Economist publishes annually the “Big Mac Index” by which they compare the
prices of the McDonald’s Corporation’s Big Mac hamburger around the world. The
index estimates the exchange rates for currencies based on the assumption that the
burgers in question are the same across the world and therefore, the price should be
the same. If a Big Mac costs $2.65 in the United States and 299 yen in Japan, what is
the estimated exchange rate of yen per dollar as hypothesized by the Hamburger
index?
A) $0.0094/¥
B) ¥115.35/$
C) $0.0087/¥
D) ¥112.83/$
Answer: D
13) Which of the following statements is FALSE?
A) Leverage decreases the risk of the equity of a firm.
B) Because the cash flows of the debt and equity sum to the cash flows of the
project, by the Law of One Price the combined values of debt and equity must be
equal to the cash flows of the project.
C) Franco Modigliani and Merton Miller argued that with perfect capital markets, the
total value of a firm should not depend on its capital structure.
D) It is inappropriate to discount the cash flows of levered equity at the same
discount rate that we use for unlevered equity.
Answer: A
Leverage increases the risk of the equity of the firm
14) Which of the following is NOT an indirect cost of bankruptcy?
A) Legal fees
B) Delayed liquidation
C) Costs to creditors
D) Loss of customers
Answer: A
15) Which of the following statements is false?
A) By including more covenants, issuers increase their costs of borrowing.
B) Once bonds are issued; equity holders have an incentive to increase dividends at
the expense of debt holders.
C) Covenants may restrict the level of further indebtedness and specify that the
issuer must maintain a minimum amount of working capital.
D) If the covenants are designed to reduce agency costs by restricting
management’s ability to take negative NPV actions that exploit debt holders, then the
reduction in the firm’s borrowing cost can more than outweigh the cost of the loss of
flexibility associated with covenants
Answer: A
16) Which of the following statements regarding real options is false?
A) If there is a lot of uncertainty, the benefit of waiting is diminished.
B) In the real option context, the dividends correspond to any value from the
investment that we give up by waiting.
C) By delaying an investment, we can base our decision on additional information.
D) Given the option to wait, an investment that currently has a negative NPV can
have a positive value.
Answer: A
17) Which of the following statements is false?
A) We can calculate the cost of capital of the firm’s assets by computing the
weighted average of the firm’s equity and debt cost of capital, which we refer to as
the firm’s weighted average cost of capital (WACC).
B) The portfolio of a firm’s equity and debt replicates the returns we would earn if the
firm were unlevered.
C) When evaluating any potential investment project, we must use a discount rate
that is appropriate given the risk of the project’s free cash flow.
D) If we can identify a comparison firm whose assets have the same risk as the
project being evaluated, and if the comparison firm is levered, then we can use its
equity cost of capital as the cost of capital for the project.
Answer: D
18)Luther Industries is currently trading for $27 per share. The stock pays no
dividends. A one -year European put option on Luther with a strike price of $30 is
currently trading for $2.60. If the risk -free interest rate is 6% per year, then the price
of a one-year European call option on Luther with a strike price of $30 will be closest
to:
A) $1.30
B) $7.10
C) $2.60
D) $1.95
Answer: A
19) Consider a project with free cash flows in one year of $90,000 in a weak
economy or $117,000 in a strong economy, with each outcome being equally likely.
The initial investment required for the project is $80,000, and the project’s cost of
capital is 15%. The risk-free interest rate is 5%. The NPV for this project is closest to:
A) $6,250
B) $14,100
C) $10,000
D) $18,600
Answer: C
NPV = 0.5(90,000+117,000)/(1.15) -80,000
20) Which of the following statements regarding firm commitment IPOs is FALSE?
A) If the entire issue does not sell out, the remaining shares must be sold at a lower
price and the underwriter must take the loss.
B) The underwriter purchases the entire issue (at the offer price) and then resells it
at a slightly higher price to interested investors.
C) It is the most common underwriting arrangement.
D) The underwriter guarantees that it will sell all of the stock at the offer price.
Answer: B
Explanation: The underwriter purchases the entire issue (at a price slightly lower than the offer price)
and then resells it at the offer price to interested investors
21) A type of agency problem that results in shareholders gaining from decisions that
increase the risk of the firm sufficiently, even if they have negative NPV is:
A) asset substitution.
B) debt overhang.
C) underinvestment.
D) cashing out.
Answer: A
22) Anyone who purchases the stock on or after the ________ date will not receive
the dividend.
A) distribution
B) record
C) ex-dividend
D) declaration
Answer: C
23) If Microsoft merged with the Coca-Cola Company, this would be an example of a
________ merger.
A) conglomerate
B) vertical
C) horizontal
D) diagonal
Answer: A
24) If Tesco and Asda were to merge, this would be an example of a ________
merger.
A) conglomerate
B) vertical
C) horizontal
D) diagonal
Answer: C
