FUNDAMENTALS OF CORPORATE
FINANCE PRACTICE EXAM QUESTIONS
AND CORRECT ANSWERS LATEST
UPDATE THIS YEAR
1. A firm is considering a project with non-conventional cash flows where a large outflow
occurs at the end of the project’s life. Which of the following is true regarding the Internal
Rate of Return (IRR)?
A. The project will always have a single unique IRR.
B. The project may have multiple IRRs, making the IRR rule unreliable.
C. The NPV and IRR rules will always yield the same decision.
D. The IRR will be lower than the hurdle rate if NPV is positive.
Answer: B
Conceptual Explanation: Non-conventional cash flows (where signs change more than
once) can result in multiple IRRs, which complicates the decision-making process using the
IRR rule alone.
2. When comparing two mutually exclusive projects with significantly different lifespans,
which method is most appropriate for a fair comparison?
A. Net Present Value (NPV)
,B. Internal Rate of Return (IRR)
C. Equivalent Annual Cost (EAC)
D. Profitability Index (PI)
Answer: C
Conceptual Explanation: The EAC method converts the NPV of projects with different
lives into an equivalent annual annuity, allowing for a direct comparison of their costs or
benefits over time.
3. According to the Hamada equation, what happens to a firm’s equity beta as its debt-to-
equity ratio increases, assuming no change in asset risk?
A. Equity beta remains constant.
B. Equity beta increases due to higher financial leverage.
C. Equity beta decreases as financial risk is mitigated.
D. Equity beta becomes equal to the market beta.
Answer: B
Conceptual Explanation: The Hamada equation shows that a firm’s equity beta (levered
beta) increases as it takes on more debt because the financial risk to shareholders
increases.
, 4. Under the Modigliani-Miller Theorem (Proposition II) with corporate taxes, the cost of
equity increases with leverage because:
A. The risk of bankruptcy disappears.
B. The tax shield decreases the total value of the firm.
C. Shareholders require a higher return to compensate for increased financial risk.
D. Debt becomes more expensive than equity.
Answer: C
Conceptual Explanation: As leverage increases, the risk to equity holders increases,
causing the required return on equity to rise linearly with the debt-to-equity ratio.
5. Which of the following best describes the ‘Pecking Order Theory’ of capital structure?
A. Firms prefer equity over debt to maintain a high credit rating.
B. Firms prioritize internal financing, then debt, and finally equity as a last resort.
C. Firms always seek an optimal target capital structure to minimize WACC.
D. Firms issue new shares whenever the stock price is undervalued.
Answer: B
Conceptual Explanation: The Pecking Order Theory suggests firms use internal funds first
to avoid asymmetric information costs associated with issuing new securities.
FINANCE PRACTICE EXAM QUESTIONS
AND CORRECT ANSWERS LATEST
UPDATE THIS YEAR
1. A firm is considering a project with non-conventional cash flows where a large outflow
occurs at the end of the project’s life. Which of the following is true regarding the Internal
Rate of Return (IRR)?
A. The project will always have a single unique IRR.
B. The project may have multiple IRRs, making the IRR rule unreliable.
C. The NPV and IRR rules will always yield the same decision.
D. The IRR will be lower than the hurdle rate if NPV is positive.
Answer: B
Conceptual Explanation: Non-conventional cash flows (where signs change more than
once) can result in multiple IRRs, which complicates the decision-making process using the
IRR rule alone.
2. When comparing two mutually exclusive projects with significantly different lifespans,
which method is most appropriate for a fair comparison?
A. Net Present Value (NPV)
,B. Internal Rate of Return (IRR)
C. Equivalent Annual Cost (EAC)
D. Profitability Index (PI)
Answer: C
Conceptual Explanation: The EAC method converts the NPV of projects with different
lives into an equivalent annual annuity, allowing for a direct comparison of their costs or
benefits over time.
3. According to the Hamada equation, what happens to a firm’s equity beta as its debt-to-
equity ratio increases, assuming no change in asset risk?
A. Equity beta remains constant.
B. Equity beta increases due to higher financial leverage.
C. Equity beta decreases as financial risk is mitigated.
D. Equity beta becomes equal to the market beta.
Answer: B
Conceptual Explanation: The Hamada equation shows that a firm’s equity beta (levered
beta) increases as it takes on more debt because the financial risk to shareholders
increases.
, 4. Under the Modigliani-Miller Theorem (Proposition II) with corporate taxes, the cost of
equity increases with leverage because:
A. The risk of bankruptcy disappears.
B. The tax shield decreases the total value of the firm.
C. Shareholders require a higher return to compensate for increased financial risk.
D. Debt becomes more expensive than equity.
Answer: C
Conceptual Explanation: As leverage increases, the risk to equity holders increases,
causing the required return on equity to rise linearly with the debt-to-equity ratio.
5. Which of the following best describes the ‘Pecking Order Theory’ of capital structure?
A. Firms prefer equity over debt to maintain a high credit rating.
B. Firms prioritize internal financing, then debt, and finally equity as a last resort.
C. Firms always seek an optimal target capital structure to minimize WACC.
D. Firms issue new shares whenever the stock price is undervalued.
Answer: B
Conceptual Explanation: The Pecking Order Theory suggests firms use internal funds first
to avoid asymmetric information costs associated with issuing new securities.
