FUNDAMENTALS OF CORPORATE
FINANCE - COMPREHENSIVE
ADVANCED ASSESSMENT QUESTIONS
AND CORRECT ANSWERS LATEST
UPDATE THIS YEAR
1. In the context of agency theory, which of the following mechanisms is most effective at
reducing the free cash flow problem in a mature firm with few growth opportunities?
A. Increasing the dividend payout ratio or initiating a stock repurchase program.
B. Granting stock options to lower-level employees to improve productivity.
C. Decreasing the debt-to-equity ratio to reduce financial distress risk.
D. Implementing a poison pill to deter hostile takeovers.
Answer: A
Conceptual Explanation: According to the agency cost of free cash flow, managers with
excess cash may invest in NPV-negative projects. Increasing payouts forces managers to be
more disciplined or return the capital to shareholders.
2. A firm is considering a project with an IRR of 14%. The project’s cash flows alternate signs
more than once. Which of the following statements is most accurate?
A. The project must have a positive NPV if the cost of capital is less than 14%.
,B. The NPV profile might cross the x-axis multiple times, making the IRR unreliable.
C. The MIRR (Modified Internal Rate of Return) will always equal the IRR in this case.
D. The profitability index will always be greater than 1.0.
Answer: B
Conceptual Explanation: Non-conventional cash flows (where signs change more than
once) can lead to multiple IRRs, rendering the IRR rule mathematically ambiguous for
decision-making.
3. Under the Modigliani-Miller Proposition II with corporate taxes, as a firm increases its
leverage, what happens to the cost of equity?
A. It remains constant because the tax shield offsets the increased risk.
B. It decreases because debt is a cheaper source of financing.
C. It increases linearly with the debt-to-equity ratio, reflecting higher financial risk.
D. It increases, but at a slower rate than without taxes due to the interest tax shield.
Answer: D
Conceptual Explanation: MM Proposition II with taxes states that the cost of equity
increases with leverage due to financial risk, but the tax deductibility of interest reduces
the effective increase compared to the no-tax scenario.
, 4. Which of the following best describes the ‘Pecking Order Theory’ of capital structure?
A. Firms prioritize internal financing, then debt, and finally external equity due to
asymmetric information.
B. Firms prefer equity over debt to maintain a low debt-to-equity ratio.
C. Firms choose a specific target debt-to-equity ratio and stick to it regardless of market
conditions.
D. Firms issue equity when the stock market is overvalued to benefit existing shareholders.
Answer: A
Conceptual Explanation: Pecking order theory suggests that due to information
asymmetry and signaling, firms use internal funds first, then safe debt, then risky debt, and
only as a last resort, external equity.
5. What is the primary difference between the APV (Adjusted Present Value) method and the
WACC method in capital budgeting?
A. APV ignores taxes, while WACC includes them.
B. APV is less accurate than WACC when the dollar amount of debt is known.
C. WACC is only used for projects with changing leverage ratios over time.
D. APV evaluates the project as if it were all-equity financed and then adds the NPV of
financing side effects.
Answer: D
FINANCE - COMPREHENSIVE
ADVANCED ASSESSMENT QUESTIONS
AND CORRECT ANSWERS LATEST
UPDATE THIS YEAR
1. In the context of agency theory, which of the following mechanisms is most effective at
reducing the free cash flow problem in a mature firm with few growth opportunities?
A. Increasing the dividend payout ratio or initiating a stock repurchase program.
B. Granting stock options to lower-level employees to improve productivity.
C. Decreasing the debt-to-equity ratio to reduce financial distress risk.
D. Implementing a poison pill to deter hostile takeovers.
Answer: A
Conceptual Explanation: According to the agency cost of free cash flow, managers with
excess cash may invest in NPV-negative projects. Increasing payouts forces managers to be
more disciplined or return the capital to shareholders.
2. A firm is considering a project with an IRR of 14%. The project’s cash flows alternate signs
more than once. Which of the following statements is most accurate?
A. The project must have a positive NPV if the cost of capital is less than 14%.
,B. The NPV profile might cross the x-axis multiple times, making the IRR unreliable.
C. The MIRR (Modified Internal Rate of Return) will always equal the IRR in this case.
D. The profitability index will always be greater than 1.0.
Answer: B
Conceptual Explanation: Non-conventional cash flows (where signs change more than
once) can lead to multiple IRRs, rendering the IRR rule mathematically ambiguous for
decision-making.
3. Under the Modigliani-Miller Proposition II with corporate taxes, as a firm increases its
leverage, what happens to the cost of equity?
A. It remains constant because the tax shield offsets the increased risk.
B. It decreases because debt is a cheaper source of financing.
C. It increases linearly with the debt-to-equity ratio, reflecting higher financial risk.
D. It increases, but at a slower rate than without taxes due to the interest tax shield.
Answer: D
Conceptual Explanation: MM Proposition II with taxes states that the cost of equity
increases with leverage due to financial risk, but the tax deductibility of interest reduces
the effective increase compared to the no-tax scenario.
, 4. Which of the following best describes the ‘Pecking Order Theory’ of capital structure?
A. Firms prioritize internal financing, then debt, and finally external equity due to
asymmetric information.
B. Firms prefer equity over debt to maintain a low debt-to-equity ratio.
C. Firms choose a specific target debt-to-equity ratio and stick to it regardless of market
conditions.
D. Firms issue equity when the stock market is overvalued to benefit existing shareholders.
Answer: A
Conceptual Explanation: Pecking order theory suggests that due to information
asymmetry and signaling, firms use internal funds first, then safe debt, then risky debt, and
only as a last resort, external equity.
5. What is the primary difference between the APV (Adjusted Present Value) method and the
WACC method in capital budgeting?
A. APV ignores taxes, while WACC includes them.
B. APV is less accurate than WACC when the dollar amount of debt is known.
C. WACC is only used for projects with changing leverage ratios over time.
D. APV evaluates the project as if it were all-equity financed and then adds the NPV of
financing side effects.
Answer: D
