Corporate Finance, Test Bank-1
Below are ten revision-style questions (with accompanying rationales) that cover key topics in Corporate
Finance. These questions are designed in the spirit of a test bank (Test Bank-1, University of
Nottingham) and aim to help you review and understand core concepts.
1. Weighted Average Cost of Capital (WACC)
Question:
Explain the components of the WACC formula. How would an increase in debt relative to equity affect
the WACC, assuming the cost of debt is lower than the cost of equity and tax shields are available?
Rationale:
Understanding WACC is crucial because it is used as a hurdle rate in investment appraisal. This question
tests your knowledge of capital structure components, tax advantages of debt, and the trade-off
between risk and return.
2. Capital Asset Pricing Model (CAPM)
Question:
Describe the CAPM model and explain the significance of the beta coefficient. What does a beta of 1.5
indicate about a stock’s risk relative to the market?
Rationale:
The CAPM is a fundamental model for understanding the risk-return relationship in financial markets.
This question ensures you can articulate how systematic risk (beta) affects expected returns and how to
interpret beta values.
3. Dividend Policy and Firm Valuation
Question:
Discuss the impact of dividend policy on firm value. Refer to the dividend irrelevance theory and any
conditions under which dividend policy might matter.
Rationale:
This question examines your grasp of dividend policy debates. It invites you to consider both the
Modigliani–Miller perspective (dividend irrelevance under perfect markets) and the real-world factors
(e.g., signaling, clientele effects) that may influence investor perception and firm value.
4. Net Present Value (NPV) in Capital Budgeting
, Question:
Define the Net Present Value (NPV) method and explain why it is preferred over other investment
appraisal methods. What assumptions underlie the NPV approach?
Rationale:
NPV is a key decision rule in capital budgeting. This question tests your ability to calculate NPV,
understand its advantages (such as considering the time value of money), and recognize its limitations
or assumptions regarding cash flows and discount rates.
5. Modigliani-Miller Theorem
Question:
Outline the Modigliani–Miller propositions regarding capital structure. What are the main assumptions
behind these propositions, and how do deviations from these assumptions (e.g., taxes, bankruptcy
costs) affect the conclusions?
Rationale:
The MM theorem provides the theoretical foundation for understanding how capital structure
influences firm value. This question assesses your comprehension of both the idealized environment
assumed by MM and the practical factors that lead to deviations in real markets.
6. Financing Options: Debt vs. Equity
Question:
Compare and contrast debt financing with equity financing. What are the advantages and disadvantages
of each, and how do they influence a firm’s risk profile and financial strategy?
Rationale:
This question explores the trade-offs between different sources of financing. It requires you to analyze
how debt and equity impact leverage, cost of capital, and control, which are central to corporate finance
decision-making.
7. Agency Problems and Corporate Governance
Question:
Explain the concept of agency costs in a corporate context. How can effective corporate governance
mechanisms mitigate these costs?
Rationale:
Agency theory is critical for understanding conflicts between managers and shareholders. This question
challenges you to discuss how misaligned incentives lead to agency costs and what governance practices
(such as board oversight or performance-based compensation) can do to reduce these issues.
Below are ten revision-style questions (with accompanying rationales) that cover key topics in Corporate
Finance. These questions are designed in the spirit of a test bank (Test Bank-1, University of
Nottingham) and aim to help you review and understand core concepts.
1. Weighted Average Cost of Capital (WACC)
Question:
Explain the components of the WACC formula. How would an increase in debt relative to equity affect
the WACC, assuming the cost of debt is lower than the cost of equity and tax shields are available?
Rationale:
Understanding WACC is crucial because it is used as a hurdle rate in investment appraisal. This question
tests your knowledge of capital structure components, tax advantages of debt, and the trade-off
between risk and return.
2. Capital Asset Pricing Model (CAPM)
Question:
Describe the CAPM model and explain the significance of the beta coefficient. What does a beta of 1.5
indicate about a stock’s risk relative to the market?
Rationale:
The CAPM is a fundamental model for understanding the risk-return relationship in financial markets.
This question ensures you can articulate how systematic risk (beta) affects expected returns and how to
interpret beta values.
3. Dividend Policy and Firm Valuation
Question:
Discuss the impact of dividend policy on firm value. Refer to the dividend irrelevance theory and any
conditions under which dividend policy might matter.
Rationale:
This question examines your grasp of dividend policy debates. It invites you to consider both the
Modigliani–Miller perspective (dividend irrelevance under perfect markets) and the real-world factors
(e.g., signaling, clientele effects) that may influence investor perception and firm value.
4. Net Present Value (NPV) in Capital Budgeting
, Question:
Define the Net Present Value (NPV) method and explain why it is preferred over other investment
appraisal methods. What assumptions underlie the NPV approach?
Rationale:
NPV is a key decision rule in capital budgeting. This question tests your ability to calculate NPV,
understand its advantages (such as considering the time value of money), and recognize its limitations
or assumptions regarding cash flows and discount rates.
5. Modigliani-Miller Theorem
Question:
Outline the Modigliani–Miller propositions regarding capital structure. What are the main assumptions
behind these propositions, and how do deviations from these assumptions (e.g., taxes, bankruptcy
costs) affect the conclusions?
Rationale:
The MM theorem provides the theoretical foundation for understanding how capital structure
influences firm value. This question assesses your comprehension of both the idealized environment
assumed by MM and the practical factors that lead to deviations in real markets.
6. Financing Options: Debt vs. Equity
Question:
Compare and contrast debt financing with equity financing. What are the advantages and disadvantages
of each, and how do they influence a firm’s risk profile and financial strategy?
Rationale:
This question explores the trade-offs between different sources of financing. It requires you to analyze
how debt and equity impact leverage, cost of capital, and control, which are central to corporate finance
decision-making.
7. Agency Problems and Corporate Governance
Question:
Explain the concept of agency costs in a corporate context. How can effective corporate governance
mechanisms mitigate these costs?
Rationale:
Agency theory is critical for understanding conflicts between managers and shareholders. This question
challenges you to discuss how misaligned incentives lead to agency costs and what governance practices
(such as board oversight or performance-based compensation) can do to reduce these issues.
