Bcom Bachelor of Commerce Corporate Finance & Financial Management 2 — Questions and Answers
Question 1: The optimal capital structure is the combination of debt and equity that:
- Uses the maximum proportion of debt
- Uses only equity with no debt
- Minimizes the Weighted Average Cost of Capital (WACC) (Correct answer)
- Maximizes the debt-to-equity ratio
Correct answer: Minimizes the Weighted Average Cost of Capital (WACC)
The optimal capital structure minimizes WACC, which in turn maximizes the market value of the firm.
Question 2: According to the Modigliani-Miller theorem in a world without taxes, firm value is:
- Maximized by using maximum debt
- Maximized by using zero debt
- Independent of the firm's capital structure (Correct answer)
- Determined entirely by dividend policy
Correct answer: Independent of the firm's capital structure
In perfect capital markets with no taxes, MM proved that firm value is determined by its assets and earnings, not by how it is financed.
Question 3: The Weighted Average Cost of Capital (WACC) is defined as:
- The average interest rate paid on all outstanding debt
- The required rate of return on equity only
- The weighted average of the after-tax costs of all capital sources (Correct answer)
- The risk-free rate plus the equity risk premium
Correct answer: The weighted average of the after-tax costs of all capital sources
WACC blends the after-tax cost of debt and the cost of equity, weighted by their proportions in the firm's capital structure.
Question 4: Under Modigliani-Miller's dividend irrelevance theory, in perfect capital markets:
- Paying higher dividends always increases share price
- Cutting dividends always decreases firm value
- Dividend policy has no effect on firm value (Correct answer)
- Investors always prefer dividends over capital gains
Correct answer: Dividend policy has no effect on firm value
MM argued that in perfect markets investors can replicate any dividend policy themselves, so dividend decisions do not affect firm value.
Question 5: Financial leverage refers to:
- Using borrowed funds to potentially amplify returns to equity holders (Correct answer)
- The ratio of fixed operating costs to variable operating costs
- Total assets divided by shareholders' equity only
- Using additional equity to reduce debt obligations
Correct answer: Using borrowed funds to potentially amplify returns to equity holders
Financial leverage involves using debt capital to increase potential returns to equity holders, while simultaneously increasing financial risk.
Question 6: The Dividend Payout Ratio is calculated as:
- Net income divided by total dividends paid
- Dividends per share divided by earnings per share (Correct answer)
- Total dividends divided by total assets
- Retained earnings divided by net income
Correct answer: Dividends per share divided by earnings per share
Dividend Payout Ratio = Dividends Per Share ÷ Earnings Per Share, indicating the fraction of earnings distributed to shareholders.
Question 7: The Pecking Order Theory of capital structure suggests that firms prefer to raise capital in which sequence?
- New equity, then debt, then retained earnings
- Debt, then new equity, then retained earnings
- Retained earnings, then debt, then new equity (Correct answer)
- New equity, then retained earnings, then debt
Correct answer: Retained earnings, then debt, then new equity
Myers and Majluf's pecking order theory holds that firms first use internal funds, then debt, and resort to new equity only as a last option to minimize information asymmetry costs.
Bcom Bachelor of Commerce Corporate Finance & Financial Management 2
The optimal capital structure is the combination of debt and equity that: