4 Corporate Finance Questions

Corporate Finance
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Question 1
Sigma Corporation is planning to launch a new product in the market for which it has paid Xylus
Consultants a fee of $4,000 to do a market survey to gauge the demand for the product. The new product
is expected to cause a 5% decline in the market share of its existing brands. Also the facilities for the
manufacturing of the project could earn a lease rent of $1,500 per month, if the project were not to be
undertaken. Which of the following regarding the project cash flow is least likely true?
A. The cash flows should not take into account the consultants fee
B. The loss in lease rent is relevant to the decision making
C. The loss of sale of existing product is irrelevant to the decision making

2
Solution 1
• C.
The cost of cannibalization should be considered in the incremental cash flows

3
Question 2
Company A's stock is selling for $120 and the expected return on equity is 10%. Dividend
planned for next year is $6 and the company plans to pay out 25% of its earnings. What is
the cost of retained earnings for Company A using the discounted cash flow approach?
A. 12.5%
B. 15%
C. 10%

4
Solution 2
▪ A.
Kre = D1/P0 + g,
where,
g = (1-payout ratio) x ROE,
P0 = Current price, and
D1 = Dividend expected.
Hence, Kre = 6/120 + (1-0.3) x 0.1 = 0.125 i.e. 12.5%

5
Question 3
A company is considering a project with future cash flows:

Year 0 1 2 3 4
Cash
-1,500 450 400 513 580
Flow
The firm plans to invest in another project after its maximum payback period of 3 years. The
WACC of the firm is 10%. Which of the following is least likely to be true regarding the
company's decision regarding the two projects?
A. The first project is least likely to be profitable within the maximum payback period
B. The first project should not have been accepted by the company in the first place
C. The firm's major concern is profitability and not liquidity as evident from the capital
budgeting methods followed by it

6
Solution 3
▪ C.
The maximum payback period method followed reflects that the firm is more concerned
about the liquidity from the project as the payback period method is not appropriate to
calculate the profitability of the project.

7
Question 4
Rio Inc has invested $650 million in a real estate project. The present value of the after tax
future cash flows from the project is $900 million, as estimated by the company. If Rio at
present has 100 million shares outstanding trading at $50 per share, what should an analyst
analysing Rio recommend to his clients about this company after receiving and analysing
this information?
A. Buy as the stock price is expected to rise to $52.5
B. Cannot be said with certainty
C. Buy as the stock price is expected to rise to $59

8
Solution 4
▪ B.
The analyst may expect a lower level of profitability than that estimated by the company

9
Question 5
A firm has a target equity share capital of $400 million and debt of $100 million. It raises
another $120 million from the market through a rights issue. If the cost of equity is 13% and
the after tax cost of debt is 8%, what is most likely the WACC of the firm after the additional
fund raised?
A. 12%
B. 12.19%
C. 11.27%

10
Solution 5
▪ A.
The WACC is calculated based on the target capital structure of the firm which is 80:20.
Hence, WACC is 0.8*0.13+0.2*0.08= 0.12

11
Question 6
Plasma Inc is considering the purchase of an automatic capping machine to reduce labor costs. The
machine is projected to save Plasma $5,000 per year. The machine costs $40,000 and is expected to last
for 15 years. Plasma has estimated that their cost of capital for such an investment is 10%. For an extra
$750 per year, Plasma can get a "Good As New" service contract. The contract keeps the machine in
new condition forever. Net of the cost of the service contract, the machine would produce cash flows of
$4,250 per year in perpetuity. Which of the following decisions is the most appropriate?
A. Plasma should not avail of the service contract
B. Plasma's profitability would increase if it accepts the service contract
C. Plasma should not accept the entire project in the first place

12
Solution 6
▪ B.
The NPV for purchase of machine only is negative (-$1,970), however with the service
contract the NPV is positive $2,500 and the IRR is more than the WACC of the firm
(10.81%).

13
Question 7
What is a firm's weighted-average cost of capital if the stock has a beta of 1.45, Treasury bills yield 5%,
and the market portfolio offers an expected return of 14%? In addition to equity, the firm finances 30% of
its assets with debt that has a yield to maturity of 9%. The firm is in the 35% marginal tax bracket.
A. 14.39%
B. 12.66%
C. 15.21%

14
Solution 7
• A.
Cost of equity = 5+1.45(14-5) = 18.05%
After tax Cost of debt = 9(1-0.35)=5.85%
WACC = 0.3*0.0,585+0.7*0.18= 14.39%

15
Question 8
The opportunity cost of capital is 8%. Your firm is evaluating two mutually exclusive projects
with scale differences. Each project requires an initial investment at time zero and produces
one cash inflow at the end of the tenth year. Project A (the smaller project, requiring an initial
investment of $10,000) has an internal rate of return of 9%. Project B (the larger project,
requiring an initial investment of $12,000) has an internal rate of return of 10%. Which of the
two projects has the higher NPV?
A. Project A has the higher NPV.
B. Project B has the higher NPV
C. Both projects have the same NPV.

16
Solution 8
▪ B.
Since the IRR of project B is higher than project A, the NPV of project B will also be higher.

17
Question 9
Chempro has planned to purchase a machine to add to the current production capacities to meet the
growing demand of its products in the market. The following are the additional information provided in
addition to the table below:
▪ All sales are on cash basis
▪ Interest on capital is 10%
▪ Corporate income tax is 40%
▪ Machine life is 2 years
Initial Investment $150,000
Estimated Sales 250,000
Cost of Goods Sold 75,000
Selling, Administration and Distribution Expenses 20,000
What is the net cash flow from the project?
A. $123,000
B. $24,000
C. $88,000

18
Solution 9
▪ A.
Initial investment 150,000
Estimated sales (Annual) 250,000
Cost of goods sold 75,000
Admin, Selling and Distribution expenses 20,000
Depreciation (2 years life) 75,000
Interest on capital (10% of investment) 15,000
PBT 40,000
Less: Tax at 40% PBT 16,000
Profit After Tax 24,000
Add: Depreciation 99,000
Net Cash Flow 123,000

19
Question 10
In a mutually exclusive project, the IRR of project A is 20% while NPV at 10% cost of capital
is $4,000. The IRR of project B is 18% while NPV at 10% cost of capital is $6,000, the
preferred capital budgeting method to be chosen is
A. IRR
B. NPV
C. Discounted Payback

20
Solution 10
• B.
For mutually exclusive projects, IRR and NPV methods can give conflicting rankings. In
such cases, NPV is the preferred capital budgeting method.

21
Question 11
In Drag on liquidity, pressures from credit management deteriorates because:

A. Payments are made before due dates to vendors, employees and contractors.
B. Banks which trade with the company reduce the line of credit.
C. Uncollected receivables are longer and many may not be collected along with increasing
bad debt expenses.

22
Solution 11
• C.
A drag on liquidity leads to reduction of cash inflows or increase of borrowing costs.

23
Question 12
Silverton Inc is considering a project in the garment manufacturing industry. It has a D/E ratio of 1.2 and
its debt currently has a after tax return of 6%.Ashley Inc is a publicly traded company which is only in the
garment manufacturing business with a D/E ratio of 2 and equity beta of 1.1. If the risk free rate is 5% and
return on market is 10%, find the appropriate WACC to be used to evaluate Silverton's project. Assume
tax rate of 40%
A. 8.6%
B. 7.5%
C. 10.3%

24
Solution 12
▪ B.
Ashley's unlevered/asset beta = 1.1*[1/{1+(1-0.4)*2}]
= 0.5. Silverton's project beta
= 0.5*[1+(1-0.40)*1.2]
= 0.86
Silverton's cost of equity using CAPM = 0.05+0.86(0.1-0.05)

=9.3%
WACC = (1.2/2.2)*0.06+(1/2.2)*0.093
= 0.075

25
Question 13
Zeta Technologies is planning to expand into China. The following information is available:
▪ Chinese US dollar denominated 10 year Govt bond yield= 8.9%
▪ 10 Year US treasury bond yield = 4.8%
▪ Annualised standard deviation of Chinese stock Index= 23%
▪ Annualised std dev of Chinese US dollar denominated 10 year govt bond = 14%
Find the country risk premium of China.
A. 8.93%
B. 5.54%
C. 6.73%

26
Solution 13
• C.
Country risk premium= (8.9-4.8)*(23/14) =6.73%

27
Question 14
What happens to a company's weighted average cost of capital if the firm's corporate tax
rate increases and if the risk free interest rate decreases, considering the two events
separately?
Tax rate increase / Decrease in risk free rate
A. Decrease / Decrease
B. Increase / Decrease
C. Decrease / Increase

28
Solution 14
▪ A.
Increase in the tax rate will reduce the cost of debt because of tax benefits. A decrease in
the risk free rate will decrease the cost of equity.

29
Question 17
The difference between primary and secondary sources of liquidity is

A. Primary source is easily accessible from the market than secondary source of liquidity.
B. Primary source is likely to affect the normal operations of the company whereas using the
secondary source will not result in company's financial and operating position.
C. The normal operations are not affected while using primary source but secondary source
will result in changing the company's financial and operating position.

30
Solution 17
• C.
Primary liquidity refers to the investment portfolio of the company. Secondary liquidity is a form of liquidity
that is part of an initial public offering when shares are distributed to both retail and institutional players.

31
Question 18
American Outlook Inc. is issuing bonds to obtain the funding necessary to acquire a major
competitor. Review of the balance sheets indicates that American Outlook has also issued
preferred and common stock in the past. Which component cost(s) should American Outlook
use in evaluating the financial cost of acquiring the new firm?
A. The weighted average component cost of common stock, preferred stock and debt
B. The price the firm paid for its assets divided by their market value
C. The cost of the new debt issue alone

32
Solution 18
• A.
How a company raises capital and how it invests it are considered independently. In the short run, a
company may highlight the latest capital issued. But in the long run the firm would look at a targeted
capital structure and hence the investment decision should be made assuming a weighted average cost
of capital including each source of capital.

33
Question 21
A company XYZ Ltd sells 10,000 units of water bottles at a price of $4 per unit. ABC's fixed
costs are $10,000 and it pays an annual interest of $ 3,000.The variable cost of production is
$ 2 per unit and the operating profit (EBIT) is $ 14,000. Which of the following statements is
true?
A. Degree of Operating leverage = 2.00, Degree of Financial leverage = 1.27
B. Degree of Operating leverage = 1.27, Degree of Financial leverage = 2.00
C. Degree of Operating leverage = 1.27, Degree of Financial leverage = 1.50

34
Solution 21
▪ A.
Degree of operating leverage = Q*(P-V)/ (Q*(P-V)-F)
Where Q = number of units sold = 10,000
P = Cost price per unit =$4
V = Variable cost per unit = $2
F = Fixed cost = $10,000
Hence DOL = 10,000*($4-$2)/ (10,000*($4-$2) -$10,000) = 2.00
Degree of Financial leverage = EBIT/ (EBIT – Interest) = $14,000/ ($14,000-$3,000) = 1.27

35
Question 22
25% increase in sales of Irrelevant Corporation causes 50% growth in EPS If operating
earnings of the company is $ 12,000 and financial leverage is 1.5. Calculate operating
earnings of the company if sales increase by 10% next year
A. 15,000
B. 14,000
C. 13,000

36
Solution 22
▪ B.
Total leverage = EPS growth/sales growth
Operating leverage (OL) = total leverage/financial leverage
New operating income = old income *(1+ OL * sales growth)

37
Question 23
1 Alan manufacturing company has 20,000 equity shares of $10 each. EBITDA for current year is
$100,000. On January 1, 2010 the market price of one share is $12. The payout ratio is maintained at
60%. Tax rate is 40%
A. 0.27
B. 0.33
C. 0.37

38
Solution 23
• A.
ROE= {100,000(1-0.4)}/200,000=0.3.
g= (0.3)*(1-0.6)=0.12.
Dividend at the end of the year= {100,000(1-0.4)(0.6)}/20,000 = $1.80.
Cost of equity=1.8/12 + 0.12=0.27.

39
Question 24
Which of the following statements is correct?
A. Greater is the proportion of fixed costs to variable costs lesser is the firm’s operating risk.
B. Degree of operating leverage is Operating income divided by Sales
C. Degree of financial leverage is percentage change in EPS divided by percentage change in EBIT.

40
Solution 24
• C.
Higher proportion of fixed costs higher the firm’s operating risk. Degree of operating leverage =
Percentage change in operating income divided by percentage change in sales. Degree of financial
leverage = percentage change in EPS divided by percentage change in EBIT.

41
Question 25
A firm has market beta of 1.3. Firm has financed its operations with 50% debt and 50% equity. Calculate
the asset beta of the company. Firms marginal tax rate is 30%.
A. 0.74
B. 0.76
C. 0.78

42
Solution 25
• B.
Asset Beta = 1.3/[1 + (1 – 0.3)*(50%/50%)] = 0.76.
Make comment or override grade.

43
Question 26
A company borrows some funds to repurchase shares then which of the following statement is correct?
A. If the after-tax cost of borrowed funds is less than earning yield of the share before repurchase then
after repurchase EPS of the company will fall.
B. If the after-tax cost of borrowed funds is more than earning yield of the share before repurchase then
after repurchase EPS of the company will fall.
C. Share repurchase does not affect EPS.

44
Solution 26
• B.
If the after –tax cost of borrowed funds is more(less) than earning yield of the share before repurchase
then the cost of repurchase will be more(less) than the decrease in the market value of the shares. Hence
EPS after share repurchase decreases(increases).

45
Question 27
Which of the following statements is correct?
A. In case of a stock split EPS does not change but dividend yield decreases.
B. In case of a stock split Dividend per share (DPS) does not change but P/E increases.
C. In case of a stock split P/E ratio and dividend yield does not change.

46
Solution 27
• C.
In case of a stock split total earning, market value of the firm remain the same but No of shares
increases hence EPS ,Price of share, Dividend per share decrease by equal proportions. So P/E and
Dividend yield = DPS/P will remain same as before the stock split.

47
Question 28
While constructing a pro forma balance sheet and income statements which of the following inputs in the
balance sheet and income statement is most likely to be changed as a percentage of sales in first
iteration?
A. Assets
B. Long –term debt
C. Common stock

48
Solution 28
• A.
In the first iteration assets are changed as a percentage of sales. However long-term debt and common
stock is not changed in the first iteration.

49
Question 29
A firm XYZ ltd has recently purchased a banker’s acceptance for $ 45,000, which will mature in 90 days
for $ 48,000. The bond equivalent yield and discount basis yield for this banker’s acceptance is:
A. Bond equivalent yield = 25%, Discount basis yield = 26.67%
B. Bond equivalent yield = 25%, Discount basis yield = 25%
C. Bond equivalent yield = 27.04%, Discount basis yield = 25%

50
Solution 29
• C.
Bond equivalent yield = (48,000-45,000)/45,000 x(365/90) =27.04%.
Discount basis yield = (48,000-45,000)/48,000 x(360/90) = 25%

51
Question 30
After a share repurchase the book value of the firm per share (BVPS) increased. Which of the following
could be the most likely reason for this?
A. Repurchase price is greater than pre purchase BVPS
B. Repurchase price is lesser than pre purchase BVPS
C. Repurchase price is lesser than market price.

52
Solution 30
• B.
Repurchase price is lesser than pre purchase BVPS then BVPS increases after stock repurchase.

53
Question 31
A company is looking for most reliable form of short term financing. Which one of the following lines of
credit should he choose?
A. Uncommitted line of credit
B. Committed line of credit
C. Revolving line of credit

54
Solution 31
• C.
Under Uncommitted line of credit a bank may extend offer of credit for certain amount but may refuse to
lend if circumstances change. Under committed line of credit a bank extends an offer of credit that it
commits to for some period of time. Revolving are more reliable and usually of longer terms than
committed line of credit.

55
Question 33
A firm has a target equity share capital of $400 million and debt of $100 million. It raises another $120
million from the market through a rights issue. If the cost of equity is 13% and the after tax cost of debt is
8%, what is most likely the WACC of the firm after the additional fund raised?
A. 12%
B. 12.19%
C. 11.27%

56
Solution 33
• A.
The WACC is calculated based on the target capital structure of the firm which is 80:20. Hence, WACC is
0.8*0.13+0.2*0.08= 0.12

57
Question 34
Brad Snell owns 300 shares of Agglomerate $34 on NYSE. The company has 4 million shares
outstanding and had reported Net Income of $6.78million last year. If the company is planning to give
10% stock dividend to all its share holders .Compare the new EPS wrt old EPS and the impact of the
share dividend on Brand Snells shares.
New EPS Worth of Brad Snell shares
A. Decrease Remain the same
B. Remain the same decreases its worth
C. Increase Remain the same

58
Solution 34
• A.
Old EPS = 6.78/4 = 1.695.
Value of Brad Snells shares = 1.695*300 = $508.5.
After the 10% stock dividend no of shares outstanding = 1.1 * 4 = 4.4 million.
New EPS = 6.78/4.4 = 1.54.
No of shares owned by Brad Snell = 300*1.1 = 330.
Value of Brad Snells shares after the stock dividend = 330* 1.54 = $508.5.

59
Question 35
A company is offered a trade discount 2/10 net 60 on its payables. The company can also avail of a short
term loan from other sources at 20%. Which of the following is the best accounts payables management
decision taken by the company?
A. The company should avail of the discount either on the 10th day or wait till the end of credit period to
clear its dues
B. The company should pay the invoice either before the 50th day or wait till the end of the credit period
C. The annualised cost of trade credit always exceeds the short term interest rate during the credit
period, hence the company should avoid the discount option

60
Solution 35
• B.
Annualised cost of trade credit on the 51st day = 19.7% [(1+0.02/(1-0.02))^(365/40)-1].
Hence it is cheaper for the company to avail of the trade credit before the 50th day or else wait till the end
to pay the dues.

61
Solution 37
• B.
13.63%. Preferred stock / Total capital = 3/(3+5+14) = 13.63%

62
Question 40
The Company wants to maintain a debt / equity ratio of 0.4. What is the weight of debt in the overall
capital structure
A. 71%
B. 29%
C. 31%

63
Solution 40
• B.
D/E = 0.4. E/(D+E) = 1/1.4 = 0.71. Weight of debt = 1-0.71 = 29%

64
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Corporate Finance

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Hence, Kre = 6/120 + (1-0.3) x 0.1 = 0.125 i.e. 12.5%

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A company is considering a project with future cash flows:

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What is the net cash flow from the project?

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In Drag on liquidity, pressures from credit management deteriorates because:

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Silverton's cost of equity using CAPM = 0.05+0.86(0.1-0.05)

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The difference between primary and secondary sources of liquidity is

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Where Q = number of units sold = 10,000

P = Cost price per unit =$4

V = Variable cost per unit = $2

F = Fixed cost = $10,000

Hence DOL = 10,000*($4-$2)/ (10,000*($4-$2) -$10,000) = 2.00

Degree of Financial leverage = EBIT/ (EBIT – Interest) = $14,000/ ($14,000-$3,000) = 1.27

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Which of the following statements is correct?

B. Degree of operating leverage is Operating income divided by Sales

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C. Share repurchase does not affect EPS.

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Which of the following statements is correct?

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Hence DOL = 10,000($4-$2)/ (10,000($4-$2) -$10,000) = 2.00