QUIZ – II

CORPORATE FINANCE – (MSC510)

Q1] Identify the statement which wrongly describes the technique used for identifying risk in
capital budgeting decision. [1]
(a) While using sensitivity analysis, managers explore the importance of various
assumptions before arriving at the investment’s NPV.
(b) Sensitivity analysis demonstrates model output changes according to model input
variations.
(c) Scenario analysis is a method of assessing probable future occurrences by taking into
account alternative probable consequences.
(d) Scenario analysis involves exploring ‘what-if’ situation to determine the variables to
which the outcomes are particularly sensitive.
(e) Scenario analysis is useful in illustrating the range of the possible NPVs and therefore,
the risk of the investments.
Ans: (d)
Correct Ans: Sensitivity analysis involves exploring ‘what-if’ situation to determine the
variables to which the outcomes are particularly sensitive.

Q2] Statements: [1]

(i) High Operating Leverage indicates a firm has low fixed cost and high variable cost.
(ii) The Operating Leverage of 1.5 means that 1% increase in EBIT is due to 1.5%
increase in sales.
(a) Both (i) and (ii) are correct.
(b) Both (i) and (ii) are incorrect.
(c) Only (i) is correct.
(d) Only (iI) is correct.
Ans: (b)
Correct Ans: (i) High operating leverage indicates a company has high fixed cost and low
variable cost; & (ii) The Operating Leverage of 1.5 means that 1% increase in sales would result
in 1.5% increase in EBIT.

Q3] Opportunistic Ltd. has issued 40,000 irredeemable 12% debentures of ₹ 150 each. The
floatation cost of debentures is 3% of the total issued amount. If the company’s tax rate is 35%,
what should be the cost of debt? [1]
(a) 8.84%
(b) 8.5%
(c) 9%
(d) 8.04%
(e) None of the above
Ans: (d)
Net Proceeds from the issue = [60,00,000 – Floatation cost@3%] = ₹58,20,000; Annual interest
charges = ₹7,20,000; so, kd = [{₹7,20,000*(1 – 0.35)}/ ₹58,20,000] = 0.0804 = 8.04%

Q4] All the following statements are correct, except: [1]

 (a) The cost of preference share capital is the rate of return that must be earned on
preference capital financed projects to keep unchanged the earnings available to equity
shareholders.
(b) Dividends payable to preference shareholders is a charge against profit, whereas the
interest payable on a debt is an appropriation of profit.
(c) Retained earnings has the cost equivalent to opportunity rate of earnings foregone by
equity shareholders.
(d) Cost of capital is the minimum rate of return, a firm has to earn to maintain its market
value and value of its shares.
Ans: (b)
Correct Ans: Dividends payable to preference shareholders is an appropriation of profit,
whereas the interest payable on a debt is a charge against profit.

Q5] Opportunistic Ltd. has 2,500 bonds outstanding that are selling for ₹1,180 each. The
company also has 5,000 shares of preferred stock at a market price of ₹ 46 each. The common
stock is priced at ₹38 a share and there are 35,000 shares outstanding. What is the weight of
the common stock as it relates to the firm's weighted average cost of capital? [1]
(a) 82.35 percent
(b) 29.49 percent
(c) 11.76 percent
(d) 54.39 percent
(e) None of the above
Ans: (b)

Q6] Opportunistic Ltd. is expected to pay an annual dividend of ₹2.80 a share next month.
The market price of the stock is ₹29.70 and the growth rate is 2 percent. The firm’s cost of
equity should be: [1]
(a) 10.28 percent
(b) 10.72 percent
(c) 9.24 percent
(d) 11.43 percent
(e) None of the above
Ans: (d) 11.43 = [(2.80/29.70) + 0.02]

Q7] Opportunistic Ltd. is considering an external financing opportunity for issuing 15%
Preference share of ₹ 100 each to be issued at par and redeemable after 5 years @5% premium,
with floatation cost of 5%. The firm assumes dividend tax rate @ 20%. The cost of the new
preference issue should be: [1]
(a) 17.28 percent
(b) 17.00 percent
(c) 19.24 percent
(d) 18.42 percent
(e) None of the above
Ans: (e)
𝑅𝑉−𝑆𝑃 105−95
𝐷𝑃 (1+𝐷1)+[ ] 15 (1+0.20)+[ ]
KP = (𝑅𝑉+𝑆𝑃)/2
𝑛
= (105+95)/2
5
= 0.20 or 20%

Q8] WACC is represented by all of the following except: [1]

 (a) WACC facilitates the computation of Financial Break Even Point.
(b) WACC computed by using book value weights will be overstated if the market value
of the share is higher than the book value and vice versa.
(c) The same after tax cost of each source of fund is used whether the WACC is computed
by using the book value weights or the market value weights.
(d) Theoretically, while computing WAAC, the market value weights should be preferred
above the book value weights, as the later reflect the actual expectation of the
investors.
Ans: (b)
Correct Ans: WACC computed by using book value weights will be understated if the market
value of the share is higher than the book value and vice versa.

Q9] Mr. Investor is planning to purchase the share of Opportunistic Ltd. which had paid the
dividend of ₹2 per share last year. His required rate of return is 20%.What growth rate is he
anticipating if he is willing to pay the price of ₹ 6? [1]
(a) 10 percent
(b) 15 percent
(c) No growth, no decline
(d) 20 percent
(e) None of the above
Ans: (e)
Correct Ans: (-) 10 percent or decline rate

Q10] Identify the correctly expressed statement relating to the computation of cost of equity
capital. [1]
(a) While comparing two firms otherwise equal, the beta of the common stock of a
levered firm is equal to the beta of the common stock of an unlevered firm.
(b) While comparing two firms otherwise equal, the beta of the common stock of a
levered firm is greater than the beta of the common stock of an unlevered firm.
(c) While comparing two firms otherwise equal, the beta of the common stock of a
levered firm is significantly less than the beta of the common stock of an unlevered
firm.
(d) While comparing two firms otherwise equal, the beta of the common stock of a
levered firm is slightly less than the beta of the common stock of an unlevered firm.
(e) While comparing two firms otherwise equal, the beta of the common stock of a
levered firm is approximately equal to the beta of the common stock of an unlevered
firm.
Ans: (b)

Q11] From the following statements, identify the correct one representing WACC. [1]

(a) In WACC, the weight assigned to the preference share is based on the coupon rate of
dividend multiplied by the par value of the share.
(b) An increase in the corporate tax rate will certainly enhance the WACC of the firm.
(c) The WACC may increase when the debt-equity ratio of the firm decreases.
(d) In computing WAAC, the weight of the equity share capital is based on the number of
shares outstanding multiplied by the book value per share.
(e) The WACC will remain constant unless a firm retires some of its debt.
Ans: (c)

Q12] Opportunistic Ltd. is expected to pay an end-of-year dividend of ₹ 5 a share. After the
dividend, its stock is expected to sell at ₹ 110. If the market capitalization rate is 8%, what is
the current stock price? [1]
(a) ₹ 97.22
(b) ₹ 95.59
(c) ₹ 97.22
(d) ₹ 104.63
(e) None of the above

Ans: (e) (5+110)/1.08 = ₹ 106.48

Q13] The following statements relating to ‘floatation costs’ are correct, except………[1]

(a) The common stock floatation costs are for non-IPOs.

(b) The average floatation costs are usually higher for equity issue rather than that of debt
issue.
(c) The cost of new common equity is higher than the cost of equity raised internally
because of floatation costs.
(d) There are no floatation costs, in case the debts are privately placed and the equity is
raised internally.
(e) The bond’s issue price is usually increased for floatation expenses and then used to
solve for after-tax yield to maturity.
Ans: (e)
Correct Ans: The bond’s issue price is reduced for floatation expenses and then used to solve
for after-tax yield to maturity.

Q14] A project has an equity beta of 1.8 and is to be financed by a combination of 40% Debt
and 60% Equity. Assume Debt Beta as zero, Risk-free rate = 13% and Market return = 18.5%.
Hence, the required rate of return of the project is [1]
(a) 16.72%
(b) 18.30%
(c) 13.45%
(d) 14.08%
(e) None of the above

Ans: (e) None of the above

Beta of the Project = [β EQUITY x {E / (D + E)}] + [ β DEBT x {D / (D + E)}] = (1.8 x 0.6) + (0 x

0.4) = 1.08; Rate of return of the project = Rp = Rf + Bp (Rm - Rf) = 13% + 1.08 (18.5% - 13%) =
13%+ 5.94% = 18.94%

Q15] Opportunistic Ltd. has EBIT of ₹10 million; Debt capital of ₹20 million with a coupon of
8%. Cost of equity is 12.5%. Ignore taxes. What is the overall cost of capital? [1]
(a) 11.47%
(b) 11.62%
(c) 16.12%
(d) 12.61%
(e) None of the above
Ans: (a) 11.47%
Market Value of equity = (EBIT-I)/ke = (10 – 1.6)/0.125 = ₹67.2 million. Total value of Firm
(V) = Equity + Debt = ₹67.2m + 20m = ₹87.2m. Overall cost of capital (Ko) = (EBIT)/V = 10/87.2
= 11.47%.

Q16] Opportunistic Ltd. has EBIT of ₹10 million; Debt capital of ₹20 million with a coupon of
8%. Cost of equity is 12.5%.The tax savings for the firm is 0.65. What is the after tax component
cost of debt capital for the firm? [1]
(a) 0.1147
(b) 0.052
(c) 0. 1612
(d) 0. 1261
(e) None of the above

Ans: (b) 0.08 * 0.65 = 0.052

Q17] The capital structure of Opportunistic Ltd. consists of 40% equity, 40% preference capital,
and 20% debt. The after-tax cost of the preference capital and debt are 15% & 7.20%
respectively. The WACC is 15.44%. Opportunistic Ltd. paid currently a dividend of ₹4 per
share. The current market price of its equity share is ₹44. The growth rate of the firm is…….[2]
(a) 20 percent
(b) 10 percent
(c) 17.2 percent
(d) 7.2 percent
(e) None of the above
Ans: (b)
Ke is assumed to be ‘x’. So, WACC = [(15%*40%) + (7.2%*20%) + (x*40%) = 15.44% or, x = 20%
If growth rate is again assumed as ‘y’; then Ke = [(D1/P0) + g] or, 0.20 = [{4(1+y)/44} + y]
Or, y = 0.10 or, 10%.

Q 18] All the statements given below relating to ‘Beta’ (β) are correct except: [1]
(a) Beta (β) is a measure of volatility of an individual security return relative to the broad
based market portfolio.
(b) Beta (β) is a measure of systematic risk.
(c) Zero Beta (β) indicates no volatility.
(d) Beta (β) ‘less than 1’ indicates that aggregate market risk is less than that of the
systematic risk – it means that the market returns fluctuate less than the security’s
return.
(e) In statistical terms, Beta (β) is basically the regression coefficient of market return and
security return.
Ans: (d)
Correct Ans: Beta (β) ‘less than 1’ indicates that systematic risk is less than that of the aggregate
market risk – it means that the security’s returns fluctuate less than the market returns.

Q19] Regarding ‘Book Value weights (BVW) vs. Market Value Weights (MVW)’, which one of
the following statements is not true? [1]

(a) BVW for Retained Earnings will be the same amount as appear in the Balance Sheet.
(b) MVW for Retained Earnings are not shown separately since the market value of equity
share represents the combined market value of equity shares and retained earnings.
 (c) The same after-tax cost of each source of fund is used whether the WACC is computed
by using BVWs or MVWs.
(d) The WACC computed as per BVWs will be overstated if the market value of the share
is higher than the book value and vice-versa.
(e) Theoretically, the MVWs should be preferred over the BVWs as MVWs reflect the real
expectations of the investors.
Ans: (d)
Correct Ans: The WACC computed as per BVWs will be understated if the market value of
the share is higher than the book value and vice-versa.

Q 20] Opportunistic Ltd. has the following capital structure: ₹5 lakh Equity share capital (BV
@ ₹10 each, traded @ 64); ₹5 lakh 15% Preference share capital (BV @ ₹100 each, traded @ 104);
₹2 lakh Retained Earnings; and ₹8 lakh 12% Debenture capital (BV @ ₹100 each, traded @ 105).
For the last year, the company has paid equity dividend of ₹ 6 per share, which is expected to
grow@ 4% forever. Corporate tax rate is 30%.
The WACC using MVWs for Opportunistic Ltd. shall be: [2]

(a) 12.76%
(b) 13.75%
(c) 14.42%
(d) 18.42%
(e) None of the above

Ans: (a)
Correct Ans:
(i) BVs & weight of - Equity capital = ₹32,00,000 (70.18%); Preference capital = ₹5,20,000
(11.40%); Debenture = ₹8,40,000 (18.42%).
(ii) After Tax cost: ke= [6(1+.04)/64]+ 0.04 = 0.1375 or 13.75%; kP= [15/104]= 0.1442 or
14.42%; Kd= [12(1-0.3)/105] = 0.08 or 8%
(iii) WACC = [(0.1375*70.18%) + (0.1442*11.4%) + (0.08* 18.42%)] = 12.76%

Q 21] Opportunistic Ltd. has the following capital structure: ₹5 lakh Equity share capital (BV
@ ₹10 each, traded @ 64); ₹5 lakh 15% Preference share capital (BV @ ₹100 each, traded @ 104);
₹2 lakh Retained Earnings; and ₹8 lakh 12% Debenture capital (BV @ ₹100 each, traded @ 105).
For the last year, the company has paid equity dividend of ₹ 6 per share, which is expected to
grow@ 4% forever. Corporate tax rate is 30%.
The WACC using BVWs for Opportunistic Ltd. shall be: [2]

(a) 12.76%
(b) 13.75%
(c) 14.42%
(d) 18.42%
(e) None of the above

Ans: (e)
Correct Ans:
(i) BVs & weight of - Equity capital = ₹5,00,000 (25%); Preference capital = ₹5,00,000 (25%);
Retained Earnings = ₹ 2,00,000 (10%); Debenture = ₹8,00,000 (40%).
(ii) After Tax cost: ke= [6(1+.04)/64]+ 0.04 = 0.1375 or 13.75%; kP= [15/104]= 0.1442 or
14.42%; Kd= [12(1-0.3)/105] = 0.08 or 8%; kre= 0.1375 i.e. same as ke
(iii) WACC = [(0.1375* 25%) + (0.1442*25%) + (0.08* 40%) + (0.1375 * 10%] = 11.63%

Q22] The Degree of Operating Leverage of A firm has installed capacity of producing 20,000
units of finished goods in a year. Actual production and sales is 75% of the installed capacity.
The selling price of the finished goods as fixed by the firm is ₹ 100; Fixed cost is ₹ 3,00,000 and
the total Operating cost is 80%. The Degree of Operating Leverage of the firm is : [2]
(a) 3
(b) 4
(c) 5
(d) None of the above

Ans: (d)
Sales= [75% of 20,000 units* ₹ 100]= ₹ 15,00,000;
Variable cost = [Total Cost(₹ 15,00,000 * 80%) – (Fixed cost of ₹ 3,00,000] = ₹ 9,00,000;
Contribution = ₹ 15,00,000 - ₹ 9,00,000 = ₹ 6,00,000;
EBIT = ₹ 6,00,000 - ₹ 3,00,000 = ₹ 3,00,000;
DOL = [Contribution/EBIT] = 2