UGC NET - Capital structure and budgeting decisions Question Bank with Options

1. When evaluating independent projects in capital budgeting, a firm should generally accept all projects with:

A) A positive payback period

B) An NPV greater than zero

C) An IRR less than the WACC

D) A PI less than one

2. Which statement best describes the relationship between financial leverage and risk according to the Trade-off Theory?

A) Increasing leverage always increases firm value.

B) Increasing leverage increases financial risk, which can lead to bankruptcy costs.

C) Leverage has no impact on risk.

D) Leverage only affects the risk of debt holders, not equity holders.

3. What is the primary purpose of capital budgeting decisions for a firm?

A) To manage short-term liabilities

B) To determine the optimal dividend payout ratio

C) To evaluate and select long-term investment projects

D) To manage daily cash inflows and outflows

4. The concept of 'agency costs' is most relevant to which aspect of capital structure theory?

A) Modigliani-Miller theorem (original)

B) Trade-off theory

C) Pecking order theory

D) Agency theory

5. Which of the following is considered a 'real' option in capital budgeting?

A) The option to abandon a project

B) The option to issue more debt

C) The option to pay dividends

D) The option to repurchase shares

6. If a firm's WACC increases, what is the likely impact on the NPV of its projects?

A) NPV will increase

B) NPV will decrease

C) NPV will remain unchanged

D) The impact is indeterminate

7. Which of the following is a key assumption of the Net Present Value (NPV) method?

A) Cash flows are received at the end of each period.

B) The firm has unlimited access to debt financing.

C) The reinvestment rate for intermediate cash flows is the risk-free rate.

D) The project's cash flows are independent of each other.

8. The 'terminal value' in a DCF analysis for capital budgeting is often calculated using a:

A) Perpetuity growth model

B) Simple average of cash flows

C) Fixed percentage of initial investment

D) Sum of all future cash flows

9. What is the primary focus of capital budgeting decisions?

A) Short-term liquidity management

B) Allocation of capital to long-term assets

C) Day-to-day operational funding

D) Dividend distribution policy

10. According to the Pecking Order Theory, why do firms prefer internal financing?

A) It is cheaper than external financing.

B) It avoids signaling financial distress to the market.

C) It increases financial leverage.

D) It leads to higher EPS.

11. The 'cost of equity' in WACC calculation is typically estimated using:

A) The dividend growth model or CAPM

B) The coupon rate of outstanding bonds

C) The interest rate on short-term loans

D) The average return on assets

12. Which capital budgeting technique provides a measure of the project's profitability as a percentage of its investment?

A) Net Present Value (NPV)

B) Internal Rate of Return (IRR)

C) Payback Period

D) Accounting Rate of Return (ARR)

13. When a firm has multiple IRRs for a project, it indicates:

A) The project is highly profitable

B) There is a change in the sign of cash flows more than once

C) The project has a negative NPV

D) The payback period is very short

14. The term 'financial distress costs' refers to:

A) The cost of issuing new debt

B) The direct and indirect costs associated with a firm nearing or entering bankruptcy

C) The interest payments on debt

D) The opportunity cost of equity financing

15. Which of the following is a component of capital structure decisions?

A) Dividend policy

B) Working capital management

C) Financing mix of debt and equity

D) Inventory control

16. What is the primary challenge in applying the Modigliani-Miller theorem in practice?

A) The irrelevance of taxes

B) The difficulty in achieving perfect capital markets

C) The simplicity of the assumptions

D) The lack of impact of debt on firm value

17. The concept of 'reinvestment assumption' is critical for which capital budgeting technique?

A) Payback Period

B) Net Present Value (NPV)

C) Internal Rate of Return (IRR)

D) Accounting Rate of Return (ARR)

18. Which capital budgeting technique is criticized for potentially ranking small projects higher than large, profitable ones?

A) Net Present Value (NPV)

B) Internal Rate of Return (IRR)

C) Payback Period

D) Profitability Index (PI)

19. In capital budgeting, what does the term 'cash flows' usually refer to?

A) Accounting profits

B) Net income after taxes

C) Incremental cash flows generated by the project

D) Total revenue from the project

20. The Modigliani-Miller theorem with taxes suggests that:

A) Firm value is maximized with 100% equity financing

B) Firm value increases with leverage due to tax benefits

C) Firm value is independent of capital structure

D) Firm value is maximized with 100% debt financing

21. What is a disadvantage of having too much debt in the capital structure?

A) Increased flexibility

B) Lower cost of capital

C) Higher risk of financial distress and bankruptcy

D) Greater control for shareholders

22. Which of the following is a potential benefit of using debt financing?

A) Reduced financial risk

B) Tax shield from interest deductibility

C) Increased control for existing shareholders

D) Higher credit rating

23. What is the cost of debt in the context of WACC calculation?

A) The stated coupon rate on debt

B) The interest rate paid on new debt, adjusted for taxes

C) The average interest rate on all outstanding debt

D) The dividend yield on preferred stock

24. The Trade-off Theory suggests that the optimal capital structure is achieved when the benefits of debt financing (like tax shields) are balanced against the costs of debt financing (like bankruptcy costs).

A) True, this is the core idea of the Trade-off Theory.

B) False, the Trade-off Theory focuses solely on tax benefits.

C) False, it emphasizes the benefits of equity financing.

D) False, it suggests an infinite debt ratio is optimal.

25. Which of the following is a measure of the risk associated with a capital budgeting project?

A) Net Present Value (NPV)

B) Internal Rate of Return (IRR)

C) Sensitivity Analysis

D) Payback Period

26. The concept of 'terminal value' in capital budgeting is used to account for:

A) Initial investment costs

B) Depreciation expenses

C) Cash flows beyond the explicit forecast period

D) Working capital changes

27. What is the main disadvantage of the IRR method when dealing with projects of unequal lives?

A) It may reject positive NPV projects

B) It assumes reinvestment at the IRR

C) It can lead to multiple IRRs

D) It does not consider the time value of money

28. In capital budgeting, the discount rate used typically reflects:

A) The firm's historical cost of capital

B) The riskiness of the project and the firm's cost of capital

C) The inflation rate

D) The interest rate on government bonds

29. Which type of capital budgeting decision involves choosing between alternative projects with different cash flow patterns?

A) Replacement decisions

B) Expansion decisions

C) Mutually exclusive decisions

D) Independent decisions

30. Opportunity cost in capital budgeting refers to:

A) The cost of borrowing money

B) The return forgone from the next best alternative investment

C) The cost of issuing new shares

D) The depreciation of assets

31. What is a 'sunk cost' in the context of capital budgeting?

A) A future cash outflow that can be avoided if a project is not undertaken

B) A past cash outflow that cannot be recovered

C) A future cash inflow that is guaranteed

D) An opportunity cost of using existing assets

32. When comparing mutually exclusive projects, the NPV rule is generally preferred over the IRR rule when:

A) Projects have different initial investments

B) Projects have different lifespans

C) Projects have different risk levels

D) All of the above

33. Which of the following capital budgeting methods is most theoretically sound for maximizing shareholder wealth?

A) Payback Period

B) Accounting Rate of Return (ARR)

C) Net Present Value (NPV)

D) Internal Rate of Return (IRR) in all cases

34. The Profitability Index (PI) is calculated as:

A) Present value of future cash flows / Initial investment

B) Initial investment / Present value of future cash flows

C) Sum of future cash flows / Initial investment

D) Initial investment / Sum of future cash flows

35. Which capital budgeting technique measures the return generated by an investment relative to its cost?

A) Payback Period

B) Net Present Value (NPV)

C) Profitability Index (PI)

D) Accounting Rate of Return (ARR)

36. The Internal Rate of Return (IRR) is the discount rate at which:

A) NPV is maximized

B) NPV is zero

C) NPV is negative

D) The project's cash inflows equal the initial investment

37. A project is considered acceptable using the NPV method if:

A) NPV is negative

B) NPV is zero

C) NPV is positive

D) NPV is equal to the initial investment

38. The Net Present Value (NPV) method discounts future cash flows at the:

A) Risk-free rate

B) Cost of debt

C) Required rate of return (or cost of capital)

D) Inflation rate

39. Which capital budgeting technique ignores the time value of money?

A) Net Present Value (NPV)

B) Internal Rate of Return (IRR)

C) Payback Period

D) Profitability Index (PI)

40. What is the primary purpose of capital budgeting?

A) To manage short-term working capital

B) To make decisions about long-term investments

C) To determine the firm's dividend policy

D) To analyze the firm's daily cash flows

41. The optimal capital structure is the mix of debt and equity that:

A) Maximizes the firm's earnings per share

B) Minimizes the firm's total debt

C) Maximizes the firm's value

D) Minimizes the firm's dividend payments

42. Which of the following is NOT a source of long-term capital for a firm?

A) Common stock

B) Retained earnings

C) Trade credit

D) Bonds

43. A higher degree of financial leverage generally leads to:

A) Lower earnings per share (EPS)

B) Lower financial risk

C) Higher risk for equity holders

D) Lower cost of equity

44. What is the Weighted Average Cost of Capital (WACC)?

A) The cost of equity only

B) The cost of debt only

C) The average cost of all the capital components of a firm, weighted by their proportion

D) The total interest paid on debt

45. The Pecking Order Theory posits that firms prefer to finance new investments using:

A) Debt first, then equity

B) Equity first, then debt

C) Internal financing (retained earnings) first, then debt, then equity

D) External equity first, then debt

46. Which theory suggests that firms with higher debt ratios have lower taxes due to the tax deductibility of interest payments?

A) Pecking Order Theory

B) Trade-off Theory

C) Agency Theory

D) Market Timing Theory

47. The Modigliani-Miller (MM) theorem, in its original form, assumes:

A) The existence of taxes and bankruptcy costs

B) Perfect capital markets and no taxes

C) Information asymmetry between managers and investors

D) Agency costs

48. Which of the following is a key component of a firm's capital structure?

A) Operating expenses

B) Accounts receivable

C) Debt

D) Inventory

49. What is the primary goal of capital structure decisions?

A) To maximize the firm's market share

B) To minimize the firm's total cost of capital

C) To maximize the firm's dividend payout ratio

D) To increase the firm's operational efficiency

Capital structure and budgeting decisions - Question Bank