SAMPLE QUESTIONS FOR FINANCE PAPER

Question 1.
The cash inflows on account of operations are presumed to have been reinvested at the cut-off rate in
case of
A. Discounted cash flow method
B. Accounting rate or return method
C. Payback method
D. All of these
Answer: A
The discounted cash flow methods do take into account the time values of money into consideration
and out of three of its sub categories
1 Net present Value 2 Internal Rate of Return and 3 Profitability Index
In properties of Net present value
i. NPVs are additive
ii. Intermediate Cash flows are invested at cost of capital
iii. NPV calculations permits Time varying Discount rates
According to second property the NPV rule assumes that any cash flows that occur between initiation
and termination of the project- are reinvested at a rate of return equal to cost of capital hence option A
is correct.
Question 2.
Operating leverage depicts the firm’s ability to use fixed operating cost to magnify the effect of
change in sales on
A. Its earnings before interest and taxes
B. The earnings after interest and taxes
C. The creditors
D. The debtors
Answer A

Sales
Operating Less: Var. cost
Leverage Contribution
Less: Fixed cost
Earnings before Int & Tax(EBIT) Total
Less: Interest on debt Leverage
Earning before Tax
Financial Less: Tax
Leverage Earnings after tax
Less: Preferred Dividend
Equity Earnings

Leverage arises from existing costs. There are two types of leverages Operating and Financial
Leverage and operating leverage arises from the existence of fixed operating expenses. When a firm
has fixed operation expenses,1 percent change in sales leads to more than 1 percent change in EBIT.
Question 3
Match the items given in the two lists :

List – I List – II

a. Debt securities
without any i. Floating Rate Bonds
explicit
interest rate

b. Company
issuing such
bonds ii. Zero-coupon bonds
experiences
less financial
distress

c. Coupon rate
quoted as iii. Income Bonds
mark-up on the
given rate

a b c
(A) i ii iii
(B) i iii ii
(C) ii iii i
(D) iii i ii
Answer C

Zero Coupon Bonds: A zero-coupon bond is a bond where the face value is repaid at the time of
maturity. This definition assumes a positive time value of money. It does not make periodic interest
payments, or have so-called coupons, hence the term zero-coupon bond

Income Bonds: An income bond is a type of debt security in which only the face value of the bond is
promised to be paid to the investor, with any coupon payments paid only if the issuing company has
enough earnings to pay for the coupon payment hence clearly a company that issues such a vond
experiences less financial distress

Floating rate Bonds: Floating rate notes are bonds that have a variable coupon, equal to a money
market reference rate, like LIBOR or federal funds rate, plus a quoted spread.
Question 4
A critical assumption of the Net Operating Income(NOI) approach to valuation is:

A. That debt and equity levels remain unchanged

B. That dividends increase at a constant rate
C. That cost of capital remains constant regardless of changes in leverage.
D. That interest expense and taxes are included in the calculation.

Answer C
Net operating income approach advocates that any change in the level of debt of company does not
influence the total value of the company. According to this approach , neither the WACC of a
company nor its total value depends upon the capital structure decision or financial leverage.
There are presumptions, which form the basis of net operating income.
1. Corporate tax does not exist
2. Overall cost of capital is not affected by changes in any leverage
3. Cost of capital depends on its business risk
4. Cost of Debt is unvarying
Question 5
According to Modi-Miller’s proposition II the cost of equity:
A. Falls as the value of the tax shield increase
B. Is constant as gearing increase
C. Rises to exactly offset the advantage of low-cost debt
D. None of these

Three basic MM propositions

1. The overall cost of capital (Ko) and the value of the firm (V) are independent of its capital
structure. The Ko and V are constant for all degree of leverages. The total value is obtained by
capitalizing the expected stream of operating earnings at a discount rate appropriate to its risk class

2. The cost of equity (Ke) is equal to the capitalization rate of a pure equity stream plus a premium
for financial risk equal to the difference between pure equity capitalization rate (Ke) and cost of
debt(Kd) times the ratio of debt t equity. In other words, Ke increases in a manner to offset exactly
the use of a less expensive source of funds represented by debt

3. The cut off rate for investment purpose is completely independent of the way which an
investment is financed

Question 6
Which of the following statements is/are true for Internal Rate of Return(IRR)?
A. A project can have only one IRR
B. If the IRR is less than firm’s cost of capital, the project should be rejected
C. A project can have multiple IRRs depending upon the cash flow of the streams
D. Both (b) and (c)

Answer D
Internal Rate of Return (IRR):

Internal rate of return is the interest rate at which the net present value of all the cash flows (both
positive and negative) from a project or investment equal zero.

Internal rate of return is used to evaluate the attractiveness of a project or investment. If the IRR of a
new project exceeds a company’s required rate of return, that project is desirable. If IRR falls below
the required rate of return, the project should be rejected.

Decision Rule

IRR>K: Project accepted

IRR<K: project Rejected

IRR=K: Indifference

Advantages Disadvantages

Consideration of time value Difficult to calculate

Easy to understand Confirm multiple rate of return

Sign of profitability Inconsistent in firm’s objective

Comprehensive Objective Reinvestment of Cash flow