CAF-7 · Chapter 9
Cost of Finance MCQs with Answers
15 multiple-choice questions on Cost of Finance for CAF-7 Business Insights and Analysis. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
A company has recently paid a dividend of Rs. 6 per share, which is expected to grow by 9% per annum in the foreseeable future. The shareholders require an annual return of 19% and the next annual dividend will be paid in one year’s time. According to the Dividend Valuation Model (DVM), what would be the market value of each share?
- A) Rs. 60.0
- B) Rs. 66.7
- C) Rs. 65.4
- D) Rs. 79.3
Show answer & explanation
Answer: C) Rs. 65.4
According to DVM: Po = D1 / (Ke - g). First find D1: 6 * 1.09 = 6.54. Then apply the formula: Po = 6.54 / (0.19 - 0.09) = 65.4.
Question 2
The WACC of a company is 12%, and 50% of its shares are held by the directors. Ignoring taxation, if annual cash profits of the company in perpetuity are Rs. 240 million, what would be the theoretical total market value of the company?
- A) Rs. 1 billion
- B) Rs. 2 billion
- C) Rs. 4 billion
- D) Rs. 480 million
Show answer & explanation
Answer: B) Rs. 2 billion
The market value of an all-equity/constant profit firm can be calculated by capitalizing its earnings: Market Value = Annual Cash Profits / WACC. Rs. 240 million / 0.12 = Rs. 2,000 million (which is Rs. 2 billion).
Question 3
When shares are traded 'ex-dividend (XD)', which of the following statements accurately describes the situation?
- A) Buyers of shares at XD price are entitled to receive the upcoming dividend payment
- B) The XD share price is typically higher than when shares are traded 'cum-dividend'
- C) Buyers of shares at XD price are not entitled to receive the upcoming dividend payment
- D) The XD share price reflects the immediate anticipation of current year dividends
Show answer & explanation
Answer: C) Buyers of shares at XD price are not entitled to receive the upcoming dividend payment
When a share is marked 'ex-dividend', it means the seller, not the buyer, will receive the recently declared dividend. Consequently, the XD share price drops to exclude the value of that dividend.
Question 4
Why is the post-tax cost of debt generally much lower than the cost of equity for a company?
- A) Because equity investors demand fixed returns while debt returns fluctuate
- B) Because debt is inherently less risky for the investor and interest payments are tax-deductible for the company
- C) Because dividends are tax-deductible while interest payments are paid from retained earnings
- D) Because debt holders have the lowest priority in the event of company liquidation
Show answer & explanation
Answer: B) Because debt is inherently less risky for the investor and interest payments are tax-deductible for the company
Debt is less risky for investors because interest is legally guaranteed and they rank higher in liquidation. For the company, debt is cheaper because interest payments shield profits from tax, lowering the effective cost.
Question 5
When calculating the cost of redeemable debt (like bonds maturing in 5 years), which financial technique must a company use to find the true cost of that debt?
- A) Dividend Valuation Model (DVM)
- B) Capital Asset Pricing Model (CAPM)
- C) Internal Rate of Return (IRR) of the after-tax cash flows
- D) Net Present Value (NPV) using a 0% discount rate
Show answer & explanation
Answer: C) Internal Rate of Return (IRR) of the after-tax cash flows
Redeemable debt involves multiple cash flows over time: initial issue price (inflow), annual interest payments (outflows), and final redemption (outflow). Finding the precise percentage cost of these combined flows requires an IRR calculation.
Question 6
What does an 'inverse' (downward-sloping) yield curve typically indicate to the financial markets?
- A) Markets expect short-term interest rates to rise at some time in the future
- B) Markets expect short-term interest rates to fall at some time in the future
- C) Inflation is expected to rise sharply
- D) Lenders demand higher compensation for long-term lending risks
Show answer & explanation
Answer: B) Markets expect short-term interest rates to fall at some time in the future
A normal yield curve slopes upwards. When it slopes downwards (inverse), long-term rates are lower than short-term rates, indicating the market anticipates a future decline in overall interest rates.
Question 7
Which TWO factors primarily justify why an equity investment is considered riskier than an investment in the debt capital of the exact same company?
- A) Ordinary shareholders have no voting rights and receive fixed returns
- B) Dividends are not a legal obligation and ordinary shareholders rank last in the event of liquidation
- C) Interest payments can be missed without consequence, but dividends must be paid
- D) Equity investments are strictly short-term while debt is permanent
Show answer & explanation
Answer: B) Dividends are not a legal obligation and ordinary shareholders rank last in the event of liquidation
Equity is riskier because a company is not legally forced to pay dividends if profits are low, and if the company goes bankrupt, equity holders are paid only after all secured and unsecured creditors have been settled.
Question 8
The process of calculating a zero-coupon yield curve (spot rates) by sequentially extracting rates from the market prices of existing coupon-bearing bonds is known as:
- A) Securitization
- B) Bootstrapping
- C) Interpolation
- D) Factoring
Show answer & explanation
Answer: B) Bootstrapping
Bootstrapping is a mathematical technique used to derive the spot yield curve for different maturities by starting with short-term zero-coupon bonds and working sequentially up to longer-term coupon bonds.
Question 9
A company issues a convertible bond. When calculating the cost of this convertible debt for the WACC, the cost is estimated as the higher of the bond's straight-debt IRR and:
- A) The risk-free rate of the country
- B) The current market price of the company's ordinary shares
- C) The IRR of the cash flows assuming conversion into equity takes place at maturity
- D) The cost of equity calculated via CAPM
Show answer & explanation
Answer: C) The IRR of the cash flows assuming conversion into equity takes place at maturity
For convertible bonds, investors will choose whichever option gives them the highest return at maturity (cash redemption or share conversion). The company must calculate the IRR of both scenarios and take the higher rate as its true cost of debt.
Question 10
How is the cost of irredeemable preference shares calculated?
- A) Preference dividend divided by the ex-dividend market price of the preference shares
- B) Preference dividend divided by the par value of the preference shares
- C) Through an Internal Rate of Return (IRR) calculation over 10 years
- D) By taking the risk-free rate and adding a fixed premium
Show answer & explanation
Answer: A) Preference dividend divided by the ex-dividend market price of the preference shares
Because irredeemable preference shares pay a constant dividend into perpetuity without ever returning the principal, their cost is simply calculated as Kp = D / Po (Dividend divided by the current ex-dividend market value).
Question 11
If a company decides to issue new shares to finance a highly risky project (one that completely alters the business's overall risk profile), why should it NOT use its existing Weighted Average Cost of Capital (WACC) to appraise the project?
- A) Because WACC only applies to debt financing
- B) Because the existing WACC reflects the risk of the company's current operations, not the new higher-risk project
- C) Because WACC cannot be calculated if a company issues new shares
- D) Because issuing new shares mathematically lowers the cost of equity to zero
Show answer & explanation
Answer: B) Because the existing WACC reflects the risk of the company's current operations, not the new higher-risk project
A company's current WACC represents its current risk profile. If a new project significantly changes the business risk (which changes the equity Beta), the existing WACC becomes invalid, and a new project-specific discount rate must be calculated.
Question 12
According to the Capital Asset Pricing Model (CAPM), what happens to a company's Cost of Equity if the Beta of its shares increases from 1.0 to 1.3?
- A) The Cost of Equity will decrease because higher beta implies lower risk
- B) The Cost of Equity will remain exactly the same as the market return
- C) The Cost of Equity will increase because investors will demand a higher return for the increased systematic risk
- D) The Cost of Equity will drop to match the risk-free rate
Show answer & explanation
Answer: C) The Cost of Equity will increase because investors will demand a higher return for the increased systematic risk
Beta measures systematic risk. A beta of 1.3 means the stock is 30% more volatile than the market average. Under CAPM, as risk (Beta) goes up, the required return (Cost of Equity) goes up to compensate investors.
Question 13
What is the formula used to calculate the cost of equity (Ke) using the Dividend Valuation Model with constant growth?
- A) Ke = (Po / D1) + g
- B) Ke = (D1 / Po) + g
- C) Ke = (D0 / Po) - g
- D) Ke = (Po * g) / D1
Show answer & explanation
Answer: B) Ke = (D1 / Po) + g
The DVM formula rearranged to solve for the cost of equity is Ke = (D1 / Po) + g, where D1 is the expected dividend next year, Po is the current ex-div share price, and g is the constant growth rate.
Question 14
A company uses the Dividend Valuation Model to value its equity. What happens mathematically to the model if the assumed dividend growth rate (g) is equal to or higher than the investors' required rate of return (Ke)?
- A) The share price becomes exactly zero
- B) The model becomes mathematically invalid as the denominator becomes zero or negative
- C) The share price exactly equals the dividend amount
- D) The company automatically shifts to using CAPM instead
Show answer & explanation
Answer: B) The model becomes mathematically invalid as the denominator becomes zero or negative
In the formula Po = D1 / (Ke - g), if g is equal to or greater than Ke, the denominator becomes zero or negative, yielding an infinite or negative stock price. The model assumes Ke must always be strictly greater than g.
Question 15
Which of the following is considered a non-cash flow item that is explicitly ignored when calculating the Internal Rate of Return (IRR) of redeemable debt?
- A) The annual coupon interest payments
- B) The initial issue price or market value of the bond
- C) The final premium paid on redemption
- D) The annual accounting depreciation of the company's assets
Show answer & explanation
Answer: D) The annual accounting depreciation of the company's assets
IRR calculations are based strictly on actual cash flows. Accounting depreciation is a non-cash expense and has no place in the direct IRR calculation for the cost of debt.