"Business Finance" — Practice

Question 1

Which of the following is a well-documented limitation of the profit maximisation objective of financial management?
(a) It gives too much weight to the timing of cash flows  (b) It ignores the time value of money  (c) It explicitly incorporates the risk associated with a project  (d) It is measured using an unambiguous, externally observable market figure

Accepted Answer

Profit maximisation treats a rupee of profit earned in year 1 as equivalent to a rupee earned in year 5, entirely disregarding the time value of money; it is also silent on risk and vague about which profit figure — before or after tax, short-run or long-run — is actually being maximised.

Answer: (b) It ignores the time value of money. Trap (a) reverses the real criticism — profit maximisation gives cash-flow timing no weight at all, not too much. Trap (c) and trap (d) both describe strengths of wealth maximisation, mistakenly attributed here to profit maximisation instead.

Question 2

Wealth maximisation as an objective of financial management is best measured, in practice, by a firm's:
(a) Market price per share of its equity  (b) Net profit before tax for the year  (c) Total revenue earned during the year  (d) Total assets employed on its balance sheet

Accepted Answer

Market price per share directly reflects the present value of a firm's expected future cash flows, discounted for both timing and risk — exactly what wealth maximisation is designed to capture.

Answer: (a) Market price per share of its equity. Trap (b) is an accounting profit figure, vulnerable to the same timing and risk blind spots profit maximisation carries. Trap (c) measures scale of sales, not value created for shareholders. Trap (d) measures the size of the asset base, saying nothing about the return or risk attached to it.

Question 3

₹1,00,000 receivable exactly 3 years from now is discounted at 10% per annum. Given the present value factor at 10% for 3 years is 0.751, its present value today is closest to:
(a) ₹90,000  (b) ₹82,500  (c) ₹75,100  (d) ₹68,300

Accepted Answer

Present value = ₹1,00,000 × 0.751 = ₹75,100.

Answer: (c) ₹75,100. Trap (a) and trap (b) both understate the discounting effect, as if a smaller rate or shorter period had been applied. Trap (d) overstates the discounting effect beyond what a 0.751 factor actually produces.

Question 4

A project requires an initial investment of ₹2,00,000 and generates equal annual cash inflows of ₹60,000 for 5 years. Given PVIFA(12%, 5 years) = 3.605, the project's NPV at a 12% discount rate is closest to:
(a) ₹24,300  (b) ₹10,300  (c) −₹16,300  (d) ₹16,300

Accepted Answer

PV of inflows = ₹60,000 × 3.605 = ₹2,16,300. NPV = ₹2,16,300 − ₹2,00,000 = ₹16,300.

Answer: (d) ₹16,300. Trap (a) and trap (b) both misstate the present value of inflows before subtracting the initial outlay. Trap (c) has the right magnitude but the wrong sign, wrongly implying the project destroys value when it actually adds it.

Question 5

A project has an initial outlay of ₹1,00,000 and equal annual cash inflows of ₹30,000 for 5 years. Given PVIFA(15%, 5) = 3.352 and PVIFA(16%, 5) = 3.274, the project's IRR, found by interpolation, is closest to:
(a) 15.2%  (b) 10.0%  (c) 13.5%  (d) 18.0%

Accepted Answer

NPV at 15% = (30,000 × 3.352) − 1,00,000 = +₹560. NPV at 16% = (30,000 × 3.274) − 1,00,000 = −₹1,780. Interpolating: IRR = 15% + [560 ÷ (560 + 1,780)] × 1% ≈ 15.24%.

Answer: (a) 15.2%. Trap (b) is even lower than the 10% rate at which this project's NPV is already strongly positive, so IRR must exceed 10%, not fall below it. Trap (c) and trap (d) both sit outside the 15%–16% bracket the interpolation was actually carried out within.

Question 6

A machine costs ₹4,50,000 and generates a constant annual cash inflow of ₹90,000 throughout its life. Its payback period is:
(a) 5.5 years  (b) 5 years  (c) 4.5 years  (d) 4 years

Accepted Answer

Payback period = ₹4,50,000 ÷ ₹90,000 = 5 years exactly.

Answer: (b) 5 years. Trap (a), trap (c), and trap (d) are all plausible-looking neighbouring values, but none matches the exact division of ₹4,50,000 by ₹90,000.

Question 7

A company's share currently trades at ₹40, is expected to pay a dividend of ₹4 next year, and dividends are expected to grow at a constant 6% per annum indefinitely. Using the dividend growth model, its cost of equity is:
(a) 10%  (b) 6%  (c) 16%  (d) 22%

Accepted Answer

Ke = (D₁ ÷ P₀) + g = (4 ÷ 40) + 0.06 = 0.10 + 0.06 = 0.16 = 16%.

Answer: (c) 16%. Trap (a) is only the dividend-yield component (D₁ ÷ P₀), leaving out growth entirely. Trap (b) is only the growth rate, leaving out the dividend yield entirely. Trap (d) overstates the total by combining the two components incorrectly.

Question 8

XYZ Ltd. is financed by equity worth ₹60 lakh (cost of equity 16%) and debt worth ₹40 lakh (pre-tax cost of debt 12%, tax rate 30%). Its WACC is closest to:
(a) 16.0%  (b) 8.4%  (c) 14.4%  (d) 12.96%

Accepted Answer

After-tax cost of debt = 12% × (1 − 0.30) = 8.4%. WACC = (0.6 × 16%) + (0.4 × 8.4%) = 9.6% + 3.36% = 12.96%.

Answer: (d) 12.96%. Trap (a) is simply the cost of equity alone, ignoring debt's weight entirely. Trap (b) is the after-tax cost of debt alone, ignoring equity's weight entirely. Trap (c) results from mistakenly weighting the pre-tax rather than the after-tax cost of debt (0.6 × 16 + 0.4 × 12 = 14.4%).

Question 9

Which capital structure theory holds that a firm's overall cost of capital and total value remain constant at every level of financial leverage, because any fall in the cost of debt is exactly offset by a rise in the cost of equity?
(a) Net Income (NI) Approach  (b) Net Operating Income (NOI) Approach  (c) Traditional Approach  (d) MM Hypothesis with corporate taxes

Accepted Answer

This constant-Ko, constant-value claim, with Ke rising to exactly absorb the extra financial risk debt introduces, is the defining position of the Net Operating Income (NOI) Approach.

Answer: (b) Net Operating Income (NOI) Approach. Trap (a) claims the opposite — that leverage changes firm value continuously. Trap (c) claims value rises only up to a point and then falls, not that it stays constant throughout. Trap (d) claims value rises continuously with debt through a tax shield, a different mechanism entirely.

Question 10

According to the Modigliani-Miller hypothesis WITH corporate taxes, the value of a levered firm compared with an identical unlevered firm is:
(a) Equal to the unlevered firm's value  (b) Lower than the unlevered firm's value, by the value of its debt  (c) Higher than the unlevered firm's value, by (tax rate × value of debt)  (d) Independent of the firm's tax rate

Accepted Answer

MM's 1963 correction to their original irrelevance result shows interest is tax-deductible, so debt creates a genuine tax shield: Value of levered firm = Value of unlevered firm + (tax rate × value of debt).

Answer: (c). Trap (a) restates MM's earlier no-tax conclusion, which no longer holds once corporate taxes are introduced. Trap (b) reverses the direction of the tax-shield effect entirely. Trap (d) is factually backwards — the entire tax-shield result depends directly on the tax rate.

Question 11

A firm has EPS = ₹10, DPS = ₹6, cost of capital Ke = 16%, and internal rate of return r = 20%. Using Walter's model, its market price per share is closest to:
(a) ₹68.75  (b) ₹62.50  (c) ₹75.00  (d) ₹56.25

Accepted Answer

P = [D + (r ÷ Ke)(E − D)] ÷ Ke = [6 + (0.20 ÷ 0.16)(10 − 6)] ÷ 0.16 = [6 + 1.25 × 4] ÷ 0.16 = [6 + 5] ÷ 0.16 = 11 ÷ 0.16 = ₹68.75.

Answer: (a) ₹68.75. Trap (b), trap (c), and trap (d) are all plausible nearby figures, but none satisfies Walter's formula worked through with these exact inputs.

Question 12

As per Walter's model, when a firm's internal rate of return (r) exceeds its cost of capital (Ke), the dividend payout ratio that maximises its share price is:
(a) 100% payout  (b) A payout ratio exactly equal to r ÷ Ke  (c) The payout ratio has no effect on share price in this case  (d) Zero payout (full retention of earnings)

Accepted Answer

Since r > Ke, the firm earns more by reinvesting retained funds than shareholders could earn on those funds elsewhere, so share price is maximised by retaining every rupee of earnings.

Answer: (d) Zero payout (full retention of earnings). Trap (a) describes the correct rule for the opposite case, a declining firm where r < Ke. Trap (b) invents a payout rule Walter's model does not specify. Trap (c) describes the separate special case where r = Ke, not the growth-firm case asked about here.

Question 13

A firm has current assets of ₹5,00,000 and current liabilities of ₹3,20,000. Its net working capital is:
(a) ₹1,80,000  (b) ₹8,20,000  (c) ₹3,20,000  (d) ₹5,00,000

Accepted Answer

Net Working Capital = Current Assets − Current Liabilities = ₹5,00,000 − ₹3,20,000 = ₹1,80,000.

Answer: (a) ₹1,80,000. Trap (b) mistakenly adds current assets and current liabilities instead of subtracting them. Trap (c) and trap (d) simply restate one of the two given figures without performing the subtraction at all.

Question 14

The Modigliani-Miller (MM) dividend irrelevance hypothesis rests critically on the assumption of:
(a) High transaction costs and flotation costs  (b) A perfect capital market with no taxes or transaction costs  (c) A statutory minimum dividend payout requirement  (d) Significant information asymmetry between managers and investors

Accepted Answer

MM's dividend irrelevance result is explicitly conditional on a frictionless, perfect capital market where investors can costlessly create their own 'homemade dividends.'

Answer: (b) A perfect capital market with no taxes or transaction costs. Trap (a) and trap (d) both describe real-world frictions whose presence would actually undermine, not support, MM's irrelevance conclusion. Trap (c) invents a regulatory constraint the model never assumes.

Practice — "Business Finance"

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