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Unit 5: Capital Structure and Dividend Theory - Practice Quiz

FIN212 — Basic Financial Management 50 Questions
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1 Which of the following best defines Capital Structure?

A. The total assets of the company
B. The mix of a firm's permanent long-term financing represented by debt, preferred stock, and common equity
C. The mix of current assets and current liabilities
D. The ratio of dividends to earnings

2 What is the primary objective of achieving an Optimum Capital Structure?

A. To minimize the Value of the Firm
B. To minimize the WACC and maximize the Value of the Firm
C. To eliminate all debt from the balance sheet
D. To maximize the Weighted Average Cost of Capital (WACC)

3 Under the Net Income (NI) Approach, what is the assumed relationship between the cost of debt () and the cost of equity ()?

A.
B.
C. There is no relationship
D.

4 According to the Net Operating Income (NOI) Approach, how does the overall cost of capital () behave as leverage increases?

A. It remains constant
B. It first decreases and then increases
C. It decreases continuously
D. It increases continuously

5 Which of the following is considered an Irrelevance Theory of capital structure?

A. Traditional Approach
B. Net Income Approach
C. Modigliani-Miller (MM) Approach without taxes
D. Pecking Order Theory

6 In the Traditional Approach to capital structure, what happens to the overall cost of capital () initially when debt is introduced?

A. It remains constant
B. It becomes zero
C. It increases immediately
D. It decreases

7 The Modigliani-Miller (MM) Hypothesis with corporate taxes suggests that:

A. Capital structure is irrelevant
B. Value of the firm increases with debt due to the tax shield
C. Dividends are irrelevant
D. Value of the firm decreases with debt

8 What is Financial Leverage?

A. The process of issuing bonus shares
B. The ratio of sales to variable costs
C. The use of fixed-income securities (debt/preference shares) in the capital structure
D. The use of fixed-cost assets in operations

9 In the context of capital structure, what is the Point of Indifference?

A. The point where the firm declares bankruptcy
B. The EBIT level where EPS is the same for two different financing plans
C. The level of sales where total revenue equals total cost
D. The dividend payout ratio where share price is maximized

10 Which formula represents the Value of the Firm ()?

A.
B.
C.
D.

11 The term 'Trading on Equity' refers to:

A. Issuing shares at a premium
B. Buying and selling shares in the stock market
C. Using borrowed funds to increase the return on owner's equity
D. Exchanging equity for debt

12 Under the MM Hypothesis, the mechanism that restores equilibrium between the value of levered and unlevered firms (in a no-tax world) is called:

A. Amortization
B. Arbitrage
C. Speculation
D. Hedging

13 Which of the following is NOT an assumption of the Modigliani-Miller (MM) Theory?

A. Asymmetric information
B. Homogeneous risk classes
C. No transaction costs
D. Perfect capital markets

14 In the Net Income Approach, what happens to the Weighted Average Cost of Capital (WACC) as the Debt-Equity ratio increases?

A. WACC becomes zero
B. WACC increases
C. WACC remains constant
D. WACC decreases

15 According to the NOI Approach, the cost of equity ():

A. Increases linearly with leverage to offset cheap debt
B. Fluctuates randomly
C. Decreases as leverage increases
D. Remains constant as leverage increases

16 Which of the following represents the formula for the Value of a Levered Firm () under MM with taxes?

A.
B.
C.
D.

17 Business Risk depends on:

A. The dividend policy
B. The firm's operating environment and nature of business
C. The capital structure decision
D. The amount of debt issuance

18 Which form of dividend involves the distribution of shares in lieu of cash?

A. Property Dividend
B. Scrip Dividend
C. Bond Dividend
D. Stock Dividend (Bonus Shares)

19 What is a Scrip Dividend?

A. Distribution of inventory
B. Buying back shares
C. Promise to pay dividend at a future date via a promissory note
D. Payment in cash

20 The Dividend Payout Ratio is calculated as:

A.
B.
C.
D.

21 Which of the following is a Dividend Relevance Theory?

A. NOI Approach
B. Modigliani-Miller Model
C. Arbitrage Pricing Theory
D. Walter’s Model

22 In Walter’s Model, if the return on investment () is greater than the cost of equity capital (), the firm should:

A. Retain 100% earnings
B. Distribute 100% dividends
C. Be indifferent
D. Distribute 50% dividends

23 What is the formula for Walter’s Model?

A.
B.
C.
D.

24 Gordon’s Model assumes that:

A. External financing is used extensively
B. The firm has a finite life
C. Retention ratio () and internal rate of return () are constant
D. Internal rate of return () changes with investment

25 The 'Bird-in-the-hand' argument supports which view?

A. Dividends should never be paid
B. High dividend payout is preferred to reduce uncertainty
C. Dividend Irrelevance
D. Capital gains are preferred over dividends

26 In Gordon’s Model, the value of a share () is given by:

A.
B.
C.
D.

27 The MM Dividend Irrelevance Theory relies heavily on the concept of:

A. Arbitrage
B. Tax Shields
C. Bird-in-the-hand
D. Variable Growth

28 What is the Residual Theory of Dividends?

A. Dividends are equal to the residual value of assets
B. Dividends are constant every year
C. Dividends are paid before anything else
D. Dividends are paid only if there are leftover funds after meeting all attractive investment opportunities

29 Which of the following is a legal constraint on paying dividends?

A. Capital Impairment Rule
B. Stock Market Reaction
C. Shareholder Preference
D. Target Payout Ratio

30 According to Walter's Model, for a declining firm where , the optimal payout ratio is:

A. Variable
B. 50%
C. 0%
D. 100%

31 The Clientele Effect suggests that:

A. Companies should change their dividend policy frequently
B. Dividends are irrelevant
C. Investors choose stocks based on the company’s dividend policy matching their own needs
D. All investors want the same dividend policy

32 What is the Information Content (Signaling) Hypothesis?

A. Dividends convey information about future earnings prospects
B. Dividends are taxed higher than capital gains
C. Investors ignore dividends
D. Dividends reduce the cash balance

33 Which of the following is a form of dividend where assets other than cash are distributed?

A. Stock Dividend
B. Interim Dividend
C. Cash Dividend
D. Property Dividend

34 An Interim Dividend is declared:

A. At the Annual General Meeting
B. Only when the company is winding up
C. Between two Annual General Meetings
D. After the financial year ends

35 Under the MM Dividend Model, the value of the firm at the end of the period () is calculated assuming:

A. No new shares can be issued
B. Debt is increased
C. Assets are sold
D. New shares are issued to finance investment and dividends

36 What effect does a Bonus Issue have on the net worth of the company?

A. No change in total net worth
B. Increases liabilities
C. Decreases net worth
D. Increases net worth

37 The Ex-Dividend Date is:

A. The date dividends are paid
B. The date shareholders must be registered to receive dividends
C. The date on or after which a security is traded without a previously declared dividend
D. The date the board declares the dividend

38 Which factor is LEAST likely to influence dividend policy?

A. Legal constraints
B. The color of the company logo
C. Access to capital markets
D. Liquidity position

39 In Gordon's Model, if is the retention ratio, then represents:

A. Growth rate
B. Cost of equity
C. Payout ratio
D. Tax rate

40 The Pecking Order Theory (often discussed alongside Trade-off theory) implies firms prefer:

A. External Equity first
B. Debt first
C. Equity first, then Debt
D. Retained Earnings first, then Debt, then Equity

41 What is the relationship between Growth Rate (), Retention Ratio (), and Return on Equity ()?

A.
B.
C.
D.

42 Which theory suggests that the shape of the average cost of capital curve is saucer-shaped?

A. Net Income Approach
B. MM Approach
C. Net Operating Income Approach
D. Traditional Approach

43 Agency Costs of debt arise due to conflicts of interest between:

A. Customers and Suppliers
B. Shareholders and Managers
C. Government and Company
D. Shareholders and Bondholders/Creditors

44 If a firm has a Target Payout Ratio, it implies:

A. It pays a fixed dollar amount regardless of earnings
B. It pays 100% of earnings always
C. It never pays dividends
D. It tries to maintain a stable percentage of earnings as dividends over the long run

45 The assumption that 'Dividends and Capital Gains are taxed at the same rate' belongs to:

A. MM Hypothesis (Perfect Markets)
B. Bird-in-the-hand
C. Traditional View
D. Real-world tax systems

46 What is the primary formula for the Cost of Equity () in the NI approach if is not given directly?

A.
B.
C.
D.

47 A Bond Dividend is primarily used when:

A. The company wants to reduce debt
B. The company is merging
C. The company has excess cash
D. The company has no cash but wants to pay a dividend

48 In the context of Capital Structure, . If taxes exist, and the firm issues debt to buy back equity, what happens to according to MM?

A. drops to zero
B. increases by the present value of tax shields
C. remains constant
D. decreases

49 Which of the following describes a Regular Dividend Policy?

A. Payment of a constant percentage of earnings
B. No dividend payment
C. Payment of dividends only in profitable years
D. Payment of dividends at the usual rate per share

50 Under Gordon's Model, for the formula to be mathematically valid, which condition must hold?

A.
B.
C.
D.
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