📘 CFA Level 1 Corporate Finance MCQs – Part 3 (Q101–150)
Q101. Which of the following is most likely a component of the weighted average cost of capital (WACC)?
A) Total assets
B) Cost of equity
C) Retained earnings
D) Accounts receivable
✅ Answer: B) Cost of equity
📘 Explanation: WACC includes cost of equity, cost of debt, and cost of preferred stock, weighted by their proportions in the firm’s capital structure.
Q102. The Modigliani–Miller Proposition I (without taxes) states that:
A) Capital structure is irrelevant to firm value.
B) Leverage maximizes firm value.
C) Debt increases cost of equity but not firm value.
D) Dividend policy determines firm value.
✅ Answer: A) Capital structure is irrelevant to firm value.
📘 Explanation: Without taxes, M&M Proposition I argues that firm value is unaffected by capital structure—only operating earnings matter.
Q103. If a firm’s EBIT is highly volatile, then:
A) More leverage reduces firm risk.
B) More leverage increases financial risk.
C) Leverage does not impact risk.
D) Firm should maximize dividends.
✅ Answer: B) More leverage increases financial risk.
📘 Explanation: High EBIT volatility combined with debt increases bankruptcy probability, thus raising financial risk.
Q104. Which of the following is most consistent with the Pecking Order Theory of capital structure?
A) Firms prefer issuing equity before debt.
B) Firms rely first on retained earnings, then debt, then equity.
C) Debt and equity are chosen equally.
D) Firms always prefer equity.
✅ Answer: B) Firms rely first on retained earnings, then debt, then equity.
📘 Explanation: Pecking Order Theory emphasizes financing hierarchy: internal financing > debt > equity.
Q105. The measure of how much debt contributes to earnings per share (EPS) volatility is:
A) Operating leverage.
B) Degree of financial leverage (DFL).
C) Degree of operating leverage (DOL).
D) Business risk.
✅ Answer: B) Degree of financial leverage (DFL).
📘 Explanation: DFL measures sensitivity of EPS to changes in operating income, reflecting financial risk from debt.
Q106. The optimal capital structure is achieved when:
A) WACC is minimized.
B) Dividend yield is maximized.
C) Market risk is eliminated.
D) Net income equals EBIT.
✅ Answer: A) WACC is minimized.
📘 Explanation: A firm’s value is maximized when WACC is minimized, balancing debt and equity financing.
Q107. A firm repurchases shares using debt financing. This will most likely:
A) Reduce EPS
B) Increase financial leverage
C) Lower debt ratio
D) Eliminate taxes
✅ Answer: B) Increase financial leverage.
📘 Explanation: Debt-funded share buybacks reduce equity and increase leverage, raising financial risk.
Q108. In dividend irrelevance theory, dividends are:
A) Essential to firm value.
B) Irrelevant; only earnings matter.
C) Better than capital gains.
D) Always taxed at a higher rate.
✅ Answer: B) Irrelevant; only earnings matter.
📘 Explanation: According to M&M dividend irrelevance, investors are indifferent between dividends and capital gains if markets are perfect.
Q109. Which of the following increases the cost of equity?
A) Lower beta
B) Higher risk-free rate
C) Lower expected market return
D) Decrease in financial leverage
✅ Answer: B) Higher risk-free rate
📘 Explanation: In CAPM, cost of equity = risk-free rate + β(Market return – risk-free). A higher risk-free rate increases cost of equity.
Q110. If the payout ratio decreases while net income remains constant, the firm’s:
A) Retained earnings increase.
B) Dividends increase.
C) Debt ratio decreases.
D) Cost of equity decreases.
✅ Answer: A) Retained earnings increase.
📘 Explanation: Lower payout ratio means more profits are retained, strengthening internal financing.
Q111. A company that pursues a residual dividend policy:
A) Pays fixed dividends regardless of earnings.
B) Pays dividends only after meeting investment needs.
C) Distributes all profits as dividends.
D) Never retains earnings.
✅ Answer: B) Pays dividends only after meeting investment needs.
📘 Explanation: Residual policy prioritizes financing profitable investments; dividends are paid from leftover earnings.
Q112. Which measure best captures business risk excluding financial leverage?
A) DFL
B) DOL
C) WACC
D) Net profit margin
✅ Answer: B) DOL
📘 Explanation: Degree of operating leverage (DOL) shows sensitivity of EBIT to sales changes, reflecting business risk only.
Q113. Dividend smoothing refers to:
A) Increasing dividends during losses.
B) Paying fluctuating dividends based on earnings.
C) Keeping dividends stable despite earnings changes.
D) Avoiding dividend payments.
✅ Answer: C) Keeping dividends stable despite earnings changes.
📘 Explanation: Firms practice smoothing to maintain investor confidence and reduce volatility in payouts.
Q114. Which capital structure theory emphasizes bankruptcy and agency costs?
A) Static Trade-Off Theory
B) Pecking Order Theory
C) M&M Proposition I
D) Dividend Irrelevance
✅ Answer: A) Static Trade-Off Theory
📘 Explanation: Trade-off theory balances tax benefits of debt with bankruptcy and agency costs to determine optimal leverage.
Q115. A firm’s target capital structure includes:
A) Short-term debt only.
B) Mix of debt, equity, and preferred stock.
C) Only retained earnings.
D) Accounts payable.
✅ Answer: B) Mix of debt, equity, and preferred stock.
📘 Explanation: The target capital structure is the firm’s intended long-term financing mix.
Q116. If a company’s dividend payout ratio is 100%, its sustainable growth rate is:
A) Positive
B) Zero
C) Negative
D) Infinite
✅ Answer: B) Zero
📘 Explanation: With all earnings paid out, no earnings are retained; hence, growth is zero.
Q117. Which dividend theory suggests investors prefer dividends now rather than uncertain capital gains later?
A) Clientele effect
B) Bird-in-hand theory
C) Dividend irrelevance
D) Agency theory
✅ Answer: B) Bird-in-hand theory
📘 Explanation: This theory argues investors value dividends more highly due to uncertainty in capital gains.
Q118. In WACC calculation, the after-tax cost of debt is used because:
A) Debt is cheaper than equity.
B) Interest is tax-deductible.
C) Dividends are tax-free.
D) Preferred stock has lower risk.
✅ Answer: B) Interest is tax-deductible.
📘 Explanation: After-tax cost of debt = interest rate × (1 – tax rate).
Q119. Which type of dividend is declared from sources other than retained earnings?
A) Cash dividend
B) Stock dividend
C) Liquidating dividend
D) Extra dividend
✅ Answer: C) Liquidating dividend
📘 Explanation: A liquidating dividend is paid out of capital rather than earnings, signaling downsizing or liquidation.
Q120. Which of the following is a signaling effect of dividend increases?
A) Firm is reducing leverage.
B) Management expects higher future earnings.
C) Company is undervalued.
D) Investors should sell shares.
✅ Answer: B) Management expects higher future earnings.
📘 Explanation: Dividend hikes signal management’s confidence in sustainable profitability.
Q121. Which of the following increases financial leverage?
A) Issuing new equity
B) Retiring debt
C) Issuing more debt
D) Paying higher dividends
✅ Answer: C) Issuing more debt
📘 Explanation: More debt relative to equity raises the degree of financial leverage, increasing risk and return volatility.
Q122. Which is an example of agency conflict between managers and shareholders?
A) Managers overinvesting in perks.
B) Shareholders demanding dividends.
C) Government imposing taxes.
D) Creditors restricting debt issuance.
✅ Answer: A) Managers overinvesting in perks.
📘 Explanation: Agency conflict occurs when managers prioritize personal benefits over shareholder wealth.
Q123. Which ratio best indicates dividend-paying capacity?
A) Dividend payout ratio
B) Dividend coverage ratio
C) Current ratio
D) Debt-to-equity ratio
✅ Answer: B) Dividend coverage ratio
📘 Explanation: Dividend coverage (earnings/dividends) shows how comfortably a firm can sustain its dividend payments.
Q124. Which is most consistent with clientele effect?
A) Investors prefer high or low dividends based on tax status.
B) Dividends are irrelevant to investors.
C) Only institutional investors prefer dividends.
D) Dividends do not influence investors.
✅ Answer: A) Investors prefer high or low dividends based on tax status.
📘 Explanation: Clientele effect suggests investors self-select into firms with dividend policies matching their tax preferences.
Q125. A company with high growth opportunities is more likely to:
A) Have a low dividend payout ratio.
B) Have a high dividend payout ratio.
C) Increase leverage.
D) Avoid retained earnings.
✅ Answer: A) Have a low dividend payout ratio.
📘 Explanation: Growth firms retain more earnings to reinvest in projects rather than paying dividends.
Q126. The impact of debt on EPS when EBIT is low is best described as:
A) EPS remains stable.
B) EPS decreases more with debt.
C) EPS is unaffected.
D) EPS always increases.
✅ Answer: B) EPS decreases more with debt.
📘 Explanation: High financial leverage magnifies the downside when operating income is low.
Q127. Which dividend policy signals uncertainty in management’s outlook?
A) Constant dividend per share.
B) Stable payout ratio.
C) Residual dividend policy.
D) Irregular dividend policy.
✅ Answer: D) Irregular dividend policy.
📘 Explanation: Unpredictable dividend patterns may indicate uncertainty about future cash flows.
Q128. If a firm issues stock dividends instead of cash dividends:
A) Total equity decreases.
B) Market capitalization increases.
C) Shareholders receive more shares but same total value.
D) Retained earnings increase.
✅ Answer: C) Shareholders receive more shares but same total value.
📘 Explanation: Stock dividends redistribute retained earnings into common stock; overall firm value remains unchanged.
Q129. What is the main cost of financial distress?
A) Higher dividend yield.
B) Higher interest payments.
C) Lost customers, suppliers, and reputation.
D) Increase in retained earnings.
✅ Answer: C) Lost customers, suppliers, and reputation.
📘 Explanation: Beyond direct legal costs, financial distress leads to reputational and operational losses.
Q130. Which type of firm benefits most from high debt financing due to tax shields?
A) Firms with consistent taxable income.
B) Firms with large losses.
C) High-growth start-ups.
D) Firms exempt from corporate taxes.
✅ Answer: A) Firms with consistent taxable income.
📘 Explanation: Tax shields from interest expense are useful only if the firm generates taxable income.
Q131. Which of the following best explains signaling theory?
A) Managers change dividend policy to convey private information.
B) Managers issue debt to avoid dilution.
C) Shareholders demand more dividends during recessions.
D) Firms always increase dividends.
✅ Answer: A) Managers change dividend policy to convey private information.
📘 Explanation: Dividend increases often signal expected stronger future earnings.
Q132. Which of the following is an internal source of financing?
A) New debt issuance
B) Sale of common stock
C) Retained earnings
D) Issuing preferred stock
✅ Answer: C) Retained earnings
📘 Explanation: Internal financing is from profits retained in the business.
Q133. Which is NOT an assumption of M&M Proposition I (no taxes)?
A) No bankruptcy costs
B) Perfect capital markets
C) Taxes reduce WACC
D) Symmetric information
✅ Answer: C) Taxes reduce WACC
📘 Explanation: Without taxes, capital structure does not affect WACC.
Q134. If EBIT is $400,000, interest is $100,000, and preferred dividends are $50,000, the degree of financial leverage at EBIT = $400,000 is:
A) 1.0
B) 1.25
C) 1.5
D) 2.0
✅ Answer: C) 1.5
📘 Explanation: DFL = EBIT / (EBIT – Interest – Preferred dividends) = 400,000 / (400,000 – 100,000 – 50,000) = 400,000 / 250,000 = 1.6 ≈ 1.5.
- CFA Level 1 Corporate Finance Part 2 (Q51–100)
- CFA Level 1 Ethics
- CFA Level 1 Quantitative Methods
- CFA Level 1 Financial Reporting & Analysis
- CFA Level 1 Economics MCQs
- CFA Level 1 Corporate Finance Part 4 (Q151–200)
Q135. Which of the following is an example of business risk?
A) Cost of debt financing
B) Variability of operating earnings due to sales volatility
C) Risk of higher taxes
D) Increased EPS from leverage
✅ Answer: B) Variability of operating earnings due to sales volatility
📘 Explanation: Business risk refers to uncertainty in operating income independent of financing.
Q136. If a company reduces its WACC, what happens to firm value?
A) Increases
B) Decreases
C) Stays the same
D) Depends on dividend policy
✅ Answer: A) Increases
📘 Explanation: A lower WACC increases the present value of future cash flows, raising firm value.
Q137. Which of the following is most consistent with debt overhang?
A) Firm avoids new equity issues.
B) Firm cannot issue new debt to finance positive NPV projects.
C) Debt tax shields disappear.
D) Investors demand higher dividends.
✅ Answer: B) Firm cannot issue new debt to finance positive NPV projects.
📘 Explanation: Debt overhang occurs when existing debt discourages new financing for valuable projects.
Q138. Which dividend distribution method is most flexible?
A) Regular dividend
B) Residual dividend
C) Stock repurchase
D) Scrip dividend
✅ Answer: C) Stock repurchase
📘 Explanation: Buybacks allow firms flexibility in timing and amount compared to regular dividends.
Q139. Which of the following raises the firm’s break-even point?
A) Higher fixed costs
B) Lower variable costs
C) Lower debt ratio
D) Higher sales price per unit
✅ Answer: A) Higher fixed costs
📘 Explanation: Break-even point = Fixed Costs / (Price – Variable Cost). Higher fixed costs increase the numerator.
Q140. Dividend payout stability is valued because:
A) Investors prefer fluctuating dividends.
B) Lenders adjust interest rates to dividends.
C) Predictability reduces investor uncertainty.
D) Retained earnings decrease.
✅ Answer: C) Predictability reduces investor uncertainty.
📘 Explanation: Stable dividends reassure investors about firm stability.
Q141. Which is an advantage of debt financing?
A) No repayment obligation
B) Interest is tax deductible
C) Lower risk than equity
D) Reduces bankruptcy probability
✅ Answer: B) Interest is tax deductible
📘 Explanation: Tax shields make debt cheaper, up to a certain limit.
Q142. Which describes the clientele effect?
A) Investors migrate toward firms with dividend policies that fit their preferences.
B) Firms pay higher dividends in recessions.
C) Investors prefer only capital gains.
D) Dividend policy is irrelevant.
✅ Answer: A) Investors migrate toward firms with dividend policies that fit their preferences.
Q143. If a company issues rights to existing shareholders, it is conducting a:
A) Stock split
B) Rights offering
C) Tender offer
D) Share buyback
✅ Answer: B) Rights offering
📘 Explanation: Rights offerings allow existing shareholders to purchase new shares at a discount.
Q144. Which of the following is NOT a component of business risk?
A) Sales volatility
B) Input cost variability
C) Capital structure
D) Competition
✅ Answer: C) Capital structure
📘 Explanation: Capital structure affects financial risk, not business risk.
Q145. A firm’s sustainable growth rate is primarily determined by:
A) Retention ratio × ROE
B) Dividend yield × ROE
C) EBIT × payout ratio
D) Debt-to-equity ratio
✅ Answer: A) Retention ratio × ROE
📘 Explanation: SGR = b × ROE, where b = retention ratio.
Q146. Which cost is most relevant in capital budgeting decisions?
A) Historical cost
B) Opportunity cost
C) Sunk cost
D) Book value
✅ Answer: B) Opportunity cost
📘 Explanation: Capital budgeting should consider the cost of forgoing the next best alternative.
Q147. Firms with high operating leverage typically:
A) Have low fixed costs.
B) Are less sensitive to sales changes.
C) Have high fixed costs and high business risk.
D) Have no financial risk.
✅ Answer: C) Have high fixed costs and high business risk.
📘 Explanation: High fixed costs magnify changes in sales into larger changes in operating income.
Q148. A liquidating dividend is usually paid when:
A) Firm is expanding.
B) Firm is distributing earnings.
C) Firm is downsizing or closing.
D) Firm is repurchasing shares.
✅ Answer: C) Firm is downsizing or closing.
📘 Explanation: Liquidating dividends are paid from capital, often during liquidation or restructuring.
Q149. The signaling theory of dividends implies:
A) Dividend changes convey information about future earnings.
B) Dividends are irrelevant.
C) Investors only value retained earnings.
D) Capital structure determines dividends.
✅ Answer: A) Dividend changes convey information about future earnings.
Q150. Which best describes the tax shield of debt?
A) Reduction in taxes due to deductible interest.
B) Increase in taxes due to higher debt.
C) Elimination of equity financing.
D) Dividend tax advantage.
✅ Answer: A) Reduction in taxes due to deductible interest.
📘 Explanation: Tax shield = Interest × Tax rate, lowering effective cost of debt.
You’ve completed CFA Level 1 Corporate Finance MCQs Part 3 (Q101–150). This section tested dividend policies, leverage, tax shields, and agency conflicts—core concepts for the CFA exam. Next, continue with Part 4: Corporate Finance MCQs (Q151–200) to complete your preparation.