Question 1

Why is the "Cost of Debt" generally lower than the "Cost of Equity"?

Equity holders have a fixed claim on assets.Interest paid on debt is tax-deductible, creating a tax shield.Debt does not require repayment.Lenders take higher risk than shareholders.

View Explanation

Interest payments reduce the taxable income of the company, effectively lowering the cost of debt by the tax rate [Kd = I(1-t)]. Equity dividends are paid out of post-tax profits and offer no tax shield.

Question 2

In the CAPM (Capital Asset Pricing Model), "Beta" measures:

Systematic Risk (Market risk) relative to the market.Unsystematic Risk (Company specific).Risk-free rate.Total Risk.

View Explanation

Beta indicates how volatile a stock is compared to the overall market. Beta > 1 means higher volatility than the market; Beta < 1 means lower volatility.

Question 3

The "Cost of Retained Earnings" is usually estimated to be:

Zero.Equal to the Cost of Equity (Ke).Higher than Cost of New Equity.Equal to the Cost of Debt.

View Explanation

Retained earnings involve an opportunity cost. Shareholders forgo dividends to let the firm reinvest. They expect a return equal to what they would demand on equity shares (Ke).

Question 4

The cost of raising an *additional* rupee of capital is called:

Fixed Cost.Sunk Cost.Marginal Cost of Capital.Average Cost of Capital.

View Explanation

Marginal cost is the incremental cost of new capital. It is the relevant rate for evaluating new investment proposals.

Question 5

Which weights are theoretically superior for calculating WACC (Weighted Average Cost of Capital)?

Book Value Weights.Historical Weights.Market Value Weights.Marginal Weights.

View Explanation

Market values reflect the current economic value of the capital employed. Using market value weights aligns the WACC with the actual cost of raising new capital in the market today.

Question 6

Formula for Cost of Equity (Ke) under CAPM is:

Rf + Beta(Rm - Rf)Rf - Beta(Rm - Rf)Rm + Beta(Rf)(D1 / P0) + g

View Explanation

Ke = Risk Free Rate + [Beta * (Market Return - Risk Free Rate)]. This adds a risk premium to the safe rate based on the stock's volatility.

Question 7

The "Cost of Preference Share Capital" is calculated as:

Preference Dividend / Net ProceedsPreference Dividend * (1 - Tax Rate) / Net ProceedsPreference Dividend / Market PriceInterest / Net Proceeds

View Explanation

Preference dividends are not tax-deductible, so no tax adjustment is made. Cost = Dp / NP.

Question 8

How do "Floatation Costs" affect the Cost of New Equity?

They reduce the dividend payout.They reduce the Cost of Equity.They have no impact.They increase the Cost of Equity.

View Explanation

Floatation costs (issue expenses) reduce the "Net Proceeds" the company receives from the issue. Since the denominator (Net Proceeds) decreases, the calculated Cost of Capital increases.

Question 9

Which of the following is NOT an assumption of the Capital Asset Pricing Model (CAPM)?

Investors hold diversified portfolios.Investors are rational and risk-averse.Markets are perfect (no taxes, no transaction costs).All investors have different expectations about future returns.

View Explanation

CAPM assumes "Homogeneous Expectations" - that all investors have the same expectations regarding expected returns, variances, and correlations.

Question 10

Retained Earnings have an "Implicit Cost" because:

It is free money.The shareholders forego the opportunity to invest dividends elsewhere.It is recorded in books.The company pays interest on it.

View Explanation

Explicit costs involve cash outflow (interest). Implicit costs are Opportunity Costs. The cost of retained earnings is the return shareholders could have earned if the money was distributed.

Question 11

When calculating the "Cost of Redeemable Debt", which factor is NOT considered?

Redemption Value and Maturity Period.Dividend Payout Ratio.Interest Rate.Tax Rate.

View Explanation

Cost of Debt depends on interest, tax shield, and redemption terms (discount/premium). Dividend Payout Ratio is relevant for Cost of Equity, not Debt.

Question 12

The "Marginal Cost of Capital" (MCC) schedule jumps (breaks) upwards when:

The amount of new capital raised exhausts a cheaper source (like Retained Earnings) and requires a more expensive source (like New Equity).Tax rates fall.Interest rates fall.The firm has excess cash.

View Explanation

This point is called the "Break Point". Once retained earnings are used up, the firm must issue new shares (incurring floatation costs), which raises the WACC.

Question 13

In the Security Market Line (SML) graph, if a stock lies ABOVE the SML line, it is considered:

Undervalued.High Risk.Correctly Valued.Overvalued.

View Explanation

If a stock is above the SML, it is offering a higher expected return than what CAPM predicts for its level of risk. Hence, it is attractive/undervalued and should be bought.

JAIIB Quiz

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