Chapter 24: Capital Structure and Cost of Capital (JAIIB – Paper 3)
1. What is the primary objective of capital structuring for a bank?
A. To maximize shareholder dividends only
B. To minimize taxation liabilities only
C. To optimize the mix of debt and equity to minimize cost of capital and maximize value
D. To increase short-term borrowings
Capital structure aims to balance debt and equity in a way that reduces the overall cost of capital while maintaining financial flexibility and shareholder value.
2. Which of the following best describes financial leverage (gearing)?
A. Using equity only to finance assets
B. Using debt in the capital structure to increase potential returns to equity shareholders
C. Investing in marketable securities
D. Retaining all earnings instead of paying dividends
Financial leverage or gearing refers to the use of debt in the capital structure to amplify potential returns to equity, but it also increases financial risk.
3. Which of the following is NOT a factor influencing a bank's capital structure decision?
A. Bank branch colors
B. Cost of debt and equity
C. Regulatory requirements like CRR and CAR
D. Earnings stability and cash flow position
Factors like cost of debt/equity, regulatory requirements, and earnings stability influence capital structure. Branch colors are irrelevant.
4. Degree of financial leverage (DFL) measures:
A. The proportion of equity in total capital
B. The proportion of current assets to total assets
C. The bank’s liquidity ratio
D. The sensitivity of net income to changes in operating income due to debt financing
DFL indicates how much net income will change in response to a change in operating income, reflecting the impact of debt financing.
5. Which of the following is a benefit of high equity financing in banks?
A. Lower financial risk and greater financial stability
B. Higher interest tax shield benefits
C. Increased leverage for maximizing returns
D. Amplifies earnings variability
High equity reduces financial risk, provides stability, and ensures the bank can meet obligations even during downturns, though it may lower returns.
6. If a bank has EBIT of ₹50 lakh, interest of ₹10 lakh, and 1 lakh shares, what is EPS before taxes? (Ignore taxes for simplicity)
A. ₹400
B. ₹600
C. ₹400
D. ₹500
EPS = (EBIT – Interest) / Number of Shares = (50,00,000 – 10,00,000) / 1,00,000 = ₹40 per share. (Note: Values simplified for exam-style calculation)
7. According to the Net Income (NI) approach, how does increasing debt in capital structure affect the firm's value?
A. Value of the firm decreases
B. Value of the firm increases due to lower overall cost of capital
C. Value of the firm remains constant
D. Value of the firm becomes unpredictable
The NI approach assumes that cost of equity remains constant and adding debt (cheaper than equity) reduces overall cost of capital, increasing firm value.
8. Which of the following is the key assumption of the Net Operating Income (NOI) approach?
A. Cost of equity remains constant regardless of debt
B. Financial leverage decreases firm value
C. Debt is more expensive than equity
D. Overall cost of capital remains constant; value of firm is independent of capital structure
The NOI approach states that cost of capital is constant and changes in debt do not affect firm value; equity cost rises with more debt, keeping WACC unchanged.
9. According to the NI approach, what is the effect on the weighted average cost of capital (WACC) when debt increases?
A. WACC decreases
B. WACC increases
C. WACC remains unchanged
D. WACC becomes zero
NI approach assumes equity cost is constant; adding cheaper debt reduces overall WACC, increasing firm value.
10. Which approach to capital structure implies that the choice between debt and equity does not affect the firm’s market value?
A. Net Income (NI) Approach
B. Traditional Approach
C. Net Operating Income (NOI) Approach
D. Modigliani-Miller Approach with taxes
NOI approach assumes firm value is independent of capital structure; debt increases equity risk but WACC remains unchanged.
11. In the Traditional approach, what happens to the WACC when a moderate amount of debt is added?
A. WACC remains unchanged
B. WACC initially decreases, then increases if debt is excessive
C. WACC increases immediately
D. WACC becomes zero
Traditional approach suggests moderate debt reduces WACC due to cheaper debt; beyond a point, excessive debt increases equity cost and overall WACC.
12. According to capital structure theories, which of the following is correct?
A. NI approach: WACC increases with more debt
B. NOI approach: Value increases with more debt
C. Traditional approach: Debt has no effect on WACC
D. NI approach: Value of firm rises as debt increases due to lower WACC
NI approach predicts firm value increases with debt because WACC falls; other approaches make different assumptions.
13. According to the Traditional approach, what is the effect of a moderate level of debt on the firm's value?
A. Firm value increases due to lower overall cost of capital
B. Firm value decreases immediately
C. Firm value remains constant
D. Firm value becomes unpredictable
The Traditional approach suggests that moderate debt reduces WACC and increases firm value; excessive debt later increases risk and WACC.
14. Which of the following is an assumption common to capital structure theories?
A. Firms can raise unlimited funds at zero cost
B. Capital markets are perfect and information is available to all
C. Firms do not aim to maximize shareholder wealth
D. Taxes are not considered at all
Most approaches assume perfect capital markets, no transaction costs, and that firms aim to maximize shareholder wealth.
15. How does corporate taxation influence the capital structure decision of a bank?
A. Taxes have no effect on capital structure decisions
B. Higher taxes favor equity financing over debt
C. Interest on debt is tax-deductible, making debt financing more attractive
D. Dividend payments are always tax-free
Tax deductibility of interest reduces the effective cost of debt, making debt financing more attractive for banks.
16. Which of the following represents the formula for the cost of debt (Kd) after tax?
A. Kd = Interest / Equity
B. Kd = EBIT / Total Capital
C. Kd = Dividend / Debt
D. Kd after tax = Interest rate × (1 – Tax rate)
Cost of debt after tax = Interest rate × (1 – Tax rate), since interest is tax-deductible.
17. A bank can borrow at 10% interest. The corporate tax rate is 30%. What is the after-tax cost of debt?
A. 10%
B. 7%
C. 3%
D. 13%
After-tax cost of debt = 10% × (1 – 0.30) = 7%.
18. Which of the following statements about the Traditional approach is correct?
A. WACC is constant irrespective of debt level
B. Firm value is independent of capital structure
C. Moderate debt lowers WACC and increases firm value, excessive debt increases WACC
D. Debt has no impact on risk perception of equity
Traditional approach assumes WACC falls with moderate debt, increasing firm value, but too much debt raises equity cost and WACC.
19. Which of the following is true about preference shares?
A. They have voting rights in all matters
B. They have no fixed dividend
C. They represent ownership with unlimited liability
D. They carry fixed dividend and have preference over equity in dividend and liquidation
Preference shares provide fixed dividends and priority over equity in payment of dividends and liquidation, but usually do not carry voting rights.
20. Which of the following statements about equity shares is correct?
A. Equity shareholders are owners of the bank and receive residual profits after debt and preference payments
B. Equity shareholders have a fixed rate of return
C. Equity capital must be repaid on demand
D. Equity shareholders have no right to vote
Equity shareholders own the bank, bear residual risk, and benefit from profits after fixed obligations like debt and preference dividends.
21. In determining capital proportions for WACC, which of the following is considered?
A. Only equity capital
B. Proportions of debt, preference, and equity in total capital
C. Only preference shares
D. Only retained earnings
WACC calculation considers the weighted proportion of all sources of capital—debt, preference, and equity.
22. Which of the following correctly defines the Weighted Average Cost of Capital (WACC)?
A. Cost of equity only
B. Cost of debt only
C. Average cost of all sources of capital weighted by their proportion in total capital
D. Return on total assets
WACC is the weighted average of the costs of debt, preference shares, and equity, according to their proportion in total capital.
23. Which of the following factors affect WACC of a bank?
A. Only interest rates on loans
B. Cost of debt, cost of equity, proportion of capital, tax rates, and market conditions
C. Only retained earnings
D. Only dividends declared
WACC depends on the costs of different capital sources, their proportions, tax benefits, and market conditions affecting required returns.
24. If a bank has 40% debt at 8% interest (after tax), 20% preference at 10%, and 40% equity at 15%, what is the WACC?
25. Why is WACC important in capital budgeting decisions?
A. It serves as the hurdle rate to evaluate investment projects
B. It determines employee bonuses
C. It is used to calculate deposit interest rates
D. It affects branch expansion plans only
WACC is used as the minimum required return for investment projects; projects with returns above WACC add value to the firm.
26. What does the Weighted Marginal Cost of Capital (WMCC) represent?
A. The average cost of capital over the past years
B. The cost of equity only
C. The cost of raising an additional unit of capital considering the mix of debt and equity
D. The market value of the firm
WMCC reflects the cost of raising additional capital, accounting for proportions of debt, preference, and equity, and helps in incremental investment decisions.
27. Why is determining the optimal capital budget important for a bank?
A. To maximize employee salaries
B. To ensure that investments are financed at a cost that maximizes firm value
C. To minimize the number of branches
D. To comply with government regulations only
Optimal capital budgeting ensures that projects undertaken provide returns above the cost of capital, thus maximizing the value of the bank.
28. What is Divisional Cost of Capital?
A. The cost of capital for the entire bank only
B. The cost of debt only for a division
C. The cost of equity only for a division
D. The weighted cost of capital specific to a division considering its risk and capital structure
Divisional cost of capital reflects the risk and capital structure specific to that division, helping evaluate projects fairly within the division.
29. How is Project Cost of Capital different from Divisional Cost of Capital?
A. Project cost of capital is adjusted for the specific risk of the project, not just the division
B. Project cost of capital ignores risk
C. Project cost of capital is always lower than WACC
D. Project cost of capital is same for all projects in the bank
Each project may have different risk characteristics; hence, project-specific cost of capital is used to evaluate its feasibility accurately.
30. When evaluating a new project, which cost of capital should a bank use?
A. Only the bank's overall WACC
B. Project-specific cost of capital adjusted for risk and financing mix
C. Only the divisional cost of capital
D. Only the cost of debt
The project-specific cost of capital reflects the unique risk and financing mix of the project, ensuring proper evaluation of its potential returns.
31. What is flotation cost?
A. Cost of maintaining bank branches
B. Cost incurred to issue new securities, including underwriting, legal, and administrative expenses
C. Cost of interest on loans only
D. Dividend paid to shareholders
Flotation costs include all expenses incurred to raise new capital, such as underwriting, legal, registration, and administrative fees.
32. How does flotation cost affect the cost of capital?
A. It has no effect on cost of capital
B. It reduces the cost of capital
C. It only affects equity but not debt
D. It increases the effective cost of capital since additional funds are required to cover issuance costs
Flotation costs increase the amount of funds required to raise capital, effectively raising the cost of capital.
33. Which of the following is a common misconception about cost of capital?
A. Cost of capital is the same for all projects regardless of risk
B. Cost of debt affects WACC
C. Equity is more expensive than debt
D. WACC is used as a benchmark for project evaluation
A common misconception is that cost of capital is uniform for all projects; in reality, riskier projects require higher capital costs.
34. How should flotation costs be accounted for in capital budgeting?
A. Ignore flotation costs for simplicity
B. Include them as operating expenses
C. Adjust the project’s required rate of return to reflect flotation costs
D. Deduct them from retained earnings only
Flotation costs should be incorporated into the required return for a project so that the project is evaluated against its true capital cost.
35. Which of the following statements regarding cost of capital is correct?
A. Cost of capital is irrelevant for investment decisions
B. Cost of capital serves as a benchmark or hurdle rate for evaluating projects
C. Cost of capital is always lower than the expected project return
D. Cost of capital is same as accounting profit
The cost of capital is the minimum return required to compensate providers of funds; it is used as a benchmark to accept or reject projects.
