Here are some sample finance questions, covering various areas, designed to test understanding of core concepts.

Sample Finance Questions

Corporate Finance

Question 1: Capital Budgeting - Net Present Value (NPV)

A company is considering investing in a new project that requires an initial investment of $500,000. The project is expected to generate cash inflows of $150,000 per year for the next 5 years. The company's required rate of return (discount rate) is 10%. Calculate the NPV of the project. Should the company undertake the project based solely on NPV?

Explanation: This question assesses the understanding of NPV, a fundamental tool for capital budgeting decisions. Students need to discount future cash flows back to their present value and compare them to the initial investment. A positive NPV indicates the project is expected to add value to the company, suggesting acceptance.

Question 2: Weighted Average Cost of Capital (WACC)

A company has a capital structure consisting of 40% debt and 60% equity. The cost of debt is 7% (after-tax), and the cost of equity is 12%. Calculate the company's WACC. Explain why WACC is important.

Explanation: This question tests the understanding of WACC, a crucial metric for evaluating investment opportunities. Students need to understand how to calculate WACC based on the proportions of debt and equity and their respective costs. WACC is important because it represents the minimum return a company needs to earn on its investments to satisfy its investors.

Question 3: Dividend Policy

Discuss the factors a company should consider when formulating its dividend policy. What are the potential advantages and disadvantages of paying out a high dividend versus retaining earnings?

Explanation: This is a conceptual question exploring the nuances of dividend policy. Factors to consider might include current and future profitability, investment opportunities, debt levels, and shareholder preferences. High dividends might attract income-seeking investors but could limit reinvestment for growth. Retaining earnings allows for future investment but may disappoint shareholders expecting regular income.

Investments

Question 4: Portfolio Diversification

Explain the concept of portfolio diversification. Why is it important, and how can investors achieve it?

Explanation: This question tests the fundamental principle of diversification. Students should explain how spreading investments across different asset classes reduces risk by mitigating the impact of any single investment's performance. Investors can achieve diversification by investing in a mix of stocks, bonds, real estate, and other assets, ideally with low correlations to each other.

Question 5: Efficient Market Hypothesis (EMH)

Describe the three forms of the Efficient Market Hypothesis (EMH): weak, semi-strong, and strong. What are the implications of each form for investors trying to outperform the market?

Explanation: This question delves into market efficiency. Students should define each form of EMH and explain its implications. Under the weak form, technical analysis is futile. Under the semi-strong form, neither technical nor fundamental analysis will consistently generate above-average returns. Under the strong form, even insider information won't guarantee superior returns.

Financial Markets

Question 6: Interest Rate Risk

Explain how changes in interest rates affect bond prices. What is duration, and how is it used to measure interest rate risk?

Explanation: This question assesses understanding of the inverse relationship between interest rates and bond prices. Students should explain that when interest rates rise, bond prices fall, and vice versa. Duration is a measure of a bond's sensitivity to interest rate changes; higher duration means greater sensitivity.