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- December 14, 2024
Question 01
A project’s payback period is the amount of time required for:
a) Total cash flows to match the initial investment.
b) The project to generate profits.
c) The IRR to equal the WACC.
d) Depreciation to equal net income.
Answer: a) Total cash flows to match the initial investment.
Explanation: The payback period measures how long it takes to recover the initial investment from the project’s cash flows.
Question 02
What is the key advantage of using the Net Present Value (NPV) method?
a) It is easy to understand and apply.
b) It adjusts for time value of money.
c) It always guarantees a positive return.
d) It disregards project risk.
Answer: b) It adjusts for time value of money.
Explanation: The NPV method accounts for the time value of money, making it a reliable measure of a project’s profitability.
Question 03
The internal rate of return (IRR) is best defined as the:
a) Required rate of return for a project to be acceptable.
b) Discount rate that makes NPV equal to zero.
c) Profitability index for a project.
d) Rate at which future cash flows exceed initial costs.
Answer: b) Discount rate that makes NPV equal to zero.
Explanation: IRR is the rate at which the present value of a project’s cash inflows equals the present value of its cash outflows.
Question 04
Which of the following is most likely to be true if a project’s IRR is less than its required rate of return?
a) The NPV is negative.
b) The project has a high profitability index.
c) The payback period is shorter than the project’s life.
d) The project will generate excess returns.
Answer: a) The NPV is negative.
Explanation: When IRR is less than the required rate of return, it indicates that the project is not expected to generate sufficient returns.
Question 05
The discounted payback period differs from the regular payback period because:
a) It does not consider project risk.
b) It includes the time value of money.
c) It ignores all cash flows after the payback point.
d) It uses accounting profits instead of cash flows.
Answer: b) It includes the time value of money.
Explanation: The discounted payback period adjusts future cash flows by discounting them, accounting for the time value of money.
Question 06
A project’s incremental cash flows are best described as:
a) The total cash flows of the company after the project is implemented.
b) The additional cash flows generated by the project.
c) The cash flows required to finance the project.
d) The cash flows generated by other projects.
Answer: b) The additional cash flows generated by the project.
Explanation: Incremental cash flows are the net additional cash inflows and outflows directly attributable to a project.
Question 07
Which of the following best describes the profitability index (PI)?
a) The difference between total revenues and total costs.
b) The ratio of net present value to initial investment.
c) The present value of the project’s cash flows.
d) The return on investment after taxes.
Answer: b) The ratio of net present value to initial investment.
Explanation: The profitability index is the ratio of the present value of cash inflows to the initial investment, measuring how much value is created per dollar invested.
Question 08
Which project evaluation method is most suitable for comparing projects with different lifespans?
a) Payback period.
b) NPV.
c) Equivalent annual cost.
d) Discounted payback.
Answer: c) Equivalent annual cost.
Explanation: The equivalent annual cost method standardizes the costs of projects with different lifespans, making comparisons easier.
Question 09
In capital budgeting, what is a sunk cost?
a) A cost that is recovered through the project’s cash flows.
b) A cost that has already been incurred and cannot be recovered.
c) A cost that will be incurred if the project is accepted.
d) A cost that changes with the level of output.
Answer: b) A cost that has already been incurred and cannot be recovered.
Explanation: Sunk costs are past expenses that should not affect future investment decisions because they cannot be recovered.
Question 10
Which one of the following is most important when considering mutually exclusive projects?
a) The project with the higher IRR should always be chosen.
b) The project with the shortest payback period is best.
c) The project with the highest NPV should be chosen.
d) The project with the least initial investment is best.
Answer: c) The project with the highest NPV should be chosen.
Explanation: For mutually exclusive projects, NPV is the best measure to determine which project will add the most value.
Question 11
What does it mean if the NPV of a project is zero?
a) The project should be rejected.
b) The project will generate no profit.
c) The project will break even in accounting terms.
d) The project’s cash inflows are exactly equal to its cash outflows.
Answer: d) The project’s cash inflows are exactly equal to its cash outflows.
Explanation: A zero NPV means the project will neither create nor destroy value, and the cash inflows are just enough to cover the costs.
Question 12
Scenario analysis is used to:
a) Measure the effect of changing one variable at a time.
b) Evaluate the different potential outcomes for a project.
c) Calculate the IRR of a project.
d) Determine the payback period.
Answer: b) Evaluate the different potential outcomes for a project.
Explanation: Scenario analysis assesses the impact of different variables on a project’s performance by modeling various scenarios.
Question 13
Sensitivity analysis is primarily used to:
a) Analyze a project’s cash flows over time.
b) Determine how changes in a single variable affect the NPV.
c) Simulate multiple project outcomes.
d) Calculate the break-even point for a project.
Answer: b) Determine how changes in a single variable affect the NPV.
Explanation: Sensitivity analysis focuses on how changes in key assumptions, like sales or costs, affect the overall project value.
Question 14
Which of the following cash flows should be included in the initial investment of a project?
a) Interest payments on debt.
b) Sunk costs.
c) The purchase of machinery.
d) Depreciation expenses.
Answer: c) The purchase of machinery.
Explanation: The purchase of machinery is part of the initial capital outlay required to start the project.
Question 15
The weighted average cost of capital (WACC) is used as:
a) A measure of a firm’s profitability.
b) A discount rate in capital budgeting.
c) A tool for tax planning.
d) An estimate of project cash flows.
Answer: b) A discount rate in capital budgeting.
Explanation: WACC represents the firm’s cost of capital and is used as a discount rate to evaluate investment projects.
Question 16
What does a higher beta coefficient indicate in the context of a capital asset pricing model (CAPM)?
a) Higher risk and higher expected returns.
b) Lower risk and lower expected returns.
c) Higher risk but lower expected returns.
d) Lower risk and higher expected returns.
Answer: a) Higher risk and higher expected returns.
Explanation: A higher beta means that the asset is more volatile compared to the market, resulting in higher expected returns to compensate for the risk.
Question 17
The IRR method assumes that the project’s cash inflows are reinvested at:
a) The WACC.
b) The IRR itself.
c) The risk-free rate.
d) The required rate of return.
Answer: b) The IRR itself.
Explanation: The IRR method assumes that future cash inflows are reinvested at the IRR, which can sometimes overstate the profitability of a project.
Question 18
Which of the following is an example of an opportunity cost in capital budgeting?
a) The cost of hiring new employees for a project.
b) The revenue foregone from using a warehouse for one project instead of another.
c) The cost of raw materials used in production.
d) The interest paid on project financing.
Answer: b) The revenue foregone from using a warehouse for one project instead of another.
Explanation: Opportunity costs represent the benefits lost when one alternative is chosen over another.
Question 19
Which one of the following is considered a major weakness of the payback period method?
a) It ignores the time value of money.
b) It is difficult to calculate.
c) It overestimates the project’s profitability.
d) It takes too long to reach a decision.
Answer: a) It ignores the time value of money.
Explanation: The payback period method does not account for the time value of money, making it less reliable for long-term projects.
Question 20
The concept of depreciation tax shield is best described as:
a) The reduction in taxable income due to depreciation expenses.
b) The elimination of taxes on depreciation expenses.
c) The total depreciation value of an asset.
d) The profit generated from the sale of a depreciated asset.
Answer: a) The reduction in taxable income due to depreciation expenses.
Explanation: Depreciation tax shield refers to the tax savings a firm realizes by deducting depreciation from its taxable income.