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web.groovymark@gmail.com
- December 14, 2024
Question 21
What happens when a project’s NPV is zero?
a) The project breaks even in accounting terms.
b) The project’s IRR is below the required return.
c) The project is expected to generate a return exactly equal to the cost of capital.
d) The project’s payback period equals the project’s life.
Answer: c) The project is expected to generate a return exactly equal to the cost of capital.
Explanation: A zero NPV means the project will generate a return that matches the cost of capital, creating no additional value.
Question 22
A project’s internal rate of return (IRR) is best defined as:
a) The discount rate that makes the project’s NPV zero.
b) The rate of return that exceeds the required return.
c) The interest rate the company expects to earn on a project.
d) The cash flow rate that equals the initial investment.
Answer: a) The discount rate that makes the project’s NPV zero.
Explanation: IRR is the rate that equates the present value of a project’s cash inflows with the present value of its cash outflows.
Question 23
What does a profitability index (PI) greater than 1 indicate?
a) The project’s NPV is negative.
b) The project will add value to the firm.
c) The project’s cash inflows are less than its cash outflows.
d) The project’s payback period is shorter than its life.
Answer: b) The project will add value to the firm.
Explanation: A PI greater than 1 means the project generates more value than the initial investment, making it worthwhile to pursue.
Question 24
When evaluating two mutually exclusive projects, the best criterion for decision-making is:
a) The internal rate of return.
b) The discounted payback period.
c) The net present value.
d) The profitability index.
Answer: c) The net present value.
Explanation: NPV is the most reliable method for choosing between mutually exclusive projects, as it measures total value creation.
Question 25
Which one of the following is not considered a part of the project’s initial investment?
a) Purchase price of equipment.
b) Installation costs.
c) Sunk costs.
d) Working capital requirements.
Answer: c) Sunk costs.
Explanation: Sunk costs are irrelevant to capital budgeting decisions because they have already been incurred and cannot be recovered.
Question 26
The payback period rule can lead to incorrect decisions because:
a) It ignores the cash flows beyond the payback period.
b) It considers the time value of money.
c) It requires a discount rate to be specified.
d) It accounts for all cash flows in the project’s life.
Answer: a) It ignores the cash flows beyond the payback period.
Explanation: The payback period does not consider cash flows occurring after the initial investment is recovered, which can lead to suboptimal decisions.
Question 27
When a firm uses the internal rate of return (IRR) method, it assumes that:
a) Cash flows are reinvested at the cost of capital.
b) Cash flows are reinvested at the IRR.
c) The project has no risk.
d) The project will not generate any losses.
Answer: b) Cash flows are reinvested at the IRR.
Explanation: The IRR method assumes that project cash flows can be reinvested at the same internal rate of return.
Question 28
What does the crossover point represent when comparing two projects?
a) The point where both projects have the same NPV.
b) The point where one project becomes unprofitable.
c) The time when the payback periods of both projects are equal.
d) The rate at which the profitability index of both projects is equal.
Answer: a) The point where both projects have the same NPV.
Explanation: The crossover point is the discount rate at which the NPVs of two projects are equal, helping in comparing mutually exclusive projects.
Question 29
The concept of soft rationing refers to:
a) A company not having enough capital to fund all positive NPV projects.
b) A temporary internal limit on capital spending.
c) A shortage of investment opportunities in the market.
d) The inability to raise debt due to high leverage.
Answer: b) A temporary internal limit on capital spending.
Explanation: Soft rationing occurs when firms impose limits on capital expenditures internally, even if external financing is available.
Question 30
The net working capital in a project’s cash flow analysis includes:
a) Only the initial investment in long-term assets.
b) Changes in current assets and liabilities.
c) Depreciation of fixed assets.
d) Interest expenses on the project.
Answer: b) Changes in current assets and liabilities.
Explanation: Net working capital represents changes in current assets and liabilities that support the project’s operations.
Question 31
Which of the following is a limitation of the internal rate of return (IRR) method?
a) It is difficult to calculate without a financial calculator.
b) It assumes cash flows are reinvested at the IRR.
c) It does not consider the profitability index.
d) It always leads to an inaccurate NPV.
Answer: b) It assumes cash flows are reinvested at the IRR.
Explanation: One limitation of IRR is that it assumes all intermediate cash flows are reinvested at the project’s IRR, which may not be realistic.
Question 32
In project analysis, the stand-alone principle assumes that:
a) A project’s cash flows are analyzed separately from the rest of the firm.
b) The project will operate independently of the company.
c) The project will be sold after completion.
d) The project will not generate any external costs.
Answer: a) A project’s cash flows are analyzed separately from the rest of the firm.
Explanation: The stand-alone principle evaluates the project on its own merits, disregarding the firm’s other assets or liabilities.
Question 33
What is the relationship between the discount rate and the NPV of a project?
a) As the discount rate increases, NPV increases.
b) As the discount rate increases, NPV decreases.
c) NPV is not affected by changes in the discount rate.
d) As the discount rate increases, NPV remains constant.
Answer: b) As the discount rate increases, NPV decreases.
Explanation: A higher discount rate reduces the present value of future cash flows, leading to a lower NPV.
Question 34
The internal rate of return (IRR) method can result in multiple rates of return if:
a) A project has uneven cash flows.
b) A project has conventional cash flows.
c) A project has cash flows that change sign more than once.
d) The project’s NPV is positive.
Answer: c) A project has cash flows that change sign more than once.
Explanation: When a project has cash flows that change from positive to negative more than once, it can result in multiple IRRs.
Question 35
Which of the following is a potential problem with using the profitability index (PI) method?
a) It does not consider the project’s risk.
b) It cannot be used for mutually exclusive projects.
c) It ignores cash flows occurring after the payback period.
d) It is more difficult to compute than NPV.
Answer: b) It cannot be used for mutually exclusive projects.
Explanation: The PI method is not suitable for mutually exclusive projects because it ranks projects based on relative rather than absolute value.
Question 36
What does the term “capital rationing” refer to in capital budgeting?
a) Setting a limit on the amount of debt a company can incur.
b) The firm has more projects than it can finance.
c) The firm is unable to secure financing from external sources.
d) The company rejects all projects with positive NPV.
Answer: b) The firm has more projects than it can finance.
Explanation: Capital rationing occurs when a firm has a limited budget and cannot finance all positive NPV projects.
Question 37
A project’s payback period measures:
a) The time required for the project’s cash inflows to cover its initial investment.
b) The overall profitability of a project.
c) The time it takes for the project’s NPV to become positive.
d) The total cash inflows over the project’s life.
Answer: a) The time required for the project’s cash inflows to cover its initial investment.
Explanation: The payback period measures how long it takes to recover the initial investment from the project’s cash inflows.
Question 38
What is the primary disadvantage of the payback period method?
a) It ignores the time value of money.
b) It is difficult to calculate.
c) It requires knowing the cost of capital.
d) It does not provide information on project liquidity.
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 evaluating long-term projects.
Question 39
Which of the following is a disadvantage of using the discounted payback period method?
a) It does not account for the time value of money.
b) It excludes cash flows occurring after the payback period.
c) It is difficult to calculate for short-term projects.
d) It cannot be used when cash flows vary.
Answer: b) It excludes cash flows occurring after the payback period.
Explanation: The discounted payback period only considers cash flows up to the point where the initial investment is recovered, ignoring subsequent cash flows.
Question 40
The weighted average cost of capital (WACC) is used in NPV calculations to:
a) Measure the cost of the project.
b) Account for project risk.
c) Discount future cash flows to the present.
d) Calculate the project’s profitability index.
Answer: c) Discount future cash flows to the present.
Explanation: WACC is used to discount a project’s future cash flows to their present value, providing an accurate assessment of its value.
