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web.groovymark@gmail.com
- December 14, 2024
Question 01
What is the main disadvantage of the payback method?
a) It ignores the risk of the project.
b) It ignores the time value of money.
c) It requires complex calculations.
d) It overestimates the project’s value.
Answer: b) It ignores the time value of money.
Explanation: The payback method does not account for the time value of money, making it less reliable for long-term projects.
Question 02
Which method best determines a project’s profitability by discounting its cash flows?
a) Internal rate of return (IRR)
b) Payback period
c) Net present value (NPV)
d) Profitability index (PI)
Answer: c) Net present value (NPV)
Explanation: NPV discounts future cash flows to their present value and compares them to the project’s initial investment to determine profitability.
Question 03
Which of the following is a limitation of using the profitability index (PI)?
a) It does not consider the project’s scale.
b) It cannot handle cash flow changes.
c) It is difficult to calculate.
d) It overestimates the project’s payback period.
Answer: a) It does not consider the project’s scale.
Explanation: PI is useful for ranking projects but does not account for the scale of the investment, which can skew decisions for large projects.
Question 04
The internal rate of return (IRR) is used to determine:
a) The discount rate that makes the NPV zero.
b) The payback period of the project.
c) The project’s overall cash flows.
d) The time it takes to recover the initial investment.
Answer: a) The discount rate that makes the NPV zero.
Explanation: IRR is the rate at which the present value of cash inflows equals the initial investment, resulting in an NPV of zero.
Question 05
What is one key advantage of the discounted payback period method over the regular payback period?
a) It does not require cash flow estimates.
b) It considers the time value of money.
c) It is easier to calculate.
d) It ignores future cash flows.
Answer: b) It considers the time value of money.
Explanation: Unlike the regular payback period, the discounted payback period accounts for the time value of money by discounting cash flows.
Question 06
Which of the following is a feature of a contingent project?
a) It has higher initial costs than other projects.
b) Its acceptance depends on the acceptance of another project.
c) It generates higher cash inflows than other projects.
d) It has lower financial risk than independent projects.
Answer: b) Its acceptance depends on the acceptance of another project.
Explanation: A contingent project’s viability depends on the success or acceptance of another project.
Question 07
What does the term “capital rationing” refer to?
a) Limiting the number of projects a firm undertakes due to budget constraints.
b) Issuing more equity to finance projects.
c) Borrowing more funds to finance all available projects.
d) Reducing the cost of capital for each project.
Answer: a) Limiting the number of projects a firm undertakes due to budget constraints.
Explanation: Capital rationing occurs when a firm cannot finance all positive NPV projects due to limited capital.
Question 08
Which of the following describes a project with mutually exclusive alternatives?
a) One project’s acceptance means the other must be rejected.
b) Both projects can be accepted independently.
c) One project’s cash flows depend on the other project.
d) Both projects can be delayed for future consideration.
Answer: a) One project’s acceptance means the other must be rejected.
Explanation: Mutually exclusive projects require choosing one project, as accepting one excludes the possibility of accepting the other.
Question 09
What is the key purpose of using the weighted average cost of capital (WACC) in capital budgeting?
a) To determine the highest discount rate available.
b) To account for the firm’s cost of debt and equity in evaluating projects.
c) To predict the maximum potential cash flows of a project.
d) To estimate the payback period of a project.
Answer: b) To account for the firm’s cost of debt and equity in evaluating projects.
Explanation: WACC represents the firm’s overall cost of capital, including both debt and equity, and is used to discount future cash flows.
Question 10
What is the crossover rate between two projects?
a) The rate at which the IRR of both projects becomes negative.
b) The discount rate at which both projects have the same NPV.
c) The time it takes for both projects to break even.
d) The payback period where both projects recover their initial investments.
Answer: b) The discount rate at which both projects have the same NPV.
Explanation: The crossover rate is the discount rate at which the NPVs of two projects are equal, helping in decision-making for mutually exclusive projects.
Question 11
What does it mean if a project has a net present value (NPV) of zero?
a) The project is highly profitable.
b) The project’s cash inflows exactly equal the initial investment in today’s terms.
c) The project should be rejected.
d) The project’s IRR is less than the required return.
Answer: b) The project’s cash inflows exactly equal the initial investment in today’s terms.
Explanation: A zero NPV indicates that the project generates enough return to cover its initial investment but does not add extra value.
Question 12
Which of the following is an incremental cash flow?
a) Sunk costs related to the project.
b) Interest expenses.
c) Cash inflows directly resulting from the project.
d) Fixed costs unrelated to the project.
Answer: c) Cash inflows directly resulting from the project.
Explanation: Incremental cash flows are the additional cash flows generated as a direct result of the project’s operations.
Question 13
A project has a conventional cash flow pattern if:
a) It has an initial outflow followed by positive inflows.
b) It has cash inflows that increase every year.
c) It has more than one change in the sign of the cash flows.
d) It requires continuous reinvestment throughout the project.
Answer: a) It has an initial outflow followed by positive inflows.
Explanation: Conventional cash flows start with a negative cash outflow (initial investment) followed by a series of positive inflows.
Question 14
What is a key disadvantage of the internal rate of return (IRR) method?
a) It ignores the time value of money.
b) It can lead to multiple IRRs for non-conventional projects.
c) It requires extensive cash flow data.
d) It always gives the same result as NPV.
Answer: b) It can lead to multiple IRRs for non-conventional projects.
Explanation: Non-conventional projects with changing signs in cash flows can produce multiple IRRs, making the method less reliable in such cases.
Question 15
What is the main purpose of scenario analysis in project evaluation?
a) To calculate the exact NPV of a project.
b) To identify the best and worst possible outcomes for the project.
c) To determine the project’s payback period.
d) To estimate the profitability index of a project.
Answer: b) To identify the best and worst possible outcomes for the project.
Explanation: Scenario analysis evaluates the potential outcomes under different conditions, helping to assess project risks.
Question 16
Which of the following best describes a project with positive NPV?
a) The project generates more cash inflows than the initial investment in present value terms.
b) The project has a payback period longer than its life.
c) The project’s IRR is below the cost of capital.
d) The project recovers its investment within the first year.
Answer: a) The project generates more cash inflows than the initial investment in present value terms.
Explanation: A positive NPV means that the project adds value to the firm by generating more cash inflows than the initial investment in present value terms.
Question 17
Which of the following is a weakness of the profitability index (PI) method?
a) It requires the use of complex financial models.
b) It does not account for the time value of money.
c) It does not compare the absolute size of different projects.
d) It ignores cash inflows occurring after the payback period.
Answer: c) It does not compare the absolute size of different projects.
Explanation: PI measures value relative to the investment but does not account for the absolute size of the project, potentially leading to misjudgment of large projects.
Question 18
In capital budgeting, an independent project is best described as one that:
a) Competes with other projects for the same resources.
b) Can be evaluated without regard to other projects.
c) Has no financial risk.
d) Has only one IRR.
Answer: b) Can be evaluated without regard to other projects.
Explanation: Independent projects do not affect or compete with other projects, allowing for separate evaluation and acceptance.
Question 19
Which method is preferred for analyzing a project with multiple rates of return?
a) Payback period
b) Net present value (NPV)
c) Internal rate of return (IRR)
d) Profitability index (PI)
Answer: b) Net present value (NPV)
Explanation: NPV is preferred because it provides a single value, avoiding the confusion caused by multiple IRRs.
Question 20
The modified internal rate of return (MIRR) adjusts for:
a) Changes in the initial investment.
b) Variations in the firm’s WACC.
c) Multiple IRRs by reinvesting at the firm’s cost of capital.
d) Fluctuations in cash inflows during the project’s life.
Answer: c) Multiple IRRs by reinvesting at the firm’s cost of capital.
Explanation: MIRR solves the issue of multiple IRRs by assuming reinvestment at the firm’s WACC instead of at the project’s IRR.
