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web.groovymark@gmail.com
- December 17, 2024
Question 21
The discount rate that equates the NPV of an investment to zero is known as the:
a) Payback period.
b) Internal rate of return (IRR).
c) Profitability index (PI).
d) Modified internal rate of return (MIRR)
Answer: b) Internal rate of return (IRR).
Explanation: The IRR is the rate at which the NPV of the investment becomes zero, representing the break-even rate of return for the project.
Question 22
What is the key benefit of using the net present value (NPV) method in capital budgeting?
a) It is easy to calculate and understand.
b) It accounts for the time value of money.
c) It always provides the highest return.
d) It is preferred by all managers.
Answer: b) It accounts for the time value of money.
Explanation: NPV considers the time value of money by discounting future cash flows, making it a reliable method for evaluating project profitability.
Question 23
When using the discounted payback period method, what is the main limitation?
a) It does not consider cash flows after the payback period.
b) It ignores the project’s cost of capital.
c) It is difficult to calculate.
d) It is only applicable to projects with short durations.
Answer: a) It does not consider cash flows after the payback period.
Explanation: The discounted payback period focuses on the time needed to recover the investment, ignoring cash flows that occur after the payback period.
Question 24
What is a characteristic of mutually exclusive projects?
a) Both projects can be undertaken simultaneously.
b) Accepting one project means rejecting the other.
c) Both projects have similar IRR values.
d) One project’s cash flows depend on the success of the other.
Answer: b) Accepting one project means rejecting the other.
Explanation: Mutually exclusive projects require a choice between alternatives, where accepting one prevents the acceptance of the other.
Question 25
What is the main purpose of sensitivity analysis in project evaluation?
a) To test the impact of varying key variables on project outcomes.
b) To calculate the payback period of the project.
c) To estimate the profitability index (PI).
d) To determine the project’s exact NPV.
Answer: a) To test the impact of varying key variables on project outcomes.
Explanation: Sensitivity analysis helps to understand how changes in key assumptions (e.g., costs or revenues) affect the overall project performance.
Question 26
A project is expected to generate a positive NPV. What does this indicate?
a) The project is expected to lose money.
b) The project will exactly break even.
c) The project is expected to add value to the firm.
d) The project will not recover its initial investment.
Answer: c) The project is expected to add value to the firm.
Explanation: A positive NPV means the project’s discounted cash inflows exceed its costs, adding value to the firm.
Question 27
Which capital budgeting method calculates the expected percentage return on a project?
a) Payback period
b) Profitability index (PI)
c) Internal rate of return (IRR)
d) Net present value (NPV)
Answer: c) Internal rate of return (IRR)
Explanation: IRR calculates the expected percentage return on a project, representing the discount rate that results in an NPV of zero.
Question 28
When should a project be rejected according to the net present value (NPV) rule?
a) When the NPV is negative.
b) When the project has a low IRR.
c) When the payback period is short.
d) When the NPV is zero.
Answer: a) When the NPV is negative.
Explanation: A negative NPV indicates that the project's costs exceed its expected inflows, making it unprofitable and thus should be rejected.
Question 29
Which method is most suitable for evaluating projects with uncertain cash flows?
a) Payback period
b) Discounted payback period
c) Sensitivity analysis
d) Scenario analysis
Answer: d) Scenario analysis
Explanation: Scenario analysis evaluates different possible outcomes, providing a better understanding of the risks and uncertainties surrounding a project’s cash flows.
Question 30
What is the primary use of the modified internal rate of return (MIRR)
a) To calculate the profitability of projects without considering risk.
b) To eliminate the issue of multiple IRRs in non-conventional cash flows.
c) To ignore the cost of capital.
d) To calculate the project’s payback period.
Answer: b) To eliminate the issue of multiple IRRs in non-conventional cash flows.
Explanation: MIRR resolves the issue of multiple IRRs by assuming that cash inflows are reinvested at the firm’s cost of capital, making it a more reliable indicator.
Question 31
Which capital budgeting technique directly considers the cost of capital in its calculation?
a) Payback period
b) Profitability index (PI)
c) Accounting rate of return (ARR)
d) Net present value (NPV)
Answer: d) Net present value (NPV)
Explanation: NPV directly factors in the cost of capital by discounting future cash flows using the required rate of return or cost of capital.
Question 32
Which of the following is an example of a project’s sunk cost?
a) Initial investment in machinery
b) Research and development expenses from the past year
c) Future costs for maintenance
d) Salaries for new project staff
Answer: b) Research and development expenses from the past year
Explanation: A sunk cost refers to an expense that has already been incurred and cannot be recovered, such as past research and development costs.
Question 33
Which of the following measures the risk of a project not reaching its expected cash flows?
a) Sensitivity analysis
b) Payback period
c) Scenario analysis
d) Break-even analysis
Answer: a) Sensitivity analysis
Explanation: Sensitivity analysis measures how changes in key variables (e.g., sales, costs) impact the project's cash flows, helping to assess the project’s risk.
Question 34
What is the main advantage of using the payback period method?
a) It accounts for the time value of money.
b) It is easy to calculate and understand.
c) It provides the highest NPV.
d) It is used for complex projects.
Answer: b) It is easy to calculate and understand.
Explanation: The payback period method is simple and straightforward, making it useful for quickly evaluating projects, though it has limitations.
Question 35
What does a profitability index (PI) greater than 1 indicate?
a) The project is unprofitable.
b) The project should be rejected.
c) The project is expected to add value to the firm.
d) The project will break even.
Answer: c) The project is expected to add value to the firm.
Explanation: A PI greater than 1 means the present value of future cash flows exceeds the initial investment, suggesting that the project adds value.
Question 36
What is the primary limitation of the internal rate of return (IRR) method?
a) It ignores the time value of money.
b) It requires complex financial software.
c) It assumes cash inflows are reinvested at the IRR, which may not be realistic.
d) It cannot be used for projects with positive NPV.
Answer: c) It assumes cash inflows are reinvested at the IRR, which may not be realistic.
Explanation: IRR assumes that all cash inflows are reinvested at the IRR, which may not always reflect real-world investment conditions.
Question 37
A project has multiple IRRs. Which method should be used to evaluate it instead?
a) Payback period
b) Net present value (NPV)
c) Profitability index (PI)
d) Accounting rate of return (ARR)
Answer: b) Net present value (NPV)
Explanation: NPV is preferred in cases with multiple IRRs because it provides a clear decision criterion without the issue of multiple rates of return.
Question 38
Which factor is most critical in determining a project’s payback period?
a) The project’s initial investment
b) The project’s discount rate
c) The project’s future cash inflows
d) The project’s salvage value
Answer: c) The project’s future cash inflows
Explanation: The payback period is determined by how quickly the project’s future cash inflows can recover the initial investment.
Question 39
What is a common criticism of the accounting rate of return (ARR) method?
a) It is difficult to calculate.
b) It ignores the time value of money.
c) It overestimates future cash inflows.
d) It is used for small projects only.
Answer: b) It ignores the time value of money.
Explanation: ARR is criticized because it is based on accounting profits rather than cash flows and does not account for the time value of money.
Question 40
A project with positive cash flows and a payback period shorter than its life should be:
a) Rejected.
b) Accepted.
c) Evaluated based on the profitability index (PI).
d) Evaluated based on sensitivity analysis.
Answer: b) Accepted.
Explanation: A project with positive cash flows and a payback period shorter than its life is generally considered viable and should be accepted.
