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web.groovymark@gmail.com
- December 14, 2024
Question 01
What is the main disadvantage of using the payback period method for project evaluation?
a) It is too complex to calculate.
b) It ignores cash flows after the payback period.
c) It does not require a discount rate.
d) It focuses too much on long-term profitability.
Answer: b) It ignores cash flows after the payback period.
Explanation: The payback period method only considers the time it takes to recover the initial investment and ignores any cash flows generated after this period.
Question 02
What is the profitability index (PI) if the net present value (NPV) of a project is $20,000 and the initial investment is $100,000?
a) 0.80
b) 1.20
c) 1.00
d) 1.50
Answer: b) 1.20
Explanation: Profitability index (PI) is calculated by dividing NPV by the initial investment. In this case, $20,000 / $100,000 = 1.20.
Question 03
Which of the following is a key assumption of the internal rate of return (IRR) method?
a) Future cash flows are reinvested at the cost of capital.
b) Future cash flows are reinvested at the IRR.
c) There are no future cash flows.
d) The project has zero risk.
Answer: b) Future cash flows are reinvested at the IRR.
Explanation: The IRR method assumes that future cash flows can be reinvested at the same rate of return as the project's internal rate of return.
Question 04
What is the role of the weighted average cost of capital (WACC) in capital budgeting?
a) It determines the payback period.
b) It is used as the discount rate in NPV calculations.
c) It eliminates the need for calculating NPV.
d) It only applies to short-term projects.
Answer: b) It is used as the discount rate in NPV calculations.
Explanation: WACC represents the firm’s cost of capital and is used as the discount rate when calculating NPV to assess the project's value.
Question 05
Which of the following best describes capital rationing?
a) Allocating unlimited funds to all profitable projects.
b) Limiting the number of projects a firm can undertake due to budget constraints.
c) Selecting projects based on their profitability index only.
d) Using NPV as the sole project selection criterion.
Answer: b) Limiting the number of projects a firm can undertake due to budget constraints.
Explanation: Capital rationing involves restricting the number of projects the firm can fund, often because of limited capital resources.
Question 06
What is the purpose of the break-even analysis in project evaluation?
a) To calculate the profitability of multiple projects.
b) To determine the point where the project generates enough cash to cover its costs.
c) To evaluate the time needed to recover the initial investment.
d) To assess the overall risk of the project.
Answer: b) To determine the point where the project generates enough cash to cover its costs.
Explanation: Break-even analysis helps determine the sales level or output at which total revenue equals total costs, indicating no profit or loss.
Question 07
What does a profitability index (PI) greater than 1 indicate?
a) The project is unprofitable.
b) The project has a negative NPV.
c) The project is expected to add value to the firm.
d) The project is likely to have multiple IRRs.
Answer: c) The project is expected to add value to the firm.
Explanation: A PI greater than 1 means that the project’s discounted future cash flows exceed the initial investment, indicating that it adds value.
Question 08
When evaluating mutually exclusive projects, which method is generally preferred?
a) Payback period
b) Profitability index (PI)
c) Net present value (NPV)
d) Internal rate of return (IRR)
Answer: c) Net present value (NPV)
Explanation: NPV is generally preferred for evaluating mutually exclusive projects because it provides a direct measure of the added value to the firm.
Question 09
Which of the following is an advantage of using the payback period method?
a) It incorporates the time value of money.
b) It focuses on liquidity and risk.
c) It gives a precise estimate of profitability.
d) It is the most accurate measure of project success.
Answer: b) It focuses on liquidity and risk.
Explanation: The payback period is useful for focusing on how quickly a project can recover its initial investment, making it suitable for liquidity and risk considerations.
Question 10
A project with non-conventional cash flows may result in:
a) A negative NPV.
b) Multiple IRRs.
c) A positive payback period.
d) A shorter discounted payback period.
Answer: b) Multiple IRRs.
Explanation: Non-conventional cash flows, where cash inflows and outflows alternate, can result in multiple IRRs, making the IRR method less reliable.
Question 11
What does the term “stand-alone principle” refer to in capital budgeting?
a) Evaluating a project as if it were an independent entity.
b) Comparing a project to other projects in the same industry.
c) Using the weighted average cost of capital for decision-making.
d) Focusing on long-term project financing.
Answer: a) Evaluating a project as if it were an independent entity.
Explanation: The stand-alone principle treats each project as a separate entity, focusing only on the project’s cash flows for evaluation.
Question 12
What is a primary benefit of using sensitivity analysis in project evaluation?
a) It provides a precise estimate of NPV.
b) It identifies which variables have the most impact on project outcomes.
c) It eliminates all uncertainty in the decision-making process.
d) It is simpler to use than scenario analysis.
Answer: b) It identifies which variables have the most impact on project outcomes.
Explanation: Sensitivity analysis helps assess how changes in key variables (e.g., costs or revenues) affect the project’s profitability or risk.
Question 13
Which of the following describes the concept of opportunity cost in capital budgeting?
a) The cost of acquiring new assets.
b) The potential return from an alternative investment.
c) The discount rate used in NPV calculations.
d) The expected rate of inflation.
Answer: b) The potential return from an alternative investment.
Explanation: Opportunity cost refers to the potential benefits that are forfeited when choosing one investment over another.
Question 14
In capital budgeting, what does a project’s beta measure?
a) The project’s profitability.
b) The project’s unique risk.
c) The project’s systematic risk.
d) The project’s future cash flows.
Answer: c) The project’s systematic risk.
Explanation: Beta measures a project's systematic risk, indicating how sensitive the project is to market movements.
Question 15
Which of the following is true regarding projects with a positive NPV?
a) The project is guaranteed to succeed.
b) The project is expected to earn a return greater than the cost of capital.
c) The project will result in a shorter payback period.
d) The project will always have a positive IRR.
Answer: b) The project is expected to earn a return greater than the cost of capital.
Explanation: A positive NPV indicates that the project’s return exceeds the cost of capital, making it a value-adding investment.
Question 16
What does the payback period fail to consider?
a) The project’s initial investment.
b) The project’s future cash inflows.
c) The time value of money.
d) The project’s profitability.
Answer: c) The time value of money.
Explanation: The payback period focuses solely on recovering the initial investment without considering the discounted value of future cash flows.
Question 17
When using the NPV method, how is a project’s cost of capital typically defined?
a) The expected rate of return for stockholders.
b) The discount rate used to evaluate future cash flows.
c) The rate of inflation.
d) The internal rate of return (IRR).
Answer: b) The discount rate used to evaluate future cash flows.
Explanation: The cost of capital serves as the discount rate in NPV calculations, representing the minimum required return to make the project viable.
Question 18
What is the goal of capital budgeting?
a) To manage short-term cash flow needs.
b) To allocate funds to profitable long-term investments.
c) To reduce project risk to zero.
d) To calculate the optimal tax rate for the company.
Answer: b) To allocate funds to profitable long-term investments.
Explanation: Capital budgeting is focused on identifying and investing in long-term projects that are expected to generate positive returns for the company.
Question 19
What is the main limitation of scenario analysis?
a) It ignores changes in project risk.
b) It is difficult to calculate the payback period.
c) It only considers the best-case scenario.
d) It relies on assumptions that may not reflect real-world outcomes.
Answer: d) It relies on assumptions that may not reflect real-world outcomes.
Explanation: Scenario analysis requires assumptions about different potential outcomes, but these assumptions may not always accurately reflect reality.
Question 20
What is the primary difference between IRR and NPV?
a) IRR is easier to calculate than NPV.
b) NPV focuses on profitability, while IRR focuses on liquidity.
c) NPV uses the cost of capital, while IRR provides the break-even rate.
d) IRR is preferred for all projects, while NPV is rarely used.
Answer: c) NPV uses the cost of capital, while IRR provides the break-even rate.
Explanation: NPV uses the cost of capital as the discount rate, whereas IRR identifies the rate at which the project’s NPV is zero (the break-even rate).
