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web.groovymark@gmail.com
- December 17, 2024
Question 21
What is the meaning of “discounted payback period”?
a) The time it takes to recover the initial investment without considering the time value of money.
b) The time it takes to recover the initial investment with the time value of money considered.
c) The time it takes for all future cash flows to equal the initial investment.
d) The time it takes for cash inflows to exceed cash outflows.
Answer: b) The time it takes to recover the initial investment with the time value of money considered.
Explanation: The discounted payback period accounts for the time value of money by discounting future cash flows to determine when the initial investment is recovered.
Question 22
What does a negative NPV indicate for a project?
a) The project will break even.
b) The project will lose value for the company.
c) The project will increase shareholder value.
d) The project has an IRR higher than the required return.
Answer: b) The project will lose value for the company.
Explanation: A negative NPV means the project's cash inflows are insufficient to cover the initial investment and required return, resulting in a loss of value.
Question 23
Which project evaluation method accounts for the time value of money?
a) Payback period
b) Internal rate of return (IRR)
c) Average accounting return (AAR)
d) Profitability index (PI)
Answer: b) Internal rate of return (IRR)
Explanation: IRR takes into account the time value of money by calculating the discount rate that makes the NPV of future cash flows equal to zero.
Question 24
What is a major weakness of the internal rate of return (IRR) method?
a) It ignores the project’s cash inflows.
b) It assumes cash flows are reinvested at the IRR.
c) It is difficult to interpret.
d) It is not commonly used in capital budgeting.
Answer: b) It assumes cash flows are reinvested at the IRR.
Explanation: IRR assumes that future cash flows are reinvested at the IRR, which may not always be realistic, especially for large projects.
Question 25
Which of the following methods does not provide a direct measure of profitability?
a) Net present value (NPV)
b) Internal rate of return (IRR)
c) Payback period
d) Profitability index (PI)
Answer: c) Payback period
Explanation: The payback period measures how long it takes to recover the initial investment but does not measure profitability or the overall value of the project.
Question 26
What is the main advantage of using the NPV method for project evaluation?
a) It is the easiest method to calculate.
b) It considers all future cash flows and the time value of money.
c) It does not require an estimate of the cost of capital.
d) It is a simple rule that managers can easily understand.
Answer: b) It considers all future cash flows and the time value of money.
Explanation: NPV provides a comprehensive evaluation of a project’s value by considering the time value of money and all future cash flows.
Question 27
In capital budgeting, what is the purpose of using a hurdle rate?
a) To determine the minimum required payback period.
b) To set a maximum limit for initial project investment.
c) To establish the minimum acceptable return on investment.
d) To calculate a project’s future cash inflows.
Answer: c) To establish the minimum acceptable return on investment.
Explanation: A hurdle rate is the minimum return a company requires before it will consider investing in a project.
Question 28
What is a key assumption of the NPV method?
a) All projects have the same level of risk.
b) Cash flows are reinvested at the cost of capital.
c) The payback period is irrelevant.
d) Interest rates are fixed throughout the project’s life.
Answer: b) Cash flows are reinvested at the cost of capital.
Explanation: The NPV method assumes that cash flows generated by the project are reinvested at the firm’s cost of capital.
Question 29
Which statement is correct regarding mutually exclusive projects?
a) Only one project can be accepted, even if multiple have positive NPVs.
b) All projects are selected based on IRR.
c) Both projects are accepted if they have positive NPVs.
d) The project with the longest payback period is selected.
Answer: a) Only one project can be accepted, even if multiple have positive NPVs.
Explanation: For mutually exclusive projects, only one project can be chosen, even if multiple projects have positive NPVs.
Question 30
What is the main difference between the NPV and the profitability index (PI) methods?
a) NPV provides a percentage return, while PI provides a dollar value.
b) PI uses the cost of capital as the discount rate, while NPV does not.
c) PI is a relative measure, while NPV is an absolute measure.
d) NPV and PI are identical methods of evaluation.
Answer: c) PI is a relative measure, while NPV is an absolute measure.
Explanation: PI expresses the project’s value relative to its cost, whereas NPV provides an absolute measure of the project’s value.
Question 31
Which of the following capital budgeting methods focuses on accounting profits rather than cash flows?
a) Net present value (NPV)
b) Internal rate of return (IRR)
c) Payback period
d) Average accounting return (AAR)
Answer: d) Average accounting return (AAR)
Explanation: AAR uses accounting profits rather than cash flows, making it less accurate for evaluating a project’s value compared to NPV or IRR.
Question 32
Which of the following methods may be biased toward shorter-term projects?
a) Payback period
b) Net present value (NPV)
c) Internal rate of return (IRR)
d) Profitability index (PI)
Answer: a) Payback period
Explanation: The payback period focuses on recovering the initial investment as quickly as possible, favoring short-term projects over long-term ones.
Question 33
When a firm is facing capital rationing, which project evaluation method is most suitable?
a) Payback period
b) Profitability index (PI)
c) Internal rate of return (IRR)
d) Net present value (NPV)
Answer: b) Profitability index (PI)
Explanation: The profitability index is useful in capital rationing because it allows the firm to prioritize projects based on their value-to-cost ratio.
Question 34
Which of the following would be considered a “conventional” project in capital budgeting?
a) A project that alternates between inflows and outflows.
b) A project with an initial outlay followed by only inflows.
c) A project with negative NPV.
d) A project with positive cash flows only in the final year.
Answer: b) A project with an initial outlay followed by only inflows.
Explanation: A conventional project involves an initial outflow (investment) followed by positive cash inflows in subsequent periods.
Question 35
If a project’s IRR is higher than the cost of capital, what should the firm do?
a) Reject the project.
b) Delay the project until the IRR decreases.
c) Accept the project.
d) Ignore the project’s cash inflows.
Answer: c) Accept the project.
Explanation: If the IRR exceeds the cost of capital, the project is expected to generate a return greater than the firm’s required rate, making it acceptable.
Question 36
Which of the following best describes soft rationing?
a) The firm does not have enough capital to finance all profitable projects.
b) The firm intentionally limits its capital budget.
c) The firm has access to unlimited funding.
d) The firm is only interested in short-term projects.
Answer: b) The firm intentionally limits its capital budget.
Explanation: Soft rationing occurs when a firm chooses to limit its capital expenditures, even though it may have access to more funds.
Question 37
What does the term “equivalent annual cost” refer to in project evaluation?
a) The initial cost of the project.
b) The project’s annual operating cost.
c) The annualized cost of a project over its lifespan.
d) The project’s average annual profit.
Answer: c) The annualized cost of a project over its lifespan.
Explanation: The equivalent annual cost spreads a project’s total costs over its useful life, making it easier to compare projects with different durations.
Question 38
Which of the following is a disadvantage of the profitability index (PI)?
a) It ignores the time value of money.
b) It does not account for the size of the project.
c) It cannot be used for capital rationing decisions.
d) It always provides negative results for projects with long payback periods.
Answer: b) It does not account for the size of the project.
Explanation: The profitability index does not consider the scale of the investment, making it less reliable for comparing projects of different sizes.
Question 39
In the case of multiple IRRs, which method should be used instead?
a) Payback period
b) Net present value (NPV)
c) Average accounting return (AAR)
d) Discounted payback period
Answer: b) Net present value (NPV)
Explanation: NPV should be used in cases where multiple IRRs exist, as it provides a more reliable evaluation of the project’s value.
Question 40
When comparing two mutually exclusive projects, which criterion is most reliable for decision-making?
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 the most reliable method for comparing mutually exclusive projects because it directly measures the value added by each project.
