1. The "Net Present Value" (NPV) method assumes that intermediate cash flows are reinvested at:
The Market Rate of Interest.
The Cost of Capital (Discount Rate).
The Internal Rate of Return (IRR).
The Risk-Free Rate.
Explanation:
A key assumption of NPV is that cash flows generated during the project life are reinvested at the firm's Cost of Capital (Required Rate of Return), which is considered more realistic than the IRR assumption.
2. If the Net Present Value (NPV) of a project is ZERO, then the Internal Rate of Return (IRR) is:
Higher than the Cost of Capital.
Equal to the Cost of Capital.
Zero.
Lower than the Cost of Capital.
Explanation:
IRR is defined as the discount rate at which NPV is zero. If NPV calculated at the cost of capital is zero, then the IRR must be exactly equal to that cost of capital.
3. A major limitation of the "Payback Period" method is that it:
Is difficult to calculate.
Ignores the initial cost.
Cannot be used for small projects.
Ignores cash flows occurring after the payback period.
Explanation:
Payback period only focuses on how quickly the initial investment is recovered. It ignores profitability (total cash flows) and the Time Value of Money (unless discounted payback is used).
4. The "Discounted Payback Period" will always be ______ than the simple "Payback Period" for the same project (assuming positive discount rate).
Longer
Shorter
Unrelated
Equal
Explanation:
Because future cash flows are discounted (reduced in value), it takes more time (more years) to recover the initial investment in present value terms compared to nominal terms.
5. A project is acceptable based on the "Profitability Index" (PI) method if:
Explanation:
PI = PV of Cash Inflows / Initial Investment. If PI > 1, it means the project generates more value than it costs (NPV is positive), so it should be accepted.
6. "Sensitivity Analysis" in capital budgeting involves:
Ignoring risk completely.
Using only the payback method.
Calculating NPV using a fixed set of assumptions.
Changing one key variable at a time (e.g., Sales, Cost) to see its impact on NPV.
Explanation:
Sensitivity Analysis helps identify which variables (like sales price or raw material cost) the project is most sensitive to, indicating where the risk lies.
7. When evaluating mutually exclusive projects, if NPV and IRR give conflicting rankings, which method should be preferred?
IRR
Accounting Rate of Return
Payback Period
NPV
Explanation:
NPV is preferred because it measures the absolute addition to shareholder wealth and uses a realistic reinvestment rate (Cost of Capital), whereas IRR assumes reinvestment at the IRR itself, which may be unrealistic.
8. The process of calculating the Present Value of future cash flows is known as:
Inflation adjustment
Discounting
Compounding
Amortization
Explanation:
Discounting is the reverse of compounding. It determines what a future amount is worth today, given a specific interest rate.
9. The "Accounting Rate of Return" (ARR) method uses:
Cash Flows.
Gross Profit.
Accounting Profit (Net Profit after Tax).
Sales Revenue.
Explanation:
Unlike other methods (NPV, IRR, Payback) which use Cash Flows, ARR uses Accounting Profit from the P&L account.
10. Which method allows ranking of projects with different investment outlays?
Payback Period
ARR
Profitability Index (PI)
NPV
Explanation:
NPV gives an absolute value which favors larger projects. PI (Benefit-Cost Ratio) gives a relative measure (Value per rupee invested), making it better for ranking projects of different sizes.
11. The "Modified Internal Rate of Return" (MIRR) addresses which major flaw of the standard IRR method?
It ignores the initial investment.
It ignores the time value of money.
It assumes reinvestment of cash flows at the project's IRR.
It cannot be calculated for long projects.
Explanation:
Standard IRR assumes cash flows are reinvested at the IRR rate (often unrealistic). MIRR assumes reinvestment at the Cost of Capital (WACC), providing a more accurate picture of profitability.
12. The "Risk-Adjusted Discount Rate" (RADR) method accounts for risk by:
Increasing the discount rate for riskier projects.
Reducing the initial investment.
Increasing the life of the project.
Reducing the cash flows.
Explanation:
Under RADR, a higher discount rate (Risk-Free Rate + Risk Premium) is used for riskier projects, which lowers the Present Value of future inflows, making the acceptance criteria stricter.
13. In Capital Budgeting, "Real Options" refer to:
Options traded on the stock exchange.
Fixed obligations.
The option to buy shares.
Managerial flexibility to alter decisions (expand, abandon, delay) regarding a project as uncertainty unfolds.
Explanation:
Traditional NPV ignores future flexibility. Real Options approach values the ability to change course (e.g., abandoning a failing project early), adding value to the investment.
14. In the "Certainty Equivalent" (CE) method of risk analysis:
The cash flows are adjusted to risk-free equivalents and discounted at the risk-free rate.
The discount rate is adjusted for risk.
The payback period is extended.
Cash flows are ignored.
Explanation:
Instead of adjusting the rate (RADR), CE adjusts the numerator (Cash Flows) by multiplying uncertain flows with a CE coefficient (0 to 1) to get certain flows, then discounts them at the risk-free rate.
15. In a "Replacement Decision" (replacing old machine with new), the relevant cash flows are:
Total cash flows of the new machine.
Total cash flows of the old machine.
Incremental (Differential) cash flows between the new and old machine.
Sunk costs of the old machine.
Explanation:
Decision making focuses on "what changes". Only the extra cash inflow or cost saving generated by the new machine over the old one is relevant.
16. A "Decision Tree Analysis" is most useful in capital budgeting when:
Decisions are sequential, and future decisions depend on the outcome of present decisions.
The discount rate is unknown.
The project has a single cash flow.
There is no risk involved.
Explanation:
Decision trees map out sequential decisions and uncertain outcomes (with probabilities), allowing managers to evaluate complex, multi-stage investment proposals.
17. A project may have "Multiple Internal Rates of Return" (Multiple IRRs) if:
Its cash flows are conventional (only initial outflow, then inflows).
It has a very long life.
The discount rate is zero.
Its cash flows are non-conventional (signs change more than once, e.g., outflow-inflow-outflow).
Explanation:
When the direction of cash flows changes more than once (e.g., heavy maintenance cost in year 5 causing a net outflow), the IRR equation can have multiple mathematical solutions, making IRR unreliable.
18. The situation where a firm has more acceptable projects (Positive NPV) than it has funds available to invest is called:
Capital Gearing.
Capital Budgeting.
Capital Structure.
Capital Rationing.
Explanation:
Under Capital Rationing, the firm must select the combination of projects that maximizes total NPV within the budget constraint (often using Profitability Index).
19. When evaluating a new project, which of the following costs should be IGNORED (treated as irrelevant)?
Opportunity Cost.
Incremental Working Capital.
Sunk Cost.
Terminal Cash Flow.
Explanation:
Sunk costs are past costs that have already been incurred and cannot be recovered (e.g., money spent on market research last year). They should not affect the decision to accept/reject a project today.
20. What is the purpose of "Post-Audit" in Capital Budgeting?
To punish managers for failure.
To compare actual results with projected results after the project is implemented.
To calculate tax.
To get a loan from the bank.
Explanation:
Post-Audit provides feedback, helps identify why forecasts went wrong, and improves future decision-making. It is a control mechanism.