Sample Questions and Answers
In capital budgeting, a project with a positive net present value (NPV) should be:
A. Rejected, as it does not meet the required rate of return.
B. Accepted, as it is expected to add value to the company.
C. Accepted, if the internal rate of return (IRR) is above the required rate of return.
D. Rejected, as it may have a longer payback period than other projects.
Answer: B
Which of the following methods provides the best approach for evaluating mutually exclusive projects?
A. Net present value (NPV).
B. Payback period.
C. Profitability index (PI).
D. Internal rate of return (IRR).
Answer: A
The “break-even point” is reached when:
A. The company’s total revenue equals its fixed costs.
B. The project’s revenue equals its total costs.
C. The project generates a positive internal rate of return (IRR).
D. The project’s cash inflows exceed its initial investment.
Answer: B
A high internal rate of return (IRR) generally indicates that:
A. The project is highly risky.
B. The project is generating high profits relative to its investment.
C. The project will generate consistent cash flows over time.
D. The project has a low required rate of return.
Answer: B
When calculating the net present value (NPV) of a project, it is important to:
A. Use the project’s risk-free rate as the discount rate.
B. Include both fixed and variable costs in the cash flows.
C. Discount all future cash flows back to the present.
D. Ignore the time value of money.
Answer: C
The “real options” approach to project evaluation allows decision-makers to:
A. Adjust the project’s cash flows for risk.
B. Value the flexibility to make future decisions that can add value to the project.
C. Calculate the project’s profitability index (PI).
D. Evaluate the project without considering the time value of money.
Answer: B
In capital budgeting, a project with a lower risk-adjusted rate of return (RAROC) than the company’s cost of capital should:
A. Be accepted, as it meets the minimum required return.
B. Be accepted if the project has a short payback period.
C. Be rejected, as it does not provide adequate return for its risk.
D. Be approved for financing under favorable terms.
Answer: C
The “real rate of return” on an investment can be calculated by:
A. Subtracting the inflation rate from the nominal rate of return.
B. Adjusting for the time value of money using a discount factor.
C. Including both tax and inflation adjustments.
D. Adding the inflation rate to the nominal rate of return.
Answer: A
The “cash flow at time 0” in a capital budgeting analysis refers to:
A. The total cash inflows from the project.
B. The initial investment required to start the project.
C. The cash flows that occur in the final year of the project.
D. The annual operating costs of the project.
Answer: B
The “profitability index” (PI) is considered more reliable than the payback period when:
A. The company is seeking to evaluate the total value generated by a project relative to its cost.
B. The project has fluctuating cash flows over time.
C. The required rate of return is not available.
D. The project has a high level of uncertainty.
Answer: A
In the context of capital budgeting, which of the following represents a “relevant cash flow”?
A. Sunk costs that are already incurred.
B. Costs that would be incurred if the project is accepted.
C. Past fixed costs that cannot be recovered.
D. Costs associated with financing the project.
Answer: B
The net present value (NPV) method assumes that:
A. Cash flows will be reinvested at the project’s internal rate of return (IRR).
B. Cash flows are reinvested at the project’s required rate of return.
C. The company’s cost of capital is not a consideration.
D. Cash flows are constant over time.
Answer: B
In the context of project evaluation, the “hurdle rate” is used to:
A. Measure the minimum acceptable return on a project.
B. Determine the payback period.
C. Calculate the profitability index (PI).
D. Adjust for inflation in future cash flows.
Answer: A
A project’s profitability index (PI) is calculated as:
A. Net present value (NPV) divided by the project’s initial investment.
B. Internal rate of return (IRR) divided by the project’s required rate of return.
C. Discounted payback period divided by total fixed costs.
D. Cash inflows divided by cash outflows.
Answer: A
When evaluating a project, “sensitivity analysis” focuses on:
A. The effect of changes in the project’s risk-free rate.
B. How changes in key variables affect project outcomes.
C. The project’s historical cash flow performance.
D. The expected return based on market conditions.
Answer: B
In the context of risk analysis, “downside risk” refers to:
A. The probability of a project exceeding expectations.
B. The likelihood of achieving the expected rate of return.
C. The potential for loss or reduction in project value.
D. The chance of outperforming market benchmarks.
Answer: C
The modified internal rate of return (MIRR) method improves upon the traditional internal rate of return (IRR) by:
A. Eliminating the possibility of multiple IRRs in projects with unconventional cash flows.
B. Providing a more conservative estimate of project profitability.
C. Using market interest rates for reinvestment rather than the project’s IRR.
D. Applying a fixed required rate of return for all types of projects.
Answer: A
In the context of investment analysis, “real options” refer to:
A. Fixed future cash flows associated with the project.
B. The flexibility to make future decisions that could add value.
C. Government regulations on capital investments.
D. The different methods of financing a project.
Answer: B
Which of the following is an example of a sunk cost in project evaluation?
A. The cost of materials purchased for the project.
B. The initial investment in the project.
C. Marketing expenses already incurred for the project.
D. Expected operating expenses for the project.
Answer: C
In capital budgeting, the term “hurdle rate” refers to:
A. The required rate of return used to evaluate potential projects.
B. The rate of return that guarantees project profitability.
C. The rate used to calculate the payback period.
D. The rate at which capital is acquired for the project.
Answer: A
In financial analysis, a “profitability index” (PI) greater than 1.0 indicates that:
A. The project’s future cash flows are less than the initial investment.
B. The project is expected to generate more value than its initial investment.
C. The project has a negative internal rate of return (IRR).
D. The project will not meet its required rate of return.
Answer: B
Which of the following is a limitation of using the payback period method for evaluating projects?
A. It ignores the time value of money.
B. It requires complex financial modeling.
C. It accounts for risk and uncertainty.
D. It focuses only on fixed costs.
Answer: A
The “discounted payback period” is a method that:
A. Ignores the time value of money when calculating payback.
B. Calculates the time required to recover the initial investment, adjusting for the time value of money.
C. Does not require a rate of return to be specified.
D. Only considers variable costs and not fixed costs.
Answer: B
In capital budgeting, which of the following is NOT considered a “cash flow”?
A. The initial investment made in the project.
B. The revenue generated from the project’s operations.
C. The operating expenses required to maintain the project.
D. The depreciation of assets used in the project.
Answer: D
The “break-even point” for a project is defined as the point where:
A. The project’s cash inflows exceed its operating expenses.
B. The project’s total costs equal its total revenues.
C. The project generates a positive internal rate of return (IRR).
D. The project’s net present value (NPV) is greater than zero.
Answer: B
A “risk-adjusted discount rate” is used to:
A. Increase the discount rate for projects with higher levels of risk.
B. Decrease the discount rate for low-risk projects.
C. Reflect the expected inflation rate.
D. Account for tax implications in project evaluation.
Answer: A
In investment analysis, “inflation” typically causes:
A. An increase in future cash flows, leading to higher returns.
B. A decrease in the real value of future cash flows.
C. A reduction in the cost of capital.
D. A rise in the profitability index.
Answer: B
Which of the following statements best defines the concept of “opportunity cost” in project evaluation?
A. The cost incurred when capital is borrowed for the project.
B. The value of the next best alternative that is foregone by choosing the project.
C. The upfront costs associated with securing financing for the project.
D. The difference between expected cash inflows and outflows.
Answer: B
A project with high uncertainty in its future cash flows is likely to have a higher required rate of return due to:
A. The potential for higher profitability.
B. The need to compensate for the higher level of risk.
C. The lack of reliable historical data.
D. The impact of inflation on future cash flows.
Answer: B
The “certainty equivalent” method in risk analysis is used to:
A. Account for inflation in future cash flows.
B. Adjust future cash flows to reflect their certainty under different risk levels.
C. Calculate the net present value (NPV) of a project.
D. Evaluate the project’s sensitivity to interest rates.
Answer: B
Which of the following factors typically increases the cost of capital for a project?
A. A lower risk level associated with the project.
B. A higher level of debt financing relative to equity financing.
C. An increase in interest rates or inflation.
D. A decrease in market risk.
Answer: C
The “hurdle rate” in investment analysis is generally:
A. The average return on equity of the company.
B. The rate of return used to calculate the break-even point.
C. The minimum return that a company requires to undertake a project.
D. The rate of return that matches the project’s internal rate of return (IRR).
Answer: C
The “internal rate of return” (IRR) is the discount rate that:
A. Causes the net present value (NPV) of a project to equal zero.
B. Is higher than the company’s cost of capital.
C. Is used to evaluate the profitability index of a project.
D. Determines the project’s cash flow timing.
Answer: A
A project with a negative net present value (NPV) indicates that:
A. The project is expected to break even.
B. The project’s return is less than the required rate of return.
C. The project will generate significant cash flows.
D. The project’s profitability index (PI) is greater than 1.
Answer: B
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