Question 1

Which one of the following capital budgeting decision models consists of dividing the total initial investment outlay by annual after-tax cash inflows (when such inflows are assumed equal over time)?

Accepted Answer

The model described in the question is the Payback period. This model calculates the amount of time it takes for the cash inflows to equal the initial investment outlay.

Question 2

A composite of the cost of various sources of funds comprising a firm's capital structure is its:

Accepted Answer

The weighted-average cost of capital (WACC) represents the composite cost of funds raised from various sources, such as equity, debt, and preferred stock, based on their respective weights in the capital structure. It is used as a benchmark to evaluate the profitability of projects or investments that require funding from these sources. The WACC is calculated by multiplying the cost of each source by its weight, and then summing up the products.

Question 3

Which one of the following methods assumes (inherently, according to some) that all interim cash inflows generated by an investment earn a return equal to the internal rate of return (IRR) of the investment?

Accepted Answer

The Internal Rate of Return (IRR) method inherently assumes that all interim cash inflows are reinvested at the project's own IRR, which is a key criticism of this method because it might not always be a realistic assumption.

Question 4

In a discounted cash flow (DCF) analysis, a required incremental investment in net working capital:

Accepted Answer

In a DCF analysis, an incremental investment in net working capital is considered an immediate cash outflow, reflecting the additional capital tied up in the business operations. This investment is typically recovered at the end of the project's life when the additional working capital is no longer needed, thus it is treated as a cash inflow at that point.

Question 5

Intolerance of uncertainty is a behavioral effect that often motivates managers to:

Accepted Answer

Intolerance of uncertainty refers to a manager's discomfort with ambiguity and unpredictability. Managers who suffer from this condition tend to prefer projects with shorter payback periods that offer more immediate returns and reduce uncertainty. This allows them to make faster decisions and move on to the next project or investment opportunity. Therefore, choice B - choosing projects with short payback periods - is the best option for managers with intolerance of uncertainty.

Question 6

A 15% internal rate of return (IRR) on a proposed capital investment indicates all of the following except:

Accepted Answer

A 15% IRR means the project's return equals 15%, and it would be acceptable if the cost of capital is lower than this, not higher. If the cost of capital is 16% or higher, the project's return would not cover the cost of capital, making it unacceptable.

Question 7

Which one of the following is the estimated rate (i.e., percentage) that makes the discounted present value of future after-tax cash inflows of a project equal to the initial investment outlay for the project?

Accepted Answer

The internal rate of return (IRR) is the estimated rate that makes the discounted present value of future after-tax cash inflows of a project equal to the initial investment outlay for the project.

Question 8

Two investments have the same total cash inflows and the same payback period. Therefore:

Accepted Answer

The payback period only measures how long it takes to recover the initial investment, not the value of money over time. Two investments can have the same payback period but different present values of cash inflows due to varying cash flow patterns over time, making one investment potentially more desirable than the other when considering the time value of money.

Question 9

Which one of the following is an advantage of the payback method of evaluating capital investment proposals?

Accepted Answer

The payback method provides a rough measure of project risk by indicating how quickly the initial investment can be recovered. A shorter payback period is generally less risky than a longer payback period. However, it does not consider the time value of money or all future cash flows, and may not be the best tool for evaluating long-term projects.

Question 10

Which one of the following is calculated by dividing average annual net operating income of a proposed project by the average investment associated with the project?

Accepted Answer

The accounting (book) rate of return (ARR) is calculated by dividing the average annual net operating income of a proposed project by the average investment associated with the project. ARR is a method of evaluating the profitability of an investment by comparing the expected returns to the average investment required to make those returns.

Question 11

Which one of the following statements concerning capital budgeting is not true?

Accepted Answer

Capital budgeting involves forecasting future events and making estimates, but these estimates are not always precise or certain. Therefore, the statement that capital budgeting is based on precise estimates of future events is not true.

Question 12

The difference between the present value of future after-tax cash inflows and the present value of future cash outflows of an investment project is the:

Accepted Answer

The difference between the present value of future after-tax cash inflows and the present value of future cash outflows of an investment project is the net present value (NPV) of the project. NPV is a measure of the profitability of an investment project and is calculated by subtracting the present value of cash outflows from the present value of cash inflows, both adjusted for time and the cost of capital. Therefore, choice D is the best answer.

Question 13

For a capital investment project, a net present value (NPV) of $500 indicates that the:

Accepted Answer

A positive NPV of $500 indicates that the project's present value of cash inflows is greater than the present value of cash outflows, after accounting for a hurdle rate or discount rate. Therefore, the project is expected to generate a rate of return greater than the hurdle rate, which indicates that the project's true or economic rate of return exceeds the hurdle rate.

Question 14

Research has shown that in framing capital investment decisions past (i.e., "sunk") costs or losses tend to:

Accepted Answer

Sunk costs tend to escalate commitment to a project, leading managers to continue investing in it even when future outcomes are questionable. This phenomenon is also known as the "sunk cost fallacy."

Question 15

Which one of the following is true for the internal rate of return (IRR) method?

Accepted Answer

Depending on the pattern of after-tax cash flows, multiple IRRs for a given proposed investment are possible. This is a drawback of the IRR method as it makes it difficult to compare investments and can lead to confusion in decision making.

Question 16

Which of the following methods can be used to deal formally with uncertainty in the capital-budgeting process?

Accepted Answer

Real options analysis is specifically designed to deal with uncertainty in the capital-budgeting process. It allows for flexibility in decision making by considering various possible future scenarios and their potential for generating positive cash flows. NPV, capital rationing analysis, linear programming optimization, and EAA are all methods that may be used in capital budgeting, but are not specifically designed to address uncertainty.

Question 17

Under conditions of capital rationing (i.e., limited capital funds are available), the optimal allocation of funds to capital investment projects occurs when management uses which one of the following decision models?

Accepted Answer

The profitability index (PI) is the best choice when capital is limited because it measures the project's net present value per dollar of investment. This means that it helps identify the project that will generate the highest return for the amount of capital invested. The other models listed do not take into account the size of the investment or the availability of funds, making them less useful in a capital rationing situation.

Question 18

A capital budgeting model that accounts for an assumed rate of return on interim-period cash inflows from an investment is the:

Accepted Answer

The modified internal rate of return (MIRR) model considers the assumption that interim-period cash inflows can be reinvested at a different rate of return than the initial investment. This makes it a more realistic model compared to the traditional internal rate of return (IRR), which assumes that interim-period cash inflows are reinvested at the same rate of return as the initial investment. The present-value payback period model does not account for any assumed rate of return on interim-period cash inflows, while both the net present value (NPV) and accounting rate of return (ARR) models focus on the total return on investment rather than the rate of return on interim-period cash inflows.

Question 19

The internal rate of return (IRR) for an investment:

Accepted Answer

The IRR may produce different results than the NPV method in evaluating projects with different useful lives because the IRR assumes all cash flows are reinvested at the project's calculated rate of return, while the NPV discounts future cash flows back to their present value using the company's cost of capital. This difference can result in conflicting results for projects with different useful lives.

Question 20

Which one of the following is an advantage of the accounting (book) rate of return (ARR) method for analyzing capital investment proposals?

Accepted Answer

Data for calculating the return are typically readily available, making the ARR method easy to use and apply in practice. However, the ARR method has several disadvantages, including that it does not account for the time value of money and can be affected by different accounting methods. It also does not necessarily approximate a project's internal rate of return (IRR).

Quiz 12: Strategy and the Analysis of Capital Investments

Which one of the following capital budgeting decision models consists of dividing the total initial investment outlay by annual after-tax cash inflows (when such inflows are assumed equal over time) ?