CBS CBS Capital Budgeting & Asset Management 2 — Questions and Answers
Question 1: Which capital budgeting technique is most susceptible to the 'multiple IRR problem'?
- Net Present Value (NPV)
- Internal Rate of Return (IRR) (Correct answer)
- Payback Period
- Accounting Rate of Return (ARR)
Correct answer: Internal Rate of Return (IRR)
IRR can produce multiple solutions when a project's cash flow stream changes sign more than once, making interpretation ambiguous.
Question 2: Incremental cash flows in capital budgeting refer to:
- The firm's total operating cash flows after the project
- Only the initial capital outlay for the project
- The change in overall firm cash flows attributable directly to the project (Correct answer)
- Cash flows discounted at the incremental borrowing rate
Correct answer: The change in overall firm cash flows attributable directly to the project
Incremental cash flows are the additional cash inflows and outflows that result specifically from undertaking the new project.
Question 3: When evaluating mutually exclusive projects of unequal lives, the most appropriate approach is the:
- Simple payback comparison
- Equivalent Annual Annuity (EAA) method (Correct answer)
- Accounting Rate of Return comparison
- Profitability Index ranking
Correct answer: Equivalent Annual Annuity (EAA) method
The EAA converts each project's NPV into an annual equivalent cash flow, enabling fair comparison across different time horizons.
Question 4: Salvage value is most relevant in capital budgeting because it represents:
- The book value of an asset at purchase
- A terminal cash inflow received when the asset is disposed of at project end (Correct answer)
- The annual depreciation charge over the asset's life
- The replacement cost of the asset adjusted for inflation
Correct answer: A terminal cash inflow received when the asset is disposed of at project end
Salvage value is the estimated proceeds from selling or disposing of the asset at the end of the project, representing a positive terminal cash flow.
Question 5: Beta coefficient in capital budgeting is primarily used to measure an asset's:
- Liquidity relative to current liabilities
- Systematic (market) risk relative to the overall market (Correct answer)
- Unsystematic risk that can be diversified away
- Profitability relative to industry peers
Correct answer: Systematic (market) risk relative to the overall market
Beta measures how sensitive an asset's returns are to market-wide movements, capturing systematic risk that cannot be eliminated through diversification.
Question 6: Which of the following is NOT included as part of the initial investment outlay in a capital budgeting analysis?
- Purchase price of the new equipment
- Shipping and installation costs
- Sunk costs from a prior feasibility study (Correct answer)
- Increase in net working capital required by the project
Correct answer: Sunk costs from a prior feasibility study
Sunk costs are already spent and irrelevant to the capital budgeting decision, so they are excluded from the initial investment calculation.
CBS CBS Capital Budgeting & Asset Management 2
Which capital budgeting technique is most susceptible to the 'multiple IRR problem'?