Certified Management Accountant Investment Decisions 2 — Questions and Answers
Question 1: A project has an IRR of 15% and the company's cost of capital is 12%. The project should be:
- Rejected because IRR exceeds cost of capital
- Accepted because IRR exceeds cost of capital (Correct answer)
- Rejected because IRR is below the cost of capital
- Deferred pending further analysis
Correct answer: Accepted because IRR exceeds cost of capital
When IRR exceeds the cost of capital, the project generates returns above the minimum required rate and should be accepted.
Question 2: Which statement about NPV and IRR is correct when evaluating independent projects?
- They always give conflicting accept/reject decisions
- NPV always produces a higher numerical value than IRR
- They give the same accept/reject decision (Correct answer)
- IRR is more theoretically sound than NPV
Correct answer: They give the same accept/reject decision
For independent projects, NPV and IRR give consistent decisions: if IRR exceeds the cost of capital, NPV is positive, and both methods recommend acceptance.
Question 3: The discount rate that makes a project's NPV equal to zero is the:
- Cost of equity
- Weighted average cost of capital
- Internal rate of return (Correct answer)
- Required rate of return
Correct answer: Internal rate of return
The IRR is defined as the specific discount rate at which the project's NPV equals exactly zero.
Question 4: When two mutually exclusive projects have conflicting NPV and IRR rankings, which method should be preferred?
- IRR, because it expresses return as a percentage
- Payback period, because it is simplest to compute
- NPV, because it measures absolute value added to the firm (Correct answer)
- Accounting rate of return, because it uses book values
Correct answer: NPV, because it measures absolute value added to the firm
NPV is preferred for mutually exclusive projects because it directly measures the absolute increase in firm value, aligning with the wealth-maximization objective.
Question 5: To calculate a project's NPV, cash flows are:
- Summed together and compared to the initial investment without adjustment
- Discounted to present value, summed, and then reduced by the initial investment (Correct answer)
- Divided by the project's life to find the average annual return
- Multiplied by the discount rate and compared to the initial cost
Correct answer: Discounted to present value, summed, and then reduced by the initial investment
NPV requires discounting each future cash flow to present value, summing those present values, and subtracting the initial investment.
Question 6: The modified internal rate of return (MIRR) addresses which key limitation of IRR?
- IRR ignores the time value of money
- IRR unrealistically assumes reinvestment at the project's IRR rate (Correct answer)
- IRR cannot be computed for projects with non-normal cash flows
- IRR ignores the scale of the initial investment
Correct answer: IRR unrealistically assumes reinvestment at the project's IRR rate
MIRR assumes interim cash flows are reinvested at the cost of capital rather than the IRR, providing a more realistic measure of project returns.
Certified Management Accountant Investment Decisions 2
A project has an IRR of 15% and the company's cost of capital is 12%.
The project should be: