Certified Management Accountant Investment Decisions 1 — Questions and Answers
Question 1: Which capital budgeting method calculates the time required to recover the initial investment?
- Net Present Value
- Internal Rate of Return
- Payback Period (Correct answer)
- Profitability Index
Correct answer: Payback Period
The payback period measures how long it takes to recover the initial cash outlay from a project's cash inflows.
Question 2: A project has an initial cost of $100,000 and generates $25,000 per year in cash inflows. What is its payback period?
- 2 years
- 3 years
- 4 years (Correct answer)
- 5 years
Correct answer: 4 years
The payback period is $100,000 ÷ $25,000 = 4 years.
Question 3: Which capital budgeting technique explicitly incorporates the time value of money?
- Payback Period
- Accounting Rate of Return
- Net Present Value (Correct answer)
- Simple Rate of Return
Correct answer: Net Present Value
NPV discounts all future cash flows to present value using the required rate of return, directly incorporating the time value of money.
Question 4: A project's net present value (NPV) is positive. This indicates the project:
- Has an IRR equal to the cost of capital
- Destroys shareholder value
- Creates value above the required rate of return (Correct answer)
- Has a payback period exceeding project life
Correct answer: Creates value above the required rate of return
A positive NPV means the project's returns exceed the required rate, creating net value for the firm.
Question 5: Which of the following is a key limitation of the payback period method?
- It is difficult to calculate
- It ignores cash flows occurring after the payback period (Correct answer)
- It requires a discount rate
- It cannot be applied to mutually exclusive projects
Correct answer: It ignores cash flows occurring after the payback period
The payback period ignores all cash flows after the initial investment is recovered, potentially leading to rejection of highly profitable long-term projects.
Question 6: The profitability index (PI) is calculated as:
- Net cash flows divided by initial investment
- Present value of future cash flows divided by initial investment (Correct answer)
- Initial investment divided by average annual cash flow
- IRR divided by cost of capital
Correct answer: Present value of future cash flows divided by initial investment
The profitability index equals the present value of future cash flows divided by the initial investment, indicating value created per dollar invested.
Certified Management Accountant Investment Decisions 1
Which capital budgeting method calculates the time required to recover the initial investment?