CFO Investment Analysis — Questions and Answers
Question 1: A project with conventional cash flows has a positive NPV when discounted at the firm's 10% cost of capital. What must be true of its IRR?
- IRR is less than 10%
- IRR is greater than 10% (Correct answer)
- IRR equals 10%
- IRR cannot be determined from NPV
Correct answer: IRR is greater than 10%
For conventional cash flows, a positive NPV at a given rate means the IRR exceeds that rate.
Question 2: A project requires a $1,000,000 investment and its future cash flows have a present value of $1,200,000. What is its profitability index?
- 0.83
- 1.00
- 1.20 (Correct answer)
- 0.20
Correct answer: 1.20
PI = PV of future cash flows ÷ initial investment = $1.2M ÷ $1.0M = 1.20.
Question 3: Two mutually exclusive projects rank differently under NPV and IRR. Which project should a value-maximizing CFO choose?
- The project with the higher IRR
- The project with the shorter payback
- The project with the higher NPV (Correct answer)
- The project with the lower initial cost
Correct answer: The project with the higher NPV
NPV measures the absolute dollar increase in shareholder wealth, so it governs when rankings conflict.
Question 4: What is the most significant weakness of the simple payback period method?
- It requires an estimate of the cost of capital
- It ignores cash flows occurring after the payback point (Correct answer)
- It is difficult to calculate
- It always favors long-lived projects
Correct answer: It ignores cash flows occurring after the payback point
Payback ignores all cash flows beyond the cutoff and also ignores the time value of money.
Question 5: What reinvestment rate assumption does the Modified Internal Rate of Return (MIRR) typically use?
- The project's own IRR
- The risk-free rate only
- The firm's cost of capital (Correct answer)
- Zero
Correct answer: The firm's cost of capital
MIRR assumes interim cash flows are reinvested at the cost of capital, which is more realistic than IRR's assumption.
Question 6: A company spent $250,000 on a market study last year before deciding whether to launch a product. How should this cost be treated in the launch NPV analysis?
- Include it as an initial outflow
- Exclude it as a sunk cost (Correct answer)
- Amortize it over the project life
- Include it only if the project is approved
Correct answer: Exclude it as a sunk cost
Sunk costs are already incurred regardless of the decision and are irrelevant to incremental cash flow analysis.
Question 7: Which technique is most appropriate for comparing mutually exclusive projects with unequal useful lives that will be replaced repeatedly?
- Simple payback period
- Accounting rate of return
- Equivalent annual annuity (EAA) (Correct answer)
- Profitability index
Correct answer: Equivalent annual annuity (EAA)
EAA converts each project's NPV into an annual equivalent, allowing fair comparison across different lives.
Question 8: Using CAPM, what is the required return on a stock with a beta of 1.5 if the risk-free rate is 4% and the expected market return is 10%?
- 10.0%
- 13.0% (Correct answer)
- 15.0%
- 19.0%
Correct answer: 13.0%
Required return = 4% + 1.5 × (10% − 4%) = 13%.
Question 9: The Sharpe ratio measures a portfolio's excess return per unit of which risk measure?
- Beta
- Standard deviation (Correct answer)
- Tracking error
- Duration
Correct answer: Standard deviation
Sharpe ratio = (portfolio return − risk-free rate) ÷ standard deviation of portfolio returns.
Question 10: Which type of risk can be substantially eliminated through diversification?
- Systematic risk
- Market risk
- Unsystematic (firm-specific) risk (Correct answer)
- Interest rate risk
Correct answer: Unsystematic (firm-specific) risk
Firm-specific risk cancels out across a well-diversified portfolio, leaving only systematic risk.
Question 11: If market interest rates rise after a fixed-rate bond is issued, what happens to the bond's market price?
- It rises
- It falls (Correct answer)
- It stays at par
- It rises only if the coupon is high
Correct answer: It falls
Bond prices move inversely to market yields because existing fixed coupons become less attractive.
Question 12: A bond has a modified duration of 6. If its yield increases by 1 percentage point, what is the approximate change in its price?
- +6%
- −1%
- −6% (Correct answer)
- −0.6%
Correct answer: −6%
Percentage price change ≈ −modified duration × change in yield = −6 × 1% = −6%.
Question 13: A stock is expected to pay a $2.00 dividend next year, dividends grow at 4% annually, and the required return is 10%. What is its value using the Gordon Growth Model?
- $20.00
- $33.33 (Correct answer)
- $34.67
- $50.00
Correct answer: $33.33
Value = D1 ÷ (r − g) = $2.00 ÷ (0.10 − 0.04) = $33.33.
Question 14: Which performance measure divides a portfolio's excess return by its beta?
- Sharpe ratio
- Treynor ratio (Correct answer)
- Information ratio
- Sortino ratio
Correct answer: Treynor ratio
The Treynor ratio measures excess return per unit of systematic risk (beta).
