CIA CIA Capital Investment & Decision Making 2 — Questions and Answers
Question 1: The Weighted Average Cost of Capital (WACC) is used in capital budgeting as:
- The discount rate that reflects the blended cost of all financing sources (Correct answer)
- The average interest rate paid on all outstanding debt
- The rate at which dividends grow annually
- The proportion of equity financing in the capital structure
Correct answer: The discount rate that reflects the blended cost of all financing sources
WACC weights the cost of each capital component (debt, equity, preferred stock) by its proportion in the firm's capital structure to derive an overall financing cost.
Question 2: Which of the following is an example of an 'opportunity cost' relevant to a capital investment decision?
- Revenue foregone from using a factory building for a new project instead of renting it out (Correct answer)
- Interest paid on a loan used to finance the project
- Depreciation expense on existing equipment
- Administrative overhead allocated to the project
Correct answer: Revenue foregone from using a factory building for a new project instead of renting it out
Opportunity cost is the value of the next-best alternative foregone, such as rental income lost by using a building internally rather than leasing it to a third party.
Question 3: A project's Modified Internal Rate of Return (MIRR) differs from the standard IRR because MIRR:
- Assumes reinvestment of cash inflows at the cost of capital rather than the IRR itself (Correct answer)
- Ignores the time value of money in its calculation
- Only applies to projects with conventional cash flow patterns
- Produces a higher return estimate than IRR in all cases
Correct answer: Assumes reinvestment of cash inflows at the cost of capital rather than the IRR itself
MIRR corrects the IRR's unrealistic reinvestment assumption by using the firm's cost of capital as the reinvestment rate for interim cash flows.
Question 4: In capital investment analysis, the 'profitability index' (PI) is calculated as:
- Present value of future cash inflows divided by the initial investment (Correct answer)
- Net income divided by total assets
- Total project revenues minus total project costs
- Operating cash flows divided by annual depreciation
Correct answer: Present value of future cash inflows divided by the initial investment
The profitability index (or benefit-cost ratio) shows the value created per dollar invested, with PI > 1 indicating a value-creating project.
Question 5: When evaluating capital projects with unequal lives, the most appropriate technique is:
- Equivalent Annual Annuity (EAA) or replacing on a common time horizon (Correct answer)
- Simply comparing the total NPV of each project
- Selecting the project with the shorter payback period
- Using the average accounting return over each project's life
Correct answer: Equivalent Annual Annuity (EAA) or replacing on a common time horizon
The EAA method converts each project's NPV into an annualized figure, enabling a fair comparison between projects of different durations.
Question 6: Sensitivity analysis in capital budgeting is used to:
- Assess how changes in key assumptions affect the project's NPV or IRR (Correct answer)
- Determine the exact probability distribution of project returns
- Calculate the optimal debt-to-equity ratio for financing
- Identify regulatory risks associated with the project
Correct answer: Assess how changes in key assumptions affect the project's NPV or IRR
Sensitivity analysis varies one input at a time (e.g., sales volume, price, costs) to reveal which assumptions have the greatest impact on the investment's viability.
CIA CIA Capital Investment & Decision Making 2
The Weighted Average Cost of Capital (WACC) is used in capital budgeting as: