CPFM Capital Budgeting Decisions 2 — Questions and Answers
Question 1: A project requires $50,000 today and returns $60,000 in one year. At a 10% discount rate, what is its NPV?
- $10,000
- $4,545
- $5,454 (Correct answer)
- $0
Correct answer: $5,454
NPV = $60,000/1.10 - $50,000 = $54,545 - $50,000 = $5,454.
Question 2: Which method ignores the time value of money entirely?
- Net present value
- Internal rate of return
- Payback period (Correct answer)
- Profitability index
Correct answer: Payback period
The basic payback period sums undiscounted cash flows until the investment is recovered.
Question 3: When NPV and IRR rank two mutually exclusive projects differently, which method should generally prevail?
- IRR, because it shows a percentage
- NPV, because it measures dollar value added (Correct answer)
- Payback, because it is conservative
- Accounting rate of return
Correct answer: NPV, because it measures dollar value added
NPV directly measures wealth created and is preferred for mutually exclusive choices.
Question 4: A capital project has an IRR of 12% and the firm's cost of capital is 14%. The project should be:
- Accepted
- Rejected (Correct answer)
- Deferred indefinitely
- Accepted only if NPV is negative
Correct answer: Rejected
IRR below the cost of capital means the project destroys value and should be rejected.
Question 5: The profitability index of a project equals:
- NPV divided by initial investment
- PV of future cash flows divided by initial investment (Correct answer)
- Initial investment divided by annual cash flow
- IRR divided by cost of capital
Correct answer: PV of future cash flows divided by initial investment
PI = present value of future cash flows / initial investment; a value above 1 indicates a positive NPV.
Question 6: Which cash flow is irrelevant in a capital budgeting decision?
- Incremental operating cash flow
- Opportunity cost of a building
- A sunk cost already incurred (Correct answer)
- Changes in net working capital
Correct answer: A sunk cost already incurred
Sunk costs are unrecoverable and do not change with the decision, so they are excluded.
Question 7: A higher discount rate applied to a conventional project will:
- Increase NPV
- Decrease NPV (Correct answer)
- Leave NPV unchanged
- Always make NPV positive
Correct answer: Decrease NPV
Higher discount rates reduce the present value of future inflows, lowering NPV.
CPFM Capital Budgeting Decisions 2
A project requires $50,000 today and returns $60,000 in one year.
At a 10% discount rate, what is its NPV?