CTP Long-Term Capital Investments 2 — Questions and Answers
Question 1: A company is evaluating two mutually exclusive projects with different useful lives. Which technique is MOST appropriate for comparing them?
- Simple payback period
- Equivalent annual annuity (EAA) (Correct answer)
- Accounting rate of return
- Profitability index
Correct answer: Equivalent annual annuity (EAA)
The equivalent annual annuity converts NPVs to annual terms, enabling valid comparison of projects with unequal lives.
Question 2: Which component is NOT included in the incremental cash flows used in capital budgeting analysis?
- Opportunity costs
- Sunk costs (Correct answer)
- Cannibalization effects
- Changes in net working capital
Correct answer: Sunk costs
Sunk costs are past expenditures that cannot be recovered and are irrelevant to future capital budgeting decisions.
Question 3: A project has an NPV of $0 when discounted at 12%. What does this indicate?
- The project destroys shareholder value
- The project exactly meets the required rate of return (Correct answer)
- The project should be rejected
- The IRR is less than 12%
Correct answer: The project exactly meets the required rate of return
An NPV of zero means the project earns exactly the required rate of return (hurdle rate), making it marginally acceptable.
Question 4: The Modified Internal Rate of Return (MIRR) differs from IRR primarily because MIRR:
- Ignores the time value of money
- Assumes reinvestment at the cost of capital rather than the IRR (Correct answer)
- Uses book values instead of market values
- Applies only to mutually exclusive projects
Correct answer: Assumes reinvestment at the cost of capital rather than the IRR
MIRR corrects the IRR's reinvestment rate assumption by assuming intermediate cash flows are reinvested at the firm's cost of capital.
Question 5: In capital budgeting, the terminal cash flow typically includes:
- Initial equipment purchase price
- Annual depreciation tax shield
- After-tax salvage value and recovery of net working capital (Correct answer)
- Incremental operating revenues
Correct answer: After-tax salvage value and recovery of net working capital
Terminal cash flows include after-tax proceeds from asset disposal and return of net working capital invested at the project's start.
Question 6: Which type of real option gives management the right to abandon a project if conditions deteriorate significantly?
- Expansion option
- Timing option
- Abandonment option (Correct answer)
- Flexibility option
Correct answer: Abandonment option
The abandonment option allows management to exit a project early and recover salvage value, limiting downside losses.
Question 7: A treasury professional is analyzing a project with uneven cash flows. Which capital budgeting method requires trial-and-error or financial calculator iteration to solve?
- Net present value
- Payback period
- Accounting rate of return
- Internal rate of return (Correct answer)
Correct answer: Internal rate of return
IRR requires finding the discount rate that sets NPV to zero, which typically requires iterative calculation for uneven cash flows.
CTP Long-Term Capital Investments 2
A company is evaluating two mutually exclusive projects with different useful lives.
Which technique is MOST appropriate for comparing them?