CTP Long-Term Capital Investments 3 — Questions and Answers
Question 1: When a firm uses MACRS depreciation for tax purposes, the accelerated depreciation in early years:
- Increases taxable income in early years
- Decreases the NPV of a project
- Increases present value of tax savings compared to straight-line (Correct answer)
- Has no effect on after-tax cash flows
Correct answer: Increases present value of tax savings compared to straight-line
Accelerated depreciation front-loads tax deductions, increasing their present value since earlier tax savings are worth more than later ones.
Question 2: A project's operating cash flow (OCF) using the tax shield approach is calculated as:
- (Sales − Costs) × (1 − T) + Depreciation
- (Sales − Costs − Depreciation) × (1 − T) + Depreciation (Correct answer)
- Net income + Depreciation − ΔWorking Capital
- EBIT × (1 − T)
Correct answer: (Sales − Costs − Depreciation) × (1 − T) + Depreciation
The tax shield formula isolates the depreciation tax shield: (Sales − Costs)(1−T) + Depreciation × T, equivalent to option B.
Question 3: Capital rationing occurs when a firm:
- Has unlimited access to funding for all positive-NPV projects
- Restricts capital spending below the level needed to fund all positive-NPV projects (Correct answer)
- Invests only in risk-free government securities
- Sets its WACC equal to the risk-free rate
Correct answer: Restricts capital spending below the level needed to fund all positive-NPV projects
Capital rationing means the firm limits its total capital budget, forcing managers to select from among positive-NPV projects.
Question 4: Under capital rationing, which metric is MOST useful for ranking independent projects?
- Net present value
- Internal rate of return
- Profitability index (Correct answer)
- Payback period
Correct answer: Profitability index
The profitability index (NPV/investment) ranks projects by value created per dollar invested, ideal when capital is constrained.
Question 5: A project has an initial outlay of $500,000 and generates after-tax cash flows of $100,000 per year for 7 years. What is the payback period?
- 3.5 years
- 5 years (Correct answer)
- 6 years
- 7 years
Correct answer: 5 years
$500,000 ÷ $100,000/year = 5 years payback period.
Question 6: Sensitivity analysis in capital budgeting examines:
- The probability distribution of all possible NPV outcomes
- How NPV changes when one input variable is changed while others are held constant (Correct answer)
- The worst-case scenario across all variables simultaneously
- The correlation between project cash flows and market returns
Correct answer: How NPV changes when one input variable is changed while others are held constant
Sensitivity analysis isolates the impact of each individual variable on NPV to identify which inputs most affect project viability.
Question 7: Which risk adjustment method adds a premium to the discount rate to account for a riskier project?
- Certainty equivalent approach
- Risk-adjusted discount rate (RADR) (Correct answer)
- Monte Carlo simulation
- Break-even analysis
Correct answer: Risk-adjusted discount rate (RADR)
The risk-adjusted discount rate (RADR) increases the discount rate for riskier projects, reducing their NPV to reflect higher required returns.
CTP Long-Term Capital Investments 3
When a firm uses MACRS depreciation for tax purposes, the accelerated depreciation in early years: