Finance for Non-Finance Managers Capital Budgeting 2 — Questions and Answers
Question 1: A project requires a $500,000 investment and generates annual cash flows of $100,000 for 7 years. What is the payback period?
- 3.5 years
- 5 years (Correct answer)
- 7 years
- 4.2 years
Correct answer: 5 years
Payback period = Initial investment / Annual cash flow = $500,000 / $100,000 = 5 years.
Question 2: Which capital budgeting method ignores the time value of money entirely?
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
- Payback Period (Correct answer)
- Profitability Index
Correct answer: Payback Period
The simple payback period adds up undiscounted cash flows and does not account for the time value of money.
Question 3: If a project's IRR exceeds the company's required rate of return (hurdle rate), the project should generally be:
- Rejected, because the IRR is too high
- Accepted, because it creates value (Correct answer)
- Deferred for further review
- Scaled down to match the hurdle rate
Correct answer: Accepted, because it creates value
An IRR above the hurdle rate means the project's return exceeds its cost of capital, indicating it creates shareholder value.
Question 4: What does a Profitability Index (PI) of 0.85 indicate?
- The project returns $0.85 for every $1 invested beyond costs
- The project destroys value and should be rejected (Correct answer)
- The project breaks even in 0.85 years
- The project has an 85% probability of success
Correct answer: The project destroys value and should be rejected
A PI below 1.0 means the present value of future cash flows is less than the initial investment, so the project destroys value.
Question 5: Terminal value in capital budgeting refers to:
- The cost to shut down a project at the end of its life
- The salvage value and working capital recovery at project end (Correct answer)
- The final year's depreciation charge
- The penalty for early project termination
Correct answer: The salvage value and working capital recovery at project end
Terminal value captures the after-tax salvage value of assets plus any net working capital released when the project concludes.
Question 6: Sunk costs should be treated in capital budgeting decisions by:
- Including them as they represent real money spent
- Excluding them because they are irrelevant to future decisions (Correct answer)
- Depreciating them over the project's life
- Subtracting them from projected revenues
Correct answer: Excluding them because they are irrelevant to future decisions
Sunk costs are past expenditures that cannot be recovered and are irrelevant to forward-looking investment decisions.
Question 7: When two mutually exclusive projects have conflicting NPV and IRR rankings, managers should generally rely on:
- IRR, because it expresses return as a percentage
- Payback period, as a tiebreaker
- NPV, because it measures absolute value creation in dollars (Correct answer)
- PI, as a compromise between the two methods
Correct answer: NPV, because it measures absolute value creation in dollars
NPV directly measures the dollar value added to the firm, making it the preferred criterion when rankings conflict with IRR.
Finance for Non-Finance Managers Capital Budgeting 2
A project requires a $500,000 investment and generates annual cash flows of $100,000 for 7 years.
What is the payback period?