Finance for Non-Finance Managers Capital Budgeting 3 — Questions and Answers
Question 1: In capital budgeting, which of the following is considered an incremental cash flow?
- Corporate headquarters rent already being paid
- Additional revenue generated by the new project (Correct answer)
- The CEO's salary allocated to the project
- Interest payments on existing company debt
Correct answer: Additional revenue generated by the new project
Incremental cash flows are those that arise specifically because of the project, such as additional revenues it generates.
Question 2: A company uses a 10% discount rate. Project A has an NPV of $50,000 and Project B has an NPV of $30,000. If they are mutually exclusive, which should be chosen?
- Project B, because it is less risky
- Project A, because it has the higher NPV (Correct answer)
- Both, to diversify
- Neither, until the discount rate changes
Correct answer: Project A, because it has the higher NPV
For mutually exclusive projects, the one with the higher positive NPV creates more value for the firm and should be selected.
Question 3: What is the primary limitation of using the payback period as a sole capital budgeting criterion?
- It is too complex for most managers to calculate
- It ignores cash flows occurring after the payback cutoff (Correct answer)
- It requires a discount rate that is hard to determine
- It only works for projects lasting fewer than 5 years
Correct answer: It ignores cash flows occurring after the payback cutoff
The payback period ignores all cash flows beyond the recovery date, potentially rejecting projects with large long-term benefits.
Question 4: Which scenario demonstrates the 'multiple IRR problem'?
- A project with a higher IRR than a competing project
- A project whose cash flows change sign more than once (Correct answer)
- A project evaluated using more than one discount rate
- A project with both domestic and international cash flows
Correct answer: A project whose cash flows change sign more than once
When a project's cash flows change from negative to positive to negative again, the IRR equation can produce multiple mathematical solutions.
Question 5: Net Working Capital (NWC) changes in capital budgeting are treated as:
- Non-cash items that are excluded from analysis
- Cash outflows at project start and inflows at project end (Correct answer)
- Tax-deductible operating expenses each year
- Fixed costs spread evenly over the project life
Correct answer: Cash outflows at project start and inflows at project end
Increases in NWC represent cash tied up in operations (an outflow) at inception, which is typically recovered (an inflow) when the project ends.
Question 6: A higher discount rate used in NPV analysis will generally:
- Increase the NPV of long-term projects
- Decrease the NPV by reducing the value of distant cash flows (Correct answer)
- Have no effect on projects with uniform annual cash flows
- Increase NPV for projects with high terminal values
Correct answer: Decrease the NPV by reducing the value of distant cash flows
A higher discount rate penalizes future cash flows more heavily, reducing the present value of benefits and thus the NPV.
Question 7: Which of the following best describes the 'hurdle rate' in capital budgeting?
- The maximum debt-to-equity ratio the firm will accept
- The minimum acceptable rate of return required to approve a project (Correct answer)
- The rate at which the project's NPV equals its IRR
- The break-even revenue level for the project
Correct answer: The minimum acceptable rate of return required to approve a project
The hurdle rate is the minimum return a project must achieve to compensate investors for risk and create value for the firm.
Finance for Non-Finance Managers Capital Budgeting 3
In capital budgeting, which of the following is considered an incremental cash flow?