Finance for Non-Finance Managers Capital Budgeting 4 — Questions and Answers
Question 1: Sensitivity analysis in capital budgeting is used to:
- Calculate the exact probability of project failure
- Assess how changes in one variable affect project NPV (Correct answer)
- Determine the optimal project financing mix
- Measure the historical volatility of similar projects
Correct answer: Assess how changes in one variable affect project NPV
Sensitivity analysis changes one input variable at a time (e.g., sales volume, price) to see how sensitive NPV is to that assumption.
Question 2: The Equivalent Annual Annuity (EAA) method is most useful when comparing projects that:
- Have identical cash flow patterns
- Have the same initial investment cost
- Have different useful lives (Correct answer)
- Generate revenues in different currencies
Correct answer: Have different useful lives
EAA converts each project's NPV into an annual equivalent, enabling fair comparison of projects with unequal lifespans.
Question 3: In capital budgeting, depreciation matters primarily because it:
- Is a direct cash outflow that reduces project returns
- Creates a tax shield that increases after-tax cash flows (Correct answer)
- Determines the project's payback period
- Sets the salvage value at the end of the project
Correct answer: Creates a tax shield that increases after-tax cash flows
Depreciation is non-cash but reduces taxable income, generating a tax shield that improves the project's actual cash flows.
Question 4: Break-even analysis in capital budgeting identifies the level of sales at which:
- The IRR equals the discount rate
- The project recovers its initial investment in one year
- The NPV equals zero (Correct answer)
- The payback period matches the project life
Correct answer: The NPV equals zero
Break-even in NPV terms finds the minimum output or price needed for the project to have a zero net present value.
Question 5: Which of the following is NOT a relevant cash flow in capital budgeting analysis?
- After-tax salvage value of old equipment being replaced
- Incremental revenues from the new project
- Market research study paid last year to evaluate the project (Correct answer)
- Increased inventory required to support the new operation
Correct answer: Market research study paid last year to evaluate the project
The market research study is a sunk cost — it was paid regardless of the project decision and is therefore irrelevant to the investment choice.
Question 6: Scenario analysis differs from sensitivity analysis in that scenario analysis:
- Changes only one variable at a time to isolate its impact
- Evaluates the combined effect of multiple variables changing simultaneously (Correct answer)
- Is limited to best-case and worst-case outcomes only
- Requires Monte Carlo simulation to execute
Correct answer: Evaluates the combined effect of multiple variables changing simultaneously
Scenario analysis examines how NPV changes when several related variables shift together, reflecting realistic combinations like a recession scenario.
Question 7: An option to expand a successful project is best described as:
- A sunk cost embedded in the initial investment
- A real option that adds strategic value to the project (Correct answer)
- A financing arrangement with the project's lender
- A required regulatory approval for the project
Correct answer: A real option that adds strategic value to the project
The option to expand is a real option — a flexibility feature that has value because management can capitalize on favorable outcomes.
Finance for Non-Finance Managers Capital Budgeting 4
Sensitivity analysis in capital budgeting is used to: