CA Inter P6 · Chapter 7
Investment Decisions MCQs with Answers
10 multiple-choice questions on Investment Decisions for CA Inter P6 Financial Management and Strategic Management. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
A project costs ₹ 5,00,000 and is expected to generate cash inflows of ₹ 1,20,000, ₹ 1,50,000, ₹ 1,80,000, ₹ 2,00,000 and ₹ 1,60,000 in years 1 to 5. Its payback period is:
- A) 3.50 years
- B) 3.09 years
- C) 3.00 years
- D) 3.25 years
Show answer & explanation
Answer: D) 3.25 years
Cumulative inflows: year 1 ₹ 1,20,000, year 2 ₹ 2,70,000, year 3 ₹ 4,50,000. A further ₹ 50,000 is needed out of year 4's ₹ 2,00,000, which is 0.25 of a year. Payback = 3 + 50,000/2,00,000 = 3.25 years. Dividing cost by the average inflow (3.09 years) is not valid when inflows are uneven.
Question 2
A machine costing ₹ 10,00,000 is expected to generate cash inflows after tax of ₹ 3,50,000 a year for 4 years, with no salvage value. The cost of capital is 10% and the PVIFA (10%, 4 years) is 3.170. The net present value is:
- A) ₹ 2,39,050
- B) ₹ 11,09,500
- C) ₹ 4,00,000
- D) ₹ 1,09,500
Show answer & explanation
Answer: D) ₹ 1,09,500
PV of inflows = 3,50,000 x 3.170 = ₹ 11,09,500. NPV = ₹ 11,09,500 - 10,00,000 = ₹ 1,09,500. The undiscounted surplus (14,00,000 - 10,00,000 = ₹ 4,00,000) ignores the time value of money. Since NPV is positive, the project is acceptable.
Question 3
A project has a present value of cash inflows of ₹ 11,09,500 and an initial outlay of ₹ 10,00,000. Its profitability index is:
- A) 0.90
- B) 1.11
- C) 1.40
- D) 0.11
Show answer & explanation
Answer: B) 1.11
Profitability index = PV of cash inflows / PV of cash outflows = 11,09,500 / 10,00,000 = 1.1095, about 1.11. A PI above 1 means the project earns more than its cost of capital. The figure 0.11 is the NPV per rupee invested (PI - 1), and 0.90 inverts the ratio.
Question 4
A project has an NPV of ₹ 18,000 at a 12% discount rate and an NPV of -₹ 6,000 at 16%. Using linear interpolation, its IRR is approximately:
- A) 15%
- B) 14%
- C) 18%
- D) 13%
Show answer & explanation
Answer: A) 15%
IRR = lower rate + [NPV at lower rate / (NPV at lower rate - NPV at higher rate)] x difference in rates = 12% + [18,000 / (18,000 + 6,000)] x 4% = 12% + 0.75 x 4% = 15%. Dividing by 18,000 - 6,000 instead of 18,000 + 6,000 is a common error.
Question 5
Equipment costs ₹ 6,00,000, has a 5-year life and a salvage value of ₹ 1,00,000. The average annual profit after depreciation and tax is ₹ 45,000. The accounting rate of return on average investment is:
- A) 15.00%
- B) 7.50%
- C) 12.86%
- D) 9.00%
Show answer & explanation
Answer: C) 12.86%
Average investment = (initial cost + salvage) / 2 = (6,00,000 + 1,00,000) / 2 = ₹ 3,50,000. ARR = 45,000 / ₹ 3,50,000 = 12.86%. Ignoring salvage gives an average investment of ₹ 3,00,000 and 15%. ARR on the initial investment of ₹ 6,00,000 gives 7.50%.
Question 6
A project's annual profit before depreciation and tax is ₹ 4,00,000. Depreciation is ₹ 1,00,000 and the tax rate is 30%. The annual cash flow after tax (CFAT) is:
- A) ₹ 2,80,000
- B) ₹ 3,80,000
- C) ₹ 3,10,000
- D) ₹ 2,10,000
Show answer & explanation
Answer: C) ₹ 3,10,000
Profit before tax = 4,00,000 - 1,00,000 = ₹ 3,00,000. Tax at 30% = ₹ 90,000. PAT = ₹ 2,10,000. CFAT = PAT + depreciation = 2,10,000 + 1,00,000 = ₹ 3,10,000. Equivalently, CFAT = 4,00,000 x 0.7 + 1,00,000 x 0.3 = 2,80,000 + 30,000 = ₹ 3,10,000, where ₹ 30,000 is the depreciation tax shield.
Question 7
A company spent ₹ 2,00,000 last year on a feasibility study for a new plant. In deciding today whether to build the plant, how should this amount be treated?
- A) Included as a cash outflow at time zero
- B) Ignored, because it is a sunk cost that cannot be recovered whatever the decision
- C) Spread equally over the life of the plant as an annual outflow
- D) Deducted from the salvage value at the end of the project
Show answer & explanation
Answer: B) Ignored, because it is a sunk cost that cannot be recovered whatever the decision
Capital budgeting uses only incremental future cash flows that depend on the decision. Money already spent cannot be recovered whether or not the plant is built, so it is a sunk cost and is ignored. Opportunity costs, by contrast, must be included.
Question 8
A firm has ₹ 10,00,000 available for investment. Three divisible, independent projects are available: P (outlay ₹ 4,00,000, NPV ₹ 1,20,000), Q (outlay ₹ 6,00,000, NPV ₹ 1,50,000) and R (outlay ₹ 5,00,000, NPV ₹ 1,60,000). Ranking by profitability index, the maximum total NPV achievable is:
- A) ₹ 2,70,000
- B) ₹ 2,80,000
- C) ₹ 2,85,000
- D) ₹ 3,05,000
Show answer & explanation
Answer: D) ₹ 3,05,000
PI = (outlay + NPV) / outlay: P = 5,20,000/4,00,000 = 1.30, Q = 7,50,000/6,00,000 = 1.25, R = 6,60,000/5,00,000 = 1.32. Rank R, P, Q. Invest ₹ 5,00,000 in R (NPV ₹ 1,60,000) and ₹ 4,00,000 in P (NPV ₹ 1,20,000), leaving ₹ 1,00,000 for 1/6 of Q (NPV ₹ 1,50,000 / 6 = ₹ 25,000). Total NPV = 1,60,000 + 1,20,000 + 25,000 = ₹ 3,05,000. Ranking by absolute NPV (R, then 5/6 of Q) gives only ₹ 1,60,000 + ₹ 1,25,000 = ₹ 2,85,000, and taking P and Q in full gives ₹ 2,70,000.
Question 9
When NPV and IRR rank two mutually exclusive projects differently, NPV is usually preferred because:
- A) NPV assumes intermediate cash flows are reinvested at the cost of capital, which is more realistic than IRR's assumption of reinvestment at the IRR itself
- B) IRR always gives multiple answers for conventional cash flows
- C) NPV can be calculated without a discount rate
- D) IRR ignores the time value of money
Show answer & explanation
Answer: A) NPV assumes intermediate cash flows are reinvested at the cost of capital, which is more realistic than IRR's assumption of reinvestment at the IRR itself
Both methods are discounted cash flow techniques. Rankings can conflict because of differences in project size or timing of cash flows. NPV implicitly assumes reinvestment at the cost of capital, while IRR assumes reinvestment at the project's own IRR, which may be unrealistically high. NPV also measures the absolute addition to shareholder wealth. Multiple IRRs arise only with non-conventional cash flows.
Question 10
A project costs ₹ 3,00,000 and generates ₹ 1,40,000 a year for 3 years. The discount factors at 10% are 0.909, 0.826 and 0.751 for years 1 to 3. The discounted payback period is approximately:
- A) 2.41 years
- B) 2.14 years
- C) 3.00 years
- D) 2.54 years
Show answer & explanation
Answer: D) 2.54 years
PV of inflows: year 1 = ₹ 1,27,260, year 2 = ₹ 1,15,640, year 3 = ₹ 1,05,140. Cumulative PV after 2 years = ₹ 2,42,900, leaving ₹ 57,100 to recover. Discounted payback = 2 + ₹ 57,100/₹ 1,05,140 = 2.54 years. Simple payback (3,00,000 / 1,40,000 = 2.14 years) ignores discounting.