CAF-7 · Chapter 13
Introduction to Project Appraisal MCQs with Answers
15 multiple-choice questions on Introduction to Project Appraisal for CAF-7 Business Insights and Analysis. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
A company commissioned a market research study last year for Rs. 5 million to determine if a new product would be successful. The company is now calculating the Net Present Value (NPV) to decide whether to build the factory. How should the Rs. 5 million research cost be treated in the NPV calculation?
- A) Included as a cash outflow in Year 0
- B) Amortized over the life of the project
- C) Excluded entirely, as it is a sunk cost
- D) Included as an opportunity cost
Show answer & explanation
Answer: C) Excluded entirely, as it is a sunk cost
Relevant costing principles dictate that only future, incremental cash flows are included in an investment appraisal. The research study was paid for in the past regardless of the decision made today, making it a sunk cost that must be ignored.
Question 2
If a company accepts a new project, it must use a warehouse it currently owns. The company currently rents this warehouse to a tenant for Rs. 1 million a year. If the project proceeds, the tenant will be evicted. In the project's NPV calculation, the lost rent is considered:
- A) A sunk cost
- B) An opportunity cost and must be deducted from the project's cash flows
- C) A non-cash expense and should be ignored
- D) A committed cost
Show answer & explanation
Answer: B) An opportunity cost and must be deducted from the project's cash flows
An opportunity cost is the benefit lost by taking one course of action instead of the next best alternative. Because the company loses the Rs. 1 million rental income by undertaking the project, it is a relevant cash outflow for the project appraisal.
Question 3
Which of the following is a major theoretical weakness of the Payback Period method for investment appraisal?
- A) It completely ignores the time value of money and any cash flows that occur after the payback point is reached
- B) It is too complex for non-financial managers to understand
- C) It strictly focuses on accounting profits rather than cash flows
- D) It assumes cash flows are reinvested at the internal rate of return
Show answer & explanation
Answer: A) It completely ignores the time value of money and any cash flows that occur after the payback point is reached
The Payback Period's greatest flaws are that it treats a rupee received in Year 1 the same as a rupee received in Year 4 (ignoring discounting), and it completely ignores how much wealth the project generates after the initial investment is recovered.
Question 4
A project requires an initial investment of Rs. 100,000. It is expected to generate an Internal Rate of Return (IRR) of 15%. The company's cost of capital (WACC) is 12%. According to the IRR decision rule, the company should:
- A) Reject the project because 12% is lower than 15%
- B) Accept the project because the IRR (15%) is greater than the company's cost of capital (12%)
- C) Delay the project until the cost of capital reaches 15%
- D) Recalculate the project using the payback period before deciding
Show answer & explanation
Answer: B) Accept the project because the IRR (15%) is greater than the company's cost of capital (12%)
The IRR is the discount rate that yields an NPV of zero. The standard decision rule is to accept the project if its IRR is strictly greater than the target required rate of return (cost of capital), as it will increase shareholder wealth.
Question 5
When capital is strictly limited at Time 0, a company cannot undertake all projects with a positive NPV. To maximize shareholder wealth across divisible projects, the company should rank the projects based on their:
- A) Internal Rate of Return (IRR)
- B) Payback Period
- C) Profitability Index (PI)
- D) Equivalent Annual Cost (EAC)
Show answer & explanation
Answer: C) Profitability Index (PI)
Under single-period capital rationing, if projects are divisible, the optimal way to allocate limited funds is to rank projects by their Profitability Index (NPV divided by Initial Investment). This identifies the projects that generate the most value per rupee invested.
Question 6
How is an investment in 'Working Capital' treated at the end of a project's life in a standard Net Present Value (NPV) calculation?
- A) It is treated as a sunk cost and written off
- B) It is added to the tax allowable depreciation
- C) It is assumed to be fully recovered and is treated as a cash inflow in the final year
- D) It is treated as a continuing cash outflow into perpetuity
Show answer & explanation
Answer: C) It is assumed to be fully recovered and is treated as a cash inflow in the final year
Working capital (inventory and receivables) is tied up during the project but is not 'consumed' like machinery. At the end of the project, inventory is sold and receivables are collected, meaning 100% of the working capital investment is recovered as a cash inflow.
Question 7
A company is comparing two different machines that produce the exact same output but have different useful lives. Machine A lasts 3 years, and Machine B lasts 5 years. Which DCF technique must be used to properly compare and select the most cost-effective machine?
- A) Profitability Index (PI)
- B) Internal Rate of Return (IRR)
- C) Equivalent Annual Cost (EAC)
- D) Discounted Payback Period
Show answer & explanation
Answer: C) Equivalent Annual Cost (EAC)
When deciding between assets with different useful economic lives (asset replacement cycles), comparing their raw NPVs is unfair. You must calculate the Equivalent Annual Cost (EAC) by dividing each machine's NPV of costs by its respective annuity factor.
Question 8
A business faces a choice between two mutually exclusive projects. Project X has an NPV of Rs. 50,000 and an IRR of 18%. Project Y has an NPV of Rs. 70,000 and an IRR of 14%. The company's cost of capital is 10%. Which project should the company accept?
- A) Project X, because its IRR is higher
- B) Project Y, because its absolute NPV is higher
- C) Both projects, because their IRRs exceed the cost of capital
- D) Neither project, because the results conflict
Show answer & explanation
Answer: B) Project Y, because its absolute NPV is higher
When NPV and IRR give conflicting rankings for mutually exclusive projects, the NPV rule must always prevail. NPV measures the absolute increase in shareholder wealth (Rs. 70,000), which is the primary objective of financial management.
Question 9
In an NPV calculation involving taxation, how should the accounting depreciation of machinery be treated?
- A) It should be deducted from cash flows as a regular cash outflow
- B) It should be added to the project's revenues
- C) It must be ignored entirely as it is a non-cash item, but the tax savings (tax shield) generated by tax allowable depreciation must be included as a cash inflow
- D) It must be discounted at the risk-free rate
Show answer & explanation
Answer: C) It must be ignored entirely as it is a non-cash item, but the tax savings (tax shield) generated by tax allowable depreciation must be included as a cash inflow
Accounting depreciation is a non-cash allocation and is excluded from DCF analysis. However, tax authorities grant 'tax-allowable depreciation,' which reduces the company's tax bill. This tax saving is a real cash benefit and must be recorded as an inflow.
Question 10
When dealing with inflation in an NPV calculation, what is the fundamental rule for matching cash flows to discount rates?
- A) Money (nominal) cash flows must be discounted at the real cost of capital
- B) Real cash flows must be discounted at the money (nominal) cost of capital
- C) Money (nominal) cash flows must be discounted at the money (nominal) cost of capital
- D) Inflation should be ignored entirely unless it exceeds 10%
Show answer & explanation
Answer: C) Money (nominal) cash flows must be discounted at the money (nominal) cost of capital
The fundamental rule for consistency in investment appraisal under inflation is to match like with like. If you inflate the specific cash flows (money cash flows), you must discount them using a rate that also includes inflation (the money/nominal cost of capital).
Question 11
A company is forced to reject a highly profitable project because its internal Board of Directors has imposed a strict limit on the capital expenditure budget for the year, prioritizing stability over rapid expansion. This scenario is an example of:
- A) Hard capital rationing
- B) Soft capital rationing
- C) The asset replacement cycle
- D) Bootstrapping
Show answer & explanation
Answer: B) Soft capital rationing
Soft capital rationing occurs when the limits on investment funds are imposed internally by the company's own management or board of directors. Hard capital rationing occurs when the restrictions are imposed externally by financial markets or banks.
Question 12
What does a 'Perpetuity Factor' allow a financial analyst to calculate?
- A) The exact date a project will break even
- B) The present value of an equal, regular cash flow that continues forever into infinity
- C) The inflation-adjusted cost of raw materials
- D) The tax shield on a machine's disposal value
Show answer & explanation
Answer: B) The present value of an equal, regular cash flow that continues forever into infinity
A perpetuity is an annuity that goes on forever. The perpetuity factor (calculated as 1 / r) allows an analyst to take a constant annual cash flow expected to last into infinity and express it as a single, finite present value today.
Question 13
A business is evaluating a project. General fixed overheads of the head office, amounting to Rs. 200,000, have been allocated to this specific project by the accounting department. In the NPV calculation, this allocated overhead should be:
- A) Treated as a relevant cash outflow in Year 1
- B) Capitalized as part of the initial investment
- C) Completely ignored, as general allocated overheads are not incremental cash flows
- D) Deducted from the working capital requirement
Show answer & explanation
Answer: C) Completely ignored, as general allocated overheads are not incremental cash flows
Under relevant costing principles, apportioned or allocated general fixed overheads are ignored because they are incurred by the company regardless of whether the project is accepted or rejected. They do not represent new, incremental cash outflows.
Question 14
At the end of a project's life, a machine is sold for Rs. 50,000. Its remaining Tax Written Down Value (WDV) is Rs. 80,000. Under the tax rules for capital allowances, this transaction will trigger:
- A) A balancing charge, resulting in a tax payment
- B) A balancing allowance, resulting in a tax saving
- C) A capital gains tax on the Rs. 30,000 difference
- D) No tax consequence, as it offsets the working capital recovery
Show answer & explanation
Answer: B) A balancing allowance, resulting in a tax saving
When an asset is sold for less than its Tax WDV, the company has not claimed enough tax depreciation over the asset's life. The tax authority grants a 'balancing allowance' for the shortfall (Rs. 30,000), generating a tax saving (inflow) in the final year.
Question 15
A project requires an initial investment of Rs. 40,000. It generates cash inflows of Rs. 15,000 in Year 1, Rs. 20,000 in Year 2, and Rs. 10,000 in Year 3. Assuming cash flows arise evenly throughout the year, what is the exact Payback Period?
- A) 2.0 years
- B) 3.0 years
- C) 2.5 years
- D) 1.5 years
Show answer & explanation
Answer: C) 2.5 years
By the end of Year 2, Rs. 35,000 has been recovered (15,000 + 20,000), leaving a shortfall of Rs. 5,000. In Year 3, Rs. 10,000 is generated. The time required in Year 3 is 5,000 / 10,000 = 0.5 years. Total payback period = 2.5 years.