CIMA BA2 · Chapter 12
Investment appraisal MCQs with Answers
13 multiple-choice questions on Investment appraisal for CIMA BA2 Fundamentals of Management Accounting. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
What is the INTERNAL RATE OF RETURN of a project?
- A) The cost of capital used to calculate the project's NPV
- B) The discount rate at which the project's net present value is zero
- C) The average annual accounting profit divided by the initial investment
- D) The rate at which the project's cash inflows double
Show answer & explanation
Answer: B) The discount rate at which the project's net present value is zero
The IRR is the discount rate that makes the present value of inflows equal to the present value of outflows, so NPV = 0. A project is acceptable if its IRR exceeds the cost of capital. Average profit divided by investment is the accounting rate of return.
Question 2
A project costs $250,000 and is expected to generate cash inflows of $70,000 in year 1, $80,000 in year 2, $90,000 in year 3 and $60,000 in year 4. Cash flows arise evenly through each year. What is the payback period, to the nearest month?
- A) 3 years 10 months
- B) 4 years 2 months
- C) 3 years 2 months
- D) 3 years 4 months
Show answer & explanation
Answer: C) 3 years 2 months
Cumulative cash inflows: year 1 $70,000; year 2 $150,000; year 3 $240,000. A further $10,000 is needed in year 4, when $60,000 arises evenly: $10,000 / $60,000 x 12 months = 2 months. Payback = 3 years 2 months (3.17 years).
Question 3
A project requires an investment of $120,000 now and will generate cash inflows of $40,000 a year for 4 years, starting in one year's time. The cost of capital is 10%. Using a 4-year annuity factor at 10% of 3.170, what is the net present value?
- A) $40,000
- B) $6,800
- C) $31,640
- D) -$6,800
Show answer & explanation
Answer: B) $6,800
PV of inflows = $40,000 x 3.170 = $126,800. NPV = $126,800 - $120,000 = $6,800. The NPV is positive, so the project is worthwhile at 10%.
Question 4
A project costs $80,000 now and generates cash inflows of $30,000, $35,000 and $40,000 at the end of years 1, 2 and 3 respectively. The cost of capital is 12% and the discount factors are: year 1 0.893, year 2 0.797, year 3 0.712. What is the net present value?
- A) $25,000
- B) -$5,240
- C) $83,165
- D) $3,165
Show answer & explanation
Answer: D) $3,165
PVs: $30,000 x 0.893 = $26,790; $35,000 x 0.797 = $27,895; $40,000 x 0.712 = $28,480. Total PV = $83,165. NPV = $83,165 - $80,000 = $3,165.
Question 5
A project costs $120,000 now and will generate cash inflows of $40,000 a year for 4 years, starting in one year's time. At a 10% discount rate the 4-year annuity factor is 3.170, giving an NPV of $6,800. At 15% the 4-year annuity factor is 2.855. Using linear interpolation, what is the internal rate of return, to one decimal place?
- A) 12.3%
- B) 12.7%
- C) 15.9%
- D) 12.5%
Show answer & explanation
Answer: B) 12.7%
NPV at 15% = ($40,000 x 2.855) - $120,000 = $114,200 - $120,000 = -$5,800. IRR = 10% + [6,800 / (6,800 + 5,800)] x (15% - 10%) = 10% + (6,800 / 12,600) x 5% = 12.7% (to one decimal place).
Question 6
An investment will pay $15,000 a year in perpetuity, with the first receipt in one year's time. The cost of capital is 8%. What is the present value of the receipts?
- A) $202,500
- B) $120,000
- C) $13,889
- D) $187,500
Show answer & explanation
Answer: D) $187,500
PV of a perpetuity starting in one year = annual cash flow / cost of capital = $15,000 / 0.08 = $187,500. Adding a further $15,000 would apply only if the first receipt were today.
Question 7
$20,000 is invested for 5 years at 6% a year compound interest. What is the value of the investment at the end of 5 years, to the nearest $?
- A) $26,765
- B) $26,000
- C) $106,000
- D) $14,945
Show answer & explanation
Answer: A) $26,765
Future value = $20,000 x (1.06)^5 = $20,000 x 1.3382 = $26,765 to the nearest $. Simple interest would give only $20,000 + (5 x $1,200) = $26,000.
Question 8
A project will generate $10,000 a year at the end of each of years 3 to 7 inclusive. The cost of capital is 10%. The annuity factors at 10% are: years 1-2 1.736; years 1-5 3.791; years 1-7 4.868. What is the present value of these cash flows?
- A) $37,910
- B) $23,810
- C) $48,680
- D) $31,320
Show answer & explanation
Answer: D) $31,320
The cash flows form an annuity for years 3-7. PV = $10,000 x (annuity factor years 1-7 - annuity factor years 1-2) = $10,000 x (4.868 - 1.736) = $10,000 x 3.132 = $31,320.
Question 9
Which of the following is a disadvantage of the PAYBACK method of investment appraisal?
- A) It is difficult to calculate and understand
- B) It favours projects that return cash quickly
- C) It uses cash flows rather than accounting profits
- D) It ignores cash flows that arise after the payback period
Show answer & explanation
Answer: D) It ignores cash flows that arise after the payback period
Payback considers only how quickly the initial investment is recovered and ignores all later cash flows, so it can reject highly profitable long-term projects. In its basic form it also ignores the time value of money. Simplicity, an emphasis on early returns and the use of cash flows are generally seen as advantages.
Question 10
Using the net present value method, when should an independent project be accepted?
- A) When its NPV is lower than its initial investment
- B) When its payback period is shorter than its life
- C) When its NPV at the cost of capital is positive
- D) When its total undiscounted inflows exceed the initial investment
Show answer & explanation
Answer: C) When its NPV at the cost of capital is positive
A positive NPV means the project's cash inflows, discounted at the cost of capital, exceed the outflows, so it increases shareholder wealth. Undiscounted comparisons ignore the time value of money.
Question 11
Which of the following should be EXCLUDED from the cash flows used in a net present value calculation?
- A) The additional working capital needed at the start of the project
- B) Depreciation of the new equipment
- C) The scrap value of the equipment at the end of the project
- D) Additional fixed overheads incurred only because of the project
Show answer & explanation
Answer: B) Depreciation of the new equipment
NPV uses relevant cash flows. Depreciation is a non-cash accounting allocation of the asset's cost; the cost itself is already included as the initial cash outflow. Working capital invested (and later released), scrap proceeds and incremental fixed costs are all relevant cash flows.
Question 12
A lender charges interest of 1.5% per month, compounded monthly. What is the equivalent annual interest rate, to two decimal places?
- A) 18.00%
- B) 18.69%
- C) 19.56%
- D) 1.50%
Show answer & explanation
Answer: C) 19.56%
Equivalent annual rate = (1 + monthly rate)^12 - 1 = (1.015)^12 - 1 = 1.1956 - 1 = 19.56%. Multiplying 1.5% by 12 (18%) ignores the compounding of interest each month.
Question 13
A company will pay $5,000 a year for 5 years to lease a machine, with each payment made IN ADVANCE (the first payment is made today). The cost of capital is 10%. The annuity factors at 10% are: 4 years 3.170; 5 years 3.791. What is the present value of the lease payments?
- A) $18,955
- B) $25,000
- C) $15,850
- D) $20,850
Show answer & explanation
Answer: D) $20,850
The first payment is at time 0 (factor 1.000) and the remaining four are at the end of years 1 to 4. PV = $5,000 x (1.000 + 3.170) = $5,000 x 4.170 = $20,850. Using the 5-year factor (3.791) wrongly assumes payments in arrears.