US CMA Part 2 · Chapter 8
Capital investment decisions MCQs with Answers
15 multiple-choice questions on Capital investment decisions for US CMA Part 2 Strategic Financial Management. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
For the Sefton Labs project (initial investment $600,000, present value of future cash inflows $644,436), what is the profitability index?
- A) 1.07
- B) 0.07
- C) 0.93
- D) 1.42
Show answer & explanation
Answer: A) 1.07
Profitability index = PV of future cash inflows / initial investment = $644,436 / $600,000 = 1.07. A PI above 1.0 corresponds to a positive NPV. 0.07 is NPV divided by investment (the net PI), which differs from the PI by exactly 1.
Question 2
Which of the following cash flows should be EXCLUDED when evaluating a proposed capital project?
- A) Interest payments on debt used to finance the project
- B) The increase in net working capital required at the start of the project
- C) Lost after-tax contribution from an existing product that the new product will replace
- D) The after-tax salvage value of the equipment at the end of the project
Show answer & explanation
Answer: A) Interest payments on debt used to finance the project
Financing costs are excluded from project cash flows because the cost of financing is captured in the discount rate; including interest as well would double count it. Salvage value, working capital investment and the erosion (cannibalization) of existing sales are all relevant incremental cash flows.
Question 3
Quayle Packaging will buy a machine for $800,000 plus $40,000 of shipping and installation, and will need an additional $60,000 of net working capital. The old machine will be sold for $100,000; its tax basis is $140,000. The tax rate is 25%. What is the net initial investment?
- A) $810,000
- B) $800,000
- C) $730,000
- D) $790,000
Show answer & explanation
Answer: D) $790,000
Tax loss on old machine = $140,000 - $100,000 = $40,000, creating a tax saving of $40,000 x 25% = $10,000. After-tax proceeds = $100,000 + $10,000 = $110,000. Net initial investment = $800,000 + $40,000 + $60,000 - $110,000 = $790,000.
Question 4
A project will increase annual revenue by $300,000 and cash operating costs by $120,000. Annual tax depreciation is $100,000 and the tax rate is 25%. What is the annual after-tax operating cash flow?
- A) $60,000
- B) $135,000
- C) $180,000
- D) $160,000
Show answer & explanation
Answer: D) $160,000
Taxable income = $300,000 - $120,000 - $100,000 = $80,000. Net income = $80,000 x (1 - 25%) = $60,000. Add back non-cash depreciation: $60,000 + $100,000 = $160,000. Alternatively: ($180,000 x 0.75) + ($100,000 x 0.25) = $135,000 + $25,000 = $160,000.
Question 5
A company records annual tax depreciation of $100,000 on new equipment and its tax rate is 25%. What is the annual depreciation tax shield?
- A) $400,000
- B) $100,000
- C) $75,000
- D) $25,000
Show answer & explanation
Answer: D) $25,000
Depreciation tax shield = depreciation x tax rate = $100,000 x 25% = $25,000. Depreciation is not a cash outflow, but it reduces taxable income and therefore cash taxes paid.
Question 6
Rowan Dental invests $500,000 in equipment expected to generate after-tax cash inflows of $120,000, $150,000, $180,000 and $200,000 in Years 1 to 4. Assuming even cash flows within each year, what is the payback period?
- A) 3.25 years
- B) 4.00 years
- C) 3.28 years
- D) 3.08 years
Show answer & explanation
Answer: A) 3.25 years
Cumulative inflows: Year 1 $120,000; Year 2 $270,000; Year 3 $450,000. $50,000 remains to be recovered in Year 4, when $200,000 is received: $50,000 / $200,000 = 0.25 year. Payback = 3 + 0.25 = 3.25 years. Dividing the investment by average annual inflow (3.08 years) is only valid for even cash flows.
Question 7
Sefton Labs is evaluating a $600,000 investment that will generate after-tax cash inflows of $170,000 per year for 5 years with no salvage value. The required return is 10% (5-year annuity factor 3.7908). What is the NPV (rounded to the nearest dollar)?
- A) $644,436
- B) $44,436
- C) $12,812
- D) $250,000
Show answer & explanation
Answer: B) $44,436
PV of inflows = $170,000 x 3.7908 = $644,436. NPV = $644,436 - $600,000 = $44,436. The project is acceptable because NPV is positive. Ignoring the time value of money gives $250,000, which overstates the gain.
Question 8
Talbot Freight can invest $400,000 in a project that produces after-tax cash inflows of $130,000 per year for 4 years. Which of the following is closest to the project's internal rate of return?
- A) 32.5%
- B) 11.4%
- C) 8.4%
- D) 7.5%
Show answer & explanation
Answer: B) 11.4%
At the IRR, the PV of inflows equals the investment, so the required annuity factor = $400,000 / $130,000 = 3.0769. The 4-year annuity factor is 3.1699 at 10% and 3.0373 at 12%, so the IRR lies between them; solving precisely gives 11.39%, or about 11.4%. 32.5% is the payback reciprocal and 7.5% is an undiscounted average return.
Question 9
Two mutually exclusive projects of the same size and life are being evaluated. Project M has the higher NPV at the firm's cost of capital, while Project N has the higher IRR. Which project should be selected, and why?
- A) Either project, because NPV and IRR always give the same ranking
- B) Project N, because a higher IRR always means a higher return to shareholders
- C) Project N, because IRR assumes reinvestment at the cost of capital
- D) Project M, because NPV measures the increase in shareholder wealth and assumes reinvestment at the cost of capital
Show answer & explanation
Answer: D) Project M, because NPV measures the increase in shareholder wealth and assumes reinvestment at the cost of capital
When NPV and IRR rank mutually exclusive projects differently (because of differences in timing of cash flows or scale), the NPV ranking should be followed. NPV measures the absolute increase in wealth and implicitly assumes reinvestment at the cost of capital, whereas IRR assumes reinvestment at the IRR itself, which is often unrealistic.
Question 10
At the end of a project, equipment with a tax basis of $0 will be sold for $50,000, and the $60,000 of net working capital invested at the start will be fully recovered. The tax rate is 25%. What is the total terminal-year non-operating cash flow?
- A) $97,500
- B) $37,500
- C) $110,000
- D) $82,500
Show answer & explanation
Answer: A) $97,500
Gain on sale = $50,000 - $0 = $50,000, so tax = $50,000 x 25% = $12,500 and after-tax salvage = $37,500. Recovery of working capital is not taxable: $60,000. Terminal cash flow = $37,500 + $60,000 = $97,500.
Question 11
Upton Robotics invests $300,000 in a project producing after-tax cash inflows of $120,000 at the end of each of the next 4 years. The discount rate is 10%. What is the discounted payback period (to two decimals, assuming even flows within the year)?
- A) 3.52 years
- B) 4.00 years
- C) 2.50 years
- D) 3.02 years
Show answer & explanation
Answer: D) 3.02 years
PV of inflows at 10%: Year 1 $109,091; Year 2 $99,174; Year 3 $90,158; Year 4 $81,962. Cumulative PV after Year 3 = $298,422, leaving $1,578 to recover from Year 4's $81,962: 0.02 year. Discounted payback = 3 + 0.02 = 3.02 years. The simple payback of 2.50 years ignores the time value of money.
Question 12
A financial analyst recalculates a project's NPV several times, changing only the sales volume assumption each time while holding all other inputs constant, to see how much NPV changes. This technique is:
- A) Monte Carlo simulation
- B) Sensitivity analysis
- C) Scenario analysis
- D) Real options analysis
Show answer & explanation
Answer: B) Sensitivity analysis
Sensitivity analysis changes one input at a time to see how responsive the outcome is, identifying the variables that matter most. Scenario analysis changes several inputs together to reflect consistent states such as best, base and worst cases. Monte Carlo simulation draws thousands of random combinations of inputs from probability distributions.
Question 13
Which statement best describes Monte Carlo simulation in capital budgeting?
- A) It calculates the single NPV that results from management's most likely estimates
- B) It converts uncertain cash flows to certainty equivalents before discounting at the risk-free rate
- C) It repeatedly draws values for uncertain inputs from probability distributions to generate a distribution of possible NPVs
- D) It discounts cash flows at a rate adjusted upward for project risk
Show answer & explanation
Answer: C) It repeatedly draws values for uncertain inputs from probability distributions to generate a distribution of possible NPVs
Monte Carlo simulation assigns probability distributions to key variables, runs many trials with randomly selected values and produces a distribution of NPV outcomes, from which management can estimate the probability of a negative NPV. Risk-adjusted discount rates and certainty equivalents are alternative ways of incorporating risk.
Question 14
A mining company's project has a slightly negative NPV based on expected cash flows, but the company can abandon the project and sell the equipment if commodity prices fall. How does this flexibility affect the evaluation?
- A) The abandonment option has value, which should be added to the static NPV and may make the project acceptable
- B) It reduces the project's value, because abandonment would mean losing the initial investment
- C) It should be ignored, because options apply only to financial securities
- D) It has no effect, because only expected cash flows matter in NPV analysis
Show answer & explanation
Answer: A) The abandonment option has value, which should be added to the static NPV and may make the project acceptable
Real options, such as the option to abandon, expand, delay or switch, give management flexibility to respond to new information. An abandonment option limits downside losses, so it has positive value. The strategic (expanded) NPV equals static NPV plus the value of the real options and can turn a marginally negative project into an acceptable one.
Question 15
Vernon Corp. has a capital budget of $1,000,000. Its independent projects cannot be divided: Project A: cost $600,000, NPV $150,000 Project B: cost $400,000, NPV $120,000 Project C: cost $500,000, NPV $140,000 Project D: cost $300,000, NPV $60,000 Which combination maximizes total NPV within the budget?
- A) A and B, with total NPV of $270,000
- B) A and D, with total NPV of $210,000
- C) B and C, with total NPV of $260,000
- D) B, C and D, with total NPV of $320,000
Show answer & explanation
Answer: A) A and B, with total NPV of $270,000
NPV per dollar invested (NPV / cost) is B 0.30, C 0.28, A 0.25 and D 0.20 (equivalent to profitability indexes of 1.30, 1.28, 1.25 and 1.20). Ranking on this basis selects B and C ($900,000, NPV $260,000), but the remaining $100,000 cannot fund another indivisible project. Checking feasible combinations: A + B uses exactly $1,000,000 for NPV $270,000, the highest. B + C + D would cost $1,200,000, which exceeds the budget. With indivisible projects, combinations must be compared directly.