CIA CIA Capital Investment & Decision Making 1 — Questions and Answers
Question 1: Which capital budgeting method calculates the time required for an investment's cash inflows to recover the initial outlay?
- Payback period (Correct answer)
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
- Profitability Index
Correct answer: Payback period
The payback period measures how quickly an investment recovers its cost, though it ignores cash flows beyond that point and the time value of money.
Question 2: A project has an NPV of $0. This means the project:
- Earns exactly the required rate of return, neither creating nor destroying value (Correct answer)
- Should be rejected because it generates no profit
- Will generate cash flows equal to the initial investment only
- Has an IRR lower than the cost of capital
Correct answer: Earns exactly the required rate of return, neither creating nor destroying value
An NPV of zero indicates the project generates returns precisely equal to the hurdle rate, meaning investors receive their required return but no surplus value is created.
Question 3: When comparing two mutually exclusive projects, which capital budgeting method is generally preferred for decision-making?
- Net Present Value (NPV) (Correct answer)
- Internal Rate of Return (IRR)
- Payback Period
- Accounting Rate of Return
Correct answer: Net Present Value (NPV)
NPV is preferred because it directly measures value creation in dollar terms and avoids the multiple-IRR problem that can arise with non-conventional cash flows.
Question 4: The 'hurdle rate' used in capital investment decisions represents:
- The minimum acceptable rate of return required to justify the investment (Correct answer)
- The maximum interest rate available on bank loans
- The historical average return of similar projects in the industry
- The tax rate applied to capital gains from the investment
Correct answer: The minimum acceptable rate of return required to justify the investment
The hurdle rate, often the weighted average cost of capital (WACC), is the benchmark return a project must exceed to be considered value-creating.
Question 5: In capital investment analysis, 'sunk costs' should be:
- Excluded from the analysis because they are irreversible and cannot be recovered (Correct answer)
- Included as a key factor in the investment decision
- Depreciated over the life of the new project
- Offset against future revenues in the NPV calculation
Correct answer: Excluded from the analysis because they are irreversible and cannot be recovered
Sunk costs have already been incurred and cannot be changed by any future decision, so including them would distort the true incremental analysis of a new investment.
Question 6: Which term describes the additional revenue or cost that arises from choosing one investment option over another?
- Incremental (differential) cash flow (Correct answer)
- Sunk cost
- Opportunity cost
- Terminal cash flow
Correct answer: Incremental (differential) cash flow
Incremental cash flows represent the change in total cash flows attributable solely to the investment decision under evaluation.
CIA CIA Capital Investment & Decision Making 1
Which capital budgeting method calculates the time required for an investment's cash inflows to recover the initial outlay?