Financial Management for Project Managers Capital Budgeting 2 — Questions and Answers
Question 1: Depreciation is relevant to capital budgeting primarily because:
- It increases a project's cash outflows
- It reduces taxable income, creating a tax shield (Correct answer)
- It directly increases project revenue
- It is added to the initial investment
Correct answer: It reduces taxable income, creating a tax shield
Depreciation reduces taxable income, which lowers the tax liability and creates a non-cash tax shield that improves after-tax cash flows.
Question 2: The discount rate used in NPV analysis for a project is most commonly the:
- Prime lending rate
- Risk-free Treasury rate
- Weighted Average Cost of Capital (WACC) (Correct answer)
- Inflation rate
Correct answer: Weighted Average Cost of Capital (WACC)
WACC represents the blended cost of all capital sources and is the standard hurdle rate used to discount project cash flows in NPV analysis.
Question 3: An incremental cash flow in capital budgeting refers to:
- Total revenue generated by the project
- Cash flows that occur only if the project is undertaken (Correct answer)
- All historical costs related to the project
- The financing costs of the project
Correct answer: Cash flows that occur only if the project is undertaken
Incremental cash flows are the additional cash flows that result specifically from accepting a project, excluding sunk costs and including opportunity costs.
Question 4: Which capital budgeting term describes the minimum acceptable rate of return on a project investment?
- Opportunity cost
- Hurdle rate (Correct answer)
- Inflation rate
- Residual value
Correct answer: Hurdle rate
The hurdle rate is the minimum rate of return required by management before approving a capital investment project.
Question 5: Sunk costs should be treated in capital budgeting decisions by:
- Including them as part of the initial investment
- Excluding them because they are irrelevant to future decisions (Correct answer)
- Subtracting them from projected cash inflows
- Amortizing them over the project life
Correct answer: Excluding them because they are irrelevant to future decisions
Sunk costs are past expenditures that cannot be recovered and therefore should not influence future capital budgeting decisions.
Question 6: The Modified Internal Rate of Return (MIRR) addresses which key weakness of traditional IRR?
- It does not account for project size
- It assumes reinvestment at the project's own IRR rather than the cost of capital (Correct answer)
- It ignores the initial investment amount
- It cannot handle negative cash flows
Correct answer: It assumes reinvestment at the project's own IRR rather than the cost of capital
MIRR corrects the reinvestment rate assumption by using the cost of capital as the reinvestment rate, making it more realistic than traditional IRR.
Financial Management for Project Managers Capital Budgeting 2
Depreciation is relevant to capital budgeting primarily because: