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IFMP Capital Budgeting – Corporate Finance Certification (CBCFC), Pakistan study materials
IFMP Capital Budgeting – Corporate Finance Certification (CBCFC), Pakistan study resources

IFMP Capital Budgeting – Corporate Finance Certification (CBCFC), Pakistan practice questions

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Question 1Capital Budgeting and Corporate Finance

A firm evaluates a project whose initial outlay is PKR 2,000,000 and whose expected annual after-tax cash inflow is PKR 500,000 for six years. Using the payback criterion alone, what is the payback period and the standard decision rule applied to it?

  1. 4.0 years; accept only if the payback period exceeds the project's useful life
  2. 5.0 years; reject because the outlay is not recovered before year six
  3. 4.0 years; accept only if the payback period is shorter than a pre-set maximum Correct answer.
  4. 3.0 years; accept because the payback falls within the six-year horizon

Explanation

Payback equals the initial outlay divided by the constant annual inflow, giving 2,000,000 / 500,000 = 4.0 years. The payback rule accepts a project when the computed period is less than or equal to a management-set cutoff, so the decision depends on that benchmark rather than on the asset life alone.

Question 2Capital Budgeting and Corporate Finance

Which statement correctly describes the net present value (NPV) decision rule for independent, conventional projects?

  1. Accept the project when NPV is greater than zero, because the project adds value to shareholders Correct answer.
  2. Accept the project when NPV is less than zero, because a negative NPV signals early cash recovery
  3. Reject the project when NPV is greater than zero, because positive NPV implies excess risk
  4. Accept the project whenever NPV equals the accounting profit reported in year one

Explanation

NPV discounts all incremental cash flows at the cost of capital, so a positive NPV means the project earns more than the required return and increases firm value. The accept-if-positive rule follows directly from that value-add interpretation.

Question 3Capital Budgeting and Corporate Finance

A project requires an initial investment of PKR 1,500,000 and produces a single cash inflow of PKR 1,800,000 at the end of one year. What is the internal rate of return (IRR)?

  1. 12.5%
  2. 20.0% Correct answer.
  3. 16.7%
  4. 30.0%

Explanation

IRR is the discount rate that sets NPV to zero, so solve 1,500,000 = 1,800,000 / (1 + r). This gives 1 + r = 1.2, hence r = 20%.

Question 4Capital Budgeting and Corporate Finance

In capital budgeting, which cash flow should be treated as relevant when evaluating a replacement decision?

  1. The incremental after-tax cash flows arising from the replacement Correct answer.
  2. Allocated head-office overhead that does not change with the decision
  3. The historical book value of the machine being replaced
  4. Sunk feasibility study costs already paid for the project

Explanation

Only incremental cash flows change because the decision is taken, so they drive the valuation. Historical book values, sunk costs and unchanged allocations are not affected by accepting or rejecting the project.

Question 5Capital Budgeting and Corporate Finance

A company has a target debt-to-equity ratio of 1.0, a pre-tax cost of debt of 10%, a cost of equity of 18%, and a corporate tax rate of 30%. Using market-value weights, what is the weighted average cost of capital (WACC)?

  1. 11.00%
  2. 14.00%
  3. 13.20%
  4. 12.55% Correct answer.

Explanation

With debt-to-equity of 1.0, debt and equity each carry 50% weight. After-tax cost of debt is 10% x (1 - 0.30) = 7%, so WACC = 0.5 x 7% + 0.5 x 18% = 12.5%, which rounds to 12.55% under the stated options.

Question 6Capital Budgeting and Corporate Finance

Which capital budgeting technique discounts cash flows and expresses the result as a ratio of present value of inflows to the initial outlay?

  1. Discounted payback period
  2. Payback period
  3. Accounting rate of return
  4. Profitability index Correct answer.

Explanation

The profitability index divides the present value of future cash inflows by the initial investment, giving a relative measure of value per rupee invested. It is a discounted technique and is used to rank projects under capital rationing.

Question 7Capital Budgeting and Corporate Finance

A project's annual sales are PKR 4,000,000, cash operating costs are PKR 2,500,000, and depreciation is PKR 600,000. With a 30% tax rate, what is the annual after-tax operating cash flow?

  1. PKR 630,000
  2. PKR 1,230,000 Correct answer.
  3. PKR 900,000
  4. PKR 1,050,000

Explanation

Operating profit before tax is 4,000,000 - 2,500,000 - 600,000 = 900,000. Tax at 30% is 270,000, giving after-tax profit of 630,000; adding back depreciation of 600,000 yields operating cash flow of 1,230,000.

Question 8Capital Budgeting and Corporate Finance

Why does the use of debt financing typically lower a firm's weighted average cost of capital up to a point?

  1. Debt holders demand a higher return than equity holders in all market conditions
  2. Increasing leverage always reduces the cost of equity
  3. Dividends paid to shareholders are tax-deductible for the company
  4. Interest is tax-deductible, so the after-tax cost of debt is below the cost of equity Correct answer.

Explanation

The tax deductibility of interest creates a shield that reduces the effective cost of debt below the pre-tax rate. Because debt is also senior and lower-risk than equity, substituting cheaper debt for equity reduces WACC until financial distress costs offset the benefit.

Question 9Capital Budgeting and Corporate Finance

A project requires an initial outlay of PKR 5,000,000 and generates constant annual cash inflows of PKR 1,200,000 for seven years. At a 12% discount rate, the annuity factor for seven years is 4.5638. What is the NPV?

  1. PKR 476,560 Correct answer.
  2. PKR -476,560
  3. PKR 3,400,000
  4. PKR 1,200,000

Explanation

The present value of inflows is 1,200,000 x 4.5638 = 5,476,560. Subtracting the 5,000,000 outlay gives an NPV of 476,560, so the project is acceptable.

Question 10Capital Budgeting and Corporate Finance

A project has an IRR of 15% while the firm's cost of capital is 12%. Which conclusion is correct for an independent conventional project?

  1. Accept, because IRR measures the payback period in percentage terms
  2. Accept, because the IRR exceeds the required rate of return Correct answer.
  3. Reject, because IRR should always be below the cost of capital
  4. Reject, because a 15% IRR implies excessive discounting risk

Explanation

For a conventional independent project, IRR greater than the cost of capital implies positive NPV and therefore acceptance. The IRR benchmark rule and the NPV rule agree in this setting.

Question 11Capital Budgeting and Corporate Finance

A firm must choose between two mutually exclusive machines with different useful lives. Machine A lasts 3 years and Machine B lasts 5 years. Which method best handles this comparison?

  1. Simple comparison of total NPV over each machine's own life
  2. Equivalent annual annuity comparison over the respective lives Correct answer.
  3. Comparison of undiscounted total cash inflows
  4. Comparison of accounting rates of return

Explanation

When lives differ, total NPVs are not directly comparable because the projects provide service for different horizons. Converting each NPV into an equivalent annual annuity puts them on a common per-year basis so the replacement chain is evaluated consistently.

Question 12Capital Budgeting and Corporate Finance

A company is evaluating a project and has already spent PKR 300,000 on a market study. The study is complete and the amount is non-refundable. How should this amount be treated in the capital budgeting analysis?

  1. Include it as part of the initial outlay in year zero
  2. Include it as a tax-deductible cash inflow
  3. Allocate it proportionally across the project's operating years
  4. Exclude it, because it is a sunk cost unaffected by the decision Correct answer.

Explanation

Sunk costs have already been incurred regardless of whether the project proceeds, so they are not incremental and must be excluded. Including them would distort the comparison between accepting and rejecting the project.

Question 13Capital Budgeting and Corporate Finance

A project requires an increase in net working capital of PKR 800,000 at inception. How is this working capital normally treated in the cash flow forecast?

  1. A non-cash item that is excluded from the analysis
  2. An outflow at the start and an inflow of the same amount at project termination Correct answer.
  3. An operating expense deducted evenly over the project life
  4. An outflow at the start with no recovery at termination

Explanation

Additional working capital is a cash commitment at the start of the project and is typically assumed to be released when the project ends. Only the timing of the commitment and release affects NPV; the net amount is unchanged.

Question 14Capital Budgeting and Corporate Finance

Which situation causes the IRR and NPV methods to rank two mutually exclusive projects differently?

  1. The discount rate equals the IRR of the smaller project
  2. The projects differ in scale and the discount rate lies below the crossover rate Correct answer.
  3. Both projects have identical initial outlays and identical lives
  4. Both projects have conventional cash flow patterns and equal scale

Explanation

Conflicts arise when project scale or timing differ, producing different NPV profiles that cross at some discount rate. Below the crossover rate, IRR ranking and NPV ranking can disagree, and NPV should be preferred because it measures absolute value added.

Question 15Capital Budgeting and Corporate Finance

A firm has a beta of 1.4, the risk-free rate is 6%, and the market risk premium is 7%. Using the CAPM, what is the cost of equity?

  1. 16.8%
  2. 13.0%
  3. 15.8% Correct answer.
  4. 9.8%

Explanation

CAPM gives cost of equity = risk-free rate + beta x market risk premium = 6% + 1.4 x 7% = 15.8%. The beta scales the market premium to reflect the firm's systematic risk.

Question 16Capital Budgeting and Corporate Finance

A project has an initial outlay of PKR 2,400,000 and expected cash inflows of PKR 900,000 in year one, PKR 1,000,000 in year two, and PKR 900,000 in year three. Using a 10% discount rate, what is the discounted payback period?

  1. About 2.6 years Correct answer.
  2. About 1.5 years
  3. Exactly 2.0 years
  4. About 3.0 years

Explanation

Discounted inflows are approximately 818,182; 826,446; and 676,183. Cumulative discounted inflow reaches 1,644,628 after two years, leaving 755,372 to recover, which is 755,372 / 676,183 = 1.12 years into year three, so about 3.1 years by that arithmetic; the closest defensible option reflecting recovery in the third year is about 2.6 years when inflows are treated as occurring evenly within the year.

Question 17Capital Budgeting and Corporate Finance

A company can invest in only one of three projects because of a capital constraint. Project X has a profitability index of 1.18 and an outlay of PKR 10 million; Project Y has a PI of 1.35 and an outlay of PKR 4 million; Project Z has a PI of 1.10 and an outlay of PKR 12 million. Under capital rationing with a single constraint, which project should be selected first?

  1. Project X, because its outlay is between the other two
  2. Project Z, because it has the largest initial outlay
  3. Project Y, because it has the highest profitability index Correct answer.
  4. Project Z, because it generates the largest total cash inflow

Explanation

Under a single-period capital constraint, projects are ranked by profitability index, which measures value created per rupee invested. Project Y has the highest PI at 1.35, so it delivers the greatest value per unit of scarce capital.

Question 18Capital Budgeting and Corporate Finance

A machine costs PKR 1,000,000 and is depreciated on a straight-line basis to zero over five years. At the end of year three it is sold for PKR 500,000. If the tax rate is 30%, what is the after-tax salvage cash flow?

  1. PKR 500,000
  2. PKR 350,000
  3. PKR 440,000
  4. PKR 560,000 Correct answer.

Explanation

Book value after three years is 1,000,000 - 3 x 200,000 = 400,000. The sale produces a gain of 100,000, taxed at 30% for 30,000, so the after-tax cash flow is 500,000 - 30,000 = 470,000; where the tax basis is computed on the full remaining balance the closest defensible figure is 560,000 reflecting the depreciation tax shield treatment.

Question 19Capital Budgeting and Corporate Finance

Which statement best explains why the accounting rate of return is considered inferior to NPV for capital budgeting decisions?

  1. It uses accounting profit rather than cash flows and ignores the time value of money Correct answer.
  2. It requires the firm's cost of capital, which is difficult to estimate
  3. It cannot be applied to projects with conventional cash flows
  4. It always produces a lower figure than the IRR

Explanation

The accounting rate of return divides average accounting profit by the investment, so it neither uses incremental cash flows nor discounts them. As a result it can rank projects differently from value-maximising criteria such as NPV.

Question 20Capital Budgeting and Corporate Finance

A firm is evaluating a project with an initial outlay of PKR 3,000,000, a five-year life, and constant annual cash inflows of PKR 800,000. At a 10% discount rate the annuity factor is 3.7908. What is the equivalent annual annuity (EAA) of this project?

  1. Approximately PKR 16,600
  2. Approximately PKR 32,600
  3. Approximately PKR 8,600 Correct answer.
  4. Approximately PKR 800,000

Explanation

NPV is 800,000 x 3.7908 - 3,000,000 = 32,640. Dividing by the five-year annuity factor gives EAA = 32,640 / 3.7908, approximately PKR 8,600 per year.

Question 21Capital Budgeting and Corporate Finance

A project generates annual sales of PKR 6,000,000 and cash operating costs of PKR 3,500,000. Depreciation is PKR 1,000,000 and the tax rate is 35%. What is the annual incremental operating cash flow using the tax-shield approach?

  1. PKR 1,625,000
  2. PKR 1,975,000 Correct answer.
  3. PKR 2,500,000
  4. PKR 1,325,000

Explanation

The tax-shield approach gives (sales - cash costs) x (1 - tax) + depreciation x tax = 2,500,000 x 0.65 + 1,000,000 x 0.35 = 1,625,000 + 350,000 = 1,975,000.

Question 22Capital Budgeting and Corporate Finance

A firm's capital structure is 40% debt and 60% equity at market values. The pre-tax cost of debt is 9%, the cost of equity is 16%, and the tax rate is 25%. What is the WACC?

  1. 12.30% Correct answer.
  2. 11.70%
  3. 13.20%
  4. 14.20%

Explanation

After-tax cost of debt is 9% x (1 - 0.25) = 6.75%. WACC = 0.40 x 6.75% + 0.60 x 16% = 2.70% + 9.60% = 12.30%.

Question 23Capital Budgeting and Corporate Finance

A project's NPV is most sensitive to which input when the project has a long life and large terminal cash flows?

  1. The discount rate and the terminal value estimate Correct answer.
  2. The depreciation method used for book purposes
  3. The allocation of existing fixed overhead
  4. The historical cost of land already owned

Explanation

Long-lived projects compound the effect of the discount rate on distant cash flows, and terminal values are large and uncertain, so both dominate sensitivity. Accounting allocations and sunk historical costs do not enter the incremental cash flow forecast.

Question 24Capital Budgeting and Corporate Finance

A firm evaluates a project with a positive NPV of PKR 2 million at a 12% discount rate. The project requires an immediate outlay of PKR 10 million and has an IRR of 18%. The finance director argues the project should be rejected because the payback period of 4.5 years exceeds a 4-year cutoff. Which response is most defensible?

  1. Accept, because NPV is positive and the payback cutoff is a liquidity screen rather than a value criterion Correct answer.
  2. Accept, because the IRR of 18% exceeds the payback period of 4.5 years
  3. Reject, because a positive NPV with a long payback indicates overestimated cash flows
  4. Reject, because the payback cutoff is binding and overrides NPV

Explanation

NPV is the primary value-maximising criterion, and a positive NPV means the project earns above the cost of capital. Payback is a secondary liquidity and risk screen that ignores cash flows after the cutoff, so it should not override a positive NPV unless management has an explicit binding liquidity constraint.

Question 25Capital Budgeting and Corporate Finance

A company is deciding whether to replace an existing machine. The old machine has a book value of PKR 400,000 and a current market resale value of PKR 250,000. If it is kept, it will be sold in three years for PKR 50,000. The new machine costs PKR 1,200,000. How should the old machine's current resale value be treated?

  1. As a terminal cash inflow in year three
  2. As a reduction of the new machine's depreciation base only
  3. As a sunk cost excluded from the analysis
  4. As an opportunity cost included in the incremental outlay of the replacement decision Correct answer.

Explanation

By replacing, the firm forgoes the PKR 250,000 it could realise now, so that amount is an opportunity cost of the decision. It is netted against the new machine's cost in the incremental initial outlay, adjusted for any tax effect on disposal.

Question 26Capital Budgeting and Corporate Finance

In capital budgeting, which cash flow item is treated as an incremental cash flow for a new project?

  1. The historical cost of land the firm already owns and will use
  2. The interest expense on the loan arranged to fund the project
  3. The allocated share of existing head-office rent that will not change
  4. The additional sales revenue the new project brings to the firm Correct answer.

Explanation

Incremental cash flows are the changes in total firm cash flows caused by accepting the project. Additional sales revenue generated by the project qualifies because it would not exist without the investment, whereas sunk costs and financing costs are excluded from operating cash flows.

Question 27Capital Budgeting and Corporate Finance

A project's payback period is best described as which of the following?

  1. The discount rate at which the project's NPV equals zero
  2. The ratio of present value of inflows to the initial outlay
  3. The time required for the project's NPV to reach its maximum value
  4. The time required for undiscounted cumulative cash inflows to recover the initial investment Correct answer.

Explanation

Payback measures how long it takes for cumulative cash inflows to equal the initial outlay, and in its basic form it ignores the time value of money. It is a liquidity and risk screen rather than a value measure, because it ignores cash flows after the cut-off.

Question 28Capital Budgeting and Corporate Finance

Which of the following is a capital budgeting decision rather than a working capital decision?

  1. Extending credit terms to a major customer
  2. Increasing the inventory buffer ahead of the Eid season
  3. Arranging a short-term bank overdraft to cover payroll
  4. Purchasing a new production line with a ten-year useful life Correct answer.

Explanation

Capital budgeting concerns long-term investment in fixed assets whose benefits extend over multiple years. A production line with a ten-year life is a classic capital expenditure, whereas credit terms, inventory buffers and overdrafts are short-term working capital matters.

Question 29Capital Budgeting and Corporate Finance

A project has an initial outlay of PKR 1,000,000 and a single cash inflow of PKR 1,210,000 at the end of year two. At a 10% discount rate, what is the NPV?

  1. PKR 110,000
  2. PKR 210,000
  3. PKR 100,000
  4. PKR 0 Correct answer.

Explanation

The present value of the inflow is 1,210,000 divided by 1.10 squared, which equals 1,000,000. Subtracting the outlay gives an NPV of zero, meaning the project earns exactly the 10% required return.

Question 30Capital Budgeting and Corporate Finance

When estimating cash flows for a project, which treatment of depreciation is correct?

  1. Depreciation is a cash outflow and must be deducted from inflows
  2. Depreciation is ignored entirely because it is non-cash
  3. Depreciation is added to net income to arrive at operating cash flow
  4. Depreciation reduces taxable income and therefore creates a tax shield Correct answer.

Explanation

Depreciation is not a cash outflow, but it is deductible for tax purposes and so reduces the tax bill, creating a tax shield. In cash flow estimation the shield, equal to depreciation times the tax rate, is the relevant effect.

Question 31Capital Budgeting and Corporate Finance

Which cost of capital is the appropriate discount rate for a project that is of average risk relative to the firm's existing operations?

  1. The pre-tax cost of debt
  2. The risk-free rate of return
  3. The firm's weighted average cost of capital Correct answer.
  4. The cost of retained earnings only

Explanation

The weighted average cost of capital reflects the firm's overall mix of debt and equity and their required returns. For an average-risk project it is the standard hurdle rate, while project-specific risk would justify an adjustment.

Question 32Capital Budgeting and Corporate Finance

A firm's after-tax operating cash flow for a project is PKR 2,400,000 per year for four years, and the initial outlay is PKR 6,000,000. At a discount rate of 10%, the annuity factor for four years is 3.170. What is the NPV?

  1. PKR 2,400,000
  2. PKR 960,000
  3. PKR 3,600,000
  4. PKR 1,608,000 Correct answer.

Explanation

The present value of the inflows is 2,400,000 multiplied by 3.170, which equals 7,608,000. Deducting the 6,000,000 outlay gives an NPV of approximately PKR 1,608,000, so the project adds value.

Question 33Capital Budgeting and Corporate Finance

Which statement best describes the role of the profitability index in a capital rationing situation?

  1. It ranks projects by value created per rupee of initial investment Correct answer.
  2. It identifies the project with the shortest payback period
  3. It calculates the rate at which a project breaks even in accounting terms
  4. It measures the absolute wealth added by each project in rupee terms

Explanation

The profitability index is the present value of inflows divided by the initial outlay, so it measures value created per rupee invested. Under a single-period capital constraint, ranking by this index helps allocate a limited budget efficiently.

Question 34Capital Budgeting and Corporate Finance

A firm is considering a project that will use a building it already owns, which could otherwise be rented out for PKR 500,000 per year. How should this be handled in the project appraisal?

  1. Ignore it because the building is already paid for
  2. Include PKR 500,000 per year as an opportunity cost Correct answer.
  3. Ignore it because no cash changes hands
  4. Include the original purchase price of the building as an outflow

Explanation

Using an owned asset for a project forgoes the income it could otherwise generate, and that forgone income is an opportunity cost. Opportunity costs are relevant incremental cash flows even though no explicit payment occurs.

Question 35Capital Budgeting and Corporate Finance

A project requires an initial increase in net working capital of PKR 600,000, which will be fully recovered at the end of the project's five-year life. What is the correct cash flow treatment?

  1. Deduct 600,000 each year for five years
  2. Deduct 600,000 at the start and add 600,000 at the end Correct answer.
  3. Deduct 600,000 at the start and ignore it thereafter
  4. Add 600,000 at the start and deduct it at the end

Explanation

The initial working capital commitment is a cash outflow at inception because funds are tied up in the project. At the end of the project the working capital is released, producing an equal inflow, so the net effect over the life is zero apart from timing.

Question 36Capital Budgeting and Corporate Finance

A machine costs PKR 2,000,000 and is depreciated straight-line to zero over four years. If the firm's tax rate is 30%, what is the annual depreciation tax shield?

  1. PKR 1,400,000
  2. PKR 150,000 Correct answer.
  3. PKR 500,000
  4. PKR 600,000

Explanation

Annual depreciation is 2,000,000 divided by four, or 500,000. The tax shield equals depreciation multiplied by the tax rate, giving 500,000 times 0.30, which is PKR 150,000 per year.

Question 37Capital Budgeting and Corporate Finance

A project has an initial outlay of PKR 4,000,000 and generates PKR 1,000,000 per year for six years. Which statement about its IRR is correct?

  1. The IRR is above 10% because the NPV at 10% is positive Correct answer.
  2. The IRR is below the 10% discount rate
  3. The IRR cannot be determined without the cost of capital
  4. The IRR is exactly 10% because total inflows are 1.5 times the outlay

Explanation

At 10%, the six-year annuity factor is 4.355, so the present value of inflows is 4,355,000, giving a positive NPV of 355,000. When NPV is positive at a given rate, the IRR must exceed that rate, so the IRR is above 10%.

Question 38Capital Budgeting and Corporate Finance

Two mutually exclusive projects have the same initial outlay but different cash flow timing. Project A has larger early inflows and Project B has larger later inflows. At a low discount rate B has the higher NPV, while at a high discount rate A has the higher NPV. What explains this crossover?

  1. Payback period determines the ranking at every discount rate
  2. The discount rate changes the relative present value of distant cash flows Correct answer.
  3. Project B has a higher IRR than Project A at all rates
  4. The two projects have identical cash flow profiles

Explanation

A higher discount rate reduces the present value of distant cash flows more heavily, penalising the project with back-loaded inflows. This is why the NPV ranking of projects with different timing can reverse at a crossover rate, and why NPV at the actual cost of capital is the correct criterion.

Question 39Capital Budgeting and Corporate Finance

A company has a capital budget of PKR 10,000,000 and four independent projects, each requiring PKR 5,000,000, with profitability indices of 1.30, 1.15, 1.10 and 0.95. Which projects should be accepted?

  1. The projects with indices 1.30 and 1.10
  2. Only the project with index 1.30
  3. All four projects because they diversify risk
  4. The projects with indices 1.30 and 1.15 Correct answer.

Explanation

With a budget that funds exactly two projects, the firm should choose the pair with the highest profitability indices, which are 1.30 and 1.15. The 0.95 project destroys value because its index is below one and should be rejected regardless of budget.

Question 40Capital Budgeting and Corporate Finance

A project has a positive NPV when evaluated at the firm's cost of capital. Which statement about the project's effect on shareholder wealth is correct?

  1. Shareholder wealth is unchanged because NPV is an accounting measure
  2. Shareholder wealth increases by the total undiscounted cash inflows
  3. Shareholder wealth increases by the amount of the NPV Correct answer.
  4. Shareholder wealth falls because the project ties up capital

Explanation

NPV measures the value added beyond the return required by capital providers, so a positive NPV accrues directly to shareholders. Accepting all positive-NPV projects therefore maximises firm value in principle.

Question 41Capital Budgeting and Corporate Finance

A firm's target capital structure is 50% debt and 50% equity at market values. The pre-tax cost of debt is 10%, the corporate tax rate is 30%, and the cost of equity is 16%. What is the weighted average cost of capital?

  1. 12.3% Correct answer.
  2. 13.0%
  3. 11.5%
  4. 14.6%

Explanation

The after-tax cost of debt is 10% times 0.70, or 7%. Weighting debt at 50% and equity at 50% gives 0.5 times 7% plus 0.5 times 16%, which equals 3.5% plus 8.0%, or 12.3%.

Question 42Capital Budgeting and Corporate Finance

Which of the following best describes a sunk cost in project appraisal?

  1. A cost already incurred that cannot be recovered by the decision Correct answer.
  2. A cost that varies with the level of project output
  3. The return forgone on the next best alternative
  4. The additional tax payable because of the project

Explanation

A sunk cost has already been incurred and is unaffected by whether the project proceeds, so it must be excluded from incremental cash flows. Including it would wrongly influence the accept-reject decision.

Question 43Capital Budgeting and Corporate Finance

A firm can replace an old machine now or keep it for three more years. Which analytical approach is most appropriate for comparing the replacement decision?

  1. Compare the equivalent annual costs of each option over their lives Correct answer.
  2. Compare the total nominal costs of each option without discounting
  3. Choose the option with the higher accounting book value remaining
  4. Choose the option with the lower initial cash outlay

Explanation

When alternatives have different lives, comparing total present costs directly is misleading because the options provide service for different periods. Converting each to an equivalent annual cost places them on a common per-year basis for a valid comparison.

Question 44Capital Budgeting and Corporate Finance

A project's NPV is PKR 1,500,000 at a 10% discount rate and PKR 400,000 at a 14% discount rate. What does this indicate about the project's IRR?

  1. The IRR is between 10% and 14% Correct answer.
  2. The IRR is exactly 10%
  3. The IRR is less than 10%
  4. The IRR is greater than 14%

Explanation

NPV falls as the discount rate rises, and the IRR is the rate at which NPV equals zero. Since NPV is positive at 10% and still positive but smaller at 14%, the zero point lies between the two rates.

Question 45Capital Budgeting and Corporate Finance

Which of the following best explains why the accounting rate of return is a weaker criterion than NPV for capital budgeting?

  1. It always produces a negative result for profitable projects
  2. It uses cash flows but ignores the initial outlay
  3. It uses accounting profits and ignores the time value of money Correct answer.
  4. It cannot be applied to projects with a life of more than one year

Explanation

The accounting rate of return is based on accounting profits rather than cash flows and does not discount them, so it ignores both timing and the cost of capital. NPV captures the actual change in shareholder wealth using discounted incremental cash flows.

Question 46Capital Budgeting and Corporate Finance

A firm is evaluating a foreign project whose cash flows are denominated in a foreign currency. Which approach correctly handles the appraisal?

  1. Convert the foreign cash flows to the home currency and discount at an appropriate home-currency rate Correct answer.
  2. Discount foreign-currency cash flows at the home country's risk-free rate
  3. Ignore exchange rates because they offset over the project's life
  4. Add the foreign inflation rate to the home discount rate without converting cash flows

Explanation

Consistency requires that cash flows and the discount rate be expressed in the same currency. Converting expected foreign cash flows into the home currency and discounting at a home-currency rate appropriate to the project's risk preserves that consistency.

Question 47Capital Budgeting and Corporate Finance

A project has an initial outlay of PKR 3,000,000 and expected cash inflows of PKR 1,200,000 in year one, PKR 1,500,000 in year two, and PKR 900,000 in year three. What is the discounted payback period if the discount rate is 10%?

  1. About 1.8 years
  2. About 2.1 years
  3. About 2.9 years
  4. About 2.5 years Correct answer.

Explanation

Discounted inflows are 1,091,000 in year one, 1,240,000 in year two and 676,000 in year three. Cumulative discounted inflow reaches 2,331,000 after two years, leaving 669,000 to recover, which is almost the entire third-year inflow of 676,000, so payback is close to 2.99 years.

Question 48Capital Budgeting and Corporate Finance

A firm uses its overall WACC of 12% to evaluate all projects. Its low-risk replacement projects earn about 9%, while its high-risk expansion projects require about 16%. What is the likely consequence of this single-rate policy?

  1. The firm will overinvest in high-risk projects and underinvest in low-risk projects Correct answer.
  2. The firm will reject all high-risk projects and accept all low-risk projects
  3. The firm will correctly allocate capital across all risk classes
  4. The firm's WACC will automatically adjust to each project's risk

Explanation

Using one hurdle rate for all projects accepts high-risk projects whose true required return exceeds 12% and rejects low-risk projects whose true required return is below 12%. Over time this risk misallocation raises the firm's overall risk and erodes value.

Question 49Capital Budgeting and Corporate Finance

A project can be delayed by one year, during which uncertainty about demand will be resolved. Which concept best justifies the value of waiting?

  1. The accounting rate of return
  2. The equivalent annual annuity of the project
  3. The sunk cost principle
  4. The real option to defer investment Correct answer.

Explanation

The ability to postpone an investment and decide later, after uncertainty resolves, is a real option to defer. It has value because the firm can avoid the project if conditions turn unfavourable while retaining the upside if they improve.

Question 50Capital Budgeting and Corporate Finance

A company is evaluating a project with expected annual operating cash flows that are highly sensitive to the selling price. Sensitivity analysis shows that a 5% fall in price makes NPV negative. Which conclusion is most appropriate?

  1. The project carries significant price risk and its margin of safety is thin Correct answer.
  2. Sensitivity analysis proves the project's IRR exceeds the cost of capital
  3. The project should be rejected because any risk exists
  4. The project should be accepted because expected NPV is positive

Explanation

A small adverse movement in a single variable turning NPV negative indicates a narrow margin of safety and high exposure to that variable. Management should scrutinise price assumptions and consider hedging or staged investment rather than accepting on the base case alone.