READING 24 CAPITAL INVESTMENTS AND CAPITAL ALLOCATION

Question 1

Which of the following capital investment types is least likely to generate revenue for a company?
A. Expansion project
B. Regulatory/compliance project
C. Other projects (e.g., new business ventures)

Answer 1

Correct Answer: B

Explanation:

B is correct because regulatory/compliance projects are typically required by government or insurance bodies and often do not generate revenue. Their goal is to ensure legal or safety compliance.

A is incorrect because expansion projects aim to grow the business and are expected to generate future revenue.

C is incorrect because while “other projects” carry risk, they are often undertaken with the expectation of revenue generation through new markets or technologies.

Question 2

A project aimed at replacing outdated but still functional machinery to improve operational efficiency would most likely be classified as which type of capital investment?
A. Expansion project
B. Going concern project
C. Other project

Answer 2

Correct Answer: B

Explanation:

B is correct because going concern projects include replacements or upgrades of equipment to maintain or improve existing operations.

A is incorrect because expansion projects involve growing the business, such as entering new markets.

C is incorrect because “other projects” typically involve ventures into unfamiliar areas or industries.

Question 3

Which of the following best characterizes a company’s expansion project?
A. Involves significant regulatory approval and is not expected to provide direct financial returns
B. Maintains current operations through replacing capital assets
C. Requires complex forecasting and decision-making to estimate future revenue and cost impact

Answer 3

Correct Answer: C

Explanation:

C is correct because expansion projects involve strategic decisions, such as entering new markets, and require detailed financial forecasting.

A is incorrect because this describes regulatory/compliance projects.

B is incorrect because this describes going concern projects.

Question 4

Which of the following statements best describes how analysts estimate capital needs for going concern projects?
A. By evaluating retained earnings over the past 5 years
B. By using annual depreciation expense as a proxy
C. By projecting total revenue growth over time

Answer 4

Correct Answer: B

Explanation:

B is correct because analysts often use depreciation as a rough estimate for how much needs to be reinvested to maintain assets.

A is incorrect because retained earnings relate to profitability, not directly to capital maintenance.

C is incorrect because revenue growth projections are used more for expansion, not maintenance.

Question 5

Which of the following capital investment types typically involves the highest level of uncertainty and risk?
A. Regulatory/compliance projects
B. Other projects
C. Going concern projects

Answer 5

Explanation:

B is correct because “other projects” often include ventures into unfamiliar industries or technologies, like startups or acquisitions, and carry high uncertainty.

A is incorrect because regulatory projects are mandated and involve compliance, not speculative outcomes.

C is incorrect because going concern projects aim to maintain existing operations and are relatively predictable.

Question 6

A company entering a foreign market with a new product line would most likely classify this as which type of capital investment?
A. Expansion project
B. Going concern project
C. Regulatory/compliance project

Answer 6

Correct Answer: A

Explanation:

A is correct because entering new geographic markets or launching new products falls under expansion, aimed at growing revenue.

B is incorrect because going concern projects focus on maintaining current operations.

C is incorrect because there’s no indication of regulatory requirements in the scenario.

Question 7

Which of the following is the most appropriate financing strategy for reducing risk when funding capital investment projects?
A. Match funding project life with capital source duration
B. Use retained earnings only to finance all projects
C. Always use short-term debt regardless of project type

Answer 7

Correct Answer: A

Explanation:

A is correct because match funding ensures the repayment period aligns with the life of the project, reducing interest rate and liquidity risk.

B is incorrect because relying solely on retained earnings limits financial flexibility.

C is incorrect because short-term debt is risky for long-term projects due to refinancing risk.

Question 8

Which of the following best explains why regulatory/compliance projects may require evaluation of alternative approaches?
A. They often require forecasting of customer demand.
B. They must be done at the lowest possible cost due to their non-revenue nature.
C. They help maintain existing processes and do not require decision-making.

Answer 8

Correct Answer: B

Explanation:

B is correct because these projects don’t produce revenue, so cost-efficiency is crucial, and alternatives are evaluated accordingly.

A is incorrect because forecasting demand is relevant to expansion projects.

C is incorrect because regulatory projects do require planning and evaluation despite their routine nature.

Question 8

Which capital investment type is most likely to involve acquiring a company in a different industry?
A. Going concern project
B. Other project
C. Expansion project

Answer 8

Correct Answer: B

Explanation:

B is correct because “other projects” often involve non-core acquisitions, new technologies, or industries outside the company’s usual operations.

A is incorrect because going concern projects deal with existing operations.

C is incorrect because expansion typically stays within the company’s main industry or markets.

Question 9

Which of the following is a key decision factor in determining whether to pursue a going concern project?
A. Whether the asset will help expand product offerings
B. Whether the existing operations should be continued
C. Whether regulatory approval is required

Answer 9

Correct Answer: B

Explanation:

B is correct because a fundamental question for going concern projects is whether the company should maintain the current operation.

A is incorrect because expanding product offerings is related to expansion projects.

C is incorrect because regulatory approval pertains to compliance-related investment

Question 10

A company is deciding whether to build a new manufacturing plant. According to the capital allocation process, which step should be performed first?
A. Estimate the expected cash flows and calculate the project’s NPV.
B. Generate ideas for potential capital investment projects.
C. Conduct a post-audit to compare actual and forecasted results.

Answer 10

Correct Answer: B

Explanation:

The first step in the capital allocation process is idea generation. Identifying good investment opportunities is the foundation of capital budgeting.

A is incorrect because analyzing cash flows and calculating NPV occurs after idea generation.

C is incorrect because post-audit is the final step, done after the project is implemented.

Question 11

Which of the following best explains why conducting a post-audit is essential in the capital allocation process?
A. It confirms whether projects are aligned with the firm’s strategic objectives.
B. It ensures actual cash flows are used instead of forecasted ones in NPV calculations.
C. It helps identify errors in forecasting to improve future project evaluation.

Answer 11

Correct Answer: C

Explanation:

Post-audits allow companies to compare actual outcomes vs. projected results, revealing systematic forecasting errors and improving future capital allocation.

A is incorrect because strategic alignment is addressed during project selection, not post-audit.

B is incorrect because NPV relies on forecasted cash flows before a project begins—not actuals.

Question 12

Which of the following best explains why capital allocation is considered one of the most important responsibilities of a financial manager?
A. It helps optimize employee performance and reduce operating costs.
B. Capital allocation decisions affect long-term value creation for shareholders.
C. It determines how the firm manages its short-term liabilities and liquidity.

Answer 12

Correct Answer: B

Explanation:

Capital allocation impacts the firm’s long-term asset base and earnings, directly influencing shareholder value—the primary goal of management.

A is incorrect because optimizing employee performance and cutting costs are operational concerns, not capital allocation.

C refers to working capital management, which is related but not the core of capital allocation.

Question 13

Which of the following corporate decisions would most appropriately be evaluated using the capital allocation framework?
A. Negotiating better terms on the company’s credit facility.
B. Selecting a new supplier to reduce cost of goods sold.
C. Expanding business operations to a new geographic region.

Answer 13

Correct Answer: C

Explanation:

Capital allocation applies to decisions with multi-period impacts, such as expansion, asset purchases, or relocation.

A is a financing decision, not capital allocation.

B relates to operational efficiency, not long-term investment analysis.

Question 14

Which of the following correctly ranks the steps in the capital allocation process from first to last?
A. Analyze project proposals → Idea generation → Monitor and conduct post-audit → Create firm-wide capital budget
B. Idea generation → Analyze proposals → Create capital budget → Monitor and conduct post-audit
C. Monitor and conduct post-audit → Create capital budget → Analyze project proposals → Idea generation

Answer 14

Correct Answer: B

Explanation:

The four proper steps are:
Idea generation
Analyze proposals
Create capital budget
Monitor and post-audit

A is out of order—idea generation comes first.

C is completely reversed.

Question 15

Why is the idea generation step often referred to as the most important in the capital allocation process?
A. It ensures the firm follows proper forecasting models.
B. Without good project ideas, even the best analysis tools cannot add value.
C. It allows firms to minimize their tax liabilities effectively.

Answer 15

Correct Answer: B

Explanation:

Capital budgeting success relies on quality ideas. Even perfect financial models cannot compensate for poor project selection.

A refers to analysis, not idea generation.

C is unrelated—tax minimization is not the purpose of idea generation.

Question 16

Question 5: Interpret the role of post-audit in improving capital allocation.
The primary benefit of conducting a post-audit on capital projects is to:
A. Provide tax benefits from realized capital losses.
B. Adjust the firm’s cost of capital based on actual project performance.
C. Compare actual versus projected results to improve future forecasting.

Answer 16

Correct Answer: C

Explanation:

Post-audits provide feedback for improving forecasting and capital allocation discipline.

A is incorrect—post-audits do not affect tax treatment.

B is incorrect—cost of capital is based on market inputs, not individual project outcomes.

Question 17

A firm has limited resources and must choose between three profitable projects. Which of the following factors is most relevant at the firm-wide capital budgeting stage?
A. The internal rate of return for each project
B. The timing of cash flows, resource constraints, and strategic fit
C. The company’s current stock price performance

Answer 17

Correct Answer: B

Explanation:

The firm-wide capital budget must consider project timing, resource limits, and strategic alignment, even when all projects are individually profitable.

A (IRR) is used at the project analysis step, not for cross-project prioritization.

C is not a factor in budgeting capital projects.

Question 18

How does effective capital allocation contribute to the primary goal of financial management?
A. By increasing operational efficiency and reducing employee turnover
B. By aligning short-term investment strategies with market trends
C. By selecting long-term projects that increase the firm’s intrinsic value

Answer 18

Correct Answer: C

Explanation:

Capital allocation aims to select projects that maximize intrinsic (shareholder) value, consistent with the primary goal of financial management.

A relates to human resource management.

B emphasizes short-termism, which is not aligned with capital allocation’s long-term focus.

Question 19

Which of the following best describes the Net Present Value (NPV) of a project?
A. The sum of all future cash inflows without discounting.
B. The present value of expected incremental cash flows minus the initial investment.
C. The discount rate that equates the present value of inflows and outflows.

Answer 19

Correct Answer: B

Explanation:

B is correct because NPV is calculated as the present value of all expected incremental cash inflows minus the initial investment.

A is incorrect because NPV involves discounting future cash flows to present value.

C describes the Internal Rate of Return (IRR), not NPV.

Question 20

For an independent project, which decision rule applies to NPV?
A. Accept if NPV is zero or positive; reject if negative.
B. Accept only if NPV is positive.
C. Reject if NPV is positive; accept if negative.

Answer 20

Correct Answer: B

Explanation:

B is correct because independent projects with positive NPV increase shareholder wealth and should be accepted.

A is incorrect since projects with zero NPV neither increase nor decrease wealth but are generally accepted only if positive.

C reverses the correct decision rule and is incorrect.

Question 21

The discount rate used in NPV calculations is generally:
A. The firm’s cost of capital adjusted for project risk.
B. The internal rate of return of the project.
C. Always 10% as a standard rate.

Answer 21

Correct Answer: A

Explanation:

A is correct since the discount rate reflects the firm’s cost of capital adjusted for the specific project risk level.

B is incorrect because the IRR is a result of calculations, not the input discount rate.

C is incorrect as there is no fixed standard rate.

Question 22

Which of the following defines the Internal Rate of Return (IRR)?
A. The discount rate that makes the NPV of the project zero.
B. The sum of undiscounted cash inflows.
C. The firm’s average cost of capital.

Answer 22

Correct Answer: A

Explanation:

A is correct; IRR is the rate at which the present value of inflows equals outflows, so NPV=0.

B ignores discounting and is not IRR.

C is unrelated to IRR directly; it is an input for decision making.

Question 23

Which statement about the IRR decision rule is correct?
A. Accept a project if IRR is less than the required rate of return.
B. Reject a project if IRR equals the required rate of return.
C. Accept a project if IRR exceeds the required rate of return.

Answer 23

Correct Answer: C

Explanation:

C is correct because projects with IRR above the required rate of return add value.

A is incorrect; lower IRR implies lower profitability.

B is incorrect; if IRR equals required return, the project breaks even and is often accepted.

Question 24

The "hurdle rate" refers to: A. The maximum IRR a project can have to be accepted. B. The minimum IRR required to accept a project. C. The actual IRR calculated for a project.

Answer 24

Correct Answer: B Explanation: B is correct as the hurdle rate is the threshold IRR needed to accept a project. A is wrong; it’s a minimum, not maximum. C is the IRR itself, not the hurdle rate.

Question 25

Which of the following cash flow patterns is considered "conventional"? A. One or more cash outflows followed by one or more cash inflows. B. Cash flows with multiple sign changes. C. Irregular time intervals between cash flows.

Answer 25

Correct Answer: A Explanation: A is correct because conventional cash flows have a single sign change, typically an initial outflow followed by inflows. B describes "unconventional" cash flows. C relates to timing, not conventionality of sign changes.

Question 26

When might spreadsheet software be preferred for calculating NPV and IRR? A. When cash flows are conventional and regular. B. When cash flows are unconventional or irregular in timing. C. When the project has only one cash inflow.

Answer 26

Correct Answer: B Explanation: B is correct; spreadsheets handle multiple sign changes and irregular timing efficiently. A is less complex and can be done without spreadsheets. C is a trivial case that rarely needs spreadsheet tools.

Question 27

Which is a key advantage of the NPV method over IRR? A. NPV provides a percentage return for easy comparison. B. NPV directly measures the expected increase in firm value. C. NPV assumes reinvestment at the IRR.

Answer 27

Correct Answer: B Explanation: B is correct; NPV quantifies expected dollar value added. A is an IRR advantage, not NPV. C incorrectly states the reinvestment assumption of NPV; that assumption belongs to IRR.

Question 28

One disadvantage of the IRR method is: A. It assumes cash flows are reinvested at the firm’s cost of capital. B. It may yield multiple IRRs for projects with unconventional cash flows. C. It cannot be calculated using financial calculators.

Answer 28

Correct Answer: B Explanation: B is correct; multiple sign changes can cause multiple IRRs, confusing interpretation. A is incorrect; IRR assumes reinvestment at IRR, not the firm’s cost of capital. C is false; financial calculators easily compute IRR.

Question 29

Which assumption is more realistic when calculating reinvestment of project cash flows? A. Reinvestment at the IRR of the project. B. Reinvestment at the firm’s required rate of return. C. No reinvestment of cash flows.

Answer 29

Correct Answer: B Explanation: B is correct; reinvesting at the firm’s required rate is generally more practical. A is IRR’s assumption, often less realistic. C ignores realistic reinvestment scenarios.

Question 30

If a project’s IRR is 15% and the required rate of return is 12%, the correct decision is: A. Reject, because IRR is below required return. B. Accept, because IRR exceeds required return. C. Reject, because IRR must equal required return to accept.

Answer 30

Correct Answer: B Explanation: B is correct; IRR > required rate means project adds value. A and C are incorrect and contradict IRR decision rules.

Question 31

Why might a project analyst adjust the required rate of return for a project above or below the firm’s average cost of capital? A. To account for differences in project risk relative to the firm’s average risk. B. To arbitrarily increase the hurdle rate for all projects. C. To ignore project-specific risk and only use market risk.

Answer 31

Correct Answer: A Explanation: A is correct; riskier projects need higher discount rates, less risky projects lower ones. B is incorrect; adjustments are based on risk, not arbitrary. C is wrong because project-specific risk must be considered.

Question 32

Which of the following best describes why Return on Invested Capital (ROIC) adds back after-tax interest expense to net income? A. To isolate the return to equity holders only B. To reflect the returns to all providers of capital, both debt and equity C. To avoid the effects of differing tax rates across firms

Answer 32

Correct Answer: B Explanation: Correct (B): ROIC includes returns to all providers of capital, so after-tax interest is added back to net income to reflect the total return to both equity and debt holders. Incorrect (A): This would describe Return on Equity (ROE), not ROIC. Incorrect (C): While tax effects do differ, the purpose of adjusting for after-tax interest is to reflect capital structure, not to normalize tax rates.

Question 33

Which of the following components is typically excluded from the calculation of invested capital when computing ROIC? A. Long-term debt B. Common equity C. Non-interest-bearing current liabilities

Answer 33

Correct Answer: C Explanation: Correct (C): Working capital items such as non-interest-bearing current liabilities (e.g., accounts payable) are typically excluded from invested capital in ROIC. Incorrect (A): Long-term debt is a key component of invested capital. Incorrect (B): Common equity is also a major part of invested capital.

Question 34

What is the most likely result if a firm’s ROIC is consistently greater than its weighted average cost of capital (WACC)? A. The firm is destroying shareholder value B. The firm is creating shareholder value C. The firm’s stock price is guaranteed to increase

Answer 34

Correct Answer: B Explanation: Correct (B): If ROIC > WACC, the firm is earning more than its cost of capital, thus creating value for shareholders. Incorrect (A): Value is destroyed when ROIC < WACC. Incorrect (C): ROIC > WACC supports long-term value creation, but stock price also depends on expectations, markets, and other factors.

Question 35

Which of the following equations correctly expresses ROIC using its two primary components? A. ROIC = Operating Margin × Total Assets B. ROIC = Operating Margin After-Tax × Capital Turnover C. ROIC = NOPAT / Revenue

Answer 35

Correct Answer: B Explanation: Correct (B): ROIC = Operating Margin After-Tax × Capital Turnover, where: Operating Margin After-Tax = NOPAT / Sales Capital Turnover = Sales / Invested Capital Incorrect (A): This mixes margin with total assets, which is not the ROIC formula. Incorrect (C): This gives operating margin, not ROIC.

Question 36

Which of the following is a key limitation of using ROIC for performance evaluation? A. It is forward-looking and may be overly optimistic B. It may be distorted by accounting differences across firms C. It only applies to individual projects, not the firm as a whole

Answer 36

Correct Answer: B Explanation: Correct (B): Differences in accounting practices (e.g., depreciation methods) can distort comparability of ROIC across companies. Incorrect (A): ROIC is backward-looking, not forward-looking. Incorrect (C): ROIC applies to the entire firm, unlike IRR or NPV which are project-specific.

Question 37

Which of the following best explains why ROIC is particularly useful to external investors? A. It is based on internal project evaluations B. It is derived from publicly available accounting data C. It includes the firm's market capitalization

Answer 37

Correct Answer: B Explanation: Correct (B): ROIC uses financial statement data that outside investors can access, making it a useful performance metric. Incorrect (A): Internal project evaluation tools like NPV or IRR are not typically available to outsiders. Incorrect (C): ROIC uses book values of capital, not market capitalization.

Question 38

Which of the following best describes how capital budgeting decisions should be evaluated? A. Based on accounting net income, as it reflects profitability B. Based on after-tax cash flows, as they reflect actual economic benefit C. Based on gross cash inflows, as tax considerations complicate projections

Answer 38

Correct Answer: B Explanation: Correct: B — After-tax cash flows are used because they reflect the actual benefit to the firm, unlike accounting income which includes non-cash items and ignores timing. Incorrect: A — Accounting income includes accruals and does not account for cash flow timing. Incorrect: C — Ignoring tax effects would overstate the project’s value.

Question 39

A firm evaluates a project that will use internally generated funds. The CFO argues that since no external financing is used, the project has no cost of capital. This reasoning is: A. Correct, because internal funds are free of cost B. Incorrect, because the cost of internal funds is the opportunity cost of equity C. Correct, because dividend policy is irrelevant in capital budgeting

Answer 39

Correct Answer: B Explanation: Correct: B — Internal funds could have been paid out as dividends, so their opportunity cost equals the cost of equity. Incorrect: A — Internal funds are not free; they have an opportunity cost. Incorrect: C — Dividend policy affects whether cash is reinvested or returned, which ties directly into capital allocation.

Question 40

Which of the following is considered a sunk cost and should be excluded from project cash flow analysis? A. Purchase of new machinery B. Estimated future maintenance costs C. Past consulting fees paid for market research

Answer 40

Correct Answer: C Explanation: Correct: C — Sunk costs are already incurred and cannot be recovered, so they are irrelevant to the accept/reject decision. Incorrect: A — Machinery purchase is a future outlay and should be included. Incorrect: B — Future costs affect cash flows and should be analyzed.

Question 41

A beverage company launches a new sugar-free version of its product, resulting in a decline in sales of its original soda. This is an example of: A. Positive externality B. Cannibalization C. Sunk cost

Answer 41

Correct Answer: B Explanation: Correct: B — Cannibalization happens when a new product reduces the sales of existing products. Incorrect: A — A positive externality would increase other product sales. Incorrect: C — This is not a past expense; it's a strategic consequence.

Question 42

When evaluating capital projects in real terms, which discount rate should be used? A. Nominal discount rate B. Risk-free rate C. Real discount rate

Answer 42

Correct Answer: C Explanation: Correct: C — If cash flows are adjusted for inflation (real terms), then the real discount rate must be used for consistency. Incorrect: A — A nominal rate includes inflation and would overstate value. Incorrect: B — Risk-free rate is not appropriate unless the project has zero risk, which is rare.

Question 43

A senior executive pushes for a capital project with overly optimistic projections and little scrutiny. This is most likely an example of: A. Cannibalization B. A behavioral bias involving pet projects C. Anchoring bias in forecasting

Answer 43

Correct Answer: B Explanation: Correct: B — Projects favored by senior management may get biased inputs and avoid rigorous review. Incorrect: A — Cannibalization refers to negative impact on existing product sales. Incorrect: C — Anchoring is when decisions are overly based on prior values, not favoritism.

Question 44

A firm continues to allocate the same capital budget amount year after year, even when market opportunities change. This behavior best illustrates: A. Rational budgeting B. Anchoring bias C. Sunk cost fallacy

Answer 44

Correct Answer: B Explanation: Correct: B — Anchoring bias occurs when budgets are set based on past allocations rather than current opportunities. Incorrect: A — Rational budgeting requires reassessing opportunities each year. Incorrect: C — Sunk cost fallacy involves continuing a failed project due to past investments, not annual budgeting habits.

Question 45

Which of the following statements best explains why time value of money is crucial in capital budgeting? A. Inflation makes future dollars worth more B. Future cash flows must be ignored in favor of upfront costs C. Cash flows received earlier are more valuable than those received later

Answer 45

Correct Answer: C Explanation: Correct: C — The time value of money principle reflects that earlier cash flows are more valuable due to their potential to earn returns. Incorrect: A — Inflation reduces the value of future dollars, not increases. Incorrect: B — Future cash flows are essential; they just need to be discounted properly.

Question 46

A manager rejects a project with a positive NPV because it would lower the firm's EPS in the short term. This decision is most likely influenced by: A. A rational valuation model B. A behavioral bias tied to compensation incentives C. Proper risk assessment

Answer 46

Correct Answer: B Explanation: Correct: B — If compensation is tied to EPS or ROE, managers may avoid long-term beneficial projects that hurt short-term metrics. Incorrect: A — Rational valuation would prioritize NPV over EPS. Incorrect: C — Risk isn't the reason for rejection here—metrics bias is.

Question 47

Which of the following best describes a cognitive error in capital budgeting? A. Failing to generate alternative investment ideas B. Forecasting errors due to misallocated overhead or ignoring competition C. Backing a favored project with overly positive projections

Answer 47

Correct Answer: B Explanation: Correct: B — Cognitive errors are calculation-related, like misforecasting due to poor assumptions or missed costs. Incorrect: A — That’s a behavioral bias involving poor decision discipline. Incorrect: C — Backing favored projects is a behavioral bias involving personal judgment.

Question 48

A company is considering investing in a new manufacturing facility but chooses to wait one year before committing, expecting more information about market demand. This is best described as a: A. Growth option B. Timing option C. Abandonment option

Answer 48

Correct Answer: B Explanation: Timing options give a firm the ability to delay a project to gather more information and make better decisions. A. Growth options relate to expanding the scale or scope of the project after initial success. C. Abandonment options allow exiting the project if it becomes unprofitable.

Question 49

A mining company owns a copper mine but only operates it when copper prices are high. This is an example of which type of real option? A. Flexibility option B. Abandonment option C. Fundamental option

Answer 49

Correct Answer: C Explanation: Fundamental options are tied to the value of an underlying asset, like copper. The company can open/close the mine based on copper prices. A. Flexibility options involve operational changes like pricing or production. B. Abandonment options refer to exiting the project permanently, not temporarily ceasing operation.

Question 50

Which of the following is most likely true about real options? A. They obligate the firm to make a specific decision in the future. B. They always decrease the Net Present Value (NPV) of a project. C. They can increase a project's value because they provide flexibility.

Answer 50

Correct Answer: C Explanation: Correct: Real options add value by allowing future decisions based on new information. A. Real options provide a right, not an obligation. B. They can increase, not decrease, the project’s NPV by adding strategic value.

Question 51

A firm includes the value of real options in its project analysis by using an option pricing model. This most likely affects the: A. Internal Rate of Return (IRR) B. Net Present Value (NPV) C. Payback Period

Answer 51

Correct Answer: B Explanation: Correct: The value of real options is added to the project's NPV, increasing the estimated value. A. IRR does not directly incorporate real options. C. Payback period is a simple time-based metric that ignores option value and time value of money.

Question 52

An option that allows a company to shut down a plant if it becomes unprofitable is best classified as: A. Abandonment option B. Flexibility option C. Timing option

Answer 52

Correct Answer: A Explanation: Correct: Abandonment options allow management to exit when staying is no longer profitable. B. Flexibility options deal with adjusting operations, not exiting. C. Timing options allow delaying the initial investment, not exiting mid-project.

Question 53

A software company launches a basic version of a product with plans to invest in advanced versions later if initial sales are strong. This is an example of a: A. Timing option B. Expansion (growth) option C. Fundamental option

Answer 53

Correct Answer: B Explanation: Correct: Growth options allow firms to make follow-on investments based on initial project success. A. Timing options delay the initial investment. C. Fundamental options depend on underlying asset prices, not user demand.

Question 54

A manager is able to switch between inputs depending on cost conditions, such as using different materials. This is best described as a: A. Price-setting option B. Production-flexibility option C. Fundamental option

Answer 54

Correct Answer: B Explanation: Correct: Production-flexibility options allow for changes in operations, such as input substitution or adjusting labor. A. Price-setting options involve changing the product's price, not production inputs. C. Fundamental options relate to asset price-driven projects, not operational flexibility.

Question 55

Which of the following is an example of a price-setting option? A. A company increasing product prices when demand is high B. A company investing in a second production facility C. A company delaying project launch to gather more data

Answer 55

Correct Answer: A Explanation: Correct: Price-setting options allow adjusting the product’s price to match market conditions. B. This is a growth option. C. This describes a timing option.

Question 56

Which method is least likely used to value real options in capital budgeting? A. Option pricing models B. Scenario analysis C. Dividend discount model

Answer 56

Correct Answer: C Explanation: Correct: The Dividend Discount Model (DDM) is for valuing stocks, not real options. A. Option pricing models are a common way to quantify real option value. B. Scenario analysis (e.g., decision trees) helps evaluate different future outcomes related to real options.

Question 57

When a project’s NPV is calculated without considering real options, this estimate is best interpreted as: A. The intrinsic value of the project B. The maximum value of the project C. The minimum value of the project

Answer 57

Correct Answer: C Explanation: Correct: NPV without real options is the minimum value—adding real options may increase value. A. Intrinsic value isn't the appropriate term in capital budgeting. B. It’s the minimum, not maximum—real options could raise the actual value above this baseline.