CMA P2 Investment Decisions: practice questions with answers

Question 1

Brookfield Valve Co. is considering a machine that costs $240,000, has a four-year life and no salvage value, and will be depreciated on a straight-line basis for tax purposes. The machine will reduce pre-tax cash operating costs by $90,000 a year. The income tax rate is 25%. What is the annual after-tax operating cash flow from the machine?

1. A $67,500
2. B $82,500
3. C $22,500
4. D $105,000

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Answer: B. Annual depreciation = $240,000 / 4 = $60,000.

After-tax cash savings = $90,000 × (1 − 0.25) = $67,500
Depreciation tax shield = $60,000 × 0.25 = $15,000
After-tax operating cash flow = $67,500 + $15,000 = $82,500

Check: net income = ($90,000 − $60,000) × 0.75 = $22,500; add back depreciation of $60,000 = $82,500.

Question 2

Kestrel Logistics is evaluating a project that requires an initial investment of $150,000 and produces after-tax cash flows of $50,000 in Year 1, $60,000 in Year 2 and $70,000 in Year 3. The required rate of return is 10%. Present value factors at 10% are 0.909 (Year 1), 0.826 (Year 2) and 0.751 (Year 3). What is the project's net present value?

1. A $30,000
2. B −$840
3. C −$2,420
4. D $12,360

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Answer: C. | Year | Cash flow | PV factor | Present value |
|---|---|---|---|
| 0 | −$150,000 | 1.000 | −$150,000 |
| 1 | $50,000 | 0.909 | $45,450 |
| 2 | $60,000 | 0.826 | $49,560 |
| 3 | $70,000 | 0.751 | $52,570 |

NPV = $147,580 − $150,000 = −$2,420. The project earns less than 10% and should be rejected.

Question 3

Hollins Media is considering a project costing $90,000 with after-tax cash flows of $30,000, $40,000, $35,000 and $25,000 in Years 1 to 4. The discount rate is 8%. Present value factors at 8% are 0.926, 0.857, 0.794 and 0.735 for Years 1 to 4. Assuming cash flows occur evenly within each year, what is the project's discounted payback period?

1. A 2.57 years
2. B 2.80 years
3. C 3.01 years
4. D 2.77 years

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Answer: C. | Year | Cash flow | PV factor | Discounted CF | Cumulative |
|---|---|---|---|---|
| 1 | $30,000 | 0.926 | $27,780 | $27,780 |
| 2 | $40,000 | 0.857 | $34,280 | $62,060 |
| 3 | $35,000 | 0.794 | $27,790 | $89,850 |
| 4 | $25,000 | 0.735 | $18,375 | $108,225 |

After Year 3, $90,000 − $89,850 = $150 remains to be recovered.
Discounted payback = 3 + $150 / $18,375 = 3.01 years.

(Simple payback would be 2 + $20,000 / $35,000 = 2.57 years; discounted payback is always longer when the discount rate is positive.)

Question 4

Halden Mining's analysis of a new mine gives a static NPV of −$2 million based on expected ore prices. If ore prices fall sharply, Halden could close the mine early and sell its equipment to another miner. Which statement about this option to abandon is correct?

1. A It lowers the project's value, because closing the mine early would force Halden to recognise losses
2. B It should be ignored, because real options matter only when the static NPV is already positive
3. C It should be reflected by discounting the mine's cash flows at the risk-free rate instead of the risk-adjusted rate
4. D It has value the static NPV ignores, so the project's true value is higher than −$2 million and could be positive

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Answer: D. A traditional (static) NPV assumes management will follow one fixed plan. Real options, such as options to expand, delay, scale back or abandon, give management flexibility to respond to new information. Because Halden can abandon only when it is beneficial, the option cuts off part of the downside.

Expanded NPV = static NPV + value of real options. The project's true value is therefore higher than −$2 million, and if the abandonment option is worth more than $2 million the project should be accepted.

Question 5

Tenby Haulage bought a truck three years ago for $300,000. For tax purposes it is depreciated straight-line over five years with no salvage value. Tenby will now sell the truck for $140,000 as part of a fleet replacement. The tax rate is 21%. What after-tax cash inflow should Tenby include for the sale?

1. A $140,000
2. B $110,600
3. C $148,400
4. D $135,800

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Answer: D. Annual tax depreciation = $300,000 / 5 = $60,000
Tax basis after 3 years = $300,000 − $180,000 = $120,000
Gain on sale = $140,000 − $120,000 = $20,000
Tax on gain = $20,000 × 21% = $4,200

After-tax cash inflow = $140,000 − $4,200 = $135,800

A sale above tax basis creates a taxable gain that reduces the cash received; a sale below tax basis creates a deductible loss that adds a tax saving.

Question 6

Hartwell Solar's analysts assign probability distributions to sales volume, selling price and installation cost, then use a computer to draw thousands of random combinations of these inputs and calculate the NPV for each. Which risk analysis technique is this?

1. A Monte Carlo simulation
2. B Sensitivity analysis
3. C Scenario analysis
4. D Certainty equivalent analysis

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Answer: A. Monte Carlo simulation specifies a probability distribution for each uncertain input, repeatedly draws random values for all inputs together, and computes the NPV for each trial. The result is a distribution of possible NPVs, from which management can estimate the expected NPV and the probability that NPV is negative.

Sensitivity analysis varies one input at a time; scenario analysis evaluates a few internally consistent sets of inputs.