Chapter 9: Capital Investment Decisions (CAIIB – Paper 3)
1. The primary objective of capital investment decisions is to:
A. Minimize operating costs
B. Increase production capacity only
C. Maximize shareholders’ wealth
D. Maintain liquidity of the firm
Capital budgeting or investment decisions focus on choosing projects that add value to the company and maximize shareholders' wealth in the long run.
2. In project cash flow estimation, which of the following should be included?
A. Incremental cash flows attributable to the project
B. Sunk costs already incurred
C. Financing costs like interest expenses
D. Non-cash charges like depreciation without adjustment
Only incremental cash flows (additional inflows and outflows due to the project) are considered. Sunk costs and financing costs are excluded.
3. Which of the following is a limitation of Payback Period as a capital budgeting technique?
A. It considers time value of money
B. It considers cash flows over the entire life of project
C. It is easy to compute and understand
D. It ignores cash flows after the payback period
Payback method is simple but does not consider the time value of money and ignores cash inflows beyond the payback cutoff period.
4. While estimating project cash flows, depreciation is:
A. Ignored completely as it is non-cash
B. Added back to profits while calculating cash flows
C. Treated as a cash outflow
D. Deducted twice from profits
Depreciation is a non-cash expense. It reduces accounting profit but not cash flow, hence it is added back to arrive at project cash inflows.
5. Which of the following is considered a relevant cash flow for investment decision?
A. Opportunity costs
B. Sunk costs
C. Book value of old assets
D. Depreciation as shown in accounts
Opportunity costs (benefits foregone by choosing one project over another) are relevant. Sunk costs and book values are not considered.
6. In capital budgeting, terminal year cash flows typically include:
A. Only project revenues
B. Only operating costs
C. Salvage value and recovery of working capital
D. Only depreciation benefits
Terminal cash flows account for salvage value of assets and recovery of net working capital at the end of the project life.
7. Forecasting of capital requirements in the short term is primarily concerned with:
A. Expansion into new business segments
B. Working capital management
C. Long-term infrastructure projects
D. Acquisitions and mergers
Short-term forecasting is linked with day-to-day liquidity needs such as inventory, receivables, and payables management, i.e., working capital.
8. Medium-term forecasting of capital is most useful for:
A. Daily cash flow adjustments
B. Long gestation infrastructure projects
C. Asset replacement and capacity enhancement
D. Amortization of bonds
Medium-term capital forecasting relates to 1–5 year horizons, often used for asset replacement, capacity enhancement, or expansion decisions.
9. Long-term capital forecasting is essential for:
A. Strategic investments in infrastructure and R&D
B. Adjusting monthly credit policies
C. Meeting short-term liquidity mismatches
D. Cash budgeting for one quarter
Long-term forecasting (beyond 5 years) helps plan for large projects, research and development, and infrastructure investments.
10. Which of the following best describes the relation between forecasting and regulation of capital?
A. Forecasting is independent of capital regulation
B. Forecasting deals only with historical data
C. Regulation of capital focuses only on equity capital
D. Accurate forecasting ensures optimal capital regulation for different time horizons
Forecasting provides estimates of future capital needs, while regulation ensures that adequate funds are available at the right time for short, medium, and long-term goals.
11. A bank plans to replace its IT systems in 3 years. This requirement falls under which category of capital forecasting?
A. Short-term forecasting
B. Long-term forecasting
C. Medium-term forecasting
D. Not part of forecasting
Medium-term forecasting (1–5 years) is appropriate for planned asset replacement and upgrades such as IT systems.
12. An airline company budgeting for new aircraft purchases over the next 10 years is an example of:
A. Short-term capital planning
B. Long-term capital forecasting
C. Medium-term capital planning
D. Cash flow management
Forecasting large capital needs like aircraft purchases for more than 5 years ahead falls under long-term capital forecasting.
13. Which budget is generally considered the starting point in the preparation of functional budgets?
A. Sales budget
B. Production budget
C. Cash budget
D. Materials purchase budget
The sales budget is prepared first as it determines the level of production and subsequently affects all other functional budgets.
14. The production budget is primarily derived from:
A. Cash availability
B. Materials purchase plan
C. Labour hours available
D. Sales budget and inventory policy
Production budget is based on the sales forecast, adjusted for opening and closing inventory levels as per company policy.
15. The materials purchase budget is prepared based on:
A. Sales budget only
B. Cash flow projections
C. Production budget and inventory requirements
D. Labour budget
Material purchase budget depends on production needs and required stock levels, derived from the production budget.
16. Which of the following is TRUE about the relationship between sales, production, and cash budgets?
A. Cash budget is prepared first and controls the sales forecast
B. Sales budget influences production budget, which in turn affects cash budget
C. Production budget has no link with cash budgeting
D. Cash budget and production budget are independent
Sales budget → Production budget → Cash budget is the logical sequence, as expected sales determine output and ultimately cash needs.
17. If a company underestimates its sales budget, which of the following is most likely to occur?
A. Excess inventory and idle resources
B. Overstated production budget
C. Surplus cash flow forecast
D. Stock-outs and inability to meet demand
If sales are underestimated, production planning will fall short, leading to stock-outs and unmet demand.
18. Which functional budget ensures that funds are available for production and other operations?
A. Sales budget
B. Production budget
C. Cash budget
D. Labour budget
The cash budget provides the framework to ensure liquidity, enabling smooth execution of sales, production, and other functional budgets.
19. The main objective of preparing a cash forecast is to:
A. Estimate profitability of the business
B. Predict liquidity position and cash requirements
C. Evaluate the value of fixed assets
D. Determine the market share of the firm
Cash forecasts help estimate cash inflows and outflows to maintain adequate liquidity and ensure timely availability of funds.
20. Cash forecasting is particularly important for:
A. Measuring ROI of a project
B. Estimating depreciation schedules
C. Preparing statutory audit reports
D. Ensuring liquidity for operations and investments
Cash forecasting ensures the firm has enough liquidity to meet obligations and fund investments without disruptions.
21. Which of the following is typically excluded from cash forecasts?
A. Receipts from customers
B. Payments to suppliers
C. Non-cash items like depreciation
D. Tax payments
Cash forecasts only include cash inflows and outflows. Non-cash items like depreciation are excluded.
22. Cost analysis in project appraisal mainly involves:
A. Identifying and classifying costs into fixed and variable
B. Only considering historical costs
C. Ignoring opportunity costs
D. Excluding overhead allocations
Project cost analysis includes classification of costs into fixed, variable, direct, indirect, and opportunity costs to assess feasibility.
23. Opportunity cost in project evaluation refers to:
A. Historical expenditure already incurred
B. Non-cash charges like depreciation
C. Fixed administrative expenses
D. Benefits foregone by choosing one alternative over another
Opportunity cost represents the return sacrificed when resources are allocated to one project instead of the next best alternative.
24. During cost analysis of a project, escalation in material prices should be treated as:
A. Non-relevant cost
B. Relevant future cost
C. Sunk cost
D. Historical fixed cost
Future escalation in material and labour costs must be considered as relevant costs while evaluating project viability.
25. Which of the following investment appraisal methods explicitly considers the time value of money?
A. Payback Period
B. Accounting Rate of Return (ARR)
C. Net Present Value (NPV)
D. Simple Return on Investment
NPV discounts future cash inflows to present values, making it a robust method that considers time value of money.
26. Which investment appraisal technique identifies the discount rate at which NPV equals zero?
A. Internal Rate of Return (IRR)
B. Payback Period
C. Profitability Index
D. Accounting Rate of Return
IRR is the discount rate that makes the NPV of a project zero, widely used for investment decision-making.
27. Profitability Index (PI) is calculated as:
A. Initial Investment / NPV
B. Average Accounting Profit / Investment
C. Cash Inflows – Cash Outflows
D. Present Value of Cash Inflows / Initial Investment
Profitability Index is the ratio of present value of inflows to initial investment, useful in ranking projects when capital is rationed.
28. Which of the following is NOT a limitation of the Payback Period method?
A. Ignores time value of money
B. Considers profitability of the project over its full life
C. Ignores cash flows after payback period
D. Focuses only on liquidity aspect
Payback does not consider the profitability of the project over its entire life, hence option B is not a limitation but an incorrect statement.
29. Social Cost Benefit Analysis (SCBA) differs from private investment appraisal because it:
A. Focuses only on accounting profits
B. Ignores externalities
C. Considers wider social and economic costs and benefits
D. Focuses exclusively on tax benefits
SCBA includes externalities, distributional effects, and impact on society, not just private financial returns.
30. In SCBA, shadow pricing is used to:
A. Adjust market prices to reflect true economic value
B. Hide actual project costs
C. Reduce the tax liability of projects
D. Eliminate inflation impact
Shadow pricing in SCBA is used where market prices are distorted, ensuring evaluation reflects the true economic cost or benefit to society.
31. A project requires an initial investment of ₹1,00,000. It generates cash inflows of ₹40,000, ₹50,000 and ₹60,000 at the end of year 1, 2 and 3 respectively. If the discount rate is 10%, what is the Net Present Value (NPV) of the project?
