IMANET IMANET Certifications IMANET-CMA Questions & Answers

• Question 271:

  When evaluating a capital budgeting project, a company's treasurer wants to know how changes in operating income and the number of years in the project's useful life will affect its breakeven internal rate of return. The treasurer is most likely to use

  A. Scenario analysis.

  B. Sensitivity analysis.

  C. Monte Carlo simulation.

  D. Learning curve analysis.

  Correct Answer: B

  Forecasts of many calculated NPVs under various assumptions are compared to see how sensitive NPV is to changing conditions. Changing or relaxing the assumptions about a certain variable or group of variables may drastically alter the NPV. Thus, the asset may appear to be much riskier than was originally predicted. In summary, sensitivity analysis is simply an iterative process of recalculated returns based on changing assumptions.

• Question 272:

  When determining net present value in an inflationary environment, adjustments should be made to

  A. Increase the discount rate, only.

  B. Increase the estimated cash inflows and increase the discount rate.

  C. Increase the estimated cash inflows but not the discount rate.

  D. Decrease the estimated cash inflows and increase the discount rate.

  Correct Answer: B

  In an inflationary environment, nominal future cash flows should increase to reflect the decrease in the value of the unit of measure. Also, the investor should increase the discount rate to reflect the increased inflation premium arising from the additional uncertainty. Lenders will require a higher interest rate in an inflationary environment.

• Question 273:

  Sensitivity analysis is used in capital budgeting to

  A. Estimate a project's internal rate of return.

  B. Determine the amount that a variable can change without generating unacceptable results.

  C. Simulate probabilistic customer reactions to a new product.

  D. Identify the required market share to make a new product viable and produce acceptable results.

  Correct Answer: B

  After a problem has been formulated into any mathematical model, it may be subjected to sensitivity analysis, which is a trial-and-error method used to determine the sensitivity of the estimates used. For example, forecasts of many calculated NPVs under various assumptions may be compared to determine how sensitive the NPV is to changing conditions. Changing the assumptions about a certain variable or group of variables may drastically alter the NPV, suggesting that the risk of the investment may be excessive.

• Question 274:

  A widely used approach that is used to recognize uncertainly about individual economic variables while obtaining an immediate financial estimate of the consequences of possible prediction errors is

  A. Expected value analysis.

  B. Learning curve analysis.

  C. Sensitivity analysis.

  D. Regression analysis.

  Correct Answer: C

  Sensitivity analysis recognizes uncertainly about estimates by making several calculations using varying estimates. For instance, several forecasts of net present value (NPV) might be calculated under various assumptions to determine the sensitivity of the NPV to changing conditions or prediction errors. Changing or relaxing the assumptions about a certain variable or group of variables may drastically alter the NPV, resulting in a much riskier asset than was originally forecast.

• Question 275:

  A manager wants to know the effect of a possible change in cash flows on the net present value of a project. The technique used for this purpose is

  A. Sensitivity analysis.

  B. Risk analysis.

  C. Cost behavior analysis.

  D. Return on investment analysis.

  Correct Answer: A

  Sensitivity analysis is a technique to evaluate a model in terms of the effect of changing the values of the parameters. It answers "what if" questions. In capital budgeting models, sensitivity analysis is the examination of alternative outcomes under different assumptions.

• Question 276:

  When the risks of the individual components of a project's cash flows are different, an acceptable procedure to evaluate these cash flows is to

  A. Divide each cash flow by the payback period.

  B. Compute the net present value of each cash flow using the firm's cost of capital.

  C. Compare the internal rate of return from each cash flow to its risk.

  D. Discount each cash flow using a discount rate that reflects the degree of risk.

  Correct Answer: D

  Risk-adjusted discount rates can be used to evaluate capital investment options. If risks differ among various elements of the cash flows, then different discount rates can be used for different flows.

• Question 277:

  The proper discount rate to use in calculating certainty equivalent net present value is the

  A. Risk-adjusted discount rate.

  B. Cost of capital.

  C. Risk-free rate.

  D. Cost of equity capital.

  Correct Answer: C

  Rational investors choose projects that yield the best return given some level of risk. If an investor desires no risk, that is, an absolutely certain rate of return, the risk4ree rate is used in calculating net present value. The risk-free rate is the return on a risk-free investment such as government bonds. Certainty equivalent adjustments involve a technique directly drawn from utility theory. It forces the decision maker to specify at what point the firm is indifferent to the choice between a sum of money that is certain and the expected value of a risky sum.

• Question 278:

  An analysis of a company's planned equity financing using the Capital Asset Pricing Model (or Security Market Line) incorporates only the

  A. Expected market earnings, the current U.S. treasury bond yield, and the beta coefficient.

  B. Expected market earnings and the price-earnings ratio.

  C. Current U.S. treasury bond yield, the price-earnings ratio, and the beta coefficient.

  D. Current U.S. treasury bond yield and the dividend payout ratio.

  Correct Answer: A

  The capital asset pricing model adds the risk-free rate to the product of the market risk premium and the beta coefficient. The market risk premium is the amount above the risk1ree rate (approximated by the U.S. treasury bond yield) that must be paid to induce investment in the market. The beta coefficient of an individual stock is the correlation between the price volatility of the stock market as a whole and the price volatility of the individual stock.

• Question 279:

  Sensitivity analysis, if used with capital projects,

  A. Is used extensively when cash flows are known with certainty.

  B. Measures the change in the discounted cash flows when using the discounted payback method rather than the net present value method.

  C. Is a "what-if" technique that asks how a given outcome will change if the original estimates of the capital budgeting model are changed.

  D. Is a technique used to rank capital expenditure requests.

  Correct Answer: C

  After a problem has been formulated into any mathematical model, it may be subjected to sensitivity analysis, which is a trial-and-error method used to determine the sensitivity of the estimates used. For example, forecasts of many calculated NPVs under various assumptions maybe compared to determine how sensitive the NPV is to changing conditions. Changing the assumptions about a certain variable or group of variables may drastically alter the NPV, suggesting that the risk of the investment may be excessive.

• Question 280:

  Mega, Inc., a large conglomerate with operating divisions in many industries, uses risk- adjusted discount rates in evaluating capital investment decisions. Consider the following statements concerning Mega's use of risk-adjusted discount rates.

  I. Mega may accept some investments with internal rates of return less than Mega's overall average cost of

  capital.

  II. Discount rates vary depending on the type of investment.

  Ill. Mega may reject some investments with internal rates of return greater than the cost of capital.

  IV. Discount rates may vary depending on the division.

  Which of the above statements are correct?

  A. I and Ill only.

  B. II and IV only.

  C. II, Ill, and IV only.

  D. I, II, Ill, and IV.

  Correct Answer: D

  Risk analysis attempts to measure the likelihood of the variability of future returns from the proposed investment. Risk can be incorporated into capital budgeting decisions in a number of ways1 one of which is to use a hurdle rate higher than the firm's cost of capital, that is, a risk-adjusted discount rate. This technique adjusts the interest rate used for discounting upward as an investment becomes riskier. The expected flow from the investment must be relatively larger, or the increased discount rate will generate a negative net present value, and the proposed acquisition will be rejected. Accordingly, the IRR (the rate at which the NPV is zero) for a rejected investment may exceed the cost of capital when the risk-adjusted rate is higher than the IRR. Conversely, the IRR for an accepted investment may be less than the cost of capital when the risk-adjusted rate is less than the IRR. In this case, the investment presumably has very little risk. Furthermore, risk-adjusted rates may also reflect the differing degrees of risk, not only among investments, but by the same investments undertaken by different organizational subunits.