IMANET IMANET Certifications IMANET-CMA Questions & Answers

• Question 281:

  A company uses portfolio theory to develop its investment portfolio. If the company wishes to obtain optimal risk reduction through the portfolio effect, it should make its next investment in an investment that

  A. Correlates negatively to the current portfolio holdings.

  B. Is uncorrelated to the current portfolio holdings.

  C. Is highly correlated to the current portfolio holdings.

  D. Is perfectly correlated to the current portfolio holdings.

  Correct Answer: A

  A common general definition is that risk is an investment with an unknown outcome but a known probability distribution of returns (a known mean and standard deviation). An increase in the standard deviation (variability) of returns is synonymous with an increase in the riskiness of a project. Risk is also increased when the project's returns are positively (directly) correlated with other investments in the company's portfolio; that is, risk increases when returns on all projects rise or fall together. Consequently, the overall risk is decreased when projects have low variability and are negatively correlated (the diversification effect).

• Question 282:

  For capital budgeting purposes, management would select a high hurdle rate of return for certain projects because management

  A. Wants to use equity funding exclusively.

  B. Believes too many proposals are being rejected.

  C. Believes bank loans are riskier than capital investments.

  D. Wants to factor risk into its consideration of projects.

  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 ways, one of which is to use a hurdle rate (desired rate of return) 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.

• Question 283:

  Willis, Inc. has a desired rate of return of 15% and is considering the acquisition of a new machine which costs $400,000 and has a useful life of 5 years. Willis projects that earnings and cash flow will increase as follows:

  

  The net present value of Willis' investment is

  A. Negative, $64,000.

  B. Negative, $14,000.

  C. Positive, $18,600.

  D. Positive, $200,000.

  Correct Answer: C

  The NPV is calculated by discounting the after-tax cash flows by the desired rate of return. The cash flows of this company constitute an annuity of $100,000 per year plus additional flows of $60,000 in Year 1 and $40,000 in Year 2. Thus, the present value of these flows is $418,600 [($100,000 x 3.36 PV of an annuity of $1 for 5 periods at 15%) + ($60,000 x .87 PV of $1 for 1 period at 15%) + ($40,000 x .76 PV of $1 for 2 periods at 15%)]. The NPV is therefore $18,600 ($418,600 --$400,000).

• Question 284:

  Willis, Inc. has a desired rate of return of 15% and is considering the acquisition of a new machine which costs $400,000 and has a useful life of 5 years. Willis projects that earnings and cash flow will increase as follows:

  

  What is the payback period of Willis' investment?

  A. 1.5 years.

  B. 3.0 years.

  C. 3.3 years.

  D. 4.0 years.

  Correct Answer: B

  The payback method calculates the number of years required to complete the return of the original investment. The initial cost is $400,000, so Willis will recoup its investment in 3 years ($160,000 in year 1 + $140,000 inyear2 + $100,000 in year 3).

• Question 285:

  The Keego Company is planning a $200,000 equipment investment which has an estimated 5-year life with no estimated salvage value. The company has projected the following annual cash flows for the investment.

  

  The net present value for the investment is

  A. $18,800

  B. $218,800

  C. $100,000

  D. $91,743

  Correct Answer: A

• Question 286:

  The Keego Company is planning a $200,000 equipment investment which has an estimated 5-year life with no estimated salvage value. The company has projected the following annual cash flows for the investment.

  

  Assuming that the estimated cash inflows occur evenly during each year, the payback period for the investment is

  A. 1.67years.

  B. 4.91 years.

  C. 2.50 years.

  D. 1.96years.

  Correct Answer: C

  The payback period is the number of years required to complete the return of the original investment. The principal problems with the payback method are that it does not consider the time value of money and the inflows after the payback period. The inflow for the first year is $120,000, the second year is $60,000, and the third year is $40,000, a total of $220,000. Given an initial investment of $200,000. the payback period must be between 2 and 3 years. If the cash inflows occur evenly throughout the year, $20,000 ($200,000 --$120,000-- $60,000) of cash inflows are needed in year 3, which is 50% of that year's total. Thus, the answer is 2.5 years.

• Question 287:

  Tonya, Inc. has a cost of capital of 15% and is considering the acquisition of a new machine that costs $800,000 and has a useful life of 5 years. Tonya projects that earnings and cash flow will increase as follows:

  

  Interest rate factors at 15% are as follows: What is the profitability index for the investment?

  

  A. 0.05

  B. 0.96

  C. 1.05

  D. 1.25

  Correct Answer: C

  The profitability index is the present value of the future net cash flows divided by the present value of the net initial investment. The present value of the future net cash flows is $837,200. Dividing the $800,000 initial cost of the investment into the $837,200 present value of the future net cash inflows produces a profitability index of approximately 1 .05. Any profitability index greater than one is considered acceptable.

• Question 288:

  Tonya, Inc. has a cost of capital of 15% and is considering the acquisition of a new machine that costs $800,000 and has a useful life of 5 years. Tonya projects that earnings and cash flow will increase as follows:

  

  Interest rate factors at 15% are as follows:

  

  The net present value of this investment is

  A. $(128,000)

  B. $200,000

  C. $37,200

  D. $400,000

  Correct Answer: C

• Question 289:

  Tonya, Inc. has a cost of capital of 15% and is considering the acquisition of a new machine that costs $800,000 and has a useful life of 5 years. Tonya projects that earnings and cash flow will increase as follows:

  

  Interest rate factors at 15% are as follows:

  

  What is the payback period of this investment?

  A. 1.Syears.

  B. 3.Oyears.

  C. 3.3 years.

  D. 4.0 years.

  Correct Answer: B

  The payback method is simply the time required to recover the investment. It does not consider the time value of money or returns after the payback period. When cash flows are not uniform, a cumulative calculation is necessary. Thus, 3.0 years is the payback period ($320,000 in the first year, $280,000 in the second year, and $200,000 in the third year).

• Question 290:

  Don Adams Breweries is considering an expansion project with an investment of $1,500,000. The equipment will be depreciated to zero salvage value on a straight-line basis over 5 years. The expansion will produce incremental operating revenue of $400,000 annually for 5 years. The company's opportunity cost of capital is 12%. Ignore taxes.What is the payback period of the project?

  A. 2years.

  B. 2.14 years.

  C. 3.75years.

  D. 5 years.

  Correct Answer: C