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Free Financial CMA Exam Questions (page: 85)

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The technique that recognizes the time value of money by discounting the after-tax cash flows for a project over its life to time period zero using the company's minimum desired rate of return is called the

  1. Net present value method.
  2. Payback method.
  3. Average rate of return method.
  4. Accounting rate of return method.

Answer(s): A

Explanation:

The net present value method discounts future cash flows to the present value using some arbitrary rate of return, which is presumably the firm's cost of capital. The initial cost of the project is then deducted from the present value. If the present value of the future cash flows exceeds the cost, the investment is considered to be acceptable.



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The technique that reflects the time value of money and is calculated by dividing the present value of the future net after- tax cash inflows that have been discounted at the desired cost of capital by the initial cash outlay for the investment is called the

  1. Capital rationing method.
  2. Average rate of return method.
  3. Profitability index method.
  4. Accounting rate of return method.

Answer(s): C

Explanation:

The profitability index is another term for the excess present value index. It measures the ratio of the present value of future net cash inflows to the original investment. In organizations with unlimited capital funds, this index will produce no conflicts in the decision process. If capital rationing is necessary, the index will be an insufficient determinant. The capital available as well as the dollar amount of the net present value must both be considered.



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The technique that measures the estimated performance of a capital investment by dividing the project's annual after4ax net income by the average investment cost is called the

  1. Average rate of return method.
  2. Internal rate of return method.
  3. Capital asset pricing model.
  4. Accounting rate of return method.

Answer(s): D

Explanation:

The accounting rate of return is calculated by dividing the annual after-tax net income from a project by the book value of the investment in that project. The time value of money is ignored.



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The technique that incorporates the time value of money by determining the compound interest rate of an investment such that the present value of the after-tax cash inflows over the life of the investment is equal to the initial investment is called the

  1. Internal rate of return method.
  2. Capital asset pricing model.
  3. Profitability index method.
  4. Accounting rate of return method.

Answer(s): A

Explanation:

The internal rate of return (IRR) is the discount rate at which the present value of the cash inflows equals the present values of the cash outflows (including the original investment). Thus, the NPV of the project is zero at the IRR. The IRR is also the maximum borrowing cost the firm can afford to pay for a specific project. The IRR is similar to the yield rate/effective rate quoted in the business media.



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