QCM : Investment Valuation and Decision-Making — 9 questions

Questions et réponses du QCM

1. What does an investment decision rule refer to?

A criterion or set of criteria used to decide whether to undertake an investment
A financial metric used to measure project profitability
The legal regulations governing investment activities
A method for calculating the net present value of a project

A criterion or set of criteria used to decide whether to undertake an investment

Explication

The source explicitly states that an 'investment decision rule is a criterion or set of criteria used by a firm to determine whether a project or investment opportunity should be undertaken,' which directly corresponds to option 2.

2. What is the primary purpose of an investment decision rule within a firm?

To determine if a project’s expected benefits justify its costs.
To calculate the exact profit from each project.
To set the market price for new investments.
To decide the salary of project managers.

To determine if a project’s expected benefits justify its costs.

Explication

An investment decision rule helps firms evaluate whether the expected benefits from a project justify its costs, guiding their investment choices based on financial metrics.

3. Who is credited with formulating the decision rule based on NPV?

Merton Miller
No specific individual
Benjamin Graham
William Sharpe

No specific individual

Explication

The source content does not specify a particular individual credited with proposing the NPV decision rule, which is a fundamental principle in capital budgeting. Therefore, the correct answer is 'No specific individual,' reflecting that the rule is a general concept in financial decision-making, not attributed to one person.

4. Who is credited with formulating the decision rule based on Net Present Value (NPV), and in which year was it introduced?

Gordon R. Newbold in 1987.
Jack L. Treynor in 1961.
Merton H. Miller in 1966.
Graham and Dodd in 1934.

Graham and Dodd in 1934.

Explication

Graham and Dodd are credited with early development of fundamental investment principles including the use of NPV for decision-making, and their influential work was published in 1934.

5. Which of the following best describes the opportunity cost of capital?

The risk-free rate of return available from government bonds.
The return foregone from investing in an alternative project of similar risk and horizon.
The total amount of capital invested in a project.
The current market value of a firm’s assets.

The return foregone from investing in an alternative project of similar risk and horizon.

Explication

Opportunity cost of capital reflects what investors forgo by choosing a particular project over other investments with similar risk and duration, representing the minimum acceptable return.

6. What is required for a project to be considered viable based on the cost of capital?

Its expected return must be lower than the cost of capital.
Its expected return must equal or exceed the cost of capital.
It must generate cash flows only in the first year.
Its total project cost must be less than the company’s total assets.

Its expected return must equal or exceed the cost of capital.

Explication

A project is considered viable if its expected return meets or exceeds the cost of capital because this indicates the project can add value to the firm based on expected cash flows.

7. How does a firm typically evaluate whether a project adds value?

By comparing its expected cash flows discounted at the project’s expected return.
By comparing the project’s cash inflows to its initial investment without discounting.
By discounting the project’s expected cash flows at the cost of capital and comparing to initial investment.
By calculating the project’s gross profit margin.

By discounting the project’s expected cash flows at the cost of capital and comparing to initial investment.

Explication

The firm discounts expected cash flows at the cost of capital to determine whether the present value exceeds initial investment, indicating potential value addition.

8. Which aspect is NOT directly considered in the investment decision logic?

Expected cash flows and their timing.
The opportunity cost of capital.
The current market price of the firm’s stock.
The costs associated with the project.

The current market price of the firm’s stock.

Explication

Market price of a firm’s stock is not a direct part of the investment decision logic which focuses on cash flows, costs, and opportunity costs for project evaluation.

9. Why is the cost of capital considered a critical benchmark in investment decisions?

Because it reflects the maximum return a project can generate.
Because it encapsulates the rate of return expected by investors for risk-bearing investments.
Because it is the minimum amount that the project must spend on marketing.
Because it is set by the government and remains constant.

Because it encapsulates the rate of return expected by investors for risk-bearing investments.

Explication

The cost of capital represents the return that investors forego and expect for providing capital, making it a vital threshold against which to measure the project's expected return.

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Investment decision rule — purpose?

To determine if a project’s benefits justify its costs.

Investment decision rule — purpose?

Determine if a project adds value.

Decision rules overview — key tools?

NPV, IRR, Payback, PI, each with strengths and limitations.

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