Incremental Analysis and Capital Budgeting Q&A
Accounting Q&A · Cost and Management Accounting · Topic 21
Work through the questions, then reveal the answers to check your reasoning.
25 short-answer questions. Try each question before revealing its answer.
Worked example
A project costs 10,000 now and yields 6,000 after one year and 5,500 after two years. At 10%, its NPV is approximately zero: 6,000 ÷ 1.10 plus 5,500 ÷ 1.21 equals 10,000.
Core concepts
1. What is incremental analysis?
Compare changes in costs and benefits caused by each option.
2. What is capital budgeting?
Evaluating long-term investments and their cash flow effects.
3. What cash flow goes into an investment appraisal?
Incremental cash flows attributable to the project under the stated assumptions.
4. Why exclude a sunk feasibility cost?
The decision cannot change an amount already spent.
5. Why include opportunity cost of owned land?
Using it prevents sale or another available use that could produce cash.
6. What is working capital investment?
Cash committed to operating balances such as inventory and receivables, net of relevant payables.
7. How is working capital recovered in a simple model?
Include release at the end only to the extent it is expected to occur.
8. What is payback period?
Time needed for cumulative undiscounted net cash inflows to recover the initial outlay.
9. What is discounted payback?
Time needed for discounted cash inflows to recover the initial outlay.
10. What is net present value?
Present value of incremental inflows less present value of outflows.
Worked applications
11. What is the present value of 11,000 due in one year at 10%?
10,000.
12. A project costs 8,000 and generates 3,000 per year. When is payback?
Two years and eight months if year-three cash flows arrive evenly.
13. What if the same 3,000 is received only at each year-end?
Payback occurs at the end of year three.
14. What is internal rate of return?
A discount rate at which NPV equals zero.
15. When can IRR be ambiguous?
Non-conventional cash flows can produce multiple rates or no meaningful rate.
16. How do you compare mutually exclusive projects using NPV?
Use consistent assumptions and choose the highest feasible value contribution, accounting for project lives where relevant.
17. What is a profitability index in a simple single-outlay case?
Present value of future net inflows divided by the initial investment.
18. If discounted inflows are 12,000 and initial outlay 10,000, what is the index?
1.20.
19. Is depreciation a cash outflow?
Depreciation is a non-cash charge. Include any relevant tax effects if the model uses after-tax cash flows.
Review and exam practice
20. What is terminal cash flow?
End-of-project cash movements such as sale proceeds, removal costs or working capital release.
21. How should inflation and discount rates be paired?
Match nominal cash flows with nominal rates and real cash flows with real rates.
22. What is sensitivity analysis?
Change one assumption and observe the effect on the decision measure.
23. How does scenario analysis differ?
Change a coherent set of assumptions together.
24. What is a common limitation of payback?
It ignores cash flows after recovery and, in its simple form, the time value of money.
25. What should an appraisal recommendation show?
Timing, assumptions, NPV, risks and constraints on implementation.
