Test 8: answer key

Question 1 · 2 marks · Investment Decisions - Capital Budgeting · medium

Scenario. Narmada Petrochem has a capital budget ceiling of ₹55 crore and five independent projects. Project A requires ₹30 crore and has NPV ₹6.00 crore; Project B requires ₹20 crore and has NPV ₹3.40 crore; Project C requires ₹10 crore and has NPV ₹1.40 crore; Project D requires ₹15 crore and has NPV ₹1.50 crore; Project E requires ₹5 crore and has NPV ₹0.40 crore. The finance manager is examining capital rationing under divisible and indivisible project assumptions.

Based on Profitability Index, which sequence ranks the five projects in descending order?

1. A, C, B, D, E
2. A, B, C, D, E (correct answer)
3. B, A, C, E, D
4. A, B, D, C, E

Answer: B — A, B, C, D, E

Working. PI A = 1 + 6.00/30 = 1.200; PI B = 1 + 3.40/20 = 1.170; PI C = 1 + 1.40/10 = 1.140; PI D = 1 + 1.50/15 = 1.100; PI E = 1 + 0.40/5 = 1.080.

Explanation. Profitability Index is present value of inflows divided by initial outlay, or 1 plus NPV divided by outlay. PI values are A 1.200, B 1.170, C 1.140, D 1.100 and E 1.080. The descending order is A, B, C, D and E.

Where it goes wrong. Ranking by absolute NPV instead of PI may put D above C because D has NPV ₹1.50 crore against C ₹1.40 crore, but PI ranking is relevant for divisible capital rationing.

Authority. Chapter 7: Investment Decisions - Capital Budgeting, Section 11.1 Capital Budgeting under Capital Rationing

Question 2 · 2 marks · Investment Decisions - Capital Budgeting · hard

If the projects are divisible and the capital ceiling is ₹55 crore, what is the maximum achievable NPV?

1. ₹9.80 crore
2. ₹9.40 crore
3. ₹10.10 crore (correct answer)
4. ₹10.80 crore

Answer: C — ₹10.10 crore

Working. A outlay 30 and NPV 6.00; B outlay 20 and NPV 3.40; balance 5; half of C gives outlay 5 and NPV 0.50 × 1.40 = 0.70. Total NPV = 6.00 + 3.40 + 0.70 = ₹10.10 crore.

Explanation. With divisible projects, the firm ranks by PI and takes A and B fully, using ₹50 crore. The remaining ₹5 crore is invested in half of C. NPV is 6.00 plus 3.40 plus 0.50 times 1.40, which equals ₹10.10 crore.

Where it goes wrong. Selecting A plus B plus E because the outlay exactly equals ₹55 crore ignores that half of C gives NPV ₹0.70 crore while E gives only ₹0.40 crore.

Authority. Chapter 7: Investment Decisions - Capital Budgeting, Section 11.1 Capital Budgeting under Capital Rationing

Question 3 · 2 marks · Investment Decisions - Capital Budgeting · hard

If the projects are indivisible, which feasible portfolio is most appropriate under the ₹55 crore ceiling?

1. A and B only, NPV ₹9.40 crore
2. A, C and D, NPV ₹8.90 crore
3. B, C, D and E, NPV ₹6.70 crore
4. A, B and E, NPV ₹9.80 crore (correct answer)

Answer: D — A, B and E, NPV ₹9.80 crore

Working. A+B+E outlay = 30+20+5 = 55; NPV = 6.00+3.40+0.40 = 9.80. A+B outlay = 50; NPV = 9.40. A+C+D outlay = 55; NPV = 6.00+1.40+1.50 = 8.90.

Explanation. For indivisible projects, the firm compares feasible combinations within the ceiling. A plus B plus E uses ₹55 crore and gives NPV ₹9.80 crore, which exceeds A plus B at ₹9.40 crore and A plus C plus D at ₹8.90 crore.

Where it goes wrong. Applying fractional PI ranking when projects are indivisible can suggest investing in half of C, which is not feasible here.

Authority. Chapter 7: Investment Decisions - Capital Budgeting, Section 11.1 Capital Budgeting under Capital Rationing

Question 4 · 2 marks · Financing Decisions - Capital Structure · medium

Scenario. Saraswati Ltd is an unlevered firm with EBIT ₹500 lakh, corporate tax rate 30 percent and unlevered cost of equity 15 percent. It plans to introduce debt of ₹300 lakh at a pre-tax cost of debt of 10 percent. The company operates in a perfect capital market with corporate taxes as per the Modigliani and Miller approach with taxes.

What is the value of the levered firm under the Modigliani and Miller approach with corporate taxes?

1. ₹2,333.33 lakh
2. ₹2,423.33 lakh (correct answer)
3. ₹2,523.33 lakh
4. ₹2,300.00 lakh

Answer: B — ₹2,423.33 lakh

Working. V_U = 500 × (1 − 0.30) / 0.15 = 350 / 0.15 = ₹2,333.33 lakh. V_L = V_U + T × D = 2,333.33 + 0.30 × 300 = ₹2,423.33 lakh.

Explanation. Under MM with taxes, value of levered firm equals value of unlevered firm plus tax shield. Unlevered value is EBIT after tax divided by unlevered cost of equity. Tax shield is tax rate multiplied by debt.

Where it goes wrong. Using EBIT without tax adjustment gives an inflated unlevered value and an incorrect levered value.

Authority. Chapter 5: Financing Decisions - Capital Structure, Section 2.4 Modigliani-Miller Approach with tax

Question 5 · 2 marks · Financing Decisions - Capital Structure · hard

What is the cost of equity of the levered firm under the MM approach with taxes?

1. 15.00 percent
2. 15.25 percent
3. 15.49 percent (correct answer)
4. 16.00 percent

Answer: C — 15.49 percent

Working. E = V_L − D = 2,423.33 − 300 = ₹2,123.33 lakh. K_e = 15% + (15% − 10%) × (1 − 0.30) × (300 / 2,123.33) = 15% + 5% × 0.70 × 0.14129 = 15.49 percent approx.

Explanation. The levered cost of equity equals unlevered cost of equity plus a financial risk premium based on after-tax debt-to-equity ratio. Market value of equity is levered firm value minus debt.

Where it goes wrong. Using debt divided by firm value instead of debt divided by equity understates the financial risk premium.

Authority. Chapter 5: Financing Decisions - Capital Structure, Section 2.4 Modigliani-Miller Approach with tax

Question 6 · 2 marks · Financing Decisions - Capital Structure · medium

What is the weighted average cost of capital of the levered firm under the MM approach with taxes?

1. 15.00 percent
2. 14.00 percent
3. 14.75 percent
4. 14.44 percent (correct answer)

Answer: D — 14.44 percent

Working. WACC = EBIT × (1 − T) / V_L = 500 × 0.70 / 2,423.33 = 350 / 2,423.33 = 14.44 percent approx.

Explanation. Under MM with taxes, WACC declines with leverage. It can be computed as EBIT after tax divided by levered firm value.

Where it goes wrong. Using the unlevered cost of equity as WACC ignores the tax shield benefit of debt.

Authority. Chapter 5: Financing Decisions - Capital Structure, Section 2.4 Modigliani-Miller Approach with tax

Question 7 · 2 marks · Investment Decisions - Capital Budgeting · medium

Scenario. Apex Solar Ltd is evaluating a project with an initial outlay of ₹100 lakh and expected cash inflows of ₹40 lakh in Year 1, ₹50 lakh in Year 2 and ₹30 lakh in Year 3. The cost of capital and reinvestment rate is 12 percent. The management is comparing the conventional Internal Rate of Return with Modified Internal Rate of Return.

What is the Modified Internal Rate of Return of the Apex Solar project?

1. 10.85 percent approx (correct answer)
2. 12.00 percent
3. 11.50 percent
4. 9.80 percent

Answer: A — 10.85 percent approx

Working. Terminal value = 40 × (1.12)^2 + 50 × (1.12) + 30 = 50.176 + 56.00 + 30 = ₹136.176 lakh. MIRR = (136.176 / 100)^(1/3) − 1 = 10.85 percent approx.

Explanation. MIRR brings all inflows to terminal value at the reinvestment rate and equates that terminal value to the initial outlay. The terminal value is compared with the initial outlay over three years.

Where it goes wrong. Using the simple average of cash inflows or treating MIRR as the same as IRR overstates or misstates the reinvestment assumption.

Authority. Chapter 7: Investment Decisions - Capital Budgeting, Section 9.5 Modified Internal Rate of Return

Question 8 · 1 marks · Investment Decisions - Capital Budgeting · medium

Which statement most appropriately distinguishes MIRR from conventional IRR?

1. IRR assumes reinvestment at the cost of capital while MIRR assumes reinvestment at IRR.
2. MIRR assumes reinvestment at the cost of capital and uses terminal value while IRR assumes reinvestment at IRR. (correct answer)
3. Both IRR and MIRR assume reinvestment at IRR.
4. MIRR ignores the initial outlay in project evaluation.

Answer: B — MIRR assumes reinvestment at the cost of capital and uses terminal value while IRR assumes reinvestment at IRR.

Working. MIRR = (Terminal value of inflows at cost of capital / Present value of outflows)^(1/n) − 1. IRR solves NPV equals zero using IRR as discount rate.

Explanation. MIRR explicitly assumes interim cash flows are reinvested at the cost of capital and converts them into a terminal value. Conventional IRR assumes reinvestment at the IRR itself.

Where it goes wrong. Reversing the reinvestment assumptions of IRR and MIRR is a common conceptual error.

Authority. Chapter 7: Investment Decisions - Capital Budgeting, Section 9.5 Modified Internal Rate of Return

Question 9 · 2 marks · Strategic Choices - Portfolio Analysis Models · medium

Scenario. Global Infotech uses the General Electric Nine-Cell Matrix for portfolio planning. Alpha Cloud operates in a highly attractive industry and has strong business strength. Beta Legacy ERP operates in a moderately attractive industry with average business strength. Gamma Hardware operates in a low-attractiveness industry with weak business strength.

In the General Electric Nine-Cell Matrix, which two dimensions form the axes for portfolio analysis?

1. Market growth rate and relative market share
2. Industry attractiveness and business strength (correct answer)
3. Market growth rate and cost leadership
4. Competitive intensity and pricing trends

Answer: B — Industry attractiveness and business strength

Working. GE matrix dimensions: vertical = industry attractiveness; horizontal = business strength. It forms a nine-cell grid with invest, selective and harvest zones.

Explanation. The GE Nine-Cell Matrix uses industry attractiveness on the vertical axis and business strength on the horizontal axis. Market growth and relative market share belong to the BCG matrix.

Where it goes wrong. Confusing GE matrix axes with BCG matrix axes is a common error.

Authority. Chapter 4: Strategic Choices, Section 4.4.4 General Electric Matrix

Question 10 · 2 marks · Strategic Choices - Portfolio Analysis Models · medium

Alpha Cloud is in a highly attractive industry with strong business strength. Which strategic prescription is most appropriate?

1. Harvest and divest
2. Hold and protect without further investment
3. Invest and expand (correct answer)
4. Liquidate the business unit

Answer: C — Invest and expand

Working. Alpha Cloud maps to high attractiveness and strong strength, which is a green zone cell. The prescribed direction is invest and expand.

Explanation. High industry attractiveness combined with strong business strength places Alpha Cloud in the green invest and grow zone. The firm should allocate resources to expand its position.

Where it goes wrong. Treating every high-growth unit as a cash cow or harvesting it prematurely ignores the strength dimension.

Authority. Chapter 4: Strategic Choices, Section 4.4.4 General Electric Matrix

Question 11 · 2 marks · Strategic Choices - Portfolio Analysis Models · medium

Gamma Hardware is in a low-attractiveness industry with weak business strength. Which strategic direction is most appropriate?

1. Invest and expand
2. Build market share aggressively
3. Selectively invest for earnings
4. Harvest or divest (correct answer)

Answer: D — Harvest or divest

Working. Gamma Hardware maps to low attractiveness and weak strength. Red zone cells indicate harvest or divest.

Explanation. Low industry attractiveness and weak business strength place Gamma Hardware in the red zone. The appropriate prescription is harvest or divest rather than committing fresh resources.

Where it goes wrong. Continuing investment because the unit is part of the current portfolio ignores the weak industry and competitive position.

Authority. Chapter 4: Strategic Choices, Section 4.4.4 General Electric Matrix

Question 12 · 2 marks · Strategy Implementation and Evaluation - Strategic Change · medium

Scenario. Paramount Bank is shifting from manual loan processing to a cloud-based digital architecture. Management first communicates the need for change and creates awareness among employees. It then trains staff and migrates pilot branches to the cloud workflow. Finally, it revises standard operating procedures, links rewards to digital adoption and monitors stability of new habits.

Paramount Bank communicates the need for change and creates awareness among employees about digital loan processing. Which stage of Kurt Lewin model is this?

1. Unfreezing (correct answer)
2. Changing
3. Refreezing
4. Benchmarking

Answer: A — Unfreezing

Working. Lewin stages: unfreezing prepares readiness; changing introduces new behaviour; refreezing reinforces and stabilizes new behaviour.

Explanation. Unfreezing breaks down old attitudes and prepares employees for change. Awareness sessions and communication of the need for change are unfreezing actions.

Where it goes wrong. Calling awareness sessions refreezing because they involve communication is incorrect; refreezing stabilizes new behaviour after implementation.

Authority. Chapter 5: Strategy Implementation and Evaluation, Section 5.3.1 Strategic Change and Kurt Lewin Model

Question 13 · 2 marks · Strategy Implementation and Evaluation - Strategic Change · medium

Paramount Bank trains staff and migrates pilot branches to the cloud workflow. Which stage of Kurt Lewin model is this?

1. Changing (correct answer)
2. Unfreezing
3. Refreezing
4. Divesting

Answer: A — Changing

Working. Unfreezing creates readiness; changing introduces the new cloud workflow; refreezing reinforces new habits.

Explanation. Changing is the movement stage in which new behaviour, processes and systems are introduced. Training and pilot migration are implementation actions in the changing stage.

Where it goes wrong. Treating training as unfreezing is incorrect if the actual new process is being implemented.

Authority. Chapter 5: Strategy Implementation and Evaluation, Section 5.3.1 Strategic Change and Kurt Lewin Model

Question 14 · 2 marks · Strategy Implementation and Evaluation - Strategic Change · medium

Paramount Bank revises standard operating procedures, links rewards to digital adoption and monitors stability of new habits. Which stage of Kurt Lewin model is this?

1. Refreezing (correct answer)
2. Unfreezing
3. Changing
4. Strategic surveillance

Answer: A — Refreezing

Working. Refreezing actions include revised policies, performance measures, reward systems and continuous reinforcement of the new work method.

Explanation. Refreezing stabilizes the new behaviour so that employees do not revert to old practices. Revised procedures, reward alignment and monitoring reinforce new digital habits.

Where it goes wrong. Calling reward alignment changing is incorrect when the purpose is to stabilize and institutionalize the new behaviour.

Authority. Chapter 5: Strategy Implementation and Evaluation, Section 5.3.1 Strategic Change and Kurt Lewin Model

Question 15 · 2 marks · Strategy Implementation and Evaluation - Digital Transformation · hard

Scenario. Vaayu Retail is redesigning its order-to-delivery process. The chief digital officer wants radical end-to-end process redesign using digital workflow, process ownership and real-time data rather than merely automating existing manual steps. The board is also examining how digital transformation differs from incremental process improvement.

Which action most appropriately represents Business Process Reengineering in the order-to-delivery process?

1. Automating existing manual order entry without changing process steps
2. Reducing invoice matching time by 5 percent through incremental effort
3. Redesigning order-to-delivery from functional handoffs to an end-to-end digital workflow with process ownership (correct answer)
4. Adding a new report to the existing ERP system

Answer: C — Redesigning order-to-delivery from functional handoffs to an end-to-end digital workflow with process ownership

Working. BPR tests: radical change, cross-functional process view, end-to-end ownership and digital workflow design. Incremental time reduction and report addition are not BPR.

Explanation. BPR involves radical redesign of processes rather than mere automation or incremental improvement. End-to-end redesign with process ownership changes the way work is performed.

Where it goes wrong. Automating an existing manual step improves speed but does not reengineer the underlying process.

Authority. Chapter 5: Strategy Implementation and Evaluation, Section 5.3.2 Digital Transformation and Change Management

Question 16 · 1 marks · Strategy Implementation and Evaluation - Digital Transformation · medium

Digital transformation in Vaayu Retail most appropriately involves which of the following?

1. Only purchasing cloud software for the existing process
2. Incremental automation of a single task
3. Replacing all employees with technology
4. Redesigning processes, capabilities and culture around digital technologies to create new value (correct answer)

Answer: D — Redesigning processes, capabilities and culture around digital technologies to create new value

Working. Digital transformation scope: process redesign, new value creation, capability development, change management and culture alignment around digital technologies.

Explanation. Digital transformation is a fundamental organizational change that uses digital technologies to develop improved or new processes, products and services. It includes process redesign, capability building and cultural change.

Where it goes wrong. Equating digital transformation with software purchase or single-task automation reduces it to a technical upgrade.

Authority. Chapter 5: Strategy Implementation and Evaluation, Section 5.3.2 Digital Transformation and Change Management