Test 2: Investment Decisions (Capital Budgeting): answer key
This chapter-wise practice test covers Investment Decisions (Capital Budgeting) - Test 2 for CA Intermediate Group 2 students preparing for the May 2027 examination attempt. It carries 50 marks across 25 questions in case scenarios and standalone practical MCQs with a time limit of 60 minutes and no negative marking.
25 questions across 1 chapter, 50 marks and 60 minutes in the timed paper. Every answer below is shown with the working behind it and the authority it rests on.
Law and standards used: ICAI Study Material for CA Intermediate Paper 6: Financial Management and Strategic Management (relevant for 2027 attempt).
Questions
25
Marks
50
Time limit
60 minutes
Attempt
May 2027
Group
Group 2
Law basis
ICAI Study Material for CA Intermediate Paper 6: Financial Management and Strategic Management (relevant for 2027 attempt)
Content as of
2026-11-10
Chapters covered
Investment Decisions (Capital Budgeting) (25 Q)
Questions, answers and explanations
Question 1 · 2 marks · Investment Decisions (Capital Budgeting) · medium
Scenario. Bharat Renewables Components Ltd. manufactures inverter housings and mounting assemblies for solar energy projects. Due to increasing demand, the company is evaluating the installation of a dedicated machining line at its existing manufacturing facility. The proposal represents an expansion of production capacity and is expected to generate incremental operating earnings. The board intends to use the simple payback method as its first investment screening technique.
The company currently finances its operations through 60% equity and 40% long-term debt carrying a coupon rate of 10%. The applicable corporate income-tax rate is 25%. For evaluating the project, annual tax is calculated on incremental EBIT. Depreciation is charged on a straight-line basis and added back after calculating profit after tax to arrive at operating cash inflows. Financing costs are not deducted from project operating cash flows.
**Project investment and operating information (₹ lakh)**
| Particulars | Amount / Details |
|---|---:|
| Machinery purchase price | 80 |
| Installation and commissioning | 5 |
| Initial working capital | 10 |
| Useful life | 4 years |
| Residual value | 5 |
| Annual depreciation | 20 |
| Tax rate | 25% |
| Feasibility study paid last year | 2 |
| Annual working-capital cycle | 45 days |
**Incremental operating estimates (₹ lakh)**
| Particulars | Year 1 | Year 2 | Year 3 | Year 4 |
|---|---:|---:|---:|---:|
| EBITDA | 38 | 42 | 46 | 50 |
| Depreciation | 20 | 20 | 20 | 20 |
The feasibility study was completed and paid for during the preceding financial year. It cannot be recovered irrespective of whether the project is accepted. The additional working capital is expected to remain constant throughout the project and will be fully released at the end of Year 4. The machinery will be disposed of for its estimated residual value at the end of its useful life. All operating cash flows are received at the end of each financial year. Management has prescribed a maximum acceptable simple payback period of 2.50 years. Ignore terminal receipts until the relevant terminal year while computing the payback period.
Calculate the total initial cash outflow required for the proposed machining line.
₹85 lakh
₹93 lakh
₹95 lakh (correct answer)
₹97 lakh
Answer: C — ₹95 lakh
Explanation. Initial investment comprises machinery purchase price of ₹80 lakh, installation and commissioning of ₹5 lakh and initial working capital of ₹10 lakh. Therefore, total initial cash outflow = ₹80 + ₹5 + ₹10 = ₹95 lakh. The feasibility study of ₹2 lakh was paid in the preceding year and is an irrecoverable sunk cost. It must not be included. Option a omits working capital, while option d incorrectly adds the historical feasibility expenditure.
Where it goes wrong. Including sunk costs in the initial investment or omitting the working-capital requirement.
Question 2 · 2 marks · Investment Decisions (Capital Budgeting) · medium
Calculate the Year 2 operating Cash Flow After Tax (CFAT) of the machining line.
₹36.50 lakh (correct answer)
₹16.50 lakh
₹42.00 lakh
₹31.50 lakh
Answer: A — ₹36.50 lakh
Explanation. Year 2 EBITDA is ₹42 lakh. Deduct depreciation of ₹20 lakh to obtain EBIT of ₹22 lakh. Tax at 25% = ₹22 lakh × 25% = ₹5.50 lakh. Profit after tax = ₹22 lakh − ₹5.50 lakh = ₹16.50 lakh. Add back depreciation of ₹20 lakh, which is a non-cash expense. Therefore, CFAT = ₹16.50 + ₹20 = ₹36.50 lakh. Option b reports PAT instead of cash flow.
Where it goes wrong. Reporting profit after tax as project cash flow without adding back non-cash depreciation.
Question 3 · 2 marks · Investment Decisions (Capital Budgeting) · hard
Determine the simple payback period of the machining line using the annual operating CFAT figures.
2.50 years
2.80 years
3.00 years
2.63 years (correct answer)
Answer: D — 2.63 years
Explanation. Annual CFAT is EBITDA less tax on EBIT, with depreciation added back. The resulting inflows are ₹33.50 lakh, ₹36.50 lakh and ₹39.50 lakh for Years 1, 2 and 3. Cumulative inflow after Year 2 is ₹70 lakh. Unrecovered investment = ₹95 − ₹70 = ₹25 lakh. Fraction of Year 3 = ₹25 ÷ ₹39.50 = 0.633. Payback = 2 + 0.633 = 2.63 years. Terminal receipts arise later and do not change this recovery point.
Where it goes wrong. Using an average annual cash inflow instead of cumulative non-uniform cash flows, or forgetting the fractional recovery year.
Question 4 · 2 marks · Investment Decisions (Capital Budgeting) · hard
The board has prescribed a maximum acceptable simple payback period of 2.50 years. Based on the calculated recovery period, what should be the recommendation under the payback decision rule?
Accept, because the project recovers its investment before the end of its useful life.
Reject, because the payback period exceeds the maximum acceptable period. (correct answer)
Accept, because the payback period is less than three years.
The project cannot be evaluated because its terminal working capital has not yet been released.
Answer: B — Reject, because the payback period exceeds the maximum acceptable period.
Explanation. The calculated simple payback period is approximately 2.63 years, whereas the management's prescribed maximum acceptable period is 2.50 years. Since 2.63 is greater than 2.50, the proposal fails the company's payback screening requirement and should be rejected under this criterion. Recovering the investment within the total useful life does not automatically make it acceptable when a stricter cut-off period is prescribed. Options a and c ignore the stated maximum.
Where it goes wrong. Comparing payback with the project's useful life instead of the expressly prescribed maximum acceptable payback period.
Question 5 · 2 marks · Investment Decisions (Capital Budgeting) · medium
Scenario. Zenith Power Systems Ltd. manufactures industrial electrical control panels and is considering the purchase of an automated assembly machine to improve production efficiency. The company expects the new machine to operate at a stable level of utilisation throughout its six-year useful life. Consequently, management expects the annual operating cash inflows after tax to remain uniform. The finance department has been asked to evaluate the proposal using simple payback, payback reciprocal and Accounting Rate of Return.
The company has a capital structure comprising 65% equity and 35% long-term debt. The term loan carries an annual coupon rate of 9.25%. The applicable tax rate is 25%. For this exercise, project earnings have been calculated before financing costs, and interest and dividends are not to be deducted while calculating project operating returns.
**Project investment and operating information (₹ lakh)**
| Particulars | Amount / Details |
|---|---:|
| Machinery and installation investment | 100 |
| Initial working-capital requirement | 20 |
| Estimated scrap value | 10 |
| Useful life | 6 years |
| Annual straight-line depreciation | 15 |
| Annual EBITDA | 55 |
| Annual EBIT | 40 |
| Annual income tax | 10 |
| Annual profit after tax | 30 |
| Annual CFAT | 45 |
| Working-capital holding cycle | 60 days |
The machine's depreciable amount is calculated after considering the estimated residual value. The working-capital investment is required to maintain raw-material inventory, work in progress and credit sales during the operating cycle. The entire additional working-capital amount will be realised at the end of the sixth year. The residual value will also be received in the terminal year. Neither terminal receipt is relevant to recovery before the end of the useful life unless the initial investment has not already been recovered.
Management uses the average-investment basis for its principal ARR assessment and separately calculates ARR on the initial fixed-investment basis for comparison. For average investment, use one-half of the sum of initial fixed-asset investment and scrap value, plus the working-capital investment. The annual profit after tax remains constant throughout the useful life. The board is also interested in whether the payback reciprocal can reasonably approximate the project's rate of return under the conditions explained in the study material.
Calculate the simple payback period of Zenith Power Systems Ltd.'s proposed automated assembly machine.
2.50 years
2.75 years
2.67 years (correct answer)
3.00 years
Answer: C — 2.67 years
Explanation. Initial investment comprises fixed-asset investment of ₹100 lakh and working capital of ₹20 lakh, totalling ₹120 lakh. Annual operating CFAT is uniform at ₹45 lakh. For uniform cash inflows, payback period = Total initial investment ÷ Annual cash inflow = ₹120 lakh ÷ ₹45 lakh = 2.6667 years, or approximately 2.67 years. The terminal working-capital release and scrap proceeds are received later and do not affect recovery because the initial amount is recovered before the terminal year.
Where it goes wrong. Excluding working capital from the initial investment or adding terminal receipts to every year's uniform operating cash flow.
Question 6 · 2 marks · Investment Decisions (Capital Budgeting) · hard
Calculate the payback reciprocal of Zenith Power Systems Ltd. and determine whether the project's useful life satisfies the study-material condition for using it as a rough approximation of IRR.
35.00%; condition not satisfied
40.00%; condition satisfied
37.50%; condition not satisfied
37.50%; condition satisfied (correct answer)
Answer: D — 37.50%; condition satisfied
Explanation. Payback reciprocal = Average annual cash inflow ÷ Initial investment × 100 = ₹45 lakh ÷ ₹120 lakh × 100 = 37.50%. The simple payback period is 2.67 years. The project life is six years, while twice the payback period is 2 × 2.67 = 5.34 years. Since the project life of six years exceeds 5.34 years and annual inflows are uniform, the stated condition for treating the reciprocal as a rough approximation of IRR is satisfied. It is not the precise IRR.
Where it goes wrong. Confusing payback reciprocal with precise IRR or failing to verify that useful life is at least twice the payback period.
Question 7 · 2 marks · Investment Decisions (Capital Budgeting) · hard
Determine the ARR of the project using the average-investment basis prescribed by management.
30.00%
40.00% (correct answer)
32.00%
25.00%
Answer: B — 40.00%
Explanation. Average annual profit after tax is ₹30 lakh. Average investment = ½(Initial fixed-asset investment + Scrap value) + Working capital. Therefore, average investment = ½(₹100 + ₹10) + ₹20 = ₹55 + ₹20 = ₹75 lakh. ARR = Average annual profit after tax ÷ Average investment × 100 = ₹30 ÷ ₹75 × 100 = 40%. Option c incorrectly omits part of the required working-capital adjustment or uses an incorrect denominator.
Where it goes wrong. Using only the average book value of the fixed asset and omitting working capital from the average-investment denominator.
Question 8 · 2 marks · Investment Decisions (Capital Budgeting) · medium
Calculate the ARR of the project using the initial fixed-investment basis instead of the average-investment basis.
30.00% (correct answer)
40.00%
25.00%
37.50%
Answer: A — 30.00%
Explanation. Under the initial fixed-investment basis, the denominator is the initial fixed-asset investment including installation, which is ₹100 lakh. Average annual profit after tax is ₹30 lakh. Therefore, ARR = ₹30 lakh ÷ ₹100 lakh × 100 = 30%. The ₹20 lakh working-capital amount is not added to this specifically prescribed initial fixed-investment denominator. Option b is the result under the average-investment basis, not the initial-investment basis.
Where it goes wrong. Applying the average-investment formula when the question specifically requires the initial fixed-investment basis.
Question 9 · 2 marks · Investment Decisions (Capital Budgeting) · hard
Scenario. Aditya Automotive Ltd. manufactures precision automotive components for domestic and international vehicle manufacturers. It proposes to install a modernised production cell to increase output and reduce manufacturing delays. The project will be financed through 55% equity and 45% long-term debt carrying a coupon rate of 9.50%. The applicable corporate income-tax rate is 25%. The company's finance department has estimated the incremental operating earnings and the corresponding post-tax project cash flows. Financing costs are excluded from these project-level earnings.
**Project investment details (₹ lakh)**
| Particulars | Amount / Details |
|---|---:|
| Machinery purchase price | 80 |
| Installation and commissioning | 8 |
| Initial working capital | 12 |
| Initial fixed-asset investment | 88 |
| Scrap value after four years | 8 |
| Useful life | 4 years |
| Annual straight-line depreciation | 20 |
| Annual working-capital cycle | 60 days |
**Incremental operating estimates (₹ lakh)**
| Particulars | Year 1 | Year 2 | Year 3 | Year 4 |
|---|---:|---:|---:|---:|
| EBITDA | 35 | 38 | 41 | 44 |
| Depreciation | 20 | 20 | 20 | 20 |
The working-capital investment will remain at ₹12 lakh throughout the project and will be released fully at the end of Year 4. The machine is expected to be sold for its stated scrap value at the same time. Taxes are calculated annually on EBIT, and the project cash flow is calculated by adding depreciation back to profit after tax.
The investment committee has prescribed two independent traditional-method screening requirements: a maximum simple payback period of three years and a minimum ARR of 25%. For ARR, management has specifically prescribed the average-investment basis. The denominator must therefore include one-half of the initial fixed-asset investment plus scrap value, together with the full working-capital investment. The annual profits after tax are to be averaged over the complete four-year project life. The committee intends to examine whether the two traditional techniques produce consistent decisions before making its final recommendation.
Calculate the Year 3 operating CFAT of Aditya Automotive Ltd.'s production cell.
₹41.00 lakh
₹15.75 lakh
₹30.75 lakh
₹35.75 lakh (correct answer)
Answer: D — ₹35.75 lakh
Explanation. Year 3 EBITDA is ₹41 lakh and annual depreciation is ₹20 lakh. EBIT = ₹41 − ₹20 = ₹21 lakh. Tax at 25% is ₹21 × 25% = ₹5.25 lakh. Profit after tax = ₹21 − ₹5.25 = ₹15.75 lakh. Depreciation is non-cash and must be added back. Therefore, Year 3 CFAT = ₹15.75 + ₹20 = ₹35.75 lakh. Option b is PAT; option c incorrectly applies the tax percentage to EBITDA rather than EBIT.
Where it goes wrong. Applying tax to EBITDA or stopping at accounting profit after tax instead of calculating post-tax cash flow.
Question 10 · 2 marks · Investment Decisions (Capital Budgeting) · hard
Calculate the simple payback period of Aditya Automotive Ltd.'s production cell using the variable annual cash inflows.
2.75 years
3.25 years
2.99 years (correct answer)
3.50 years
Answer: C — 2.99 years
Explanation. Initial cash outflow = ₹88 lakh fixed-asset investment + ₹12 lakh working capital = ₹100 lakh. Annual CFAT is ₹31.25 lakh, ₹33.50 lakh, ₹35.75 lakh and ₹38 lakh. Cumulative cash inflow through Year 2 is ₹64.75 lakh. Balance unrecovered = ₹100 − ₹64.75 = ₹35.25 lakh. Fraction of Year 3 = ₹35.25 ÷ ₹35.75 = 0.986. Payback = 2 + 0.986 = 2.99 years approximately.
Where it goes wrong. Using the uniform cash-flow formula for a project with non-uniform inflows or dividing the unrecovered balance by the wrong year's inflow.
Question 12 · 2 marks · Investment Decisions (Capital Budgeting) · hard
Evaluate the production cell under both screening requirements prescribed by Aditya Automotive Ltd. Which conclusion is correct?
Both techniques reject the project.
Payback accepts the project, but ARR rejects it. (correct answer)
Payback rejects the project, but ARR accepts it.
Both techniques accept the project.
Answer: B — Payback accepts the project, but ARR rejects it.
Explanation. The simple payback period is approximately 2.99 years, which is within the maximum acceptable period of three years. Therefore, the project passes the payback test. ARR using the prescribed average-investment basis is 24.38%, which is below the minimum required ARR of 25%. Therefore, it fails the ARR test. The two traditional methods produce different conclusions because payback measures recovery time while ARR measures average accounting profitability.
Where it goes wrong. Assuming that satisfying one traditional investment appraisal criterion automatically means satisfying every other criterion.
Question 13 · 2 marks · Investment Decisions (Capital Budgeting) · medium
Scenario. A manufacturing company invests ₹1,44,00,000 in a machine. The machine is expected to generate uniform annual after-tax cash inflows of ₹36,00,000. Calculate its simple payback period.
A manufacturing company invests ₹1,44,00,000 in a machine. The machine is expected to generate uniform annual after-tax cash inflows of ₹36,00,000. Calculate its simple payback period.
3 years
3.50 years
4 years (correct answer)
5 years
Answer: C — 4 years
Explanation. Where annual cash inflows are uniform, simple payback period = Total initial capital investment ÷ Annual expected after-tax net cash flow. Substituting the figures gives ₹1,44,00,000 ÷ ₹36,00,000 = 4 years. The project will recover the complete initial investment at the end of the fourth year. Options a and b understate the time required, while option d overstates the recovery period.
Where it goes wrong. Dividing annual cash inflow by investment instead of dividing initial investment by annual cash inflow.
Question 14 · 2 marks · Investment Decisions (Capital Budgeting) · hard
Scenario. A company invests ₹1,50,000 in a project with the following annual after-tax cash inflows:
Year 1: ₹35,000
Year 2: ₹45,000
Year 3: ₹50,000
Year 4: ₹60,000
Determine the payback period, assuming inflows occur evenly throughout each year.
A company invests ₹1,50,000 in a project with the following annual after-tax cash inflows:
Year 1: ₹35,000
Year 2: ₹45,000
Year 3: ₹50,000
Year 4: ₹60,000
Determine the payback period, assuming inflows occur evenly throughout each year.
3.20 years
3.50 years
4.00 years
3.33 years (correct answer)
Answer: D — 3.33 years
Explanation. Cumulative inflows are ₹35,000 after Year 1, ₹80,000 after Year 2 and ₹1,30,000 after Year 3. The unrecovered investment after Year 3 is ₹1,50,000 − ₹1,30,000 = ₹20,000. Year 4 inflow is ₹60,000. Fraction of Year 4 required = ₹20,000 ÷ ₹60,000 = 0.3333 year. Therefore, total payback period = 3 + 0.3333 = 3.33 years. Option c incorrectly rounds recovery up to a full fourth year.
Where it goes wrong. Ignoring the fraction of the year needed to recover the remaining investment.
Question 15 · 2 marks · Investment Decisions (Capital Budgeting) · hard
Scenario. A project requires an initial investment of ₹1,00,000 and is expected to generate after-tax cash inflows of ₹20,000, ₹25,000, ₹30,000 and ₹15,000 over its four-year life. What is the appropriate payback conclusion?
A project requires an initial investment of ₹1,00,000 and is expected to generate after-tax cash inflows of ₹20,000, ₹25,000, ₹30,000 and ₹15,000 over its four-year life. What is the appropriate payback conclusion?
4 years exactly
The investment is not recovered within the project's useful life. (correct answer)
3.67 years
5 years
Answer: B — The investment is not recovered within the project's useful life.
Explanation. Total cash inflows over four years are ₹20,000 + ₹25,000 + ₹30,000 + ₹15,000 = ₹90,000. The initial investment is ₹1,00,000. Even after receiving all four annual inflows, ₹10,000 remains unrecovered. Consequently, the project does not achieve payback during its four-year useful life. It would be incorrect to report four years because recovery has not actually occurred by the end of Year 4. No fifth-year inflow is specified.
Where it goes wrong. Assuming that the end of the project's useful life automatically means the initial investment has been recovered.
Question 16 · 2 marks · Investment Decisions (Capital Budgeting) · hard
Scenario. A project requires an initial investment of ₹1,50,000 and generates uniform annual cash inflows of ₹45,000 for five years. Calculate the payback reciprocal and assess whether the useful-life condition for using it as an approximate IRR is satisfied.
A project requires an initial investment of ₹1,50,000 and generates uniform annual cash inflows of ₹45,000 for five years. Calculate the payback reciprocal and assess whether the useful-life condition for using it as an approximate IRR is satisfied.
30%; condition not satisfied (correct answer)
30%; condition satisfied
33.33%; condition not satisfied
33.33%; condition satisfied
Answer: A — 30%; condition not satisfied
Explanation. Payback period = ₹1,50,000 ÷ ₹45,000 = 3.333 years. Payback reciprocal = ₹45,000 ÷ ₹1,50,000 × 100 = 30%. For the reciprocal to provide a reasonable approximation of IRR under the stated condition, project life must be at least twice the payback period. Twice the payback period = 6.666 years, which exceeds the actual useful life of five years. Therefore, the condition is not satisfied.
Where it goes wrong. Calculating the reciprocal correctly but overlooking the requirement that project life must be at least twice the payback period.
Question 17 · 2 marks · Investment Decisions (Capital Budgeting) · medium
Scenario. A company invests ₹60,00,000 in machinery, including installation. Its average annual profit after tax and depreciation over the useful life of the project is ₹9,00,000. Calculate ARR using the initial-investment basis.
A company invests ₹60,00,000 in machinery, including installation. Its average annual profit after tax and depreciation over the useful life of the project is ₹9,00,000. Calculate ARR using the initial-investment basis.
12%
18%
20%
15% (correct answer)
Answer: D — 15%
Explanation. Under the initial-investment basis, ARR = Average annual net profit after tax ÷ Initial investment × 100. Average annual PAT is ₹9,00,000 and initial investment, including installation, is ₹60,00,000. Therefore, ARR = ₹9,00,000 ÷ ₹60,00,000 × 100 = 15%. The denominator remains the initial investment throughout the calculation. Options based on an average book value or an incorrectly selected denominator are not applicable to this question.
Where it goes wrong. Using average investment or annual cash inflow in place of the expressly required initial investment and average annual PAT.
Question 18 · 2 marks · Investment Decisions (Capital Budgeting) · hard
Scenario. A project has an initial fixed-asset investment of ₹40,00,000, an estimated scrap value of ₹8,00,000 and a working-capital requirement of ₹6,00,000. Average annual profit after tax is ₹9,00,000. Calculate ARR using the average-investment basis.
A project has an initial fixed-asset investment of ₹40,00,000, an estimated scrap value of ₹8,00,000 and a working-capital requirement of ₹6,00,000. Average annual profit after tax is ₹9,00,000. Calculate ARR using the average-investment basis.
25%
36%
30% (correct answer)
32%
Answer: C — 30%
Explanation. Average investment = ½(Initial investment + Scrap value) + Working capital. Hence, average investment = ½(₹40,00,000 + ₹8,00,000) + ₹6,00,000 = ₹24,00,000 + ₹6,00,000 = ₹30,00,000. ARR = Average annual PAT ÷ Average investment × 100 = ₹9,00,000 ÷ ₹30,00,000 × 100 = 30%. Option a omits working capital from the denominator.
Where it goes wrong. Using one-half of initial investment alone without adding the full working-capital requirement.
Question 19 · 2 marks · Investment Decisions (Capital Budgeting) · hard
Scenario. A project requires fixed-asset investment of ₹50 lakh, has an expected scrap value of ₹10 lakh and requires working capital of ₹10 lakh. The annual profits after tax over four years are ₹5 lakh, ₹7 lakh, ₹9 lakh and ₹11 lakh. Determine ARR using the average-investment basis.
A project requires fixed-asset investment of ₹50 lakh, has an expected scrap value of ₹10 lakh and requires working capital of ₹10 lakh. The annual profits after tax over four years are ₹5 lakh, ₹7 lakh, ₹9 lakh and ₹11 lakh. Determine ARR using the average-investment basis.
20% (correct answer)
18%
25%
16%
Answer: A — 20%
Explanation. Average annual PAT = (₹5 + ₹7 + ₹9 + ₹11) lakh ÷ 4 = ₹32 lakh ÷ 4 = ₹8 lakh. Average investment = ½(₹50 + ₹10) + ₹10 = ₹30 + ₹10 = ₹40 lakh. ARR = ₹8 lakh ÷ ₹40 lakh × 100 = 20%. Option b results from an incorrect annual profit average, while option c generally arises from omitting the working-capital amount or miscalculating the average investment.
Where it goes wrong. Using total profit instead of average annual profit or incorrectly treating working capital as a depreciable asset.
Question 20 · 2 marks · Investment Decisions (Capital Budgeting) · medium
Scenario. A company invests ₹35 lakh in a project. Its profits after tax and depreciation for four years are ₹5.50 lakh, ₹6.50 lakh, ₹7.50 lakh and ₹8.50 lakh. The company requires an ARR of at least 18% on the initial-investment basis. Determine the ARR and recommendation.
A company invests ₹35 lakh in a project. Its profits after tax and depreciation for four years are ₹5.50 lakh, ₹6.50 lakh, ₹7.50 lakh and ₹8.50 lakh. The company requires an ARR of at least 18% on the initial-investment basis. Determine the ARR and recommendation.
18%; accept
20%; accept (correct answer)
22%; reject
25%; accept
Answer: B — 20%; accept
Explanation. Total profit after tax over four years = ₹5.50 + ₹6.50 + ₹7.50 + ₹8.50 = ₹28 lakh. Average annual PAT = ₹28 lakh ÷ 4 = ₹7 lakh. ARR on initial investment basis = ₹7 lakh ÷ ₹35 lakh × 100 = 20%. Since 20% exceeds the minimum acceptable rate of 18%, the project should be accepted under the ARR decision rule. Option a incorrectly treats the prescribed cut-off rate as the calculated ARR.
Where it goes wrong. Confusing the minimum acceptable ARR with the actual ARR calculated from average annual PAT.
Question 21 · 2 marks · Investment Decisions (Capital Budgeting) · hard
Scenario. A company purchases machinery for ₹80 lakh and incurs installation costs of ₹4 lakh. The estimated scrap value is ₹4 lakh and useful life is four years. Annual earnings before depreciation and tax are ₹30 lakh, ₹34 lakh, ₹38 lakh and ₹42 lakh respectively. If the tax rate is 30%, calculate ARR on the initial-investment basis and determine whether the project meets a minimum acceptable ARR of 12%.
A company purchases machinery for ₹80 lakh and incurs installation costs of ₹4 lakh. The estimated scrap value is ₹4 lakh and useful life is four years. Annual earnings before depreciation and tax are ₹30 lakh, ₹34 lakh, ₹38 lakh and ₹42 lakh respectively. If the tax rate is 30%, calculate ARR on the initial-investment basis and determine whether the project meets a minimum acceptable ARR of 12%.
11.20%; reject
12.00%; accept
13.33%; accept (correct answer)
16.00%; accept
Answer: C — 13.33%; accept
Explanation. Initial investment = ₹80 + ₹4 = ₹84 lakh. Annual depreciation = (₹84 − ₹4) ÷ 4 = ₹20 lakh. EBIT is ₹10, ₹14, ₹18 and ₹22 lakh. PAT at 30% tax is ₹7, ₹9.80, ₹12.60 and ₹15.40 lakh. Average annual PAT = ₹44.80 ÷ 4 = ₹11.20 lakh. ARR = ₹11.20 ÷ ₹84 × 100 = 13.33%. It exceeds the 12% cut-off, so accept.
Where it goes wrong. Calculating ARR from earnings before depreciation and tax rather than profit after tax and using the wrong depreciation amount.
Question 22 · 2 marks · Investment Decisions (Capital Budgeting) · hard
Scenario. Two mutually independent projects, A and B, each require an initial investment of ₹100 lakh and have a four-year useful life. Their projected annual profits after tax are uniform at ₹10 lakh for A and ₹18 lakh for B. Their annual operating cash inflows are as follows:
| Year | Project A | Project B |
|---|---:|---:|
| 1 | ₹60 lakh | ₹25 lakh |
| 2 | ₹40 lakh | ₹45 lakh |
| 3 | ₹30 lakh | ₹50 lakh |
| 4 | ₹30 lakh | ₹40 lakh |
Determine which project ranks higher under ARR and which ranks higher under simple payback.
Two mutually independent projects, A and B, each require an initial investment of ₹100 lakh and have a four-year useful life. Their projected annual profits after tax are uniform at ₹10 lakh for A and ₹18 lakh for B. Their annual operating cash inflows are as follows:
| Year | Project A | Project B |
|---|---:|---:|
| 1 | ₹60 lakh | ₹25 lakh |
| 2 | ₹40 lakh | ₹45 lakh |
| 3 | ₹30 lakh | ₹50 lakh |
| 4 | ₹30 lakh | ₹40 lakh |
Determine which project ranks higher under ARR and which ranks higher under simple payback.
Project A ranks higher under both methods.
Project B ranks higher under both methods.
Project A has higher ARR, while Project B has shorter payback.
Project B has higher ARR, while Project A has shorter payback. (correct answer)
Answer: D — Project B has higher ARR, while Project A has shorter payback.
Explanation. ARR of A = ₹10 lakh ÷ ₹100 lakh × 100 = 10%. ARR of B = ₹18 lakh ÷ ₹100 lakh × 100 = 18%. Thus, B ranks higher under ARR. For A, cumulative cash inflow reaches ₹100 lakh at the end of Year 2, giving payback of two years. For B, cumulative inflow is ₹70 lakh after Year 2, leaving ₹30 lakh; Year 3 inflow is ₹50 lakh, so payback = 2 + 30/50 = 2.60 years. A therefore has shorter payback.
Where it goes wrong. Assuming that a project with a higher ARR must also have a shorter payback period.
Question 23 · 2 marks · Investment Decisions (Capital Budgeting) · medium
Scenario. A company is comparing two mutually exclusive projects requiring identical initial investments of ₹120 lakh. The expected cash inflows are:
| Year | Project M | Project N |
|---|---:|---:|
| 1 | ₹40 lakh | ₹55 lakh |
| 2 | ₹50 lakh | ₹45 lakh |
| 3 | ₹60 lakh | ₹30 lakh |
Which project should be preferred under the simple payback method?
A company is comparing two mutually exclusive projects requiring identical initial investments of ₹120 lakh. The expected cash inflows are:
| Year | Project M | Project N |
|---|---:|---:|
| 1 | ₹40 lakh | ₹55 lakh |
| 2 | ₹50 lakh | ₹45 lakh |
| 3 | ₹60 lakh | ₹30 lakh |
Which project should be preferred under the simple payback method?
Project M, with payback of 2.50 years. (correct answer)
Project N, with payback of 2.50 years.
Project M, with payback of 3.00 years.
Project N, with payback of 3.00 years.
Answer: A — Project M, with payback of 2.50 years.
Explanation. For Project M, cumulative inflows after Years 1 and 2 are ₹40 lakh and ₹90 lakh. Remaining investment is ₹30 lakh, recovered from the Year 3 inflow of ₹60 lakh. Payback = 2 + 30/60 = 2.50 years. For Project N, cumulative inflows after Year 2 are ₹100 lakh; the remaining ₹20 lakh is recovered from the Year 3 inflow of ₹30 lakh. Payback = 2 + 20/30 = 2.67 years. Therefore, M has the shorter payback period.
Where it goes wrong. Selecting the project with the larger initial-year cash inflow without considering cumulative recovery.
Question 24 · 2 marks · Investment Decisions (Capital Budgeting) · hard
Scenario. Two projects each require an initial investment of ₹100 lakh and generate the following cash inflows:
| Year | Project A | Project B |
|---|---:|---:|
| 1 | ₹60 lakh | ₹50 lakh |
| 2 | ₹40 lakh | ₹50 lakh |
| 3 | Nil | ₹100 lakh |
| 4 | Nil | ₹100 lakh |
What is the most appropriate interpretation of the payback method in this situation?
Two projects each require an initial investment of ₹100 lakh and generate the following cash inflows:
| Year | Project A | Project B |
|---|---:|---:|
| 1 | ₹60 lakh | ₹50 lakh |
| 2 | ₹40 lakh | ₹50 lakh |
| 3 | Nil | ₹100 lakh |
| 4 | Nil | ₹100 lakh |
What is the most appropriate interpretation of the payback method in this situation?
Project B has a shorter payback because its total lifetime inflows are higher.
Both have a two-year payback, so the method does not distinguish B's additional post-payback inflows or account for the time value of money. (correct answer)
Project A is automatically superior because its Year 1 inflow is larger.
Project B has a longer payback because more cash is received after Year 2.
Answer: B — Both have a two-year payback, so the method does not distinguish B's additional post-payback inflows or account for the time value of money.
Explanation. For Project A, cumulative inflows of ₹60 lakh and ₹40 lakh recover ₹100 lakh at the end of Year 2. For Project B, ₹50 lakh in each of the first two years also recovers ₹100 lakh at the same point. Both therefore have a two-year payback period. However, B generates an additional ₹200 lakh in Years 3 and 4. Simple payback ignores these later cash flows and does not discount the cash received at different times.
Where it goes wrong. Assuming equal payback periods imply equal overall profitability or that cash flows after recovery are irrelevant to the investment decision.
Question 25 · 2 marks · Investment Decisions (Capital Budgeting) · hard
Scenario. Two projects require an identical initial investment of ₹60 lakh and have a four-year useful life. Their annual profits after tax are as follows:
| Year | Project A | Project B |
|---|---:|---:|
| 1 | ₹18 lakh | ₹6 lakh |
| 2 | ₹6 lakh | ₹6 lakh |
| 3 | ₹6 lakh | ₹6 lakh |
| 4 | ₹6 lakh | ₹18 lakh |
Calculate ARR using the initial-investment basis and identify the limitation demonstrated by the result.
Two projects require an identical initial investment of ₹60 lakh and have a four-year useful life. Their annual profits after tax are as follows:
| Year | Project A | Project B |
|---|---:|---:|
| 1 | ₹18 lakh | ₹6 lakh |
| 2 | ₹6 lakh | ₹6 lakh |
| 3 | ₹6 lakh | ₹6 lakh |
| 4 | ₹6 lakh | ₹18 lakh |
Calculate ARR using the initial-investment basis and identify the limitation demonstrated by the result.
A: 22.50%; B: 7.50%; ARR prefers A.
A: 10%; B: 15%; ARR prefers B.
A: 7.50%; B: 22.50%; ARR prefers B.
Both projects have 15% ARR, so ARR does not reflect the different timing of their accounting profits. (correct answer)
Answer: D — Both projects have 15% ARR, so ARR does not reflect the different timing of their accounting profits.
Explanation. Total PAT for A = ₹18 + ₹6 + ₹6 + ₹6 = ₹36 lakh. Total PAT for B is also ₹36 lakh. Average annual PAT for each = ₹36 lakh ÷ 4 = ₹9 lakh. ARR for both = ₹9 lakh ÷ ₹60 lakh × 100 = 15%. Although A earns more profit in Year 1 and B earns more in Year 4, ARR produces identical results because it uses average annual accounting profit and ignores the time value of money.
Where it goes wrong. Assuming ARR reflects the timing of profits merely because it considers accounting earnings over the entire project life.
What does this Investment Decisions (Capital Budgeting) - Test 2 practice test cover?
This practice test carries 50 marks across 25 questions covering core concepts, mathematical financial models, strategic management frameworks, and practical ICAI case scenarios.
How many questions are there and what is the time limit?
There are 25 questions carrying 2 marks each, giving a maximum score of 50 marks in 60 minutes with no negative marking.
Which study material and syllabus apply to these questions?
Questions strictly reflect the official ICAI Study Material for CA Intermediate Paper 6 Financial Management and Strategic Management for the 2027 examination sessions.
Can I sit this test in both exam and practice modes?
Yes. Practice mode gives immediate answers with step-by-step workings and trap explanations after each question. Exam mode simulates actual exam conditions with a live timer and issues a downloadable performance certificate.
