Capital Investment Decision Analysis.docx

Foundations of Finance Capital Investment Decision Analysis-I 1) Free cash flows represent the benefits generated from accepting a capital-budgeting proposal. Answer: TRUE 1) The most critical aspect in determining the acceptability of a capital budgeting project is the impact the project will have on the company's net income over the projects entire useful life. Answer: FALSE 2) Advantages of the payback period include that it is easy to calculate, easy to understand, and that it is based on cash flows rather than on accounting profits. Answer: TRUE Keywords: Payback Period 3) If project A generates $10 million of free cash flow over its five year useful life and project B generates $8 million of free cash flow over its useful life, then Project A will have a shorter payback period than Project B, assuming both projects require the same initial investment. Answer: FALSE Keywords: Payback Period 4) A project with a payback period of four years is acceptable as long as the company's target payback period is greater than or equal to four years. Answer: TRUE Keywords: Payback Period 5) Two projects that have the same cost and the same expected cash flows will have the same net present value. Answer: FALSE Keywords: Net Present Value, Discount Rate 6) The profitability index is the ratio of the company's net income (or profits) to the initial outlay or cost of a capital budgeting project. Answer: FALSE Keywords: Profitability Index 7) If a project is acceptable using the net present value criteria, then it will also be acceptable under the less stringent criteria of the payback period. Answer: FALSE Keywords: Net Present Value, Payback Period 8) An acceptable project should have a net present value greater than or equal to zero and a profitability index greater than or equal to one. Answer: TRUE Keywords: Net Present Value, Profitability Index 9) If a project's internal rate of return is greater than the project's required return, then the project's profitability index will be greater than one. Answer: TRUE , Profitability Index 10) The net present value profile clearly demonstrates that the NPV of a project increases as the discount rate increases. Answer: FALSE Keywords: Net Present Value Profile, Discount Rate 11) The modified internal rate of return represents the project's internal rate of return assuming that intermediate cash flows from the project can be reinvested at the project's required return. Answer: TRUE Keywords: Modified Internal Rate of Return, Required Return 12) One drawback of the payback method is that some cash flows may be ignored. Answer: TRUE Keywords: Payback Period 13) The required rate of return reflects the costs of funds needed to finance a project. Answer: TRUE Keywords: Required Return 14) The profitability index provides an advantage over the net present value method by reporting the present value of benefits per dollar invested. Answer: TRUE Keywords: Profitability Index, Net Present Value 15) The net present value of a project will increase as the required rate of return is decreased (assume only one sign reversal). Answer: TRUE Keywords: Net Present Value, Required Return 16) Whenever the internal rate of return on a project equals that project's required rate of return, the net present value equals zero. Answer: TRUE , Net Present Value, Required Return 17) One of the disadvantages of the payback method is that it ignores time value of money. Answer: TRUE Keywords: Payback Period, Time Value of Money 18) The capital budgeting decision-making process involves measuring the incremental cash flows of an investment proposal and evaluating the attractiveness of these cash flows relative to the project's cost. Answer: TRUE Keywords: Capital Budgeting, Incremental Cash Flows 19) When several sign reversals in the cash flow stream occur, a project can have more than one IRR. Answer: TRUE Keywords: Multiple Internal Rates of Return, Sign Reversals 20) Many firms today continue to use the payback method but also employ the NPV or IRR methods especially when large projects are being analyzed. Answer: TRUE Keywords: Payback Period, NPV, IRR 21) NPV is the most theoretically correct capital budgeting decision tool examined in the text. Answer: TRUE Keywords: NPV 22) If the net present value of a project is zero, then the profitability index will equal one. Answer: TRUE Keywords: Net Present Value, Profitability Index, Decision Rules 23) The internal rate of return will equal the discount rate when the net present value equals zero. Answer: TRUE , Discount Rate, Net Present Value 24) Mutually exclusive projects have more than one IRR. Answer: FALSE Keywords: Mutually Exclusive Projects, IRR 25) For a project with multiple sign reversals in its cash flows, the net present value can be the same for two entirely different discount rates. Answer: TRUE Keywords: Sign Reversals, Net Present Value, Discount Rates 26) The internal rate of return is the discount rate that equates the present value of the project's future free cash flows with the project's initial outlay. Answer: TRUE 27) If a project's profitability index is less than one then the project should be rejected. Answer: TRUE Keywords: Profitability Index 28) If a project is acceptable using the NPV criteria, it will also be acceptable when using the profitability index and IRR criteria. Answer: TRUE Keywords: NPV, PI, IRR 29) If a firm imposes a capital constraint on investment projects, the appropriate decision criterion is to select the set of projects that has the highest positive net present value subject to the capital constraint. Answer: TRUE Keywords: Capital Constraint, Net Present Value 30) For any individual project, if the project is acceptable based on its internal rate of return, then the project will also be acceptable based on its modified internal rate of return. Answer: TRUE , Modified Internal Rate of Return 31) One positive feature of the payback period is it emphasizes the earliest forecasted free cash flows, which are less uncertain than later cash flows and provide for the liquidity needs of the firm. Answer: TRUE Keywords: Payback Period 32) The main disadvantage of the NPV method is the need for detailed, long-term forecasts of free cash flows generated by prospective projects. Answer: TRUE Keywords: NPV, Free Cash Flow 33) The profitability index is the ratio of the present value of the future free cash flows to the initial investment. Answer: TRUE Keywords: Profitability Index 34) Marketing is crucial to capital budgeting success because the goal of a good capital budgeting project is to maximize the company's sales. Answer: FALSE Keywords: Capital Budgeting, Shareholder Wealth Maximization 35) Because the NPV and PI methods both yield the same accept/reject decision, a company attempting to rank capital budgeting projects for funding consideration can use either method and get the same results. Answer: FALSE Keywords: NPV, PI 36) A project's IRR is analogous to the concept of the yield to maturity for bonds. Answer: TRUE , Yield to Maturity 37) NPV assumes reinvestment of intermediate free cash flows at the cost of capital, while IRR assumes reinvestment of intermediate free cash flows at the IRR. Answer: TRUE , Reinvestment Rate 38) A project's net present value profile shows how sensitive the project is to the choice of a discount rate. Answer: TRUE Keywords: Net Present Value Profile, Discount Rate 39) If a project has multiple internal rates of return, the lowest rate should be used for decision making purposes. Answer: FALSE , Multiple IRRs 40) The payback period ignores the time value of money and therefore should not be used as a screening device for the selection of capital budgeting projects. Answer: FALSE Keywords: Payback Period, Time Value of Money 41) Many financial managers believe the payback period is of limited usefulness because it ignores the time value of money; hence, it is referred to as the discounted payback period. Answer: FALSE Keywords: Discounted Payback Period, Payback Period, Time Value of Money 42) The discounted payback period takes the time value of money into account in that it uses discounted free cash flows rather than actual undiscounted free cash flows in calculating the payback period. Answer: TRUE Keywords: Discounted Payback Period, Time Value of Money 43) Any project deemed acceptable using the discounted payback period will also be acceptable if using the traditional payback period. Answer: TRUE Keywords: Discounted Payback Period, Payback Period 44) A major disadvantage of the discounted payback period is the arbitrariness of the process used to select the maximum desired payback period. Answer: TRUE Keywords: Discounted Payback Period, Arbitrary Decision Rule 45) A project with a NPV of zero should be rejected since even the returns on U.S. Treasury bill are greater than zero. Answer: FALSE Keywords: NPV, Decision Rule 46) NPV may be calculated on an Excel spreadsheet simply by entering the project's free cash flows into Excel's NPV function. Answer: FALSE Keywords: NPV, Excel 47) The internal rate of return is the discount rate that equates the present value of the project's free cash flows with the project's initial cash outlay. Answer: TRUE 48) A project that is very sensitive to the selection of a discount rate will have a steep net present value profile. Answer: TRUE Keywords: Net Present Value Profile 49) Because the MIRR assumes reinvestment at the cost of capital while IRR assumes reinvestment at the project's IRR, the MIRR will always be less than the IRR. Answer: FALSE , MIRR, Reinvestment Rate 50) Calculating the modified internal rate of return on an Excel spreadsheet involves the use of the IRR function multiple times, once using the financing rate, and once using the reinvestment rate. Answer: FALSE Keywords: MIRR, Excel, Reinvestment Rate 51) The capital budgeting manager for XYZ Corporation, a very profitable high technology company, completed her analysis of Project A assuming 5-year depreciation. Her accountant reviews the analysis and changes the depreciation method to 3-year depreciation. This change will A) increase the present value of the NCFs. B) decrease the present value of the NCFs. C) have no effect on the NCFs because depreciation is a non-cash expense. D) only change the NCFs if the useful life of the depreciable asset is greater than 5 years. Answer: A Keywords: Net Present Value, Depreciation Expense 52) Project W requires a net investment of $1,000,000 and has a payback period of 5.6 years. You analyze Project W and decide that Year 1 free cash flow is $100,000 too low, and Year 3 free cash flow is $100,000 too high. After making the necessary adjustments A) the payback period for Project W will be longer than 5.6 years. B) the payback period for Project W will be shorter than 5.6 years. C) the IRR of Project W will increase. D) the NPV of Project W will decrease. Answer: C Keywords: Payback Period, Net Present Value, Internal Rate of Return 53) Project Alpha has an internal rate of return (IRR) of 15 percent. Project Beta has an IRR of 14 percent. Both projects have a required return of 12 percent. Which of the following statements is MOST correct? A) Both projects have a positive net present value (NPV). B) Project Alpha must have a higher NPV than Project Beta. C) If the required return were less than 12 percent, Project Beta would have a higher IRR than Project Alpha. D) Project Beta has a higher profitability index than Project Alpha. Answer: A , Net Present Value, Required Return 54) Which of the following statements is MOST correct? A) If a project's internal rate of return (IRR) exceeds the required return, then the project's net present value (NPV) must be negative. B) If Project A has a higher IRR than Project B, then Project A must also have a higher NPV. C) The IRR calculation implicitly assumes that all cash flows are reinvested at a rate of return equal to the IRR. D) A project with a NPV = 0 is not acceptable. Answer: C , Net Present Value, Reinvestment Rate 55) DYI Construction Co. is considering a new inventory system that will cost $750,000. The system is expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in year four. DYI's required rate of return is 8%. What is the payback period of this project? A) 4.00 years B) 3.09 years C) 2.91 years D) 2.50 years Answer: D Keywords: Payback Period 56) DYI Construction Co. is considering a new inventory system that will cost $750,000. The system is expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in year four. DYI's required rate of return is 8%. What is the net present value of this project? A) $104,089 B) $100,328 C) $96,320 D) $87,417 Answer: A Keywords: Net Present Value 57) DYI Construction Co. is considering a new inventory system that will cost $750,000. The system is expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in year four. DYI's required rate of return is 8%. What is the internal rate of return of this project? A) 10.87% B) 11.57% C) 13.68% D) 15.13% Answer: D 58) DYI Construction Co. is considering a new inventory system that will cost $750,000. The system is expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in year four. DYI's required rate of return is 8%. What is the modified internal rate of return of this project? A) 10.87% B) 11.57% C) 13.68% D) 15.13% Answer: B Keywords: Modified Internal Rate of Return 59) Project LMK requires an initial outlay of $400,000 and has a profitability index of 1.5. The project is expected to generate equal annual cash flows over the next twelve years. The required return for this project is 20%. What is project LMK's net present value? A) $600,000 B) $150,000 C) $120,000 D) $80,000 Answer: B Keywords: Net Present Value, Profitability Index 60) Project LMK requires an initial outlay of $500,000 and has a profitability index of 1.4. The project is expected to generate equal annual cash flows over the next ten years. The required return for this project is 16%. What is project LMK's internal rate of return? A) 19.88% B) 22.69% C) 24.78% D) 26.12% Answer: D , Profitability Index, Ordinary Annuity 61) A capital budgeting project has a net present value of $30,000 and a modified internal rate of return of 15%. The project's required rate of return is 13%. The internal rate of return is A) greater than $30,000. B) less than 13%. C) between 13% and 15%. D) greater than 15% Answer: D Keywords: Modified Internal Rate of Return, Net Present Value, Internal Rate of Return, Required Return 62) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. The firm's required rate of return for these projects is 10%. The net present value for Project A is A) $12,358. B) $16,947. C) $19,458. D) $26,074. Answer: D Keywords: Net Present Value 63) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The net present value for Project B is A) $58,097. B) $66,363. C) $74,538. D) $112,000. Answer: B Keywords: Net Present Value 64) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The profitability index for Project A is A) 1.27. B) 1.22. C) 1.17. D) 1.12. Answer: A Keywords: Profitability Index 65) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The profitability index for Project B is A) 1.55. B) 1.48. C) 1.39. D) 1.33. Answer: A Keywords: Profitability Index 66) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The internal rate of return for Project A is A) 31.43%. B) 29.42%. C) 25.88%. D) 19.45%. Answer: B 67) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The internal rate of return for Project B is A) 29.74%. B) 30.79%. C) 35.27%. D) 36.77%. Answer: C 68) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%.The modified internal rate of return for Project A is A) 19.19%. B) 24.18%. C) 26.89%. D) 29.63%. Answer: B Keywords: Modified Internal Rate of Return 69) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The modified internal rate of return for Project B is A) 17.84%. B) 18.52%. C) 19.75%. D) 22.80%. Answer: D Keywords: Modified Internal Rate of Return 70) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. Which project would you recommend using the replacement chain method to evaluate the projects with different lives? A) Project B because its NPV is higher than Project A's replacement chain NPV of $47,623 B) Project A because its replacement chain NPV is $76,652, which exceeds the NPV for Project B C) Project A because its replacement chain NPV is $45,642, which is less than the NPV for Project B D) Both projects will be valued the same since they are now both four year projects. Answer: A Keywords: Replacement Chain, Net Present Value 71) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The equivalent annual annuity amount for project B, rounded to the nearest dollar, is A) $17,385. B) $20,936. C) $22,789. D) $26,551. Answer: B Keywords: Equivalent Annual Annuity 72) The net present value method A) is consistent with the goal of shareholder wealth maximization. B) recognizes the time value of money. C) uses all of a project's cash flows. D) all of the above. Answer: D Keywords: Net Present Value 73) Arguments against using the net present value and internal rate of return methods include that A) they fail to use accounting profits. B) they require detailed long-term forecasts of the incremental benefits and costs. C) they fail to consider how the investment project is to be financed. D) they fail to use the cash flow of the project. Answer: B Keywords: Net Present Value, Internal Rate of Return 74) All of the following are sufficient indications to accept a project EXCEPT (assume that there is no capital rationing constraint, and no consideration is given to payback as a decision tool) A) the net present value of an independent project is positive. B) the profitability index of an independent project exceeds one. C) the IRR of a mutually exclusive project exceeds the required rate of return. D) the NPV of a mutually exclusive project is positive and exceeds that of all other projects. Answer: C Keywords: Net Present Value, Profitability Index, Internal Rate of Return, Mutually Exclusive Projects, Independent Projects 75) When reviewing the net present profile for a project A) the higher the discount rate, the higher the NPV. B) the higher the discount rate, the higher the IRR. C) the IRR will always be a point on the horizontal axis line where NPV = 0. D) the IRR will always be a point on the horizontal axis equal to the required return. Answer: C Keywords: Net Present Value Profile, IRR, NPV 76) A project requires an initial investment of $389,600. The project generates free cash flow of $540,000 at the end of year 4. What is the internal rate of return for the project? A) 138.6% B) 38.6% C) 8.5% D) 6.9% Answer: C 77) Raindrip Corp. can purchase a new machine for $1,875,000 that will provide an annual net cash flow of $650,000 per year for five years. The machine will be sold for $120,000 after taxes at the end of year five. What is the net present value of the machine if the required rate of return is 13.5%. A) $558,378 B) $513,859 C) $473,498 D) $447,292 Answer: D Keywords: Net Present Value 78) Given the following annual net cash flows, determine the internal rate of return to the nearest whole percent of a project with an initial outlay of $750,000. Year Net Cash Flow 1 $500,000 2 $150,000 3 $250,000 A) 9% B) 11% C) 13% D) 15% Answer: B 79) A machine that costs $1,500,000 has a 3-year life. It will generate after tax annual cash flows of $700,000 at the end of each year. It will be salvaged for $200,000 at the end of year 3. If your required rate of return for the project is 13%, what is the NPV of this investment? A) $291,417 B) $400,000 C) $600,000 D) $338,395 Answer: A Keywords: Net Present Value 80) Initial Outlay Cash Flow in Period 1 2 3 4 $4,000,000 $1,546,170 $1,546,170 $1,546,170 $1,546,170 The Internal Rate of Return (to nearest whole percent) is A) 10%. B) 18%. C) 20%. D) 24%. Answer: C 81) We compute the profitability index of a capital budgeting proposal by A) multiplying the internal rate of return by the cost of capital. B) dividing the present value of the annual after tax cash flows by the cost of capital. C) dividing the present value of the annual after tax cash flows by the cash investment in the project. D) multiplying the cash inflow by the internal rate of return. Answer: C Keywords: Profitability Index 82) What is the payback period for a project with an initial investment of $180,000 that provides an annual cash inflow of $40,000 for the first three years and $25,000 per year for years four and five, and $50,000 per year for years six through eight? A) 5.80 years B) 5.20 years C) 5.40 years D) 5.59 years Answer: B Keywords: Payback Period 83) The advantages of NPV are all of the following EXCEPT A) it can be used as a rough screening device to eliminate those projects whose returns do not materialize until later years. B) it provides the amount by which positive NPV projects will increase the value of the firm. C) it allows the comparison of benefits and costs in a logical manner through the use of time value of money principles. D) it recognizes the timing of the benefits resulting from the project. Answer: A Keywords: Net Present Value 84) The disadvantage of the IRR method is that A) the IRR deals with cash flows. B) the IRR gives equal regard to all returns within a project's life. C) the IRR will always give the same project accept/reject decision as the NPV. D) the IRR requires long, detailed cash flow forecasts. Answer: D 85) The internal rate of return is A) the discount rate that makes the NPV positive. B) the discount rate that equates the present value of the cash inflows with the present value of the cash outflows. C) the discount rate that makes NPV negative and the PI greater than one. D) the rate of return that makes the NPV positive. Answer: B 86) All of the following are criticisms of the payback period criterion EXCEPT A) time value of money is not accounted for. B) cash flows occurring after the payback are ignored. C) it deals with accounting profits as opposed to cash flows. D) none of the above; they are all criticisms of the payback period criteria. Answer: C Keywords: Payback Period 87) Southeast Compositions, Inc. is considering a project with the following cash flows: Initial Outlay = $126,000 Cash Flows: Year 1 = $44,000 Year 2 = $59,000 Year 3 = $64,000 Compute the net present value of this project if the company's discount rate is 14%. A) -$249,335 B) -$138,561 C) $239,209 D) $725,000 Answer: A Keywords: Net Present Value 88) Design Quilters is considering a project with the following cash flows: Initial Outlay = $126,000 Cash Flows: Year 1 = $44,000 Year 2 = $59,000 Year 3 = $64,000 If the appropriate discount rate is 11.5%, compute the NPV of this project. A) -$14,947 B) $2,892 C) $7,089 D) $41,000 Answer: C Keywords: Net Present Value 89) Your company is considering a project with the following cash flows: Initial Outlay = $3,000,000 Cash Flows Year 1-8 = $547,000 Compute the internal rate of return on the project. A) 6.38% B) 8.95% C) 9.25% D) 12.34% Answer: C 90) For the net present value (NPV) criteria, a project is acceptable if NPV is ________, while for the profitability index a project is acceptable if PI is ________. A) greater than zero; greater than the required return B) greater than or equal to zero; greater than zero C) greater than one; greater than or equal to one D) greater than or equal to zero; greater than or equal to one Answer: D Keywords: Net Present Value, Profitability Index 91) Compute the discounted payback period for a project with the following cash flows received uniformly within each year and with a required return of 8%: Initial Outlay = $100 Cash Flows: Year 1 = $40 Year 2 = $50 Year 3 = $60 A) 2.10 years B) 2.21 years C) 2.33 years D) 3.00 years Answer: C Keywords: Discounted Payback Period 92) Consider a project with the following information: After-tax After-tax Accounting Cash Flow Year Profits from Operations 1 $799 $750 2 150 1,000 3 200 1,200 Initial outlay = $1,500 Compute the profitability index if the company's discount rate is 10%. A) 15.8 B) 1.61 C) 1.81 D) 0.62 Answer: B Keywords: Profitability Index 93) If the NPV (Net Present Value) of a project with one sign reversal is positive, then the project's IRR (Internal Rate of Return) ________ the required rate of return. A) must be less than B) must be greater than C) could be greater or less than D) cannot be determined without actual cash flows Answer: B Keywords: Net Present Value, Internal Rate of Return 94) You are considering investing in a project with the following year-end after-tax cash flows: Year 1: $57,000 Year 2: $72,000 Year 3: $78,000 If the initial outlay for the project is $185,000, compute the project's internal rate of return. A) 3.98% B) 5.54% C) 11.89% D) 14.74% Answer: B 95) Different discounted cash flow evaluation methods may provide conflicting rankings of investment projects when A) the size of investment outlays differ. B) the projects are mutually exclusive. C) the accounting policies differ. D) the internal rate of return equals the cost of capital. Answer: A Keywords: Capital Budgeting Decisions, Size, Cash Flows vs Accounting Income 96) The Net Present Value (or NPV) criteria for capital budgeting decisions assumes that expected future cash flows are reinvested at ________, and the Internal Rate of Return (or IRR) criteria assumes that expected future cash flows are reinvested at ________. A) the firm's discount rate; the internal rate of return B) the internal rate of return; the internal rate of return C) the internal rate of return; the firm's discount rate D) Neither criteria assumes reinvestment of future cash flows. Answer: A Keywords: Net Present Value, Internal Rate of Return, Reinvestment Rate 97) A significant advantage of the payback period is that it A) places emphasis on time value of money. B) allows for the proper ranking of projects. C) tends to reduce firm risk because it favors projects that generate early, less uncertain returns. D) gives proper weighting to all cash flows. Answer: C Keywords: Payback Period 98) A significant disadvantage of the payback period is that it A) is complicated to explain. B) increases firm risk. C) does not properly consider the time value of money. D) provides a measure of liquidity Answer: C Keywords: Payback Period 99) Your firm is considering an investment that will cost $750,000 today. The investment will produce cash flows of $250,000 in year 1, $300,000 in years 2 through 4, and $100,000 in year 5. What is the investment's discounted payback period if the required rate of return is 10%? A) 3.33 years B) 3.16 years C) 2.67 years D) 2.33 years Answer: B Keywords: Discounted Payback Period 100) A significant advantage of the internal rate of return is that it A) provides a means to choose between mutually exclusive projects. B) provides the most realistic reinvestment assumption. C) avoids the size disparity problem. D) considers all of a project's cash flows and their timing. Answer: D 101) An independent project should be accepted if it A) produces a net present value that is greater than or equal to zero. B) produces a net present value that is greater than the equivalent IRR. C) has only one sign reversal. D) produces a profitability index greater than or equal to zero. Answer: A Keywords: Independent Projects, Net Present Value 102) What is the net present value's assumption about how cash flows are reinvested? A) They are reinvested at the IRR. B) They are reinvested at the APR. C) They are reinvested at the firm's discount rate. D) They are reinvested only at the end of the project. Answer: C Keywords: Net Present Value, Reinvestment Rate Assumption 103) Your firm is considering an investment that will cost $920000 today. The investment will produce cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in year 5. The discount rate that your firm uses for projects of this type is 11.25%. What is the investment's net present value? A) $540,000 B) $378,458 C) $192,369 D) $112,583 Answer: C Keywords: Net Present Value 104) Your firm is considering an investment that will cost $920,000 today. The investment will produce cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in year 5. The discount rate that your firm uses for projects of this type is 11.25%. What is the investment's profitability index? A) 1.21 B) 1.26 C) 1.43 D) 1.69 Answer: A Keywords: Profitability Index 105) Your firm is considering an investment that will cost $920,000 today. The investment will produce cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in year 5. The discount rate that your firm uses for projects of this type is 11.25%. What is the investment's internal rate of return? A) 27.28% B) 21.26% C) 20.53% D) 15.98% Answer: C 106) Which of the following statements about the internal rate of return (IRR) is true? A) It has the most conservative and realistic reinvestment assumption. B) It never gives conflicting answers. C) It fully considers the time value of money. D) It is greater than the modified internal rate of return if the discount rate is higher than the IRR. Answer: C 107) A significant disadvantage of the internal rate of return is that it A) does not fully consider the time value of money. B) does not give proper weight to all cash flows. C) can result in multiple rates of return (more than one IRR). D) is expressed as a percentage. Answer: C 108) A significant disadvantage of the internal rate of return is that it A) does not fully consider the time value of money. B) does not give proper weight to all cash flows. C) may have an unrealistic reinvestment assumption. D) is expressed as a percentage. Answer: C 109) A one-sign-reversal project should be accepted if it A) generates an internal rate of return that is higher than the profitability index. B) produces an internal rate of return that is greater than the firm's discount rate. C) results in an internal rate of return that is above a project's equivalent annual annuity. D) results in a modified internal rate of return that is higher than the internal rate of return. Answer: B 110) What is the internal rate of return's assumption about how cash flows are reinvested? A) They are reinvested at the firm's discount rate. B) They are reinvested at the required rate of return. C) They are reinvested at the project's internal rate of return. D) They are only reinvested at the end of the project. Answer: C , Reinvestment Rate Assumption 111) If the NPV (Net Present Value) of a project with multiple sign reversals is positive, then the project's required rate of return ________ its calculated IRR (Internal Rate of Return). A) must be less than B) must be greater than C) could be greater or less than D) cannot be determined without actual cash flows Answer: C Keywords: Net Present Value, Internal Rate of Return, Multiple Sign Reversals 112) Kingston Corp. is considering a new machine that requires an initial investment of $480,000 installed, and has a useful life of 8 years. The expected annual after-tax cash flows for the machine are $89,000 for each of the 8 years and nothing thereafter. a. Calculate the net present value of the machine if the required rate of return is 11 percent. b. Calculate the IRR of this project. c. Should Kingston accept the project (assume that it is independent and not subject to any capital rationing constraint)? Explain your answer. Answer: a. NPV = ($21,995) From Excel Spreadsheet NPV function with rate = .11, cash flows as given, and then subtracting the initial investment of $480,000. b. IRR = 9.7% From Excel Spreadsheet IRR function, with cash flows as given above. c. No, the projects NPV is negative and the IRR is less than the required rate of return. Acceptance of this project would reduce shareholder value. 113) D&B Contracting plans to purchase a new backhoe. The one under consideration costs $233,000, and has a useful life of 8 years. After-tax cash flows are expected to be $31,384 in each of the 8 years and nothing thereafter. Calculate the internal rate of return for the grader. Answer: IRR = 1.69% from Excel Spreadsheet function IRR with cash flows of -233000 followed by eight cash flows of 3384) 114) Consider two mutually exclusive projects X and Y with identical initial outlays of $600,000 and useful lives of 5 years. Project X is expected to produce an after-tax cash flow of $180,000 each year. Project Y is expected to generate a single after-tax net cash flow of $1,015,000 in year 5. The discount rate is 14 percent. a. Calculate the net present value for each project. b. Calculate the IRR for each project. c. What decision should you make regarding these projects? Answer: a. NPV of A = $17,955 NPV of B = $23,242 b. IRR of A = 15.24% IRR of B = 14.87% c. B should be accepted because it is the mutually exclusive project with the highest positive NPV. 115) A project that requires an initial investment of $340,000 is expected to have an after-tax cash flow of $70,000 per year for the first two years, $90,000 per year for the next two years, and $150,000 for the fifth year? Assume the required return for this project is 10%. a. What is the NPV of the project%? b. What is the IRR of the project? c. What is the MIRR of the project? d. What is the PI of the project? e. What decision would you make regarding this project if the required rate of return is 10%? f. What is the equivalent annual annuity using a 10% required rate of return? Answer: a. NPV = $3,715.34 b. IRR = 10.38% c. MIRR = 10.24% d. PI = 1.011 e. Accept the project because its NPV is positive, or because its IRR and MIRR are greater than the required return of 10%, or because the PI is greater than 1. f. The EAA = $980.10 , MIRR, PI, Equivalent Annual Annuity 116) The Bolster Company is considering two mutually exclusive projects: Year Initial Outlay NPV 0 -$100,000 -$100,000 1 31,250 0 2 31,250 0 3 31,250 0 4 31,250 0 5 31,250 200,000 The required rate of return on these projects is 12 percent. a. What is each project's payback period? b. What is each project's discounted payback period? c. What is each project's net present value? d. What is each project's internal rate of return? e. Fully explain the results of your analysis. Which project do you prefer, and why? Answer: a. Payback of A = 3.2 years Payback of B = 4.5 years b. Discounted Payback of A = 4.29 Discounted Payback of B = 4.88 b. NPV of A = $12,649.26 NPV of B = $13,485.37 c. IRR of A = 16.99% IRR of B = 14.87% d. B is preferred because it has the greatest positive NPV. Keywords: Payback Period, Net Present Value, Internal Rate of Return Learning Objective 3 1) The payback period may be more appropriate to use for companies experiencing capital rationing. Answer: TRUE Keywords: Payback Period, Capital Rationing 2) The profitability index can be helpful when a financial manager encounters a situation where capital rationing is required. Answer: TRUE Keywords: Profitability Index, Capital Rationing 3) Positive NPV projects may be rejected when capital must be rationed. Answer: TRUE Keywords: Capital Rationing, NPV 4) Capital rationing generally leads to higher stock prices as management is doing the best job it can in selecting only the best capital budgeting projects. Answer: FALSE Keywords: Capital Rationing, Firm Value 5) When capital rationing exists, the divisibility of projects is ignored and projects are funded in order of their PI's or IRR's. Answer: FALSE Keywords: Capital Rationing, PI, IRR 6) The net present value always provides the correct decision provided that A) cash flows are constant over the asset's life. B) the required rate of return is greater than the internal rate of return. C) capital rationing is not imposed. D) the internal rate of return is positive. Answer: C Keywords: Net Present Value, Capital Rationing 7) Capital rationing may be imposed because of all of the following EXCEPT A) capital market conditions are poor. B) management has a fear of debt. C) stockholder control problems prevent issuance of additional stock. D) the company's stock price is at an historically high level. Answer: D Keywords: Capital Rationing 8) You are in charge of one division of Yeti Surplus Inc. Your division is subject to capital rationing. Your division has 4 indivisible projects available, detailed as follows: Project Initial Outlay IRR NPV 1 2 million 18% 2,500,000 2 1 million 15% 950,000 3 1 million 10% 600,000 4 3 million 9% 2,000,000 If you must select projects subject to a budget constraint of 5 million dollars, which set of projects should be accepted so as to maximize firm value? A) Projects 1, 2 and 3 B) Project 1 only C) Projects 1 and 4 D) Projects 2, 3 and 4 Answer: C Keywords: Capital Rationing, Net Present Value 9) Under what condition would you NOT accept a project that has a positive net present value? A) If the project has a profitability index less than zero. B) If two or more projects are mutually inclusive. C) If the firm is limited in the capital it has available (capital rationing). D) If a project has more than one sign reversal. Answer: C Keywords: Net Present Value, Capital Rationing 10) I301 Motors has several investment projects under consideration, all with positive net present values. However, due to a shortage of trained personnel, a limit of $1,250,000 has been placed on the capital budget for this year. Which of the projects listed below should be included in this year's capital budget? Explain your answer. Project Initial Outlay NPV A $250,000 $325,000 B 250,000 350,000 C 100,000 700,000 D 375,000 112,500 E 375,000 75,000 Answer: Accept B and C because their combined NPV ($1,050,000) is the greatest of any combination of projects that fit within the capital constraint. Keywords: Capital Rationing, NPV Learning Objective 4 1) If two projects are mutually exclusive then the IRR is more important than the NPV in deciding the project that should be chosen. Answer: FALSE Keywords: Mutually Exclusive, IRR, NPV 2) IRR should not be used to choose between mutually exclusive projects. Answer: TRUE , Mutually Exclusive Projects 3) The mutually exclusive project with the highest positive NPV will also have the highest IRR. Answer: FALSE Keywords: Mutually Exclusive Projects, NPV, IRR 4) The size disparity problem occurs when mutually exclusive projects of unequal size are being examined. Answer: TRUE Keywords: Size Disparity, Mutually Exclusive Projects 5) A project's equivalent annual annuity (EAA) is the annuity cash flow that yields the same present value as the project's NPV. Answer: TRUE Keywords: Equivalent Annual Annuity 6) An infinite-life replacement chain allows projects of different lengths to be compared. Answer: TRUE Keywords: Infinite-life Replacement Chain 7) Two projects are mutually exclusive if the accept/reject decision for one project has no impact on the accept/reject decision for the other project. Answer: FALSE Keywords: Mutually Exclusive Projects 8) Finance theory suggests that the IRR criterion is the most favorable capital budgeting decision tool. Answer: FALSE 9) If a project is acceptable using the NPV criterion, then it will also be acceptable using the discounted payback period since both methods use discounted cash flows to make the accept/reject decision. Answer: FALSE Keywords: NPV, Discounted Payback Period 10) Both the profitability index (PI) and net present value (NPV) are based on the present value of all future free cash flows, but the PI is a relative measure while the NPV is an absolute measure of a project's desirability. Answer: TRUE Keywords: Profitability Index, Net Present Value 11) If a project's IRR is equal to its required return, then the project's NPV is equal to zero and its PI is equal to one. Answer: TRUE Keywords: NPV, PI, IRR 12) If a project is acceptable using the IRR criterion, it will also be acceptable using the MIRR criterion. Answer: TRUE , MIRR 13) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The equivalent annual annuity amount for project A is A) $12,989. B) $13,357. C) $15,024. D) $18,532 Answer: C Keywords: Equivalent Annual Annuity 14) Interstate Appliance Inc. is considering the following 3 mutually exclusive projects. Projected cash flows for these ventures are as follows: Plan A Plan B Plan C Initial Initial Initial Outlay=$3,600,000 Outlay=$6,000,000 Outlay=$3,500,000 Cash Flow: Cash Flow: Cash Flow: Yr 1=$ -0- Yr 1=$4,000,000 Yr 1=$2,000,000 Yr 2= -0- Yr 2= 3,000,000 Yr 2= -0- Yr 3= -0- Yr 3= 2,000,000 Yr 3=2,000,000 Yr 4= -0- Yr 4= -0- Yr 4=2,000,000 Yr 5=$7,000,000 Yr 5= -0- Yr 5=2,000,000 If Interstate Appliance has a 12% cost of capital, what decision should be made regarding the projects above? A) accept plan A B) accept plan B C) accept plan C D) accept Plans A, B and C Answer: C Keywords: Net Present Value, Mutually Exclusive Projects 15) Your company is considering an investment in one of two mutually exclusive projects. Project one involves a labor intensive production process. Initial outlay for Project 1 is $1,495 with expected after tax cash flows of $500 per year in years 1-5. Project two involves a capital intensive process, requiring an initial outlay of $6,704. After tax cash flows for Project 2 are expected to be $2,000 per year for years 1-5. Your firm's discount rate is 10%. If your company is not subject to capital rationing, which project(s) should you take on? A) Project 1 B) Project 2 C) Projects 1 and 2 D) Neither project is acceptable. Answer: B Keywords: Mutually Exclusive Projects, Net Present Value 16) Your firm is considering investing in one of two mutually exclusive projects. Project A requires an initial outlay of $3,500 with expected future cash flows of $2,000 per year for the next three years. Project B requires an initial outlay of $2,500 with expected future cash flows of $1,500 per year for the next two years. The appropriate discount rate for your firm is 12% and it is not subject to capital rationing. Assuming both projects can be replaced with a similar investment at the end of their respective lives, compute the NPV of the two chain cycle for Project A and three chain cycle for Project B. A) $2,232 and $85 B) $5,000 and $1,500 C) $2,865 and $94 D) $3,528 and $136 Answer: A Keywords: Replacement Chain, Net Present Value, Mutually Exclusive Projects 17) Determine the five-year equivalent annual annuity of the following project if the appropriate discount rate is 16%: Initial Outflow = $150,000 Cash Flow Year 1 = $40,000 Cash Flow Year 2 = $90,000 Cash Flow Year 3 = $60,000 Cash Flow Year 4 = $0 Cash Flow Year 5 = $80,000 A) $7,058 B) $8,520 C) $9,454 D) $9,872 Answer: B Keywords: Equivalent Annual Annuity 18) Which of the following statements about the net present value is true? A) It produces a percentage result that is easy to describe. B) It has an inadequate reinvestment assumption. C) It is likely that there will be more than one NPV for a project. D) It may be used to select among projects of different sizes. Answer: D Keywords: Net Present Value, Unequal Size Projects 19) A project would be acceptable if A) the payback is greater than the discounted equivalent annual annuity. B) the equivalent annual annuity is greater than or equal to the firm's discount rate. C) the profitability index is greater than the net present value. D) the net present value is positive. Answer: D Keywords: Net Present Value, Equivalent Annual Annuity 20) Mutually exclusive projects occur when A) projects have uneven cash flows. B) more than one firm can use the projects. C) a set of investment proposals perform essentially the same task. D) projects are independent. Answer: C Keywords: Mutually Exclusive Projects 21) Which of the following methods of evaluating investment projects can properly evaluate projects of unequal lives? A) the net present value B) the payback C) the internal rate of return D) the equivalent annual annuity Answer: D Keywords: Equivalent Annual Annuity 22) Your firm is considering an investment that will cost $920,000 today. The investment will produce cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in year 5. The discount rate that your firm uses for projects of this type is 11.25%. What is the investment's equivalent annual annuity? A) $52,377 B) $42,923 C) $41,387 D) $40,399 Answer: A Keywords: Equivalent Annual Annuity 23) Consider the following two projects: Initial Outlay Net Cash Flow Each Period 1 2 3 4 Project A $4,000,000 $2,003,000 $2,003,000 $2,003,000 $2,003,000 Project B $4,000,000 0 0 0 $11,000,000 a. Calculate the net present value of each of the above projects, assuming a 14 percent discount rate. b. What is the internal rate of return for each of the above projects? c. Compare and explain the conflicting rankings of the NPVs and IRRs obtained in parts a and b above. d. If 14 percent is the required rate of return, and these projects are independent, what decision should be made? e. If 14 percent is the required rate of return, and the projects are mutually exclusive, what decision should be made? Answer: a. NPV of A = $1,836,166 NPV of B = $2,512,883 b. IRR of A = 35.0% IRR of B = 28.78% c. B has more distant cash flows, thus its IRR is less while its NPV is greater. This time disparity is one of IRR's ranking problems. d. If these projects are independent we would accept them both because they each have a positive NPV. e. If these projects are mutually exclusive we would select B because it has the highest positive NPV. , NPV, Mutually Exclusive Projects, Independent Projects 24) The Meacham Tire Company is considering two mutually exclusive projects with useful lives of 3 and 6 years. The after-tax cash flows for projects S and L are listed below. Year Cash Flow S Cash Flow L 0 -$60,000 -$115,000 1 38,000 28,500 2 25,000 49,500 3 35,000 26,850 4 22,600 5 18,750 6 23,500 The required rate of return on these projects is 14 percent. What decision should be made? As part of your answer, calculate the NPV assuming a replacement chain for Project S, and also calculate the equivalent annual annuity for each project. Answer: Accept Project S because its replacement chain NPV of $1,999.96 is positive and is greater than the NPV of Project L of $1,237.09. Also, the equivalent annual annuity for Project S is $514.30 while that of Project L is only $318.13. Keywords: NPV, Replacement Chain, Equivalent Annual Annuity 25) The Dickerson PR Firm is considering two mutually exclusive projects with useful lives of 3 and 6 years. The after-tax cash flows for projects S and L are listed below. Year Cash Flow S Cash Flow L 0 -$60,000 -$51,500 1 40,000 13,000 2 20,000 19,000 3 17,000 11,000 4 20,000 5 10,000 6 8,000 Calculate the equivalent annual annuity for each project assuming a required return of 15%. What decision should be made? Answer: Choose Project S. Although the NPV of Project L (NPV = $1,269.21) is greater than the NPV of Project S (NPV = $1,083.26), this is due to the longer life of project L. The equivalent annual annuity for Project S is $474.44, while the equivalent annual annuity for Project L is only $335.37. Keywords: NPV, Equivalent Annual Annuity 26) Company K is considering two mutually exclusive projects. The cash flows of the projects are as follows: Year Project A Project B 0 -$2,000,000 -$2,000,000 1 500,000 2 500,000 3 500,000 4 500,000 5 500,000 6 500,000 7 500,000 5,650,000 a. Compute the NPV and IRR for the above two projects, assuming a 13% required rate of return. b. Discuss the ranking conflict. c. What decision should be made regarding these two projects? Answer: a. NPV of A = $211,305 NPV of B = $401,592.64 IRR of A = 16.33% IRR of B = 15.99% b. The later cash flow of B causes its lower IRR even though it has the higher NPV. c. B should be accepted because it is the mutually exclusive project with the highest positive NPV.