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Foundations of Finance Capital Investment Decision Analysis-I     1) Free cash flows represent the benefits generated from accepting a capital-budgeting proposal

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Foundations of Finance

Capital Investment Decision Analysis-I

 

 

1) Free cash flows represent the benefits generated from accepting a capital-budgeting proposal.

 

 

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.

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.

 

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.

 

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.

 

5) Two projects that have the same cost and the same expected cash flows will have the same net present value.

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.

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.

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.

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.

10) The net present value profile clearly demonstrates that the NPV of a project increases as the discount rate increases.

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.

12) One drawback of the payback method is that some cash flows may be ignored.

13) The required rate of return reflects the costs of funds needed to finance a project.

14) The profitability index provides an advantage over the net present value method by reporting the present value of benefits per dollar invested.

15) The net present value of a project will increase as the required rate of return is decreased (assume only one sign reversal).

16) Whenever the internal rate of return on a project equals that project's required rate of return, the net present value equals zero.

17) One of the disadvantages of the payback method is that it ignores 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.

19) When several sign reversals in the cash flow stream occur, a project can have more than one IRR.

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.

21) NPV is the most theoretically correct capital budgeting decision tool examined in the text.

22) If the net present value of a project is zero, then the profitability index will equal one.

23) The internal rate of return will equal the discount rate when the net present value equals zero.

24) Mutually exclusive projects have more than one 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.

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.

27) If a project's profitability index is less than one then the project should be rejected.

28) If a project is acceptable using the NPV criteria, it will also be acceptable when using the profitability index and IRR criteria.

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.

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.

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.

32) The main disadvantage of the NPV method is the need for detailed, long-term forecasts of free cash flows generated by prospective projects.

33) The profitability index is the ratio of the present value of the future free cash flows to the initial investment.

34) Marketing is crucial to capital budgeting success because the goal of a good capital budgeting project is to maximize the company's sales.

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.

36) A project's IRR is analogous to the concept of the yield to maturity for bonds.

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.

38) A project's net present value profile shows how sensitive the project is to the choice of a discount rate.

39) If a project has multiple internal rates of return, the lowest rate should be used for decision making purposes.

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.

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.

 

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.

43) Any project deemed acceptable using the discounted payback period will also be acceptable if using the traditional 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.

45) A project with a NPV of zero should be rejected since even the returns on U.S. Treasury bill are greater than zero.

46) NPV may be calculated on an Excel spreadsheet simply by entering the project's free cash flows into Excel's NPV function.

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.

48) A project that is very sensitive to the selection of a discount rate will have a steep 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.

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.

 

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.

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.

 

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.

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.

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

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

 

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%

 

 

 

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%

 

 

 

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

 

 

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%

 

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%

 

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.

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.

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.

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.

 

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%.

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%.

 

 

 

 

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%.

 

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%.

 

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.

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.

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.

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.

 

 

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.

 

 

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.

 

 

 

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%

 

 

 

 

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

 

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%

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

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%.

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.

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

 

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.

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.

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.

 

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.

 

 

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

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

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%

 

 

 

 

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

 

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

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

 

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

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%

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.

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.

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.

 

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

 

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

 

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.

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.

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.

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

 

 

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

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%

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.

 

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.

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.

 

 

 

 

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.

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.

 

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

 

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.

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.

 

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?

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?

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?

Learning Objective 3

 

1) The payback period may be more appropriate to use for companies experiencing capital rationing.

2) The profitability index can be helpful when a financial manager encounters a situation where capital rationing is required.

3) Positive NPV projects may be rejected when capital must be rationed.

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.

5) When capital rationing exists, the divisibility of projects is ignored and projects are funded in order of their PI's or IRR's.

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.

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.

 

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

 

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.

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

 

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.

2) IRR should not be used to choose between mutually exclusive projects.

3) The mutually exclusive project with the highest positive NPV will also have the highest IRR.

4) The size disparity problem occurs when mutually exclusive projects of unequal size are being examined.

5) A project's equivalent annual annuity (EAA) is the annuity cash flow that yields the same present value as the project's NPV.

6) An infinite-life replacement chain allows projects of different lengths to be compared.

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.

8) Finance theory suggests that the IRR criterion is the most favorable capital budgeting decision tool.

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.

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.

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.

12) If a project is acceptable using the IRR criterion, it will also be acceptable using the MIRR criterion.

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

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

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.

 

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

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

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.

 

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.

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.

 

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

 

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

 

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?

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.

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?

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?