Chapter 7

1. The advantages of the payback method of project analysis include the: I. application of a discount rate to each separate cash flow. II. bias towards liquidity. III. ease of use. IV. arbitrary cutoff point. a. I and II only b. I and III only c. II and III only d. II and IV only e. II, III, and IV only Answer: c 2. You are trying to determine whether to accept project A or project B. These projects are mutually exclusive. As part of your analysis, you should compute the incremental IRR by determining: a. the internal rate of return for the cash flows of each project. b. the net present value of each project using the internal rate of return as the discount rate. c. the discount rate that equates the discounted payback periods for each project. d. the discount rate that makes the net present value of each project equal to 1. e. the internal rate of return for the differences in the cash flows of the two projects. Answer: e 3. In actual practice, managers frequently use the: I. AAR because the necessary accounting numbers are readily available. II. IRR because the results are easy to communicate and understand. III. payback because of its simplicity. IV. net present value because it is considered by many to be the best method of analysis. a. I and III only b. II and III only c. I, III, and IV only d. II, III, and IV only e. I, II, III, and IV Answer: e 4. You are considering a project with the following data:

Which one of the following is correct given this information? a. The discount rate used in computing the net present value must have been less than 8.7%. b. The discounted payback period will have to be less than 2.44 years. c. The discount rate used to compute the profitability ratio was equal to the internal rate of return. d. This project should be accepted based on the profitability ratio. e. This project should be rejected based on the internal rate of return. Answer: e

5. The elements that cause problems with the use of the IRR in projects that are mutually exclusive are: a. the discount rate and scale problems. b. timing and scale problems. c. the discount rate and timing problems. d. scale and reversing flow problems. e. timing and reversing flow problems. Answer: b 6. Which of the following statement is true? a. One must know the discount rate to compute the NPV of a project but one can compute the IRR without referring to the discount rate. b. One must know the discount rate to compute the IRR of a project but one can compute the NPV without referring to the discount rate. c. Payback accounts for time value of money. d. There will always be one IRR regardless of cash flows. e. Average accounting return is the ratio of total assets to total net income. Answer: a 7. You are considering two mutually exclusive projects with the following cash flows. Will your choice between the two projects differ if the required rate of return is 8% rather than 11%? If so, what should you do?

a. yes; Select A at 8% and B at 11%. b. yes; Select B at 8% and A at 11%. c. yes; Select A at 8% and select neither at 11%. d. no; Regardless of the required rate, project A always has the higher NPV. e. no; Regardless of the required rate, project B always has the higher NPV. Answer: a

Feedback: 8. You are considering an investment with the following cash flows. If the required rate of return for this investment is 13.5%, should you accept it based solely on the internal rate of return rule? Why or why not?

a. yes; because the IRR exceeds the required return b. yes; because the IRR is a positive rate of return c. no; because the IRR is less than the required return d. no; because the IRR is a negative rate of return e. You can not apply the IRR rule in this case because there are multiple IRRs.

Answer: e Feedback: Since C03 is a negative value, there are multiple IRRs. Thus, the IRR rule does not apply. 9. Based on the profitability index (PI) rule, should a project with the following cash flows be accepted if the discount rate is 8%? Why or why not?

a. yes; because the PI is 1.008 b. yes; because the PI is .992 c. yes; because the PI is .999 d. no; because the PI is 1.008 e. no; because the PI is .992 Answer: e

Feedback: Difficulty level: Medium Topic: PROFITABILITY INDEX 10. Ginny Trueblood is considering an investment which will cost her $120,000. The investment produces no cash flows for the first year. In the second year the cash inflow is $35,000. This inflow will increase to $55,000 and then $75,000 for the following two years before ceasing permanently. Ginny requires a 10% rate of return and has a required discounted payback period of three years. Ginny should _____ this project because the discounted payback period is _____. a. accept; 2.03 years. b. accept; 2.97 years. c. accept; 3.97 years. d. reject; 3.03 years. e. reject; 3.97 years. Answer: e

Feedback: Feedback: Ginny should reject the project since the payback period of 3.97 years exceeds the required 3 years. Difficulty level: Medium Topic: DISCOUNTED PAYBACK PERIOD 11. The Winston Co. is considering two mutually exclusive projects with the following cash flows. The incremental IRR is _____ and if the required rate is higher than the crossover rate then project _____ should be accepted.

a. 13.94%; A b. 13.94%; B c. 15.44%; A d. 15.44%; B e. 15.86%; A Answer: b

Feedback:

Feedback: The crossover rate is 13.94%. At a rate higher than the crossover rate, such as 15%, Project B will have the higher NPV and should be accepted. Reference: 07_107 You are analyzing a project and have prepared the following data:

12. Based on the profitability index of _____ for this project, you should _____ the project. a. .86; reject b. 1.00; accept c. 1.04; accept d. 1.07; accept e. 1.14; accept Answer: e

Feedback: 13. Based on the internal rate of return of _____ for this project, you should _____ the project. a. 10%; accept b. 11.50%; accept c. 15.40%; accept d. 17.26%; accept e. 9.80%; reject Answer: d

Feedback: Difficulty level: Easy Topic: INTERNAL RATE OF RETURN Refer To: 07_107 14. Based on the net present value of _____ for this project, you should _____ the project. a. -$2,405; reject b. -$3,958; reject c. $14,029; accept d. $16,454; accept e. $17,796; accept Answer: c

Feedback: Difficulty level: Easy Topic: NET PRESENT VALUE Refer To: 07_107 15. Based on the payback period of _____ for this project, you should _____ the project. a. 2.0 years; reject b. 2.5 years; accept c. 2.5 years; reject d. 3.0 years; reject e. 3.0 years; accept Answer: b Reference: 17_20 You are considering the following two mutually exclusive projects. Both projects will be depreciated using straight-line depreciation to a zero book value over the life of the project. Neither project has any

salvage value.

16. Based on the net present value method of analysis and given the information in the problem, you should: a. accept both project A and project B. b. accept project A and reject project B. c. accept project B and reject project A. d. reject both project A and project B. e. accept whichever one you want as they represent equal opportunities. Answer: c

Feedback: 17. Based upon the internal rate of return (IRR) and the information provided in the problem, you should: a. accept both project A and project B. b. reject both project A and project B. c. accept project A and reject project B. d. accept project B and reject project A. e. ignore the IRR rule and use another method of analysis. Answer: e Feedback: Because these are mutually exclusive projects, the IRR rule should not be applied. Difficulty level: Medium

18. Based upon the payback period and the information provided in the problem, you should: a. accept both project A and project B. b. reject both project A and project B. c. accept project A and reject project B. d. accept project B and reject project A. e. require that management extend the payback period for project A since it has a higher initial cost. Answer: b

Feedback: Difficulty level: Medium 19. An investment cost $10,000 with expected cash flows of $3,000 for 5 years. The discount rate is 15.2382%. The NPV is ___ and the IRR is ___ for the project. a. $0; 15.2382%. b. $3.33; 27.2242%. c. $5,000; 0%. d. Can not answer without one or the other value as input. e. None of these. Answer: a

Feedback: 20. A $25 investment produces $27.50 at the end of the year with no risk. Which of the following is true? a. NPV is positive if the interest rate is less than 10%. b. NPV is negative if the interest rate is less than 10%. c. NPV is zero if the interest rate is equal to 10%. d. Both A and C. e. None of these. Answer: d Feedback: NPV = ($27.50/1.1) - $25.00 = $0