CHAPTER 9

Net Present Value and Other Investment Criteria

I. DEFINITIONS
NET PRESENT VALUE
a 1. The difference between the present value of an investment and its cost is the:
a. net present value.
b. internal rate of return.
c. payback period.
d. profitability index.
e. discounted payback period.
DISCOUNTED CASH FLOW VALUATION
b 2. The process of valuing an investment by determining the present value of its future
cash flows is called (the):
a. constant dividend growth model.
b. discounted cash flow valuation.
c. average accounting valuation.
d. expected earnings model.
e. apital !sset "ricing #odel.
NET PRESENT VALUE RULE
c $. %hich one of the following statements concerning net present value (&"') is correct(
a. !n investment should be accepted if) and only if) the &"' is exactly e*ual to +ero.
b. !n investment should be accepted only if the &"' is e*ual to the initial cash flow.
c. !n investment should be accepted if the &"' is positive and re,ected if it is negative.
d. !n investment with greater cash inflows than cash outflows) regardless of when the cash
flows occur) will always have a positive &"' and therefore should always be accepted.
e. !ny pro,ect that has positive cash flows for every time period after the initial investment
should be accepted.
PAYBACK
c -. The length of time re*uired for an investment to generate cash flows sufficient to recover
the initial cost of the investment is called the:
a. net present value.
b. internal rate of return.
c. payback period.
d. profitability index.
e. discounted cash period.
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PAYBACK RULE
a .. %hich one of the following statements is correct concerning the payback period(
a. !n investment is acceptable if its calculated payback period is less than some pre/
specified period of time.
b. !n investment should be accepted if the payback is positive and re,ected if it is negative.
c. !n investment should be re,ected if the payback is positive and accepted if it is negative.
d. !n investment is acceptable if its calculated payback period is greater than some pre/
specified period of time.
e. !n investment should be accepted any time the payback period is less than the
discounted payback period) given a positive discount rate.
DISCOUNTED PAYBACK
e 0. The length of time re*uired for a pro,ect1s discounted cash flows to e*ual the initial cost
of the pro,ect is called the:
a. net present value.
b. internal rate of return.
c. payback period.
d. discounted profitability index.
e. discounted payback period.
DISCOUNTED PAYBACK RULE
d 2. The discounted payback rule states that you should accept pro,ects:
a. which have a discounted payback period that is greater than some pre/specified period of
time.
b. if the discounted payback is positive and re,ected if it is negative.
c. only if the discounted payback period e*uals some pre/specified period of time.
d. if the discounted payback period is less than some pre/specified period of time.
e. only if the discounted payback period is e*ual to +ero.
AVERAGE ACCOUNTING RETURN
c 3. !n investment1s average net income divided by its average book value defines the
average:
a. net present value.
b. internal rate of return.
c. accounting return.
d. profitability index.
e. payback period.
AVERAGE ACCOUNTING RETURN RULE
b 4. !n investment is acceptable if its average accounting return (!!5):
a. is less than a target !!5.
b. exceeds a target !!5.
c. exceeds the firm1s return on e*uity (567).
d. is less than the firm1s return on assets (56!).
e. is e*ual to +ero and only when it is e*ual to +ero.
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INTERNAL RATE OF RETURN
b. 18. The discount rate that makes the net present value of an investment exactly e*ual to
+ero is called the:
a. external rate of return.
b. internal rate of return.
c. average accounting return.
d. profitability index.
e. e*uali+er.
INTERNAL RATE OF RETURN RULE
d 11. !n investment is acceptable if its 955:
a. is exactly e*ual to its net present value (&"').
b. is exactly e*ual to +ero.
c. is less than the re*uired return.
d. exceeds the re*uired return.
e. is exactly e*ual to 188 percent.
MULTIPLE RATES OF RETURN
e 12. The possibility that more than one discount rate will make the &"' of an investment
e*ual to +ero is called the ::::: problem.
a. net present value profiling
b. operational ambiguity
c. mutually exclusive investment decision
d. issues of scale
e. multiple rates of return
MUTUALLY EXCLUSIVE PROJECTS
c 1$. ! situation in which accepting one investment prevents the acceptance of another
investment is called the:
a. net present value profile.
b. operational ambiguity decision.
c. mutually exclusive investment decision.
d. issues of scale problem.
e. multiple choices of operations decision.
PROFITABILITY INDEX
d. 1-. The present value of an investment1s future cash flows divided by the initial cost of the
investment is called the:
a. net present value.
b. internal rate of return.
c. average accounting return.
d. profitability index.
e. profile period.
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PROFITABILITY INDEX RULE
a 1.. !n investment is acceptable if the profitability index ("9) of the investment is:
a. greater than one.
b. less than one.
c. greater than the internal rate of return (955).
d. less than the net present value (&"').
e. greater than a pre/specified rate of return.
II. CONCEPTS
CAPITAL BUDGETING DECISIONS
a 10. apital budgeting decisions generally:
a. have long/term effects on a firm.
b. are of short/duration.
c. are easy to revise once implemented.
d. focus solely on whether or not a particular asset should be purchased.
e. have minimal effects on a firm1s operations.
CAPITAL BUDGETING DECISIONS
e 12. %hich of the following are capital budgeting decisions(
9. determining whether to sell bonds or issue stock
99. deciding which product markets to enter
999. deciding whether or not to purchase a new piece of e*uipment
9'. determining which) if any) new products should be produced
a. 9 only
b. 999 only
c. 99 and 9' only
d. 9) 999) and 9' only
e. 99) 999) and 9' only
NET PRESENT VALUE
d 13. !ll else constant) the net present value of a pro,ect increases when:
a. the discount rate increases.
b. each cash inflow is delayed by one year.
c. the initial cost of a pro,ect increases.
d. the rate of return decreases.
e. all cash inflows occur during the last year of a pro,ect1s life instead of
periodically throughout the life of the pro,ect.
NET PRESENT VALUE
a 14. The primary reason that company pro,ects with positive net present values are
considered acceptable is that:
a. they create value for the owners of the firm.
b. the pro,ect1s rate of return exceeds the rate of inflation.
c. they return the initial cash outlay within three years or less.
d. the re*uired cash inflows exceed the actual cash inflows.
e. the investment1s cost exceeds the present value of the cash inflows.
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NET PRESENT VALUE
d 28. 9f a pro,ect has a net present value e*ual to +ero) then:
9. the present value of the cash inflows exceeds the initial cost of the pro,ect.
99. the pro,ect produces a rate of return that ,ust e*uals the rate re*uired to accept the
pro,ect.
999. the pro,ect is expected to produce only the minimally re*uired cash inflows.
9'. any delay in receiving the pro,ected cash inflows will cause the pro,ect to have a
negative net present value.
a. 99 and 999 only
b. 99 and 9' only
c. 9) 99) and 9' only
d. 99) 999) and 9' only
e. 9) 99) and 999 only
NET PRESENT VALUE
b 21. %hen computing the net present value of a pro,ect) the net amount received from
salvaging the fixed assets used in the pro,ect is:
a. subtracted from the initial cash outlay.
b. included in the final cash flow of the pro,ect.
c. excluded from the analysis since it occurs only when the pro,ect ends.
d. subtracted from the original cost of the assets.
e. added to the net present value of the pro,ect to determine if the pro,ect is
acceptable.
NET PRESENT VALUE
d 22. &et present value:
9. when applied properly) can accurately predict the cash flows that will occur if a pro,ect
is implemented.
99. is highly independent of the rate of return assigned to a particular pro,ect.
999. is the preferred method of analy+ing a pro,ect even though the cash flows are only
estimates.
9'. is affected by the timing of each and every cash flow related to a pro,ect.
a. 9 only
b. 999 only
c. 99 and 9' only
d. 999 and 9' only
e. 9) 999) and 9' only
NET PRESENT VALUE
b 2$. &et present value:
a. cannot be used when deciding between two mutually exclusive pro,ects.
b. is more useful to decision makers than the internal rate of return when comparing
different si+ed pro,ects.
c. is easy to explain to non/financial managers and thus is the primary method of analysis
used by the lowest levels of management.
d. is computed the same as present value when using excel spreadsheets to analy+e a
pro,ect.
e. is very similar in its methodology to the average accounting return.
CHAPTER 9
PAYBACK
c 2-. "ayback is fre*uently used to analy+e independent pro,ects because:
a. it considers the time value of money.
b. all relevant cash flows are included in the analysis.
c. the cost of the analysis is less than the potential loss from a faulty decision.
d. it is the most desirable of all the available analytical methods from a financial
perspective.
e. it produces better decisions than those made using either &"' or 955.
PAYBACK
c 2.. The advantages of the payback method of pro,ect analysis include the:
9. application of a discount rate to each separate cash flow.
99. bias towards li*uidity.
999. ease of use.
9'. arbitrary cutoff point.
a. 9 and 99 only
b. 9 and 999 only
c. 99 and 999 only
d. 99 and 9' only
e. 99) 999) and 9' only
PAYBACK
d 20. ;nder the payback method of analysis:
a. the initial cash outlay is ignored.
b. the cash flow in year $ is ignored if the re*uired payback period is - years.
c. a pro,ect1s initial cost is discounted.
d. the cash flow in year 2 is valued ,ust as highly as the cash flow in year 1 as long as the
re*uired payback period is $ years or more.
e. a pro,ect will be acceptable whenever the payback period exceeds the pre/specified
number of years.
PAYBACK
d 22. !ll else e*ual) the payback period for a pro,ect will decrease whenever the:
a. initial cost increases.
b. re*uired return for a pro,ect increases.
c. assigned discount rate decreases.
d. cash inflows are moved forward in time.
e. duration of a pro,ect is lengthened.
DISCOUNTED PAYBACK
e 23. <iscounted payback is used less fre*uently than payback because:
a. the methodology is less desirable from a financial perspective.
b. it is so simple to calculate.
c. it re*uires an arbitrary cutoff point.
d. it is biased towards li*uidity.
e. it includes time value of money calculations.
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DISCOUNTED PAYBACK
d 24. The discounted payback period of a pro,ect will decrease whenever the:
a. discount rate applied to the pro,ect is increased.
b. initial cash outlay of the pro,ect is increased.
c. time period of the pro,ect is increased.
d. amount of each pro,ect cash flow is increased.
e. costs of the fixed assets utili+ed in the pro,ect increase.
DISCOUNTED PAYBACK
a $8. The discounted payback rule may cause:
a. some positive net present value pro,ects to be re,ected.
b. the most li*uid pro,ects to be re,ected in favor of less li*uid pro,ects.
c. pro,ects to be incorrectly accepted due to ignoring the time value of money.
d. pro,ects with negative net present values to be accepted.
e. some pro,ects to be accepted which would otherwise be re,ected under the payback
rule.
AVERAGE ACCOUNTING RETURN
e $1. The average accounting rate of return:
a. is actually based more on financial values than on accounting values.
b. measures net income against the market value of a firm.
c. is highly recommended by financial professionals as one of the two best methodologies
used in the analysis of independent pro,ects.
d. is the primary methodology used in analy+ing independent pro,ects.
e. is similar to the return on assets ratio.
AVERAGE ACCOUNTING RETURN
d $2. !ssuming that straight line depreciation is used) the average accounting return for a
pro,ect is computed as the average:
a. net income of a pro,ect divided by the average total assets of a firm.
b. book value of a pro,ect multiplied by the average profit margin of the pro,ect.
c. book value of a pro,ect divided by the average net income of the pro,ect.
d. net income of a pro,ect divided by the average investment in the pro,ect.
e. net income of the firm divided by the average investment in a pro,ect.
AVERAGE ACCOUNTING RETURN
d $$. %hich of the following are disadvantages associated with the average accounting
return(
9. difficulty in obtaining necessary information to do computation
99. exclusion of time value of money considerations
999. the use of a cutoff rate as a benchmark
9'. the accounting basis of the values used in the computation
a. 9 and 9' only
b. 99 and 999 only
c. 9) 99) and 999 only
d. 99) 999) and 9' only
e. 9) 99) and 9' only
CHAPTER 9
AVERAGE ACCOUNTING RETURN
b $-. The average accounting return:
a. reflects the pro,ected net effect of the cash flows from a pro,ect on the overall firm.
b. is comparable to the return on assets and thus provides a similar measure of
performance.
c. reflects the anticipated net impact of a pro,ect on the shareholders of the firm.
d. rule) when applied) guarantees that only pro,ects that increase shareholder wealth will
be accepted.
e. ignores all income produced by a pro,ect after an arbitrarily assigned cutoff point.
INTERNAL RATE OF RETURN
b $.. The internal rate of return (955):
9. rule states that a pro,ect with an 955 that is less than the re*uired rate should be
accepted.
99. is the rate generated solely by the cash flows of an investment.
999. is the rate that causes the net present value of a pro,ect to exactly e*ual +ero.
9'. can effectively be used to analy+e all investment scenarios.
a. 9 and 9' only
b. 99 and 999 only
c. 9) 99) and 999 only
d. 99) 999) and 9' only
e. 9) 99) 999) and 9'
INTERNAL RATE OF RETURN
e $0. The internal rate of return method of analysis:
9. may produce multiple rates of return for a single pro,ect.
99. may lead to incorrect decisions when comparing mutually exclusive pro,ects.
999. is generally more popular in practice than &"'.
9'. works best for independent pro,ects with conventional cash flows.
a. 9 and 99 only
b. 999 and 9' only
c. 9) 999) and 9' only
d. 9) 99) and 9' only
e. 9) 99) 999) and 9'
INTERNAL RATE OF RETURN
a $2. The internal rate of return for a pro,ect will increase if:
a. the initial cost of the pro,ect can be reduced.
b. the total amount of the cash inflows is reduced.
c. each cash inflow is moved such that it occurs one year later than originally pro,ected.
d. the re*uired rate of return is reduced.
e. the salvage value of the pro,ect is omitted from the analysis.
CHAPTER 9
INTERNAL RATE OF RETURN
c $3. The internal rate of return is:
a. more reliable as a decision making tool than net present value whenever you are
considering mutually exclusive pro,ects.
b. e*uivalent to the discount rate that makes the net present value e*ual to one.
c. difficult to compute without the use of either a financial calculator or a computer.
d. dependent upon the interest rates offered in the marketplace.
e. a better methodology than net present value when dealing with unconventional cash
flows.
INTERNAL RATE OF RETURN
d $4. %hich of the following are elements of the internal rate of return method of analysis(
9. the timing of the cash flows
99. the cutoff point after which any future cash flows are ignored
999. the rate designated as the minimum acceptable rate for a pro,ect to be accepted
9'. the initial cost of an investment
a. 9 and 99 only
b. 999 and 9' only
c. 9) 99) and 999 only
d. 9) 999) and 9' only
e. 99) 999) and 9' only
INTERNAL RATE OF RETURN
a -8. The internal rate of return tends to be:
a. easier for managers to comprehend than the net present value.
b. extremely accurate even when cash flow estimates are faulty.
c. ignored by most financial analysts.
d. used primarily to differentiate between mutually exclusive pro,ects.
e. utili+ed in pro,ect analysis only when multiple net present values apply.
CROSSOVER POINT
e -1. =ou are trying to determine whether to accept pro,ect ! or pro,ect >. These pro,ects
are mutually exclusive. !s part of your analysis) you should compute the crossover
point by determining:
a. the internal rate of return for the cash flows of each pro,ect.
b. the net present value of each pro,ect using the internal rate of return as the discount
rate.
c. the discount rate that e*uates the discounted payback periods for each pro,ect.
d. the discount rate that makes the net present value of each pro,ect e*ual to 1.
e. the internal rate of return for the differences in the cash flows of the two pro,ects.
CHAPTER 9
CROSSOVER POINT
c -2. =ou are comparing two mutually exclusive pro,ects. The crossover point is 4 percent.
=ou determine that you should accept pro,ect ! if the re*uired return is 0 percent. This
implies that you should:
9. re,ect pro,ect > if the re*uired return is 0 percent.
99. always accept pro,ect ! and always re,ect pro,ect >.
999. always re,ect pro,ect ! any time the discount rate is greater than 4 percent.
9'. accept pro,ect ! any time the discount rate is less than 4 percent.
a. 9 and 99 only
b. 999 and 9' only
c. 9) 999) and 9' only
d. 9) 99) and 9' only
e. 9) 99) 999) and 9'
CROSSOVER POINT
b -$. ?raphing the crossover point helps explain:
a. why one pro,ect is always superior to another pro,ect.
b. how decisions concerning mutually exclusive pro,ects are derived.
c. how the duration of a pro,ect affects the decision as to which pro,ect to accept.
d. how the net present value and the initial cash outflow of a pro,ect are related.
e. how the profitability index and the net present value are related.
PROFITABILITY INDEX
d --. The profitability index is closely related to:
a. payback.
b. discounted payback.
c. the average accounting return.
d. net present value.
e. mutually exclusive pro,ects.
PROFITABILITY INDEX
b -.. !nalysis using the profitability index:
a. fre*uently conflicts with the accept and re,ect decisions generated by the application of
the net present value rule.
b. is useful as a decision tool when investment funds are limited.
c. is useful when trying to determine which one of two mutually exclusive pro,ects
should be accepted.
d. utili+es the same basic variables as those used in the average accounting return.
e. produces results which typically are difficult to comprehend or apply.
PROFITABILITY INDEX
e -0. 9f you want to review a pro,ect from a benefit/cost perspective) you should use the
::::: method of analysis.
a. net present value
b. payback
c. internal rate of return
d. average accounting return
e. profitability index
CHAPTER 9
PROFITABILITY INDEX
b -2. %hen the present value of the cash inflows exceeds the initial cost of a pro,ect) then
the pro,ect should be:
a. accepted because the internal rate of return is positive.
b. accepted because the profitability index is greater than 1.
c. accepted because the profitability index is negative.
d. re,ected because the internal rate of return is negative.
e. re,ected because the net present value is negative.
MUTUALLY EXCLUSIVE PROJECTS
c -3. %hich one of the following is the best example of two mutually exclusive pro,ects(
a. planning to build a warehouse and a retail outlet side by side
b. buying sufficient e*uipment to manufacture both desks and chairs simultaneously
c. using an empty warehouse for storage or renting it entirely out to another firm
d. using the company sales force to promote sales of both shoes and socks
e. buying both inventory and fixed assets using funds from the same bond issue
MUTUALLY EXCLUSIVE PROJECTS
d -4. The @iberty o. is considering two pro,ects. "ro,ect ! consists of building a wholesale
book outlet on lot A104 of the 7nglewood 5etail enter. "ro,ect > consists of building
a sit/down restaurant on lot A104 of the 7nglewood 5etail enter. %hen trying to
decide whether or build the book outlet or the restaurant) management should rely
most heavily on the analysis results from the ::::: method of analysis.
a. profitability index
b. internal rate of return
c. payback
d. net present value
e. accounting rate of return
MUTUALLY EXCLUSIVE PROJECTS
c .8. %hen two pro,ects both re*uire the total use of the same limited economic resource)
the pro,ects are generally considered to be:
a. independent.
b. marginally profitable.
c. mutually exclusive.
d. acceptable.
e. internally profitable.
MUTUALLY EXCLUSIVE PROJECTS
b .1. The final decision on which one of two mutually exclusive pro,ects to accept
ultimately depends upon the:
a. initial cost of each pro,ect.
b. re*uired discount rate.
c. total cash inflows of each pro,ect.
d. assigned payback period of each pro,ect.
e. length of each pro,ect1s life.
CHAPTER 9
MUTUALLY EXCLUSIVE PROJECTS
c .2. #att is analy+ing two mutually exclusive pro,ects of similar si+e and has prepared the
following data. >oth pro,ects have . year lives.
"ro,ect ! "ro,ect >
&et present value B1.)848 B1-)04$
"ayback period 2.20 years 2..1 years
!verage accounting return 4.$ percent 4.0 percent
5e*uired return 3.$ percent 3.8 percent
5e*uired !!5 4.8 percent 4.8 percent
#att has been asked for his best recommendation given this information. Cis
recommendation should be to accept:
a. pro,ect > because it has the shortest payback period.
b. both pro,ects as they both have positive net present values.
c. pro,ect ! and re,ect pro,ect > based on their net present values.
d. pro,ect > and re,ect pro,ect ! based on their average accounting returns.
e. pro,ect > and re,ect pro,ect ! based on both the payback period and the average
accounting return.
INVESTMENT ANALYSIS
a .$. ?iven that the net present value (&"') is generally considered to be the best method
of analysis) why should you still use the other methods(
a. The other methods help validate whether or not the results from the net present value
analysis are reliable.
b. =ou need to use the other methods since conventional practice dictates that you only
accept pro,ects after you have generated three accept indicators.
c. =ou need to use other methods because the net present value method is unreliable
when a pro,ect has unconventional cash flows.
d. The average accounting return must always indicate acceptance since this is the best
method from a financial perspective.
e. The discounted payback method must always be computed to determine if a pro,ect
returns a positive cash flow since &"' does not measure this aspect of a pro,ect.
INVESTMENT ANALYSIS
e .-. 9n actual practice) managers fre*uently use the:
9. !!5 because the information is so readily available.
99. 955 because the results are easy to communicate and understand.
999. payback because of its simplicity.
9'. net present value because it is considered by many to be the best method of analysis.
a. 9 and 999 only
b. 99 and 999 only
c. 9) 999) and 9' only
d. 99) 999) and 9' only
e. 9) 99) 999) and 9'
CHAPTER 9
INVESTMENT ANALYSIS
a ... &o matter how many forms of investment analysis you do:
a. the actual results from a pro,ect may vary significantly from the expected results.
b. the internal rate of return will always produce the most reliable results.
c. a pro,ect will never be accepted unless the payback period is met.
d. the initial costs will generally vary considerably from the estimated costs.
e. only the first three years of a pro,ect ever affect its final outcome.
INVESTMENT ANALYSIS
b .0. %hich of the following may have contributed to the change in the primary methods
used by chief financial officers to evaluate pro,ects over the past forty years(
9. an increased emphasis on ease of use and simplicity of method
99. an increased availability of computers and financial calculators to handle the more
complex computations
999. an increased level of financial knowledge by increasing sophisticated business
executives
9'. an increasing emphasis by financial executives on accounting values rather than
financial values
a. 9 and 99 only
b. 99 and 999 only
c. 999 and 9' only
d. 9) 99) and 9' only
e. 99) 999) and 9' only
INVESTMENT ANALYSIS
b .2. %hich of the following methods of pro,ect analysis are biased towards short/term
pro,ects(
9. internal rate of return
99. accounting rate of return
999. payback
9'. discounted payback
a. 9 and 99 only
b. 999 and 9' only
c. 99 and 999 only
d. 9 and 9' only
e. 99 and 9' only
INVESTMENT ANALYSIS
a .3. 9f a pro,ect is assigned a re*uired rate of return e*ual to +ero) then:
a. the timing of the pro,ect1s cash flows has no bearing on the value of the pro,ect.
b. the pro,ect will always be accepted.
c. the pro,ect will always be re,ected.
d. whether the pro,ect is accepted or re,ected will depend on the timing of the cash flows.
e. the pro,ect can never add value for the shareholders.
CHAPTER 9
DECISION RULES
e .4. =ou are considering a pro,ect with the following data:
9nternal rate of return 3.2 percent
"rofitability ratio .43
&et present value /B$4$
"ayback period 2.-- years
5e*uired return 4.. percent
%hich 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 3.2
percent.
b. The discounted payback period will have to be less than 2.-- years.
c. The discount rate used to compute the profitability ratio was e*ual to the internal rate
of return.
d. This pro,ect should be accepted based on the profitability ratio.
e. This pro,ect should be re,ected based on the internal rate of return.
DECISION RULES
c 08. %hich of the following statements are correct(
9. ! positive net present value signals an accept decision.
99. "ro,ects should be accepted when the profitability index is less than 1.
999. ! payback period that is less than the re*uired period signals an accept decision.
9'. %hen the internal rate of return exceeds the re*uired return) a pro,ect should be
accepted.
a. 9 and 999 only
b. 99) 999) and 9' only
c. 9) 999) and 9' only
d. 9) 99) and 999 only
e. 9) 99) 999) and 9'
III. PROBLEMS
NET PRESENT VALUE
b 01. %hat is the net present value of a pro,ect with the following cash flows and a re*uired
return of 12 percent(
=ear ash Dlow
8 /B23)488
1 B12)-.8
2 B14)0$8
$ B 2)2.8
a. /B232.22
b. /B122.02
c. B122.02
d. B28-.$0
e. B232.22
CHAPTER 9
NET PRESENT VALUE
a 02. %hat is the net present value of a pro,ect that has an initial cash outflow of B12)028
and the following cash inflows( The re*uired return is 11.. percent.
=ear ash 9nflows
1 B-)$2.
2 B 8
$ B3)2.8
- B-)188
a. B213.03
b. B$28.10
c. B203.28
d. B1)2-4.0.
e. B1)$21.82
NET PRESENT VALUE
b 0$. ! pro,ect will produce cash inflows of B1)2.8 a year for four years. The pro,ect
initially costs B18)088 to get started. 9n year five) the pro,ect will be closed and as a
result should produce a cash inflow of B3).88. %hat is the net present value of this
pro,ect if the re*uired rate of return is 1$.2. percent(
a. /B.)-2-.20
b. /B1)811.-8
c. /B4$...0
d. B1)811.-8
e. B.)-2-.20
NET PRESENT VALUE
a 0-. =ou are considering the following two mutually exclusive pro,ects. The re*uired rate
of return is 11.2. percent for pro,ect ! and 18.2. percent for pro,ect >. %hich
pro,ect
should you accept and why(
=ear "ro,ect ! "ro,ect >
8 /B-3)888 /B120)488
1 B13)-88 B 04)288
2 B$1)$88 B 38)488
$ B11)288 B 8
a. pro,ect !E because its &"' is about B$$. more than the &"' of pro,ect >
b. pro,ect !E because it has the higher re*uired rate of return
c. pro,ect >E because it has the largest total cash inflow
d. pro,ect >E because it returns all its cash flows within two years
e. pro,ect >E because it is the largest si+ed pro,ect
CHAPTER 9
NET PRESENT VALUE
a 0.. =ou are considering two mutually exclusive pro,ects with the following cash flows.
%ill your choice between the two pro,ects differ if the re*uired rate of return is 3
percent rather than 11 percent( 9f so) what should you do(
=ear "ro,ect ! "ro,ect >
8 /B2-8)888 /B143)888
1 B 8 B118)388
2 B 8 B 32).88
$ B$2.)888 B -.)888
a. yesE Felect ! at 3 percent and > at 11 percent.
b. yesE Felect > at 3 percent and ! at 11 percent.
c. yesE Felect ! at 3 percent and select neither at 11 percent.
d. noE 5egardless of the re*uired rate) pro,ect ! always has the higher &"'.
e. noE 5egardless of the re*uired rate) pro,ect > always has the higher &"'.
INTERNAL RATE OF RETURN
b 00. %hat is the internal rate of return on an investment with the following cash flows(
=ear ash Dlow
8 /B12$)-88
1 B $0)288
2 B .-)388
$ B -3)188
a. ..4$ percent
b. ..40 percent
c. 0.8- percent
d. 0.84 percent
e. 0.1$ percent
INTERNAL RATE OF RETURN
a 02. !n investment has the following cash flows. Fhould the pro,ect be accepted if it has
been assigned a re*uired return of 4.. percent( %hy or why not(
=ear ash Dlow
8 /B2-)888
1 B 3)888
2 B12)888
$ B 4)888
a. yesE because the 955 exceeds the re*uired return by about 8.$4 percent
b. yesE because the 955 is less than the re*uired return by about $.4 percent
c. yesE because the 955 is positive
d. noE because the 955 exceeds the re*uired return by about $.4 percent
e. noE because the 955 is 4.34 percent
CHAPTER 9
INTERNAL RATE OF RETURN AND NET PRESENT VALUE
e 03. =ou are considering two independent pro,ects with the following cash flows. The
re*uired return for both pro,ects is 18 percent. ?iven this information) which one of
the following statements is correct(
=ear "ro,ect ! "ro,ect >
8 /B4.8)888 /B12.)888
1 B$$8)888 B ..)888
2 B-88)888 B .8)888
$ B-.8)888 B .8)888
a. =ou should accept pro,ect > since it has the higher 955 and re,ect pro,ect ! because
you can not accept both pro,ects.
b. =ou should accept pro,ect ! because it has the lower &"' and re,ect pro,ect >.
c. =ou should accept pro,ect ! because it has the higher &"' and you can not accept
both pro,ects.
d. =ou should accept pro,ect > because it has the higher 955 and re,ect pro,ect !.
e. =ou should accept both pro,ects if the funds are available to do so.
INTERNAL RATE OF RETURN
e 04. =ou are considering an investment with the following cash flows. 9f the re*uired rate
of return for this investment is 1$.. percent) should you accept it based solely on the
internal rate of return rule( %hy or why not(
=ear ash Dlow
8 /B12)888
1 B .).88
2 B 3)888
$ /B 1).88
a. yesE because the 955 exceeds the re*uired return
b. yesE because the 955 is a positive rate of return
c. noE because the 955 is less than the re*uired return
d. noE because the 955 is a negative rate of return
e. =ou can not apply the 955 rule in this case because there are multiple 955s.
PROFITABILITY INDEX
d 28. %hat is the profitability index for an investment with the following cash flows given a
4 percent re*uired return(
=ear ash Dlow
8 /B21).88
1 B 2)-88
2 B 4)388
$ B 3)488
a. .40
b. .43
c. 1.88
d. 1.82
e. 1.8-
CHAPTER 9
PROFITABILITY INDEX
e 21. >ased on the profitability index ("9) rule) should a pro,ect with the following cash
flows be accepted if the discount rate is 3 percent( %hy or why not(
=ear ash Dlow
8 /B13)088
1 B18)888
2 B 2)$88
$ B $)288
a. yesE because the "9 is 1.883
b. yesE because the "9 is .442
c. yesE because the "9 is .444
d. noE because the "9 is 1.883
e. noE because the "9 is .442
PROFITABIILITY INDEX
c 22. =ou are considering two independent pro,ects both of which have been assigned
a discount rate of 3 percent. >ased on the profitability index) what is your
recommendation concerning these pro,ects(
"ro,ect ! "ro,ect >
=ear ash Dlow =ear ash Dlow
8 /B$3).88 8 /B-2)888
1 B28)888 1 B18)888
2 B2-)888 2 B-8)888
a. =ou should accept both pro,ects since both of their "9s are positive.
b. =ou should accept pro,ect ! since it has the higher "9.
c. =ou should accept both pro,ects since both of their "9s are greater than 1.
d. =ou should only accept pro,ect > since it has the largest "9 and the "9 exceeds 1.
e. &either pro,ect is acceptable.
PROFITABILITY INDEX
d 2$. =ou would like to invest in the following pro,ect.
=ear ash Dlow
8 /B..)888
1 B$8)888
2 B$2)888
'ictoria) your boss) insists that only pro,ects that can return at least B1.18 in today1s
dollars for every B1 invested can be accepted. Fhe also insists on applying a 18 percent
discount rate to all cash flows. >ased on these criteria) you should:
a. accept the pro,ect because it returns almost B1.22 for every B1 invested.
b. accept the pro,ect because it has a positive "9.
c. accept the pro,ect because the &"' is B2)3.1.
d. re,ect the pro,ect because the "9 is 1.8..
e. re,ect the pro,ect because the 955 exceeds 18 percent.
CHAPTER 9
PAYBACK PERIOD
c 2-. 9t will cost B2)088 to ac*uire a small ice cream cart. art sales are expected to be
B1)-88 a year for three years. !fter the three years) the cart is expected to be worthless
as that is the expected remaining life of the cooling system. %hat is the payback period
of the ice cream cart(
a. .30 years
b. 1.-0 years
c. 1.30 years
d. 2.-0 years
e. 2.30 years
PAYBACK PERIOD
e 2.. =ou are considering a pro,ect with an initial cost of B-)$88. %hat is the payback
period for this pro,ect if the cash inflows are B..8) B428) B2)088) and B.88 a year over
the next four years) respectively.
a. 2.8- years
b. 2.$0 years
c. 2.34 years
d. $.8- years
e. $.$0 years
PAYBACK PERIOD
d 20. ! pro,ect has an initial cost of B1)488. The cash inflows are B8) B.88) B488) and B288
over the next four years) respectively. %hat is the payback period(
a. 2.21 years
b. 2.43 years
c. $.11 years
d. $.21 years
e. never
PAYBACK PERIOD
e 22. Gack is considering adding toys to his general store. Ce estimates that the cost of
inventory will be B-)288. The remodeling expenses and shelving costs are estimated at
B1).88. Toy sales are expected to produce net cash inflows of B1)288) B1).88) B1)088)
and B1)2.8 over the next four years) respectively. Fhould Gack add toys to his store if
he assigns a three/year payback period to this pro,ect(
a. yesE because the payback period is 2.4- years
b. yesE because the payback period is 2.82 years
c. yesE because the payback period is $.38 years
d. noE because the payback period is 2.82 years
e. noE because the payback period is $.38 years
CHAPTER 9
DISCOUNTED PAYBACK PERIOD
e 23. ! pro,ect has an initial cost of B3).88 and produces cash inflows of B2)088) B-)488)
and B1).88 over the next three years) respectively. %hat is the discounted payback
period if the re*uired rate of return is 2 percent(
a. 2.1$ years
b. 2.$$ years
c. 2.02 years
d. 2.41 years
e. never
DISCOUNTED PAYBACK PERIOD
c 24. =ancy is considering a pro,ect which will produce cash inflows of B488 a year for -
years. The pro,ect has a 4 percent re*uired rate of return and an initial cost of B2)388.
%hat is the discounted payback period(
a. $.11 years
b. $.13 years
c. $.32 years
d. -.13 years
e. never
DISCOUNTED PAYBACK PERIOD
e 38. ?inny Trueblood is considering an investment which will cost her B128)888. The
investment produces no cash flows for the first year. 9n the second year the cash
inflow is B$.)888. This inflow will increase to B..)888 and then B2.)888 for the
following two years before ceasing permanently. ?inny re*uires a 18 percent rate of
return and has a re*uired discounted payback period of three years. ?inny should
::::: this pro,ect because the discounted payback period is :::::
a. acceptE 2.8$ years.
b. acceptE 2.42 years.
c. acceptE $.42 years.
d. re,ectE $.8$ years.
e. re,ectE $.42 years.
DISCOUNTED PAYBACK PERIOD
e 31. Tim is considering two pro,ects both of which have an initial cost of B12)888 and total
cash inflows of B1.)888. The cash inflows of pro,ect ! are B1)888) B2)888) B-)888) and
B3)888 over the next four years) respectively. The cash inflows for pro,ect > are
B3)888) B-)888) B2)888 and B1)888 over the next four years) respectively. %hich one of
the following statements is correct if Tim re*uires a 18 percent rate of return and has a
re*uired discounted payback period of $ years(
9. Tim should accept pro,ect ! because it has a payback period of 2.0. years.
99. Tim should re,ect pro,ect ! because it never pays back at a 18 percent rate.
999. Tim should accept pro,ect > as long as the discount rate is 18 percent or less.
9'. Tim should accept pro,ect > because it has a discounted payback period of 2.4. years.
a. 9 and 999 only
b. 9 and 9' only
c. 99 and 999 only
d. 99 and 9' only
e. 99) 999) and 9' only
AVERAGE ACCOUNTING RETURN
e 32. @arry1s @anterns is considering a pro,ect which will produce sales of B2-8)888 a year
CHAPTER 9
for the next five years. The profit margin is estimated at 0 percent. The pro,ect will
cost B248)888 and be depreciated straight/line to a book value of +ero over the life of
the pro,ect. @arry1s has a re*uired accounting return of 3 percent. This pro,ect should
be ::::: because the !!5 is :::::
a. re,ectedE -.1- percent.
b. re,ectedE 0 percent.
c. re,ectedE 3.23 percent.
d. acceptedE 3.23 percent.
e. acceptedE 4.4$ percent.
AVERAGE ACCOUNTING RETURN
d 3$. ! pro,ect has an initial cost of B$3)888 and a four/year life. The company uses
straight/line depreciation to a book value of +ero over the life of the pro,ect. The
pro,ected net income from the pro,ect is B1)888) B1)288) B1).88) and B1)288 a year for
the next four years) respectively. %hat is the average accounting return(
a. $... percent
b. -.1$ percent
c. -.23 percent
d. 2.11 percent
e. 1-.21 percent
AVERAGE ACCOUNTING RETURN
d 3-. ! pro,ect produces annual net income of B4).88) B12).88) and B1.).88 over the three
years of its life) respectively. The initial cost of the pro,ect is B208)-88. This cost is
depreciated straight/line to a +ero book value over three years. %hat is the average
accounting rate of return if the re*uired discount rate is 2 percent(
a. -.38 percent
b. 2.$2 percent
c. 3.42 percent
d. 4.08 percent
e. 18.22 percent
AVERAGE ACCOUNTING RETURN
d 3.. ! pro,ect has average net income of B2)188 a year over its -/year life. The initial cost
of the pro,ect is B0.)888 which will be depreciated using straight/line depreciation to a
book value of +ero over the life of the pro,ect. The firm wants to earn a minimal
average accounting return of 3.. percent. The firm should ::::: the pro,ect based on
the !!5 of :::::
a. acceptE 0.-0 percent.
b. acceptE 4.04 percent.
c. acceptE 12.42 percent.
d. re,ectE 0.-0 percent.
e. re,ectE 12.42 percent.
CHAPTER 9
AVERAGE ACCOUNTING RETURN
a 30. #artin is analy+ing a pro,ect and has gathered the following data. >ased on this data)
what is the average accounting rate of return( The firm depreciates it assets using
straight/line depreciation to a +ero book value over the life of the asset.
=ear ash Dlow &et 9ncome
8 /B0-2)888 nHa
1 B128)888 B 4).88
2 B2-8)888 B24).88
$ B28.)888 B--).88
- B14.)888 B$-).88
a. 1$.83 percent
b. 1..22 percent
c. 21.3$ percent
d. 20.12 percent
e. $1..- percent
CROSSOVER RATE
e 32. =ou are analy+ing the following two mutually exclusive pro,ects and have developed
the following information. %hat is the crossover rate(
"ro,ect ! "ro,ect >
=ear ash Dlow ash Dlow
8 /B3-).88 /B20)488
1 B24)888 B2.)888
2 B-8)888 B$.)888
$ B22)888 B20)888
a. 11.11$ percent
b. 1$.883 percent
c. 1-.481 percent
d. 10.2.8 percent
e. 12.344 percent
CROSSOVER RATE
b 33. The %inston o. is considering two mutually exclusive pro,ects with the following
cash flows. The crossover rate is ::::: and if the re*uired rate is higher than the
crossover rate then pro,ect ::::: should be accepted.
"ro,ect ! "ro,ect >
=ear ash Dlow ash Dlow
8 /B2.)888 /B08)888
1 B$8)888 B2.)888
2 B$.)888 B$8)888
$ B$.)888 B2.)888
a. 1$.4- percentE !
b. 1$.4- percentE >
c. 1..-- percentE !
d. 1..-- percentE >
e. 1..30 percentE !
Use the !""!#$%& $%!'()t$!% t! )%s#e' *+est$!%s ,9 th'!+&h 9-.
CHAPTER 9
=ou are analy+ing a pro,ect and have prepared the following data:
=ear ash flow
8 /B104)888
1 B -0)288
2 B 32)$88
$ B -1)888
- B $4)888
5e*uired payback period 2.. years
5e*uired !!5 2.2. percent
5e*uired return 3..8 percent
PROFITABILITY INDEX
b 34. >ased on the profitability index of ::::: for this pro,ect) you should ::::: the
pro,ect.
a. .42E accept
b. 1.8.E accept
c. 1.13E accept
d. .42E re,ect
e. 1.8.E re,ect
INTERNAL RATE OF RETURN
b 48. >ased on the internal rate of return of :::::for this pro,ect) you should ::::: the
pro,ect.
a. 3.4. percentE accept
b. 18.2. percentE accept
c. 3.-- percentE re,ect
d. 4.02 percentE re,ect
e. 18.$$ percentE re,ect
NET PRESENT VALUE
c 41. >ased on the net present value of :::::for this pro,ect) you should ::::: the
pro,ect.
a. /B2)821.23E re,ect
b. /B-80.14E re,ect
c. B2)423.22E accept
d. B4)3$0.2-E accept
e. B12)03-.2$E accept
PAYBACK PERIOD
c 42. >ased on the payback period of :::::for this pro,ect) you should ::::: the
pro,ect.
a. 1.32 yearsE accept
b. 2.32 yearsE accept
c. 2.32 yearsE re,ect
d. $.1$ yearsE re,ect
e. $.32 yearsE re,ect
CHAPTER 9
Use the !""!#$%& $%!'()t$!% t! )%s#e' *+est$!%s 9. th'!+&h 9/.
=ou are considering the following two mutually exclusive pro,ects. >oth pro,ects will be
depreciated using straight/line depreciation to a +ero book value over the life of the pro,ect.
&either pro,ect has any salvage value.
"ro,ect ! "ro,ect >
=ear ash Dlow =ear ash Dlow
8 /B2.)888 8 /B28)888
1 B14)888 1 B18)888
2 B-3)888 2 B10)888
$ B12)888 $ B22)888
5e*uired rate of return 18 percent 1$ percent
5e*uired payback period 2.8 years 2.8 years
5e*uired accounting return 3 percent 11 percent
NET PRESENT VALUE
c 4$. >ased on the net present value method of analysis and given the information in the
problem) you should:
a. accept both pro,ect ! and pro,ect >.
b. accept pro,ect ! and re,ect pro,ect >.
c. accept pro,ect > and re,ect pro,ect !.
d. re,ect both pro,ect ! and pro,ect >.
e. accept whichever one you want as they represent e*ual opportunities.
INTERNAL RATE OF RETURN
e 4-. >ased upon the internal rate of return (955) and the information provided in the
problem) you should:
a. accept both pro,ect ! and pro,ect >.
b. re,ect both pro,ect ! and pro,ect >.
c. accept pro,ect ! and re,ect pro,ect >.
d. accept pro,ect > and re,ect pro,ect !.
e. ignore the 955 rule and use another method of analysis.
PAYBACK PERIOD
b 4.. >ased upon the payback period and the information provided in the problem) you
should:
a. accept both pro,ect ! and pro,ect >.
b. re,ect both pro,ect ! and pro,ect >.
c. accept pro,ect ! and re,ect pro,ect >.
d. accept pro,ect > and re,ect pro,ect !.
e. re*uire that management extend the payback period for pro,ect ! since it has a higher
initial cost.
CHAPTER 9
PROFITABILITY INDEX
e 40. >ased upon the profitability index ("9) and the information provided in the problem)
you should:
a. accept both pro,ect ! and pro,ect >.
b. accept pro,ect ! and re,ect pro,ect >.
c. accept pro,ect > and re,ect pro,ect !.
d. re,ect both pro,ect ! and pro,ect >.
e. disregard the "9 method in this case.
AVERAGE ACCOUNTING RETURN
e 42. >ased upon the average accounting return (!!5) and the information provided in the
problem) you:
a. should accept both pro,ect ! and pro,ect >.
b. should accept pro,ect ! because the !!5 exceeds the re*uired rate.
c. should accept pro,ect ! because the !!5 is less than the re*uired rate.
d. should accept whichever pro,ect you prefer as they are e*uivalent from an !!5
perspective.
e. can not compute the !!5 of either pro,ect.
ESSAYS
NPV AND FIRM VALUE
43. !ccording to the text) the &"' rule states that) I!n investment should be accepted if the net
present value J&"'K is positive and re,ected if it is negative.L %hat does an &"' of +ero
mean( 9f you were a decision/maker faced with a pro,ect with a +ero &"' (or very close to
+ero) what would you do( %hy(
!lthough the possibility of a +ero &"' is remote) it makes for an interesting *uestion and
tests the student1s understanding of the underlying theory. 9n strict economic terms) one
should be indifferent to the pro,ectE however) many pro,ects re*uire further considerations. !
key point in the student1s answer should be that they stress the pro,ect provides a return ,ust
e*ual to the firm1s re*uired return. This *uestion provides a good lead/in to the two capital
budgeting chapters that follow.
INTERNAL RATE OF RETURN
44. @ist and briefly discuss the advantages and disadvantages of the internal rate of return (955)
rule.
The advantages of the rule are its close relationship with &"' and the ease with which it is
understood and communicated. The two disadvantages are that there may be multiple
solutions and the rule may lead to a ranking conflict in evaluating mutually exclusive
investments. The student should add a brief explanation demonstrating their understanding of
each.
CHAPTER 9
NPV VS. PI
188. 7xplain the differences and similarities between net present value (&"') and the
profitability index ("9).
The &"' and "9 are basically the same calculation) and both rules lead to the same
acceptHre,ect decision. The main difference between the two is that the "9 may be useful in
determining which pro,ects to accept if funds are limitedE however) the "9 may lead to
incorrect decisions in considering mutually exclusive investments.
NPV AND PROJECT VALUE
181. ?iven the goals of firm value and shareholder wealth maximi+ation) we have stressed the
importance of net present value (&"'). !nd yet) many financial decision/makers at some of
the most prominent firms in the world continue to use less desirable measures such as the
payback period and the average accounting return (!!5). %hy do you think this is the case(
This is an open/ended *uestion which allows the creative student to speculate on the value of
non/discounted cash flow evaluation measures. %e use it as a springboard to stress that even
rational financial managers sometimes find it expedient to use a group of measures. Dor
example) firms may rely on the 955 because it is easier to explain to board members than
&"'. !lso) for large pro,ects) !!5 provides shareholders with some insights as to the
pro,ect1s impact on net income and earnings per share.