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Foundations of Finance, 8e, Global Edition, (Keown/Martin/Petty)
Chapter 10 Capital Investment Decision Analysis-I
Learning Objective 1
1) Free cash flows represent the benefits generated from accepting a capital-budgeting proposal.
Answer: TRUE
Diff: 1
Keywords: Capital Budgeting, Free Cash Flow
AACSB: Reflective thinking skills
Learning Objective 2
1) The most critical aspect in determining the acceptability of a capital budgeting project is the impact the
project will have on the company's net income over the projects entire useful life.
Answer: FALSE
Diff: 1
Keywords: Income vs. Cash Flow
AACSB: Reflective thinking skills
2) Advantages of the payback period include that it is easy to calculate, easy to understand, and that it is
based on cash flows rather than on accounting profits.
Answer: TRUE
Diff: 1
Keywords: Payback Period
AACSB: Reflective thinking skills
3) If project A generates $10 million of free cash flow over its five year useful life and project B generates
$8 million of free cash flow over its useful life, then Project A will have a shorter payback period than
Project B, assuming both projects require the same initial investment.
Answer: FALSE
Diff: 1
Keywords: Payback Period
AACSB: Analytic skills
4) A project with a payback period of four years is acceptable as long as the company's target payback
period is greater than or equal to four years.
Answer: TRUE
Diff: 1
Keywords: Payback Period
AACSB: Reflective thinking skills
5) Two projects that have the same cost and the same expected cash flows will have the same net present
value.
Answer: FALSE
Diff: 1
Keywords: Net Present Value, Discount Rate
AACSB: Analytic skills
7) If a project is acceptable using the net present value criteria, then it will also be acceptable under the
less stringent criteria of the payback period.
Answer: FALSE
Diff: 1
Keywords: Net Present Value, Payback Period
AACSB: Analytic skills
8) An acceptable project should have a net present value greater than or equal to zero and a profitability
index greater than or equal to one.
Answer: TRUE
Diff: 1
Keywords: Net Present Value, Profitability Index
AACSB: Reflective thinking skills
9) If a project's internal rate of return is greater than the project's required return, then the project's
profitability index will be greater than one.
Answer: TRUE
Diff: 2
Keywords: Internal Rate of Return, Profitability Index
AACSB: Analytic skills
10) The net present value profile clearly demonstrates that the NPV of a project increases as the discount
rate increases.
Answer: FALSE
Diff: 1
Keywords: Net Present Value Profile, Discount Rate
AACSB: Reflective thinking skills
11) The modified internal rate of return represents the project's internal rate of return assuming that
intermediate cash flows from the project can be reinvested at the project's required return.
Answer: TRUE
Diff: 1
Keywords: Modified Internal Rate of Return, Required Return
AACSB: Reflective thinking skills
12) One drawback of the payback method is that some cash flows may be ignored.
Answer: TRUE
Diff: 1
Keywords: Payback Period
AACSB: Reflective thinking skills
14) The profitability index provides an advantage over the net present value method by reporting the
present value of benefits per dollar invested.
Answer: TRUE
Diff: 1
Keywords: Profitability Index, Net Present Value
AACSB: Reflective thinking skills
15) The net present value of a project will increase as the required rate of return is decreased (assume only
one sign reversal).
Answer: TRUE
Diff: 1
Keywords: Net Present Value, Required Return
AACSB: Analytic skills
16) Whenever the internal rate of return on a project equals that project's required rate of return, the net
present value equals zero.
Answer: TRUE
Diff: 1
Keywords: Internal Rate of Return, Net Present Value, Required Return
AACSB: Analytic skills
17) One of the disadvantages of the payback method is that it ignores time value of money.
Answer: TRUE
Diff: 1
Keywords: Payback Period, Time Value of Money
AACSB: Reflective thinking skills
18) The capital budgeting decision-making process involves measuring the incremental cash flows of an
investment proposal and evaluating the attractiveness of these cash flows relative to the project's cost.
Answer: TRUE
Diff: 1
Keywords: Capital Budgeting, Incremental Cash Flows
AACSB: Reflective thinking skills
19) When several sign reversals in the cash flow stream occur, a project can have more than one IRR.
Answer: TRUE
Diff: 1
Keywords: Multiple Internal Rates of Return, Sign Reversals
AACSB: Analytic skills
21) NPV is the most theoretically correct capital budgeting decision tool examined in the text.
Answer: TRUE
Diff: 1
Keywords: NPV
AACSB: Reflective thinking skills
22) If the net present value of a project is zero, then the profitability index will equal one.
Answer: TRUE
Diff: 1
Keywords: Net Present Value, Profitability Index, Decision Rules
AACSB: Analytic skills
23) The internal rate of return will equal the discount rate when the net present value equals zero.
Answer: TRUE
Diff: 1
Keywords: Internal Rate of Return, Discount Rate, Net Present Value
AACSB: Analytic skills
25) For a project with multiple sign reversals in its cash flows, the net present value can be the same for
two entirely different discount rates.
Answer: TRUE
Diff: 1
Keywords: Sign Reversals, Net Present Value, Discount Rates
AACSB: Analytic skills
26) The internal rate of return is the discount rate that equates the present value of the project's future free
cash flows with the project's initial outlay.
Answer: TRUE
Diff: 1
Keywords: Internal Rate of Return
AACSB: Reflective thinking skills
27) If a project's profitability index is less than one then the project should be rejected.
Answer: TRUE
Diff: 1
Keywords: Profitability Index
AACSB: Analytic skills
29) If a firm imposes a capital constraint on investment projects, the appropriate decision criterion is to
select the set of projects that has the highest positive net present value subject to the capital constraint.
Answer: TRUE
Diff: 1
Keywords: Capital Constraint, Net Present Value
AACSB: Reflective thinking skills
30) For any individual project, if the project is acceptable based on its internal rate of return, then the
project will also be acceptable based on its modified internal rate of return.
Answer: TRUE
Diff: 2
Keywords: Internal Rate of Return, Modified Internal Rate of Return
AACSB: Reflective thinking skills
31) One positive feature of the payback period is it emphasizes the earliest forecasted free cash flows,
which are less uncertain than later cash flows and provide for the liquidity needs of the firm.
Answer: TRUE
Diff: 1
Keywords: Payback Period
AACSB: Reflective thinking skills
32) The main disadvantage of the NPV method is the need for detailed, long-term forecasts of free cash
flows generated by prospective projects.
Answer: TRUE
Diff: 1
Keywords: NPV, Free Cash Flow
AACSB: Reflective thinking skills
33) The profitability index is the ratio of the present value of the future free cash flows to the initial
investment.
Answer: TRUE
Diff: 1
Keywords: Profitability Index
AACSB: Reflective thinking skills
34) Marketing is crucial to capital budgeting success because the goal of a good capital budgeting project
is to maximize the company's sales.
Answer: FALSE
Diff: 1
Keywords: Capital Budgeting, Shareholder Wealth Maximization
AACSB: Reflective thinking skills
36) A project's IRR is analogous to the concept of the yield to maturity for bonds.
Answer: TRUE
Diff: 1
Keywords: IRR, Yield to Maturity
AACSB: Reflective thinking skills
37) NPV assumes reinvestment of intermediate free cash flows at the cost of capital, while IRR assumes
reinvestment of intermediate free cash flows at the IRR.
Answer: TRUE
Diff: 1
Keywords: NPV, IRR, Reinvestment Rate
AACSB: Reflective thinking skills
38) A project's net present value profile shows how sensitive the project is to the choice of a discount rate.
Answer: TRUE
Diff: 1
Keywords: Net Present Value Profile, Discount Rate
AACSB: Reflective thinking skills
39) If a project has multiple internal rates of return, the lowest rate should be used for decision making
purposes.
Answer: FALSE
Diff: 2
Keywords: Internal Rate of Return, Multiple IRRs
AACSB: Reflective thinking skills
40) The payback period ignores the time value of money and therefore should not be used as a screening
device for the selection of capital budgeting projects.
Answer: FALSE
Diff: 1
Keywords: Payback Period, Time Value of Money
AACSB: Analytic skills
41) Many financial managers believe the payback period is of limited usefulness because it ignores the
time value of money; hence, it is referred to as the discounted payback period.
Answer: FALSE
Diff: 1
Keywords: Discounted Payback Period, Payback Period, Time Value of Money
AACSB: Reflective thinking skills
43) Any project deemed acceptable using the discounted payback period will also be acceptable if using
the traditional payback period.
Answer: TRUE
Diff: 2
Keywords: Discounted Payback Period, Payback Period
AACSB: Reflective thinking skills
44) A major disadvantage of the discounted payback period is the arbitrariness of the process used to
select the maximum desired payback period.
Answer: TRUE
Diff: 1
Keywords: Discounted Payback Period, Arbitrary Decision Rule
AACSB: Reflective thinking skills
45) A project with a NPV of zero should be rejected since even the returns on U.S. Treasury bill are
greater than zero.
Answer: FALSE
Diff: 1
Keywords: NPV, Decision Rule
AACSB: Reflective thinking skills
46) NPV may be calculated on an Excel spreadsheet simply by entering the project's free cash flows into
Excel's NPV function.
Answer: FALSE
Diff: 1
Keywords: NPV, Excel
AACSB: Reflective thinking skills
47) The internal rate of return is the discount rate that equates the present value of the project's free cash
flows with the project's initial cash outlay.
Answer: TRUE
Diff: 1
Keywords: Internal Rate of Return
AACSB: Reflective thinking skills
48) A project that is very sensitive to the selection of a discount rate will have a steep net present value
profile.
Answer: TRUE
Diff: 1
Keywords: Net Present Value Profile
AACSB: Reflective thinking skills
50) Calculating the modified internal rate of return on an Excel spreadsheet involves the use of the IRR
function multiple times, once using the financing rate, and once using the reinvestment rate.
Answer: FALSE
Diff: 1
Keywords: MIRR, Excel, Reinvestment Rate
AACSB: Reflective thinking skills
51) The capital budgeting manager for XYZ Corporation, a very profitable high technology company,
completed her analysis of Project A assuming 5-year depreciation. Her accountant reviews the analysis
and changes the depreciation method to 3-year depreciation. This change will
A) increase the present value of the NCFs.
B) decrease the present value of the NCFs.
C) have no effect on the NCFs because depreciation is a non-cash expense.
D) only change the NCFs if the useful life of the depreciable asset is greater than 5 years.
Answer: A
Diff: 2
Keywords: Net Present Value, Depreciation Expense
AACSB: Analytic skills
52) Project W requires a net investment of $1,000,000 and has a payback period of 5.6 years. You analyze
Project W and decide that Year 1 free cash flow is $100,000 too low, and Year 3 free cash flow is $100,000
too high. After making the necessary adjustments
A) the payback period for Project W will be longer than 5.6 years.
B) the payback period for Project W will be shorter than 5.6 years.
C) the IRR of Project W will increase.
D) the NPV of Project W will decrease.
Answer: C
Diff: 2
Keywords: Payback Period, Net Present Value, Internal Rate of Return
AACSB: Analytic skills
53) Project Alpha has an internal rate of return (IRR) of 15 percent. Project Beta has an IRR of 14 percent.
Both projects have a required return of 12 percent. Which of the following statements is MOST correct?
A) Both projects have a positive net present value (NPV).
B) Project Alpha must have a higher NPV than Project Beta.
C) If the required return were less than 12 percent, Project Beta would have a higher IRR than Project
Alpha.
D) Project Beta has a higher profitability index than Project Alpha.
Answer: A
Diff: 2
Keywords: Internal Rate of Return, Net Present Value, Required Return
AACSB: Reflective thinking skills
55) DYI Construction Co. is considering a new inventory system that will cost $750,000. The system is
expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one,
$325,000 in year two, $150,000 in year three, and $180,000 in year four. DYI's required rate of return is 8%.
What is the payback period of this project?
A) 4.00 years
B) 3.09 years
C) 2.91 years
D) 2.50 years
Answer: D
Diff: 1
Keywords: Payback Period
AACSB: Analytic skills
56) DYI Construction Co. is considering a new inventory system that will cost $750,000. The system is
expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one,
$325,000 in year two, $150,000 in year three, and $180,000 in year four. DYI's required rate of return is 8%.
What is the net present value of this project?
A) $104,089
B) $100,328
C) $96,320
D) $87,417
Answer: A
Diff: 2
Keywords: Net Present Value
AACSB: Analytic skills
57) DYI Construction Co. is considering a new inventory system that will cost $750,000. The system is
expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one,
$325,000 in year two, $150,000 in year three, and $180,000 in year four. DYI's required rate of return is 8%.
What is the internal rate of return of this project?
A) 10.87%
B) 11.57%
C) 13.68%
D) 15.13%
Answer: D
Diff: 2
Keywords: Internal Rate of Return
AACSB: Analytic skills
59) Project LMK requires an initial outlay of $400,000 and has a profitability index of 1.5. The project is
expected to generate equal annual cash flows over the next twelve years. The required return for this
project is 20%. What is project LMK's net present value?
A) $600,000
B) $150,000
C) $120,000
D) $80,000
Answer: B
Diff: 2
Keywords: Net Present Value, Profitability Index
AACSB: Analytic skills
60) Project LMK requires an initial outlay of $500,000 and has a profitability index of 1.4. The project is
expected to generate equal annual cash flows over the next ten years. The required return for this project
is 16%. What is project LMK's internal rate of return?
A) 19.88%
B) 22.69%
C) 24.78%
D) 26.12%
Answer: D
Diff: 3
Keywords: Internal Rate of Return, Profitability Index, Ordinary Annuity
AACSB: Analytic skills
61) A capital budgeting project has a net present value of $30,000 and a modified internal rate of return of
15%. The project's required rate of return is 13%. The internal rate of return is
A) greater than $30,000.
B) less than 13%.
C) between 13% and 15%.
D) greater than 15%
Answer: D
Diff: 2
Keywords: Modified Internal Rate of Return, Net Present Value, Internal Rate of Return, Required Return
AACSB: Analytic skills
63) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is
expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected
to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four.
Lithium, Inc.'s required rate of return for these projects is 10%. The net present value for Project B is
A) $58,097.
B) $66,363.
C) $74,538.
D) $112,000.
Answer: B
Diff: 2
Keywords: Net Present Value
AACSB: Analytic skills
64) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is
expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected
to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four.
Lithium, Inc.'s required rate of return for these projects is 10%. The profitability index for Project A is
A) 1.27.
B) 1.22.
C) 1.17.
D) 1.12.
Answer: A
Diff: 2
Keywords: Profitability Index
AACSB: Analytic skills
66) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is
expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected
to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four.
Lithium, Inc.'s required rate of return for these projects is 10%. The internal rate of return for Project A is
A) 31.43%.
B) 29.42%.
C) 25.88%.
D) 19.45%.
Answer: B
Diff: 2
Keywords: Internal Rate of Return
AACSB: Analytic skills
67) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is
expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected
to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four.
Lithium, Inc.'s required rate of return for these projects is 10%. The internal rate of return for Project B is
A) 29.74%.
B) 30.79%.
C) 35.27%.
D) 36.77%.
Answer: C
Diff: 2
Keywords: Internal Rate of Return
AACSB: Analytic skills
69) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is
expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected
to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four.
Lithium, Inc.'s required rate of return for these projects is 10%. The modified internal rate of return for
Project B is
A) 17.84%.
B) 18.52%.
C) 19.75%.
D) 22.80%.
Answer: D
Diff: 2
Keywords: Modified Internal Rate of Return
AACSB: Analytic skills
70) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is
expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected
to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four.
Lithium, Inc.'s required rate of return for these projects is 10%. Which project would you recommend
using the replacement chain method to evaluate the projects with different lives?
A) Project B because its NPV is higher than Project A's replacement chain NPV of $47,623
B) Project A because its replacement chain NPV is $76,652, which exceeds the NPV for Project B
C) Project A because its replacement chain NPV is $45,642, which is less than the NPV for Project B
D) Both projects will be valued the same since they are now both four year projects.
Answer: A
Diff: 2
Keywords: Replacement Chain, Net Present Value
AACSB: Reflective thinking skills
73) Arguments against using the net present value and internal rate of return methods include that
A) they fail to use accounting profits.
B) they require detailed long-term forecasts of the incremental benefits and costs.
C) they fail to consider how the investment project is to be financed.
D) they fail to use the cash flow of the project.
Answer: B
Diff: 1
Keywords: Net Present Value, Internal Rate of Return
AACSB: Reflective thinking skills
74) All of the following are sufficient indications to accept a project EXCEPT (assume that there is no
capital rationing constraint, and no consideration is given to payback as a decision tool)
A) the net present value of an independent project is positive.
B) the profitability index of an independent project exceeds one.
C) the IRR of a mutually exclusive project exceeds the required rate of return.
D) the NPV of a mutually exclusive project is positive and exceeds that of all other projects.
Answer: C
Diff: 2
Keywords: Net Present Value, Profitability Index, Internal Rate of Return, Mutually Exclusive Projects, Independent
Projects
AACSB: Reflective thinking skills
76) A project requires an initial investment of $389,600. The project generates free cash flow of $540,000 at
the end of year 4. What is the internal rate of return for the project?
A) 138.6%
B) 38.6%
C) 8.5%
D) 6.9%
Answer: C
Diff: 2
Keywords: Internal Rate of Return
AACSB: Analytic skills
77) Raindrip Corp. can purchase a new machine for $1,875,000 that will provide an annual net cash flow
of $650,000 per year for five years. The machine will be sold for $120,000 after taxes at the end of year five.
What is the net present value of the machine if the required rate of return is 13.5%.
A) $558,378
B) $513,859
C) $473,498
D) $447,292
Answer: D
Diff: 2
Keywords: Net Present Value
AACSB: Analytic skills
78) Given the following annual net cash flows, determine the internal rate of return to the nearest whole
percent of a project with an initial outlay of $750,000.
Year
Net Cash Flow
1
$500,000
2
$150,000
3
$250,000
A) 9%
B) 11%
C) 13%
D) 15%
Answer: B
Diff: 2
Keywords: Internal Rate of Return
AACSB: Analytic skills
82) What is the payback period for a project with an initial investment of $180,000 that provides an annual
cash inflow of $40,000 for the first three years and $25,000 per year for years four and five, and $50,000 per
year for years six through eight?
A) 5.80 years
B) 5.20 years
C) 5.40 years
D) 5.59 years
Answer: B
Diff: 2
Keywords: Payback Period
AACSB: Analytic skills
86) All of the following are criticisms of the payback period criterion EXCEPT
A) time value of money is not accounted for.
B) cash flows occurring after the payback are ignored.
C) it deals with accounting profits as opposed to cash flows.
D) none of the above; they are all criticisms of the payback period criteria.
Answer: C
Diff: 1
Keywords: Payback Period
AACSB: Reflective thinking skills
88) Design Quilters is considering a project with the following cash flows:
Initial Outlay = $126,000
Cash Flows: Year 1 = $44,000
Year 2 = $59,000
Year 3 = $64,000
If the appropriate discount rate is 11.5%, compute the NPV of this project.
A) -$14,947
B) $2,892
C) $7,089
D) $41,000
Answer: C
Diff: 2
Keywords: Net Present Value
AACSB: Analytic skills
89) Your company is considering a project with the following cash flows:
Initial Outlay = $3,000,000
Cash Flows Year 1-8 = $547,000
Compute the internal rate of return on the project.
A) 6.38%
B) 8.95%
C) 9.25%
D) 12.34%
Answer: C
Diff: 2
Keywords: Internal Rate of Return
AACSB: Analytic skills
91) Compute the discounted payback period for a project with the following cash flows received
uniformly within each year and with a required return of 8%:
Initial Outlay = $100
Cash Flows: Year 1 = $40
Year 2 = $50
Year 3 = $60
A) 2.10 years
B) 2.21 years
C) 2.33 years
D) 3.00 years
Answer: C
Diff: 2
Keywords: Discounted Payback Period
AACSB: Analytic skills
94) You are considering investing in a project with the following year-end after-tax cash flows:
Year 1: $57,000
Year 2: $72,000
Year 3: $78,000
If the initial outlay for the project is $185,000, compute the project's internal rate of return.
A) 3.98%
B) 5.54%
C) 11.89%
D) 14.74%
Answer: B
Diff: 2
Keywords: Internal Rate of Return
AACSB: Analytic skills
95) Different discounted cash flow evaluation methods may provide conflicting rankings of investment
projects when
A) the size of investment outlays differ.
B) the projects are mutually exclusive.
C) the accounting policies differ.
D) the internal rate of return equals the cost of capital.
Answer: A
Diff: 2
Keywords: Capital Budgeting Decisions, Size, Cash Flows vs Accounting Income
AACSB: Reflective thinking skills
96) The Net Present Value (or NPV) criteria for capital budgeting decisions assumes that expected future
cash flows are reinvested at ________, and the Internal Rate of Return (or IRR) criteria assumes that
expected future cash flows are reinvested at ________.
A) the firm's discount rate; the internal rate of return
B) the internal rate of return; the internal rate of return
C) the internal rate of return; the firm's discount rate
D) Neither criteria assumes reinvestment of future cash flows.
Answer: A
Diff: 2
Keywords: Net Present Value, Internal Rate of Return, Reinvestment Rate
AACSB: Analytic skills
99) Your firm is considering an investment that will cost $750,000 today. The investment will produce cash
flows of $250,000 in year 1, $300,000 in years 2 through 4, and $100,000 in year 5. What is the investment's
discounted payback period if the required rate of return is 10%?
A) 3.33 years
B) 3.16 years
C) 2.67 years
D) 2.33 years
Answer: B
Diff: 2
Keywords: Discounted Payback Period
AACSB: Analytic skills
102) What is the net present value's assumption about how cash flows are reinvested?
A) They are reinvested at the IRR.
B) They are reinvested at the APR.
C) They are reinvested at the firm's discount rate.
D) They are reinvested only at the end of the project.
Answer: C
Diff: 2
Keywords: Net Present Value, Reinvestment Rate Assumption
AACSB: Reflective thinking skills
103) Your firm is considering an investment that will cost $920000 today. The investment will produce
cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in year 5. The discount rate
that your firm uses for projects of this type is 11.25%. What is the investment's net present value?
A) $540,000
B) $378,458
C) $192,369
D) $112,583
Answer: C
Diff: 2
Keywords: Net Present Value
AACSB: Analytic skills
104) Your firm is considering an investment that will cost $920,000 today. The investment will produce
cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in year 5. The discount rate
that your firm uses for projects of this type is 11.25%. What is the investment's profitability index?
A) 1.21
B) 1.26
C) 1.43
D) 1.69
Answer: A
Diff: 2
Keywords: Profitability Index
AACSB: Analytic skills
106) Which of the following statements about the internal rate of return (IRR) is true?
A) It has the most conservative and realistic reinvestment assumption.
B) It never gives conflicting answers.
C) It fully considers the time value of money.
D) It is greater than the modified internal rate of return if the discount rate is higher than the IRR.
Answer: C
Diff: 2
Keywords: Internal Rate of Return
AACSB: Reflective thinking skills
110) What is the internal rate of return's assumption about how cash flows are reinvested?
A) They are reinvested at the firm's discount rate.
B) They are reinvested at the required rate of return.
C) They are reinvested at the project's internal rate of return.
D) They are only reinvested at the end of the project.
Answer: C
Diff: 1
Keywords: Internal Rate of Return, Reinvestment Rate Assumption
AACSB: Reflective thinking skills
111) If the NPV (Net Present Value) of a project with multiple sign reversals is positive, then the project's
required rate of return ________ its calculated IRR (Internal Rate of Return).
A) must be less than
B) must be greater than
C) could be greater or less than
D) cannot be determined without actual cash flows
Answer: C
Diff: 2
Keywords: Net Present Value, Internal Rate of Return, Multiple Sign Reversals
AACSB: Analytic skills
112) Kingston Corp. is considering a new machine that requires an initial investment of $480,000 installed,
and has a useful life of 8 years. The expected annual after-tax cash flows for the machine are $89,000 for
each of the 8 years and nothing thereafter.
a. Calculate the net present value of the machine if the required rate of return is 11 percent.
b. Calculate the IRR of this project.
c. Should Kingston accept the project (assume that it is independent and not subject to any capital
rationing constraint)? Explain your answer.
Answer:
a. NPV = ($21,995) From Excel Spreadsheet NPV function with rate = .11, cash flows as given, and then
subtracting the initial investment of $480,000.
b. IRR = 9.7% From Excel Spreadsheet IRR function, with cash flows as given above.
c. No, the projects NPV is negative and the IRR is less than the required rate of return. Acceptance of
this project would reduce shareholder value.
Diff: 2
Keywords: NPV, IRR
AACSB: Analytic skills
114) Consider two mutually exclusive projects X and Y with identical initial outlays of $600,000 and useful
lives of 5 years. Project X is expected to produce an after-tax cash flow of $180,000 each year. Project Y is
expected to generate a single after-tax net cash flow of $1,015,000 in year 5. The discount rate is 14 percent.
a. Calculate the net present value for each project.
b. Calculate the IRR for each project.
c. What decision should you make regarding these projects?
Answer:
a. NPV of A = $17,955 NPV of B = $23,242
b. IRR of A = 15.24%
IRR of B = 14.87%
c. B should be accepted because it is the mutually exclusive project with the highest positive NPV.
Diff: 2
Keywords: NPV, IRR
AACSB: Analytic skills
115) A project that requires an initial investment of $340,000 is expected to have an after-tax cash flow of
$70,000 per year for the first two years, $90,000 per year for the next two years, and $150,000 for the fifth
year? Assume the required return for this project is 10%.
a. What is the NPV of the project%?
b. What is the IRR of the project?
c. What is the MIRR of the project?
d. What is the PI of the project?
e. What decision would you make regarding this project if the required rate of return is 10%?
f. What is the equivalent annual annuity using a 10% required rate of return?
Answer:
a. NPV = $3,715.34
b. IRR = 10.38%
c. MIRR = 10.24%
d. PI = 1.011
e. Accept the project because its NPV is positive, or because its IRR and MIRR are greater than the
required return of 10%, or because the PI is greater than 1.
f. The EAA = $980.10
Diff: 2
Keywords: NPV, IRR, MIRR, PI, Equivalent Annual Annuity
AACSB: Analytic skills
Initial Outlay
-$100,000
31,250
31,250
31,250
31,250
31,250
NPV
-$100,000
0
0
0
0
200,000
Learning Objective 3
1) The payback period may be more appropriate to use for companies experiencing capital rationing.
Answer: TRUE
Diff: 1
Keywords: Payback Period, Capital Rationing
AACSB: Reflective thinking skills
2) The profitability index can be helpful when a financial manager encounters a situation where capital
rationing is required.
Answer: TRUE
Diff: 1
Keywords: Profitability Index, Capital Rationing
AACSB: Reflective thinking skills
5) When capital rationing exists, the divisibility of projects is ignored and projects are funded in order of
their PI's or IRR's.
Answer: FALSE
Diff: 2
Keywords: Capital Rationing, PI, IRR
AACSB: Reflective thinking skills
6) The net present value always provides the correct decision provided that
A) cash flows are constant over the asset's life.
B) the required rate of return is greater than the internal rate of return.
C) capital rationing is not imposed.
D) the internal rate of return is positive.
Answer: C
Diff: 2
Keywords: Net Present Value, Capital Rationing
AACSB: Analytic skills
Initial Outlay
2 million
1 million
1 million
3 million
IRR
18%
15%
10%
9%
NPV
2,500,000
950,000
600,000
2,000,000
If you must select projects subject to a budget constraint of 5 million dollars, which set of projects should
be accepted so as to maximize firm value?
A) Projects 1, 2 and 3
B) Project 1 only
C) Projects 1 and 4
D) Projects 2, 3 and 4
Answer: C
Diff: 2
Keywords: Capital Rationing, Net Present Value
AACSB: Analytic skills
9) Under what condition would you NOT accept a project that has a positive net present value?
A) If the project has a profitability index less than zero.
B) If two or more projects are mutually inclusive.
C) If the firm is limited in the capital it has available (capital rationing).
D) If a project has more than one sign reversal.
Answer: C
Diff: 1
Keywords: Net Present Value, Capital Rationing
AACSB: Reflective thinking skills
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
A
B
C
D
E
Initial
Outlay
$250,000
250,000
100,000
375,000
375,000
NPV
$325,000
350,000
700,000
112,500
75,000
Answer: Accept B and C because their combined NPV ($1,050,000) is the greatest of any combination of
projects that fit within the capital constraint.
Diff: 2
Keywords: Capital Rationing, NPV
AACSB: Reflective thinking skills
3) The mutually exclusive project with the highest positive NPV will also have the highest IRR.
Answer: FALSE
Diff: 1
Keywords: Mutually Exclusive Projects, NPV, IRR
AACSB: Analytic skills
4) The size disparity problem occurs when mutually exclusive projects of unequal size are being
examined.
Answer: TRUE
Diff: 1
Keywords: Size Disparity, Mutually Exclusive Projects
AACSB: Reflective thinking skills
5) A project's equivalent annual annuity (EAA) is the annuity cash flow that yields the same present value
as the project's NPV.
Answer: TRUE
Diff: 1
Keywords: Equivalent Annual Annuity
AACSB: Reflective thinking skills
7) Two projects are mutually exclusive if the accept/reject decision for one project has no impact on the
accept/reject decision for the other project.
Answer: FALSE
Diff: 2
Keywords: Mutually Exclusive Projects
AACSB: Reflective thinking skills
9) If a project is acceptable using the NPV criterion, then it will also be acceptable using the discounted
payback period since both methods use discounted cash flows to make the accept/reject decision.
Answer: FALSE
Diff: 2
Keywords: NPV, Discounted Payback Period
AACSB: Analytic skills
10) Both the profitability index (PI) and net present value (NPV) are based on the present value of all
future free cash flows, but the PI is a relative measure while the NPV is an absolute measure of a project's
desirability.
Answer: TRUE
Diff: 1
Keywords: Profitability Index, Net Present Value
AACSB: Reflective thinking skills
11) If a project's IRR is equal to its required return, then the project's NPV is equal to zero and its PI is
equal to one.
Answer: TRUE
Diff: 2
Keywords: NPV, PI, IRR
AACSB: Analytic skills
12) If a project is acceptable using the IRR criterion, it will also be acceptable using the MIRR criterion.
Answer: TRUE
Diff: 1
Keywords: IRR, MIRR
AACSB: Analytic skills
13) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is
expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected
to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four.
Lithium, Inc.'s required rate of return for these projects is 10%. The equivalent annual annuity amount for
project A is
A) $12,989.
B) $13,357.
C) $15,024.
D) $18,532
Answer: C
Diff: 2
Keywords: Equivalent Annual Annuity
AACSB: Analytic skills
Plan B
Initial
Outlay=$6,000,000
Cash Flow:
Yr 1=$4,000,000
Yr 2= 3,000,000
Yr 3= 2,000,000
Yr 4= -0Yr 5= -0-
Plan C
Initial
Outlay=$3,500,000
Cash Flow:
Yr 1=$2,000,000
Yr 2= -0Yr 3=2,000,000
Yr 4=2,000,000
Yr 5=2,000,000
If Interstate Appliance has a 12% cost of capital, what decision should be made regarding the projects
above?
A) accept plan A
B) accept plan B
C) accept plan C
D) accept Plans A, B and C
Answer: C
Diff: 2
Keywords: Net Present Value, Mutually Exclusive Projects
AACSB: Analytic skills
15) Your company is considering an investment in one of two mutually exclusive projects. Project one
involves a labor intensive production process. Initial outlay for Project 1 is $1,495 with expected after tax
cash flows of $500 per year in years 1-5. Project two involves a capital intensive process, requiring an
initial outlay of $6,704. After tax cash flows for Project 2 are expected to be $2,000 per year for years 1-5.
Your firm's discount rate is 10%. If your company is not subject to capital rationing, which project(s)
should you take on?
A) Project 1
B) Project 2
C) Projects 1 and 2
D) Neither project is acceptable.
Answer: B
Diff: 2
Keywords: Mutually Exclusive Projects, Net Present Value
AACSB: Reflective thinking skills
17) Determine the five-year equivalent annual annuity of the following project if the appropriate discount
rate is 16%:
Initial Outflow = $150,000
Cash Flow Year 1 = $40,000
Cash Flow Year 2 = $90,000
Cash Flow Year 3 = $60,000
Cash Flow Year 4 = $0
Cash Flow Year 5 = $80,000
A) $7,058
B) $8,520
C) $9,454
D) $9,872
Answer: B
Diff: 2
Keywords: Equivalent Annual Annuity
AACSB: Analytic skills
18) Which of the following statements about the net present value is true?
A) It produces a percentage result that is easy to describe.
B) It has an inadequate reinvestment assumption.
C) It is likely that there will be more than one NPV for a project.
D) It may be used to select among projects of different sizes.
Answer: D
Diff: 2
Keywords: Net Present Value, Unequal Size Projects
AACSB: Reflective thinking skills
21) Which of the following methods of evaluating investment projects can properly evaluate projects of
unequal lives?
A) the net present value
B) the payback
C) the internal rate of return
D) the equivalent annual annuity
Answer: D
Diff: 1
Keywords: Equivalent Annual Annuity
AACSB: Reflective thinking skills
22) Your firm is considering an investment that will cost $920,000 today. The investment will produce cash
flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in year 5. The discount rate that
your firm uses for projects of this type is 11.25%. What is the investment's equivalent annual annuity?
A) $52,377
B) $42,923
C) $41,387
D) $40,399
Answer: A
Diff: 3
Keywords: Equivalent Annual Annuity
AACSB: Analytic skills
1
$2,003,000
0
4
$2,003,000
$11,000,000
a. Calculate the net present value of each of the above projects, assuming a 14 percent discount rate.
b. What is the internal rate of return for each of the above projects?
c. Compare and explain the conflicting rankings of the NPVs and IRRs obtained in parts a and b above.
d. If 14 percent is the required rate of return, and these projects are independent, what decision should
be made?
e. If 14 percent is the required rate of return, and the projects are mutually exclusive, what decision
should be made?
Answer:
a. NPV of A = $1,836,166 NPV of B = $2,512,883
b. IRR of A = 35.0%
IRR of B = 28.78%
c. B has more distant cash flows, thus its IRR is less while its NPV is greater. This time disparity is one of
IRR's ranking problems.
d. If these projects are independent we would accept them both because they each have a positive NPV.
e. If these projects are mutually exclusive we would select B because it has the highest positive NPV.
Diff: 2
Keywords: IRR, NPV, Mutually Exclusive Projects, Independent Projects
AACSB: Analytic skills
0
1
2
3
4
5
6
Cash Flow L
-$115,000
28,500
49,500
26,850
22,600
18,750
23,500
The required rate of return on these projects is 14 percent. What decision should be made? As part of your
answer, calculate the NPV assuming a replacement chain for Project S, and also calculate the equivalent
annual annuity for each project.
Answer: Accept Project S because its replacement chain NPV of $1,999.96 is positive and is greater than
the NPV of Project L of $1,237.09. Also, the equivalent annual annuity for Project S is $514.30 while that of
Project L is only $318.13.
Diff: 2
Keywords: NPV, Replacement Chain, Equivalent Annual Annuity
AACSB: Analytic skills
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.
0
1
2
3
4
5
6
Cash Flow L
-$51,500
13,000
19,000
11,000
20,000
10,000
8,000
Calculate the equivalent annual annuity for each project assuming a required return of 15%. What
decision should be made?
Answer: Choose Project S. Although the NPV of Project L (NPV = $1,269.21) is greater than the NPV of
Project S (NPV = $1,083.26), this is due to the longer life of project L. The equivalent annual annuity for
Project S is $474.44, while the equivalent annual annuity for Project L is only $335.37.
Diff: 2
Keywords: NPV, Equivalent Annual Annuity
AACSB: Analytic skills
0
1
2
3
4
5
6
7
Year Project A
-$2,000,000
500,000
500,000
500,000
500,000
500,000
500,000
500,000
Project B
-$2,000,000
5,650,000
a. Compute the NPV and IRR for the above two projects, assuming a 13% required rate of return.
b. Discuss the ranking conflict.
c. What decision should be made regarding these two projects?
Answer:
a. NPV of A = $211,305
NPV of B = $401,592.64
IRR of A = 16.33%
IRR of B = 15.99%
b. The later cash flow of B causes its lower IRR even though it has the higher NPV.
c. B should be accepted because it is the mutually exclusive project with the highest positive NPV.
Diff: 2
Keywords: NPV, IRR
AACSB: Analytic skills