Ch 8 Study Questions
The correct equation for the Profitability Index (PI) is given by:
PI = NPV/Initial Investment
A company has the opportunity to invest in one of two mutually exclusive projects. Project A has an initial cost of $1.2 million and cash flows with a present value of $4.5 million. Project B has an initial cost of $2 million and cash flows with a present value of $5 million. Which project should the firm choose to invest in?
Project A because it has a higher net present value
The limit set on the amount of funds available for investment is referred to as:
capital rationing
Making the choice to invest today or to postpone that investment to a future date is a choice between mutually exclusive projects. When making this choice, what is the correct criterion to use?
choose the investment date that produces the highest NPV today.
The internal rate of return (IRR) is also called the:
discounted cash flow (DCF) rate of return
Which capital budgeting decision method finds the present value of each cash flow before calculating a payback period?
discounted payback period
The ___________ method of project selection asks, "How long must the project last in order to offer a positive net present value?"
discounted-payback
The rate of return rule states that the rate of return is the discount rate at which NPV:
equals 0
The cash flow per period with the same present value as the cost of buying and operating a machine is called the:
equivalent annual annuity
True or false: the payback rule states that a project should be accepted if its payback period is greater than a specified cutoff period.
false
Since a risky dollar is worth less than a safe one, returns for risky projects must be ________ than those of a risk-free investment.
higher
The IRR rule specifies that a firm should select any project whose IRR is __________ the firm's ___________.
higher than; opportunity cost of capital
Select which of the following relationships is correct:
if the opportunity cost of capital is less than a project's rate of return, then the NPV of the project is positive
If choices you make today do not affect future investment opportunities, then
it is enough simply to compare the NPV of the projects.
If two projects (investments) A and B are said to be mutually exclusive then we know that the firm ______________.
must choose to invest in either A or B, but not both.
By definition, if the Profitability Index is greater than 0, then ________ .
net present value (NPV) is greater than 0
The rate of return rule states that a firm should invest in any project offering a rate of return that is higher than the:
opportunity cost of capital
In simple cases of capital rationing, the _________ can tell a firm which projects to accept.
profitability index (PI)
A project's IRR measures the _________ whereas the opportunity cost of capital is equal to the ____________.
profitability of a project; return offered by equivalent-risk investments in the capital market
The opportunity cost of capital is determined by the ______ of a project.
risk
The Internal Rate of Return (IRR) can best be defined as:
the discount rate at which the NPV equals zero
The opportunity cost of capital can best be described as:
the expected rate of return given up by investing in a project rather than in the capital market
When considering mutually exclusive projects, the project that adds most to shareholder wealth is the one with:
the highest NPV
The payback period for a project can best be defined as:
the length of time before you recover your initial investment
The discount rate used to value capital investments is often referred to as ____.
the opportunity cost of capital
True or false: IRR is essentially the same as the opportunity cost of capital.
False
The single variable of interest for the investment timing problem is
NPV
Which of the following is the capital investment decision criterion that will always lead management to make the value-maximizing choice?
NPV
When there is no real capital rationing the preferred valuation metric is
NPV, because it will favor large projects over small ones.
A project has an initial investment of $1.4 million and a present value of cash flows totaling $4 million. What is the project's net present value (NPV)?
NPV=initial investment + PV of cash flows= -$1.4 million + 4 million = $2.6 million
What is the NPV of a project with an initial investment of $95, a cash flow in one year of $107, and a discount rate of 6%? (Be sure to record the initial investment as a negative number.)
$5.94
Which two investment criterion methods are most used by firms?
- internal rate of return - net present value
Under which of the following situations should the IRR decision rule be avoided?
- selection of mutually exclusive projects - a project with multiple rates of return - project NPV does not decline smoothly as discount rate increases
Which of the following are problems that managers may encounter when deciding between mutually exclusive projects?
- the choice between short and long-lived equipment - when equipment should be replaced - the timing of investments
Which of the following is the correct definition of the Equivalent Annual Annuity (EAA)?
A stream of cash flows or payments that have the same present value as a project or investment's cash flows.
Project A has an initial investment of $10,000 and an NPV of $15,000. Project B has an initial investment of $100,000 and an NPV of $101,000. Based on the PI (Profitability Index), project _______ would be selected. Based on the NPV, project _______ would be accepted. Selecting project ______ will actually maximize shareholder value.
A; B; B
