chapter 10 exam 3

what is the profitability index used for?

To show projects that will produce the best return given the amount that must be invested initially to rank potential investments by taking into account both the time value of money and the initial cost of the project

what do firms operate under most often? a) capital rationing b) unlimited funds

a) capital rationing

which is the correct statement? a) fixed asset outlays are capital expenditures but not all capital expenditures are classified as fixed assets b) all capital expenditures are classified as fixed assets but fixed asset outlays are not capital expenditures

a) fixed asset outlays are capital expenditures but not all capital expenditures are classified as fixed assets

when is the profitability index used ?

for a project that has an initial cash outflow and followed by cash inflows

a firm should undertake an investment only if the present value of cash flow is _______ ______ the cost of making the investment in first place

greater than

if the NPV is greater than $0, we will earn a return _____ _____ cost of capital

greater than (inflows exceed outflows on present value basis)

projects are acceptable if the PI ______

greater than 1

when companies evaluate investment opportunities using the PI, they invest in project if the index is

greater than 1

do you want a higher or lower IRR

higher

what do NPV and IRR reach same conclusions about

if they are acceptable

what do projects with higher returns do

increase firm's value

what type of project are those with cash flows unrelated one another; accepting or rejecting on project doesn't change the desirability of other projects?

independent projects

what is the discount rate that makes NPV of an investment opportunity equal to $0

internal rate of return (irr)

if the project generates a positive EVA

it's worth undertaking

the ranking approach helps managers to identify the combination of projects that create what?

most value for investors

what type of projects are those that have essentially the same function and therefore compete with one another; accepting one project eliminates other projects from further consideration?

mutually exclusive projects

what is the method used by most large companies to evaluate investment projects

net present value

small and medium sized firms often use what approach to evaluate investments?

payback period

the time it takes an investment to generate cash inflows sufficient to recoup the initial outlay required to make the investment

payback period

what are the three most widely used capital budgeting techniques:

payback period, net present value, & internal rate of return (IRR)

what is the payback period's main weakness?

payback threshold is subjective & no solid connection to value creation

what are examples of investment projects that take a long time to pay off but create enormous value

pharmaceutical projects

PI greater than 1.0 corresponds to a ________ net present value

positive

the IRR is the discount rate that equates the present value of a project's inflows to the

present value of its cash outflows

what is a variation of the NPV rule

profitability index

the EVA method determines whether a project earns a

pure economic profit

when the profit is higher than expected given the competitive rate of return

pure economic profit

if there are more investment ideas that pass the accept-reject threshold than a company can undertake, then managers take the extra step to

rank or prioritize investment projects

NPV and PI don't always

rank projects in same order

there is no guarantee that the NPV and IRR will what

rank projects in same order

if the IRR starts with an outflow, and the IRR is less than the cost of capital

reject

if NPV is less than 0

reject the project

what step aims to improve the accuracy of cash flow estimates and increase value of investments on an ongoing basis

step 5) follow up

what step is often ignored

step 5) follow up

what steps consume the majority of time and effort?

steps 2) review and analysis and 3) decision making

a project has a large NPV when it's cash flows are discounted at 10%, this implies what

the IRR must be greater than 10%

what does a PI greater than 1 imply

the present value of cash inflows is greater than the (absolute value of the) initial cash outflow

the ranking of capital expenditure projects on the basis of some predetermined measure, such as _____

the rate of return

the best techniques for evaluating projects are based on

the timing and risk of the cash flows they generate

what does the discounted payback method make adjustments for

time value of money

by measuring how quickly the firm recovers its initial investment, the payback period gives us some consideration to what

timing of cash flows

why would a firm apply capital budgeting methods ?

to estimate whether investment is likely to increase or decrease shareholders value

when a firm has sufficient internal funds/can raise external funds to pay for all attractive investments

unlimited funds

what do firms use when they apply the same discount rate to every investment project

use the WACC

if the payback period is less than the max acceptable payback period

we accept the project

if the payback period is greater than the max acceptable payback period

we reject the project

the NPV and PI will always come to the same conclusions regarding whether a particular investment is

worth doing or not

What is the second thing the payback period ignore?

fail to fully account for time value of money

what are the two categories most investments fall into

1) independent projects 2) mutually exclusive projects

when undertaking large investments, what two questions do firms have to answer?

1) is the investment a good one/does it create value for shareholder 2) where will the money to pay for the investment come from?

what are the five steps of the capital budgeting process?

1) proposal generation 2) review and analysis 3) decision making 4) implementation 5) follow-up

What does EVA stand for?

Economic Value Added

what is also the annual compound rate of return that a company earns on investment projects, assuming the project inflows and outflows occur as projected

IRR

What does NOPAT represent?

Net operating profit after tax

Which of the following is true of the NPV profile? a. It charts the net present value of a project as function of the cost of capital. b. It is used for evaluating and comparing independent projects when conflicting ranking exist. c. It is a graph that illustrates a project's IRR against various values of NPV. d. It shows an inverse relationship between a project's IRR and NPV.

a. It charts the net present value of a project as function of the cost of capital.

if the IRR starts with an outflow, and the IRR is greater than the cost of capital

accept

if the NPV is greater than $0

accept the project

what is the evaluation of capital expenditure proposals to determine whether they meet the firm's minimum acceptance criterion?

accept-reject decision

As an analyst for your firm, you have found an IRR of 21.55% for the following project cash flows. If your firm has a 13% cost of capital, what is your recommendation for this project? Year Project 0 $350,000 1 -$225,000 2 -$150,000 3 -$85,000 4 -$35,000 a. The project should be accepted because the IRR is greater than the cost of capital. b. The project should be rejected because the IRR is greater than the cost of capital. c. The project should be accepted because the IRR is less than the cost of capital. d. The project should be rejected because the IRR is less than the cost of capita

b. The project should be rejected because the IRR is greater than the cost of capital.

During the COVID-19 pandemic, many firms have been reluctant to undertake new projects due to the economic uncertainty. If a firm were to allot a fixed budget for capital expenditures, such that projects would compete for funding, this would be an example of ____________? a. independent projects b. capital rationing c. mutually exclusive projects d. unlimited funding

b. capital rationing

A capital budgeting technique that can be computed by subtracting a project's initial investment from the present value of its cash inflows discounted at a rate equal to a firm's cost of capital is called ________. a. internal rate of return b. net present value c. profitability index d. economic value added

b. net present value

A firm finances its activities with both debt (that costs 8%) and equity (that costs 14%). The firm can borrow additional funds at 8% if it so desires. A financial analyst at this firm argues that the firm should undertake any investment that earns a return of at least 8% because such investments will enable the firm to pay debtholders what they require, and any earnings above 8% will go to stockholders. If a firm decides to make investments based on this logic it will ________. a. decline to make investments that it should undertake b. undertake investments that it should decline c. make only those investment decisions that increase shareholder value d. have exorbitant interest expenses

b. undertake investments that it should decline

because the NPV is > 0, the IRR must

be higher still

what type of investments do firms use capital budgeting to analyze?

building new factories, buying equipment, launching new products and conducting r & d

Which of the following is not a disadvantage of the payback period method of capital budgeting evaluation? a. It ignores the cash flow beyond the payback period. b. It may reject (accept) positive (negative) NPV projects. c. It is straightforward and simple to compute. d. It does not estimate the change in firm value.

c. It is straightforward and simple to compute.

Which of the following is a reason the IRR and NPV methods may provide different rankings for investment projects? a. The projects have conventional cash flows. b. The projects have very different risk characteristics. c. The projects have very different investment requirements. d. The projects have nonconventional cash flows.

c. The projects have very different investment requirements.

The return that must be earned on a project in order to leave the firm's value unchanged is ________. a. the internal rate of return b. the interest rate c. the cost of capital d. the compound rate of return

c. the cost of capital

what is the process of evaluating and selecting investments that are worth more than they cost and create wealth for investors?

capital budgeting

what is an outlay of funds that produces benefits over several years?

capital expenditure

when a firm has a fixed investment budget and that numerous projects compete for those dollars?

capital rationing

What is the third thing the payback period ignore?

cash flows beyond payback period

an EVA is a pure economic loss (negative) if it did not earn a return greater than the

cost of capital

in theory, a firm should undertake any investment that it expects will _____

create wealth for investors

what does a higher NPV mean

creates more value for investors

__________ projects have the same function; the acceptance of one _________ the others from consideration. a. Capital; eliminates b. Independent; does not eliminate c. Replacement; eliminates d. Mutually exclusive; eliminates

d. Mutually exclusive; eliminates

for NPV, cash flows from riskier investments are

discounted at higher rates

what is one way to improve payback period approach

discounted payback period

what is the time required for an investment to generate discounted cash inflows sufficient to recoup the initial cost

discounted payback period

what is the minimum return that a project must earn to satisfy the firm's investors

discounted rate in NPV calculations

what gives managers a tool to measure an investment's performance on a year-by-year basis as well as over its life

economic value added

A firm is evaluating an investment proposal, which has an initial investment of $8,000 and discounted cash flows valued at $6,000. The net present value of this investment is: · $6,000 · $2,000 · -$2,000

· -$2,000 --A firm is evaluating an investment proposal, which has an initial investment of $8,000 and discounted cash flows valued at $6,000. The net present value of this investment is -$2,000. § The NPV is defined as the present value of the project's cash flows minus the initial investment. In this case: § NPV = $6,000 - $8,000 = -$2,000.

A firm must choose from the 5 capital budgeting proposals outlined below. The firm is subject to capital rationing and has a capital budget of $500,000. The firm's cost of capital is 12%. Project Initial Investment IRR NPV 1 $100,000 17% $50,000 2 $200,000 15% $10,000 3 $125,000 14% $30,000 4 $100,000 11% -$2,500 5 $75,000 19% $25,000 Using the net present value approach to ranking projects, which projects should the firm accept? · 1,2 and 5 · 1,2,3 and 5 · 1,2 and 3

· 1,2,3 and 5

When resources are limited you should select the projects with the: · Highest NPV · Lowest NPV · Highest payback period

· Highest NPV

_____ are projects where the acceptance of one project automatically means we are rejecting other options · Independent projects · Replacement projects · Mutually exclusive projects

· Mutually exclusive projects

To evaluate differences in project scale, a financial manager should always use ___________ as the primary capital budgeting evaluation tool. · IRR · MIRR · NPV

· NPV

Which of the following decision techniques provides the clearest link to the goal of maximizing shareholder wealth? · Payback Period · IRR · NPV

· NPV

Software Design Inc. is considering a number of capital budgeting projects. However, the company is currently constrained by the number of programmers that it employs. The company has 20 programmers on its staff and will not be able to hire any new programmers in the near future. Which of the following methods should the company use to choose which projects to accept? · Rank the projects based on IRR and select the highest IRRs. · Rank the projects based on profitability index (PI) and select the highest PIs. · Rank the projects based on payback period and select the shortest paybacks.

· Rank the projects based on profitability index (PI) and select the highest PIs.

An NPV profile is __________. · a chart showing a project's NPV at different points in time · a graph of a project's NPV over a range of different discount rates · an estimate of a project's IRR using the trial-and-error approach

· a graph of a project's NPV over a range of different discount rates

A conventional cash flow pattern associated with capital investment projects consists of an initial outflow followed by: · a series of inflows · inflows followed by more outflows · a series of outflows

· a series of inflows

MIRR is used when: · projects have unequal lives · cash flows of a project change sign · there is capital rationing

· cash flows of a project change sign

Capital budgeting is the process of: · making a cash budget for the firm. · preparing a statement of cash inflows and outflows. · evaluating a firm's investment choices.

· evaluating a firm's investment choices.

Unlike the IRR criteria, the NPV approach assumes an interest rate equal to the: · project's internal rate of return · firm's cost of capital · market rate of interest

· firm's cost of capital

One weakness of the payback period is that it: · uses an inappropriate discount rate · places higher weights on cash flows occurring later. · ignores cash flows that occur after the end of the payback period

· ignores cash flows that occur after the end of the payback period

Projects that do not compete with one another so that the acceptance of one project will have no bearing on the acceptance of other projects being considered by the firm are known as: · mutually exclusive projects · replacement projects · independent projects

· independent projects

The IRR can lead to incorrect project rankings because projects with much higher NPVs may also have: · higher required returns · longer project lives · shorter project lives

· longer project lives --A particular project could have a very high IRR and only last one year. Therefore, a project with a slightly lower IRR that lasts several years may be preferred over the higher IRR. The NPV will correctly rank these projects if you rank them from the highest NPV to the lowest NPV.

The first step in the capital budgeting process is: · proposal generation · analyzing cash flows · identifying cash flows

· proposal generation

A firm that is earning profits over and above what should be considered normal for that line of business is earning a(n) __________. · accounting profit · supernormal profit · pure economic profit

· pure economic profit

The minimum return that must be earned on a project in order to leave the firm's value unchanged is: · the fed funds rate · the prime rate · the discount rate

· the discount rate --The firm selects a required rate of return that it must earn on any capital budgeting projects and then uses this rate as the discount rate to compute the present value of the project's cash flows. All projects must earn a minimum return equivalent to this discount rate.

The profitability index is a ratio of: · profit to cost of an asset · the present value of cash inflows to initial cash outflow · operating profits to fixed and intangible assets

· the present value of cash inflows to initial cash outflow

Capital rationing is the process of: · determining the present value of the firm's investment choices · using limited cash to select among investments available · making a cash budget for the firm

· using limited cash to select among investments available