Chapter 8

When using equivalent annual annuities to compare the costs of projects with different lives, you should not consider any changes in the expected replacement cost of equipment. True or False.

FALSE

When different investment rules give conflicting answers, then decisions should be based on the Net Present Value rule, as it is the most reliable and accurate decision rule. True or False

TRUE

You can evaluate alternative projects with different lives by calculating and comparing their equivalent annual annuity. True or False.

TRUE

Which of the following best describes the Net Present Value rule?

Take any investment opportunity where the net present value (NPV) is not negative; turn down any opportunity when it is negative.

You are opening up a brand new retail strip mall. You presently have more potential retail outlets wanting to locate in your mall than you have space available. What is the most appropriate tool to use if you are trying to determine the optimal allocation of your retail space?

profitability index

Which of the following is a disadvantage of the Net Present Value rule?

relies on accurate estimate of the discount rate

A firm is considering several mutually exclusive investment opportunities. The best way to choose between them is which of the following? A) profitability index B) payback period C) net present value (NPV) D) internal rate of return (IRR)

net present value (NPV)

You are trying to decide between three mutually exclusive investment opportunities. The most appropriate tool for identifying the correct decision is _______

net present value (NPV)

Which of the following decision rules is best defined as the amount of time it takes to pay back the initial investment?

payback period

Which of the following decision rules might best be used as a supplement to net present value (NPV) by a firm that favors liquidity?

payback period

Most corporations measure the value of a project in terms of which of the following?

present value (PV)

When comparing two projects with different lives, why do you compute an annuity with an equivalent present value (PV) to the net present value (NPV)?

so that the projects can be compared on their cost or value created per year

The present value (PV) of an investment is _______

the amount that an investment would yield if the benefit were realized today

A farmer sows a certain crop. It costs $240,000 to buy the seed, prepare the ground, and sow the crop. In one yearʹs time it will cost $93,200 to harvest the crop. If the crop will be worth $350,000 , and the interest rate is 7%, what is the net present value (NPV) of this investment? A) $240,000 B) $87,103 C) $0 D) $567,103

$0

A firm has an opportunity to invest $95,000 today that will yield $109,250 in one year. If interest rates are 4%, what is the net present value (NPV) of this investment? A) $10,048 B) $11,053 C) $16,077 D) $14,250

$10,048

A car dealership offers a car for $14,000 , with up to one year to pay for the car. If the interest rate is 5%, what is the net present value (NPV) of this offer to buyers who elect not to pay for the car for one year? A) $667 B) $1333 C) $13,333 D) $14,000

$667

A delivery service is buying 600 tires for its fleet of vehicles . . .

-$574

A security company offers to provide CCTV coverage for . . .

-36,475

A company buys a color printer that will cost $16,000 to buy, and last 5 years. It is assumed that it will require servicing costing $500 each year. What is the equivalent annual annuity of this deal, given a cost of capital of 8%? A) -$3155 B) -$3606 C) -$4057 D) -$4507

-4507

A florist is buying a number of motorcycles to expand its delivery service. These will cost $78,000 but are expected to increase profits by $3000 per month over the next four years. What is the payback period in this case? A) 10.40 months B) 15.60 months C) 19.50 months D) 26.00 months

26 months

Martin is offered an investment where for $6000 today, he will receive $6180 in one year. He decides to borrow $6000 from the bank to make this investment. What is the maximum interest rate the bank needs to offer on the loan if Martin is at least to break even on this investment?

3%

The owner of a hair salon spends $1,000,000 to renovate its premises, estimating that this will increase her cash flow by $220,000 per year. She constructs the above graph, which shows the net present value (NPV) as a function of the discount rate. At what discount rate does her decision to renovate become vulnerable? (with a graph)

3.3 - the point at which the graph cuts the Discount Rate axis

An auto-parts company is deciding whether to sponsor a racing team for a cost of $1 million. The sponsorship would last for three years and is expected to increase cash flows by $570,000 per year. If the discount rate is 6.9%, what will be the change in the value of the company if it chooses to go ahead with the sponsorship? A) $498,597 B) $747,896 C) $797,756 D) $847,615

A) $498,597

A manufacturer of video games develops a new game over two years. This costs $830,000 per year with one payment made immediately and the other at the end of two years. When the game is released, it is expected to make $1.20 million per year for three years after that. What i the NPV of this decision if the cost of capital is 10%?

A) $950,349

An orcharder spends $110,000 to plant pomegranate bushes. It will take four years for the bushes to provide a usable crop. He estimates that every year for 20 years after that he will receive a crop worth $10,500 per year. If the discount rate is 9%, what is the net present value (NPV) of this investment? A) -$42,098 B) -$21,049 C) $8420 D) $12,629

A) -$42,098

Mary is in contract negotiations with a publishing house for her new novel. She has two options. She may be paid $100,000 up front, and receive royalties that are expected to total $26,000 at the end of each of the next five years. Alternatively, she can receive $200,000 up front and no royalties. Which of the following investment rules would indicate that she should take the former deal, given a discount rate of 8%? Rule I: The Net Present Value rule Rule II: The Payback Rule with a payback period of two years Rule III: The internal rate of return (IRR) Rule A) Rule I only B) Rule III only C) Rule II and III D) Rule I and II

A) Rule I only

A lottery winner can take $6 million now or be paid $600,000 at the end of each of the next 16 years. The winner calculates the internal rate of return (IRR) of taking the money at the end of each year and, estimating that the discount rate across this period will be 4%, decides to take the money at the end of each year. Was her decision correct? A) Yes, because it agrees with the Net Present Value rule. B) Yes, because it agrees with the payback rule. C) Yes, because it agrees with both the Net Present Value rule and the payback rule. D) Yes, because it disagrees with the Net Present Value rule.

A) Yes, because it agrees with the Net Present Value rule.

Which of the following is true regarding the profitability index?

Attention must be taken when using it to make sure that all of the constrained resource is utilized.

A consultancy calculates that it can supply crude oil assaying services to a small oil producer for $115,000 per year for five years. There are some upfront costs the consultancy will require the oil producer to absorb. What is the maximum that these upfront costs could be, if the equivalent annual annuity to the oil company is to be under $160,000 , given that the cost of capital is 9%? A) $45,000 B) $175,034 C) $201,289 D) $160,000

B) $175,034

The owner of a number of gas stations is considering installing coffee machines in his gas stations. It will cost $270,000 to install the coffee machines, and they are expected to boost cash flows by $120,536 per year for their five-year working life. What must the cost of capital be if this investment has a profitability index of 1? A) 1.89% B) 3.78% C) 7.55% D) 9.44%

B) 3.78%

Which of the following statements is FALSE? A) The payback investment rule is based on the notion that an opportunity that pay back its initial investments quickly is a good idea. B) An internal rate of return (IRR) will always exist for an investment opportunity. C) A net present value (NPV) will always exist for an investment opportunity. D) In general, there can be as many internal rates of return as the number of times the project's cash flows change sign over time.

B) An internal rate of return (IRR) will always exist for an investment opportunity.

A small department store in a mall has the opportunity to rent an additional 20,000 square feet of space for five years. It can divide up this space between the above new departments. Each department will require a different amount of space, and each department is expected to make a yearly profit as shown, for each of the next five years. The discount rate is 10%. Based on this information, what departments should be added? A) Pet, Fabrics, Hardware, and Shoe Repair B) Fabrics, Luggage, Hardware, Watches, and Shoe Repair C) Pets, Fabrics, Books, and Luggage D) Pet, Fabrics, Luggage, Hardware, and Shoe Repair

B) Fabrics, Luggage, Hardware, Watches, and Shoe Repair

The owner of a hair salon spends $1,000,000 to renovate its premises, estimating that this will increase her cash flow by $220,000 per year. She constructs the above graph, which shows the net present value (NPV) as a function of the discount rate. If her discount rate is 6%, should she accept the project? A) Yes, because the NPV is positive at that rate. B) No, because the NPV is negative at that rate. C) No, because the NPV is positive at that rate. D) Cannot be determined from the information given.

B) No, because the NPV is negative at that rate.

A lawn maintenance company compares two ride-on mowers—the Excelsior, which has an expected working-life of six years, and the Grassassinator, which has a working life of four years. After examining the equivalent annual annuities of each mower, the company decides to purchase the Excelsior. Which of the following, if true, would be most likely to make them change that decision? A) Fuel prices are expected to rise and raise the annual running costs of all mowers. B) The mower is only expected to be needed for three years. C) The prices of equivalent mowers are expected to grow in the future as lawnmower manufacturers consolidate. D) The number of customers requiring lawn-mowing services is expected to sharply increase in the near future.

B) The mower is only expected to be needed for three years.

Peter has a business opportunity that requires him to invest $10,000 today, and receive $12,000 in one year. He can either use $10,000 that he already has for this investment or borrow the money from his bank at an interest rate of 10%. However, the $10,000 he has right now is needed for urgent repairs to his home, repairs that will cost at least $15,000 if he delays them for a year. What is the best alternative for Peter out of the following choices? A) No, since the net present value (NPV) of the investment, should he take it, is less than the net present value (NPV) of the home repairs if he delays them for one year. B) Yes, since he can borrow the $10,000 from a bank, repair his home, invest $10,000 in the business opportunity, which, since it has a NPV > 0 will mean he will still come out ahead after repaying the loan. C) Yes, since the net present value (NPV) of the investment is greater than zero he can invest the $10,000 in the business opportunity, and then next year use this money plus the benefit from this money to make the necessary home repairs. D) Yes, since the net present value (NPV) of the investment, should he take it, is greater than the net present value (NPV) of the home repairs if he delays them for one year.

B) Yes, since he can borrow the $10,000 from a bank, repair his home, invest $10,000 in the business opportunity, which, since it has a NPV > 0 will mean he will still come out ahead after repaying the loan.

A company has identified the following investments as looking promising. Each requires an initial investment of $1.2 million. Which is the best investment? A) a perpetuity that generates a cash flow at the end of year 1 of $100,000, has a growth rate of 1.25%, and a cost of capital of 11.0% B) a perpetuity that generates a cash flow at the end of year 1 of $800,000, has a growth rate of 2.25%, and a cost of capital of 11.8% C) an investment that generates a cash flow of $400,000 at the end of each of the next five years, when the cost of capital is 6.1% D) an investment that generates a cash flow of $200,000 at the end of each of the next ten years, when the cost of capital is 6.1%

B) a perpetuity that generates a cash flow at the end of year 1 of $800,000, has a growth rate of 2.25%, and a cost of capital of 11.8%

An investor is considering a project that will generate $900,000 per year for four years. In addition to upfront costs at the completion of the project at the end of the fifth year there will be shut-down costs of $400,000. If the cost of capital is 4.4%, based on the MIRR, at what upfront costs does this project cease to be worthwhile? A)$2.62 million B)$2.91 million C)$3.21 million D)$3.50 million

B)$2.91 million

A local government awards a landscaping company a contract worth $1.5 million per year for five year . . . A) $5.69 million B) $6.00 million C) $6.32 million D) $6.63 million

D) $6.32 million

When different projects put different demands on a limited resource, then net present value (NPV) is always the best way to choose the best project. True or False

FALSE

A mining company plans to mine a beach for rutile. . . . A) -60.97% B) -78.39 C) -87.10% D) -95.81%

C) -87.10%

Two mutually exclusive investment opportunities require an initial investment of $7 million. Investment A pays $2.0 million per year in perpetuity, while investment B pays $1.4 million in the first year, with cash flows increasing by 4% per year after that. At what cost of capital would an investor regard both opportunities as being equivalent? A) 3% B) 7% C) 13% D) 15%

C) 13%

Jenkins Security has learned that a rival has offered to supply a parking garage with security for ten years for $45,000 up front and a further $15,000 per year. If Jenkins Security offers to provide security for eight years for an upfront cost of $60,000 and a separate yearly payment, by what maximum amount can this yearly payment be over $20,000, so that Jenkinsʹ offer matches the equivalent annual annuity of their rivalʹs offer? (Assume a cost of capital of 5%.) A) -$89 B) -$94 C) -$100 D) -$111

D) -$111

Which of the following situations can lead to IRR giving a different decision than NPV? A) delayed investment B) multiple IRRs C) differences in project scale D) All of the above can lead to IRR giving a different decision than NPV.

D) All of the above can lead to IRR giving a different decision than NPV.

A garage is comparing the cost of buying two different car hoists. Hoist A will cost . . . .

D) Hoist B, since it has a greater equivalent annual annuity.

Which of the following statements is false? A) In general, the difference between the cost of capital and the internal rate of return (IRR) is the max amt. of estimation error in the cost of capital estimate that can exist without altering the original decision. B) The internal rate of return can provide info on how sensitive your analysis is to errors in the estimate of your cost of capital. C) If you are unsure of your cost of capital estimate, it is important to determine how sensitive your analysis is to errors in this estimate. D) If the cost of capital estimate is more than the internal rate of return (IRR), the net present value (NPV) will be positive.

D) If the cost of capital estimate is more than the internal rate of return (IRR), the net present value (NPV) will be positive.

A janitorial services firm is considering two brands of industrial vacuum cleaners to equip their staff. Option A will cost $1,500, require servicing of $200 per year, and it will last five years. Option B will cost $1,000, require servicing of $100 per year, and it will last three years. If the cost of capital is 8%, which is the better option, given that the firm has an ongoing requirement for vacuum cleaners? A) Option A, since it has a lower equivalent annual annuity. B) Option B, since it has a lower equivalent annual annuity. C) Option A, since it has a greater equivalent annual annuity. D) Option B, since it has a greater equivalent annual annuity.

D) Option B, since it has a greater equivalent annual annuity.

A company that creates education products is planning to create a suite of books to help customers prepare for high-stakes tests for entry into college and grad school. They have 33 in-house writers to create these books. Due to the expertise needed in creating this content it will not be possible to hire temporary writers within the planned time-frame. Which projects should be undertaken? A) Prep for the College Entry Test and Prep for the Law School Entry Test B) Prep for the College Entry Test and Prep for the Grad School Entry Test C) Prep for the Dental School Entry Test, Prep for the Grad School Entry Test, and Prep for the Medical School Entry Test D) Prep for the Grad School Entry Test, Prep for the Law School Entry Test, and Prep for the Medical School Entry Test

D) Prep for the Grad School Entry Test, Prep for the Law School Entry Test, and Prep for the Medical School Entry Test

Internal Rate of Return (IRR) can reliably be used to choose between mutually exclusive projects. True or False.

FALSE

Preference for cash today versus cash in the future in part determines net present value. True or False.

FALSE

The internal rate of return (IRR) rule will agree with the Net Present Value rule even when positive cash flows precede negative cash flows. True or False.

FALSE

According to Graham and Harvey's 2001 survey, the most popular decision rules for capital budgeting used by CFOs are ________.

IRR, NPV, Payback period

Which of the following is NOT a limitation of the payback period rule?

It is difficult to calculate

Which of the following is NOT a limitation of the payback rule?

It is difficult to calculate.

A print shop has contracted to print a number of jobs within 24 hours. Any jobs not completely printed within this time will result in a penalty, as shown in the table above. However too many jobs have been accepted, and not all can be printed. Which jobs should be printed in the next 24 hours?

Job C, Job B and Job E

A convenience store owner is contemplating putting a large neon sign over his store. It would cost $50,000, but is expected to bring an additional $24,000 of profit to the store every year for five years. Would this project be worthwhile if evaluated using a payback period of two years or less and if the cost of capital is 10%?

No, since the value of the cash flows over the first two years are less than the initial investment.

When comparing mutually exclusive projects which have different scales, you must know the dollar impact of each investment rather than percentage returns. True or False.

TRUE

If WiseGuy Inc. uses payback period rule to choose projects, which of the projects (Project A or Project B) will rank highest?

Project A

If WiseGuy Inc. uses IRR rule to choose projects, which of the projects (Project A or Project B) will rank highest?

Project B

Net present value (NPV) is the difference between the present value (PV) of the benefits and the present value f the costs of a project or investment. True or False.

TRUE

Net present value (NPV) is usefully supplemented by internal rate of return (IRR), since IRR gives a good indication of the sensitivity of any decision made to changes in the discount rate. True or False.

TRUE

The Net Present Value rule implies that we should compare a project's net present value (NPV) to zero. True or False

TRUE

The payback rule is based on the idea that an opportunity that pays back its initial investment quickly is a worthwhile opportunity. True or False.

TRUE

The profitability index can break down completely when dealing with multiple resource restraints. True or False.

TRUE

When an alternative decision rule disagrees with the net present value (NPV), the NPV should be followed. True or False.

TRUE

Tanner is choosing between two investment options. He can invest $500 now and get (guaranteed) $550 in one year, or invest $500 now and get (guaranteed) $531.40 back later today. The risk-free rate is 3.5%. Which investment should Tanner prefer?

Tanner should be indifferent between the two investments, since both are equivalent to the same amount of cash today.

Which of the following is NOT a valid method of modifying cash flows to produce a MIRR?

Turn multiple negative cash flows into a single negative cash flow by summing all negative cash flows over the project's lifetime.

The owner of a hair salon spends $1,000,000 to renovate its premises, estimating that this will increase her cash flow by $220,00 per year. She constructs the above graph, which shows the net present value as a function of the discount rate. At what dollar value should the NPV profile cross the vertical axis? A) $780,000 B) $1,000,000 C) Cannot be determined because inadequate information is given. D) The vertical axis crossing point cannot be calculated since the cash inflows are in perpetuity.

The vertical axis crossing point cannot be calculated since the cash inflows are in perpetuity.

A bakery is deciding whether to buy an extra van to help deliver its products. The van will cost $28,000, but is expected to increase profits by $6,500 per year over the five years of its working life. Which of the following is the correct net present value profile for this purchase. (4 graphs to chose from)

graph that crosses between 5 and 6