Finance 341 Quiz 3

The internal rate of return is the discount rate at which the NPV of the project is zero

True

The internal rate of return will give you the same investment decision as NPV if the initial cash flow is negative followed by all positive cash flows, and the investment decision does not affect the decision to accept or reject another investment.

True

A friend comes to you and says, "Microsoft is worth $115 billion and General Motors is worth $42.4 billion. Yet, Microsoft only earns $2.25 billion per year while GM earns $4.73 billion per year. How can a company that earns about half as much of GM be worth almost 3 times as much as it?!" What do you tell your friend? "Get a life." is not a good answer.

A company's value can come from two sources. One is current earnings, and the other is growth. If the stock market is willing to value Microsoft highly despite its low current earnings, it must simply be that market participants expect strong growth in the future--much higher than the growth they expect from GM.

Which of the following is NOT an advantage of the valuation multiple method as compared to the discounted free cash flow method? a. calculations are simple and easy to communicate b. results are based upon actual stock prices of real firms c. does not rely on estimates of future cash flows d. calculations are based upon widely available information e. takes into account important differences between different firms

E

For an investment, the IRR decision rule states that if the benchmark rate exceeds IRR, accept the project.

False

IRR is generally preferred to NPV in making correct capital budgeting acceptance decisions.

False

NPV can normally be directly observed in the marketplace.

False

NPV should never be used if the project under consideration has nonconventional cash flows.

False

Stocks are easier to value than bonds because bonds have more uncertain cash flows. For stock valuation, the method of multiples has a more solid economic foundation than discounting cash

False

The NPV rule is not as conceptually legitimate as is the payback rule.

False

The internal rate of return is the best tool we have for deciding in which projects to invest. The internal rate of return is just as good as NPV for deciding in which projects to invest, but no better.

False

The main weakness of the NPV decision criterion is that it ignores distant cash flows.

False

The payback decision criterion is preferred to IRR because payback measures value created while IRR does not.

False

Investors will pay somewhat less for each dollar of earnings if those earnings are expected to grow.

False Answer: D. The opposite is true, investors will pay higher multiples if they expect higher growth.

The internal rate of return is compared to the hurdle rate: the IRR rule says to always accept the project if the IRR is greater than the hurdle rate.

False d is not exactly right because when the project looks like borrowing instead of investing, the IRR rule is the opposite of what is stated.

Which of the following investment rules might not use all possible cash flows in its calculations? I. Internal Rate of Return II. Payback Period III. Net Present Value (NPV) IV. Discounted Payback period a. I only b. I & II only c. II & III only d. I & IV only e. I & III only f. II only g. II & IV only h. III & IV only j. I, II, and IV only k. I, II, & III only

G Answer: IRR and NPV require that we use all CFs, while both payback rules ignore all CFs beyond the arbitrary payback benchmark.

Which of the following statements is true? a. The method of multiples has a more solid economic foundation than discounting cash flows. b. Stocks are easier to value than bonds because the latter have more uncertain cash flows. c. Conceptually, investors value stock by forecasting the expected dividends and price change in the stock, and adjusting for risk by discounting the CFs using a risk-adjusted required return. d. In the firm's capital structure, preferred shares have priority over bonds. e. The best way to value preferred stock is to take the present value of its dividends, typically assuming a dividend growth rate approximately equal to the firm's sales growth rate.

C

An investor estimates the value of a firm that sells software by examining the cash flows of similar firms. Which of the following is assumed to be the same for these firms? a. payout rates b. annual growth rates c. profit margins d. all of the above

D

Which of the following statements is (or are) true? I. The payback decision criterion is preferred to IRR because payback measures value created while IRR does not. II. The main weakness of the NPV decision criterion is that it ignores distant cash flows. III. The IRR is just as good as NPV for deciding in which projects to invest, but no better. IV. For an investment, the IRR decision rule states that if the IRR exceeds the benchmark rate, accept the project. a. I only b. II only c. III only d. IV only e. I & II only f. I & III only g. I, II & III only h. I & IV only j. II & III only k. I, II & IV only m. II & IV only n. III & IV only o. II, III & IV only p. I, III & IV only q. none of these

D Answer: IV is correct here, because for an investment, the IRR rule states exactly that. However, for a borrowing, we would have to reverse the rule.

Which of the following statements are true? The internal rate of return (IRR): I. is useful for maximizing value for shareholders—it triumphs where NPV falls short. II. is the discount rate at which the NPV of the project is zero. III. should be compared to a benchmark rate that reflects the risk of the project being considered. IV. will give you the same investment decision as NPV if the initial cash flow is negative followed by all positive cash flows, and the investment decision does not affect the decision to accept or reject another investment. a. I only b. II only c. III only d. IV only e. I & II only f. I & III only g. I, II & III only h. I & IV only j. II & III only k. I, II & IV only m. II & IV only n. III & IV only o. II, III & IV only p. I, III & IV only q. none of these

O

Even two firms in the same industry selling the same types of products, while similar in many respects, are likely to be of different size or scale. In the method of comparable trades, we estimate the value of a firm based on the value of other, comparable firms or investments that we expect will generate very similar cash flows in the future. The most common valuation multiple is the price-earnings ratio.

True

If the financial manager relies on NPV in making capital budgeting decisions, she acts in the shareholders' best interests.

True

In some instances, the IRR rule will be equivalent to the NPV rule for deciding in which projects to invest.

True

In the firm's capital structure, preferred shares have priority over common shares. Conceptually, investors value stock by forecasting the expected dividends and price change in the stock, and adjusting for risk by discounting the CFs using a risk-adjusted required return.

True