Module 10

One advantage of the payback method for evaluating potential investments is that it provides some information about a project's liquidity and risk. A. True B. False

A. True

The owner of a hair salon spends $1,000,000 to renovate its premises, believing that this will increase her future cash flow. She constructs the graph below, which shows the net present value (NPV) as a function of the discount rate. At what discount rate does her decision to renovate become untenable? A. 3.0% B. 3.3% C. 4.0% D. 4.8%

B. 3.3%

All else constant, an increase in the cost of capital will result in a decrease in a project's IRR. A. True B. False

B. 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. A. True B. False

B. False

Which of the following is NOT a limitation of the payback rule? A. It does not consider the time value of money. B. It cannot be used for projects with non-normal cash flows. C. It is difficult to calculate. D. It does not consider cash fl ows occurring after the payback period

C. It is difficult to calculate.

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. A. A project's regular IRR is found by discounting the cash inflows at the WACC to find the present value (PV), then compounding this PV to find the IRR. B. If a project's IRR is greater than the WACC, then its NPV must be negative. C. To find a project's IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project's costs. D. To find a project's IRR, we must find a discount rate that is equal to the WACC.

C. To find a project's IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project's costs.

Which of the following decision rules is best defined as the amount of time it takes to pay back the initial investment? A. internal rate of return (IRR) B. net present value (NPV) C. payback period D. None of the above

C. payback period

Which of the following statements is CORRECT? A. Projects with "normal" cash flows can have only one IRR. B. Projects with "normal" cash flows can have two or more real IRRs. C. Projects with "normal" cash flows must have two changes in the sign of the cash flows, e.g., from negative to positive to negative. If there are more sign changes, then the cash flow stream is "non-normal." D. The "multiple IRR problem" can arise if a project's cash flows are "normal." E. Projects with "non-normal" cash flows are never encountered in the real world.

A. Projects with "normal" cash flows can have only one IRR.

The NPV method's assumption that cash inflows are reinvested at the cost of capital is more reasonable than the IRR's assumption that cash flows are reinvested at the IRR. A. True B. False

A. True

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

A. True

Under certain conditions, a project may have more than one IRR. One such condition is when, in addition to the initial investment at time = 0, a negative cash flow (or cost) occurs at the end of the project's life. A. True B. False

A. True

A decrease in the firm's discount rate (r, or WACC) will increase NPV of a project with normal cash flows, which could change the accept/reject decision for any independent project under the NPV method. However, since such a change would have no impact on the pr oject's IRR, the accept/reject decision of the independent project under the IRR method does not depend on the cost of capital. A. True B. False

B. False

Internal rate of return (IRR) can reliably be used to choose between mutually exclusive projects. A. True B. False

B. False

Which of the following statements is FALSE? A. The payback period is a useful indicator of the risk and liquidity of a project. B. The payback rule is reliable because it considers the time value of money and depends on the cost of capital. C. For most investment opportunities expenses occur initially and cash is received later. D. Fifty percent of firms surveyed reported using the payback rule for making decisions.

B. The payback rule is reliable because it considers the time value of money and depends on the cost of capital.

Which of the following statements is FALSE? A. The payback investment rule is based on the notion that an opportunity that pays back its initial investments quickly is a good idea. B. There is always one internal rate of return (IRR) 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 (IRRs) as the number of times the project's cash flows change sign over time.

B. There is always one internal rate of return (IRR) for an investment opportunity.

A firm is considering several mutually exclusive investment opportunities. The best way to choose between them is which of the following? A. payback period B. net present value (NPV) C. internal rate of return (IRR) D. None of the above

B. net present value (NPV)

Which of the following situations can lead to IRR giving a different decision than NPV for mutually exclusive projects? A. Differences in timing of cash flows. 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

Which of the following statements is CORRECT? A. For a project to have more than one IRR, then both IRRs must be greater than the WACC. B. If two projects are mutually exclusive, then they are likely to have multiple IRRs. C. If a project is independent, then it cannot have multiple IRRs. D. Multiple IRRs can only occur if the signs of the cash flows change more than once. E. If a project has two IRRs, then the smaller one is the one that is most relevant, and it should be accepted and relied upon.

D. Multiple IRRs can only occur if the signs of the cash flows change more than once.

The cash flows for three projects are shown below. The cost of capital is 7.5%. If an investor decided to take projects with a payback period two years or less, which of these projects would he take? A. Investment A B. Investment B C. Investment C D. None of these investments

D. None of these investments

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. A. If Project A has a higher IRR than Project B, then Project A must have the lower NPV. B. If Project A has a higher IRR than Project B, then Project A must also have a higher NPV. C. The IRR calculation implicitly assumes that all cash flows are reinvested at the WACC. D. The IRR calculation implicitly assumes that cash flows are withdrawn from the business rather than being reinvested in the business. E. If a project has normal cash flows and its IRR exceeds its WACC, then the project's NPV must be positive.

E. If a project has normal cash flows and its IRR exceeds its WACC, then the project's NPV must be positive.

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. A. True B. False

A. True

Assuming that their NPVs based on the firm's cost of capital are equal, the NPV of a project whose cash flows accrue relatively rapidly will be more sensitive to changes in the discount rate than the NPV of a project whose cash flows come in later in its life. A. True B. False

B. False

Suppose there are two mutually exclusive projects - Project X and Project Y - with normal cash flows. If the IRR of Project X is greater than the IRR of Project Y, we can conclude that the firm should select X rather than Y if X has NPV > 0. A. True B. False

B. False

The IRR of normal Project X is greater than the IRR of normal Project Y, and both IRRs are greater than zero. Also, the NPV of X is greater than the NPV of Y at the cost of capital of 10%. If the two projects are mutually exclusive, Project X will be selected over Project Y at all discount rates (at which NPV of X is positive). A. True B. False

B. False

Which of the following is NOT a limitation of the payback period rule? A. It does not account for the time value of money. B. It is difficult to calculate. C. It ignores cash flows after payback. D. It does not account for changes in the discount rate.

B. It is difficult to calculate.

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. A. The longer a project's payback period, the more desirable the project is normally considered to be by this criterion. B. One drawback of the payback criterion for evaluating projects is that this method does not properly account for the time value of money. C. If a project's payback is positive, then the project should be rejected because it must have a negative NPV. D. The payback period can never lead to the acceptance of a negative NPV project.. E. If a company uses the same payback requirement to evaluate all projects, say it requires a payback of 4 years or less, then the company will tend to reject projects with relatively short lives and accept long-lived projects, and this will cause its risk to increase over time.

B. One drawback of the payback criterion for evaluating projects is that this method does not properly account for the time value of money.

Which of the following statements is FALSE for normal projects (i.e., projects with normal cash flows)? A. In general, the difference between the cost of capital and the internal rate of return (IRR) is the maximum amount of estimation error in the cost of capital estimate that can exist without altering the original decision. B. The internal rate of return (IRR) can provide information 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.

Which of the following statements is CORRECT? A. The internal rate of return method (IRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. B. The payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. C. The project's IRR increases as the WACC declines. D. The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. E. The project's regular payback increases as the WACC declines.

D. The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.