Smartbook 9

Which of the following projects is acceptable if the average accounting return is required to be at least 20%

Book Store: Average income: $140,000 Average book value: $600,000 Restaurant: Average income: $450,000 Average book value: $2,180,000

The discounted payback period has which of these weaknesses?

Exclusion of some cash flows Loss of simplicity as compared to payback method Arbitrary cutoff date

T/F - The MIRR function eliminates multiple IRRs and should replace NPV

False

The basic NPV investment rule is:

If the NPV is equal to zero, acceptance or rejection of the project is a matter of indifference. Accept a project if the NPV is greater than zero Reject a project if its NPV is less than zero

The three attributes of NPV are that it:

Uses all the cash flows of a project Discounts the cash flows properly Uses cash flows

What are the advantages of the payback period method for management?

it allows lower level managers to make small decisions effectively the payback period method is easy to use the payback period method is ideal for short projects

By ignoring time value, the payback period rule may accept projects with a ____ (positive/negative) NPV

negative

Arrange the steps involved in the discounted payback period in order starting with the first step

1. Discount the cash flows using the discount rate 2. Add the discounted cash flows 3. Accept if the discounted payback period is less than some pre-specified number of years

According to the average accounting return rule, a project is acceptable if its average accounting return exceeds:

A target average accounting return

What is the NPV of a project with an initial investment of $95, cash flow in one year of $107, and a discount rate of 6%

NPV=-$95+(107/1.06) $5.94

This capital budgeting method allows longer management to make smaller, everyday financial decisions effectively

Payback method

In which of the following scenarios would IRR always recommend the wrong decision?

Starting cash flow: 1000 Ending cash flow: -2000

T/F - IRR approach may lead to incorrect decisions in comparison of two mutually exclusive projects

True

Which of the following are advantages of AAR?

easy to compute information always available

The profitability index is calculated by dividing the PV of the ___ cash flows by the initial investment

future

The amount of time needed for the cash flows from an investment to pay for its initial cost is the

payback period

For a project with conventional cash flows, the NPV is ___ if the required return is less than the IRR, and it is ___ if the required return is greater than the IRR

positive negative

T/F - Some projects, such as mines, have cash outflows followed by cash inflows and cash outflows again, giving the project multiple internal rates of return

True

T/F - The crossover rate is the rate at which the NPVs of two projects are equal

True

Project Alpha's NPV profile crosses the vertical axis at $230,000. Project Beta's NPV profile crosses the vertical axis at $150,000. If Projects Alpha and Beta have conventional cash flows, are mutually exclusive and the NPV profiles cross at 15% (where the NPVs are positive), which of the projects has a higher internal rate of return?

Beta The 2 projects have a crossover point above the horizontal axis, and Alpha crosses the vertical axis above beta. Because the cash flows are conventional, their NPV profiles cross only once, so alpha must have a steeper NPV profile, but beta must have a higher IRR.

The payback period can lead to incorrect decisions if it is used too literally because it ____

ignores cash flows after the cutoff date

Saxon company is considering a project that will generate net income of $50,000 in Year 1, $75,000 in Year 2, and $90,000 in Year 3. The cost of the project is $700,000, and this cost will be depreciated to zero in three years of the investment. What is their average accounting return?

1. avg net income= 71,666.67 2. avg book value= 700,000/2=350,000 3. 20.48%

A(n) ___ project does not rely on the acceptance or rejection of another project

independent

The present value of all cash flows (after the initial investment) is divided by the ___ to calculate the profitability index

initial investment

The most important alternative to NPV is the ___ method

internal rate of return

IRR continues to be very popular in practice, partly because:

it gives a rate of return rather than a dollar value

When cash flows are conventional, NPV is ____ if the discount rate is above the IRR

negative

In capital budgeting, the net ___ determines the value of a project to the company

present value

If the IRR is greater than the ___ ___, we should accept the project

required return

The payback period rule ___ a project if it has a payback period that is less than or equal to a particular cutoff date

suggests accepting

The point at which the NPV profile crosses the vertical axis is the:

sum of the cash flows of the project

Capital Corp is considering a project whose internal rate of return is 14%. If Capital's required return is 14%, the project's NPV is:

zero

Which of the following are mutually exclusive investments?

two different choices for the assembly lines that will make the same product a restaurant or gas station on the same piece of land

The IRR is the discount rate that makes the NPV of a project equal to ___

zero

What is the IRR for a project with an initial investment of $250 and subsequent cash inflows of $100 per year for 3 years?

9.70%

How do the timing and the size of cash flows affect the payback method? Assume the project does payback within the project's lifetime.

An increase in the size of the first cash inflow will decrease the payback period, all else held constant

T/F - Investing more money in a project will always lead to greater profits

False

If a project has multiple internal rates of return, which of the following methods should be used?

NPV MIRR

According to Graham and Harvey's 1999 survey of 392 CFOs, which of the following two capital budgeting methods are most used by firms in the United States?

Net Present Value IRR (Internal Rate of Return)

The PI rule for an independent project is to ___ the project if the PI is greater than 1

accept

Capital ___ is the decision-making process for accepting and rejecting projects

budgeting

The IRR rule can lead to bad decisions when ___ or ___

cash flows are not conventional projects are mutually exclusive

NPV ___ cash flows properly

discounts