Ch. 8 Concepts

_____ is a measure of how much value is created or added by undertaking an investment.

Net Present Value

Which of the following is a disadvantage of the payback period rule?

Requires an arbitrary cutoff point

What is the primary concern of the payback period rule?

How long it takes to recover the initial investment

Which of the following is a disadvantage of the Profitability Index?

It cannot rank mutually exclusive projects.

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

a target average accounting return

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

accept

The profitability index is calculated by dividing the PV of the _____ cash inflows by the initial investment.

future

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

independent

According to the basic IRR rule, we should:

reject a project if the IRR is less than the required return

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

required return

True or False: According to Graham and Harvey's 1999 survey of 392 CFOs (published in 2001), the internal rate of return and the NPV are the two most popular capital budgeting methods used by firms in the US and Canada.

True

True or false: A project with non-conventional cash flows will produce two or more IRRs.

True

Which of the following are reasons why IRR continues to be used in practice?

1.) It is easier to communicate information about a proposal with an IRR 2.) Businesspeople prefer to talk about rates of return. 3.) The IRR of a proposal can be calculated without knowing the appropriate discount rate.

True or false: When calculating NPV, the present value of the (nth) cash flow is found by dividing the (nth) cash flow by 1 plus the discount rate raised to the (nth) power.

True

The spreadsheet function for calculating net present value is:

=NPV(rate,CF1, ..., CFn) + CF0

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

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

True or false: An advantage of the AAR is that it is base on book values, not market values.

False

True or false: A disadvantage of the AAR is that it does not take into account the time value of money.

True

True or false: The measure of average accounting profit is in the numerator of the average accounting return (AAR) formula.

True

The internal rate of return is a function of ______.

a project's cash flows

The payback period can lead to foolish decisions if it is used too literally because:

it ignores cash flows after the cutoff date

The discounted cash flow valuation shows that higher cash flows earlier in a project's life are _____ valuable than higher cash flows later on.

more

If a firm is evaluating two possible projects, both of which require the use of the same production facilities, and taking one project means that we cannot take the other, these projects would be considered ___.

mutually exclusive

In capital budgeting, _____ determines the dollar value of a project to the company.

net present value

The _____ method evaluates a project by determining the time needed to recoup the initial investment.

payback

The _____ is best suited for decisions on relatively small, minor projects while _____ is more appropriate for large complex projects.

payback period NPV

True or false: The IRR is easy to use because you only need to know the appropriate discount rate.

False

True or false: The discounted cash flow (DCF) valuation estimates future value as the difference between the market price and the cost of the investment.

False

True or false: The payback period takes into consideration the time value of money.

False

True or false: There is only one way to calculate the modified IRR.

False

True or false: The profitability index rule for an independent project states that, if a project has a positive NPV, then the present value of the future cash flows must be smaller than the initial ivestment.

False *If a project has a positive NPV, then the present value of the future cash flows must be LARGER than the initial investment.

True or false: The PI always results in the correct decision in comparisons of mutually exclusive investments.

False *The PI may lead to incorrect decisions in comparisons of mutually exclusive investments.

True or false: 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 *Whenever subsequent cash flows are both negative & positive, multiple internal rates of return may occur.

A project should be ___ if its NPV is greater than zero.

accepted

The present value of the future cash inflows are divided by the _____ to calculate the profitability index.

initial investment

The basic NPV investment rule is:

1.) ACCEPT a project if the NPV is GREATER THAN ZERO 2.) If the NPV is = to zero, acceptance or rejection of the project is a matter of INDIFFERENCE. 3.) REJECT a project if its NPV is LESS THAN ZERO.

Which of the following present problems when using the IRR method?

1.) Mutually exclusive projects 2.) Non-conventional cash flows

Which of the following are weaknesses of the payback period?

1.) The cutoff date is arbitrary 2.) Time value of money principles are ignored 3.) Cash flows received after the payback period are ignored

Specifying variables in the Excel NPV function differs from the manner in which they are entered in a financial calculator in which of the following ways?

1.) The range of cash flows specified in Excel begins with Cashflow 1, not Cashflow 0. 2.) The discount rate in Excel is entered as a decimal, or as a percentage with a percent sign. 3.) With the Excel NPV function, Cashflow 0 must be handled outside the NPV function 4.) The Excel NPV function is actually a PV function

True or false: The profitability index (PI) is calculated by dividing the present value of an investment's future cash flows by its future cost.

False *The profitability index (PI) is calculated by dividing the present value of an investment's future cash flows by its initial cost.

]Based on the average accounting return rule, a project is _____ if its average accounting return exceeds a target average accounting return.

acceptable

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

accepts

The Average Accounting Return is defined as:

average net income/average book value

When calculating NPV, the present value of the (nth) cash flow is found by dividing the (nth) cash flow by 1 plus _____ rate raised to the (nth) power.

the discount

The IRR is the discount rate that makes NPV equal to _____.

zero

The multiple rates of return problem is the possibility that more than one discount rate may make the net present value of an investment equal to _____.

zero

The Combination MIRR method is used by the Excel MIRR function and uses which of the following?

1.) A reinvestment rate for compounding 2.) Discounting all cash OUTFLOWS to 0 3.) Compounding cash INFLOWS to the end of the project 4.) A financing rate for discounting

Which of the following are methods of calculating the MIRR of a project?

1.) The Combination Approach 2.) The Discounting Approach 3.) The Reinvestment Approach

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

Internal rate of return (IRR) must be compared to the _____ in order to determine the acceptability of a project.

required return

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

1.) The payback period method is ideal for minor projects 2.) It allows lower level managers to make small decisions effectively 3.) The payback period method is easy to use