CH 8: Net Present Value and Other Investment Criteria

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

- non-conventional cash flows - mutually exclusive projects

In general, NPV is ___.

- positive for discount rates below the IRR - negative for discount rates above the IRR - equal to zero when the discount rate equals the IRR

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 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 ______

0

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 based on book values, not market values.

False

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

False

_______ 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

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

The Combination Approach The Reinvestment Approach The Discounting Approach

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

True

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

- NPV - MIRR

The internal rate of return is a function of ____.

a project's cash flows

The Profitability Index is also called the __________ ratio.

cost-benefit

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

initial cost

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

payback

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

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

False

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

False

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

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

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

initial investment

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

According to Graham and Harvey's 1999 survey of 392 CFOs (published in 2001), which of the following two capital budgeting methods are widely used by firms in the US and Canada?

net present value internal rate of return

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

payback period; NPV

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

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

- A financing rate for discounting - Discounting all cash outflows to time 0 - A reinvestment rate for compounding - Compounding cash inflows to the end of the project

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

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

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?

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

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.

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

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

accepted

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

net present value

One of the weaknesses of the payback period is that the cutoff date is a(n) ______ standard.

arbitrary

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

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 investment.

False

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

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: 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

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

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 period that is less than or equal to a particular cutoff date.

accepts