Chapter 8
Which of the following situations can lead to IRR giving a different decision than NPV?
All of the above can lead to IRR giving a different decision than NPV.
Which of the following statements is FALSE?
An internal rate of return (IRR) will always exist for an investment opportunity.
Which of the following is true regarding the profitability index?
Attention must be taken when using it to make sure that all of the constrained resource is utilized.
Internal rate of return (IRR) can reliably be used to choose between mutually exclusive projects.
FALSE
Preference for cash today versus cash in the future in part determines net present value (NPV).
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.
FALSE
When different projects put different demands on a limited resource, then net present value (NPV) is always the best way to choose the best project.
FALSE
When using equivalent annual annuities to compare the costs of projects with different lives, you should not consider any changes in the expected replacement cost of equipment.
FALSE
According to Graham and Harveyʹs 2001 survey (Figure 8.2 in the text), the most popular decision rules for capital budgeting used by CFOs are ________.
IRR, NPV, Payback period
Which of the following statements is FALSE?
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 is NOT a limitation of the payback period rule?
It is difficult to calculate.
Which of the following is NOT a limitation of the payback rule?
It is difficult to calculate.
A security firm is offered $80,000 in one year for providing CCTV coverage of a property. The cost of providing this coverage to the security firm is $74,000, payable now, and the interest rate is 8.5%. Should the firm take the contract?
No, since net present value (NPV) is negative.
A convenience store owner is contemplating putting a large neon sign over his store. It would cost $50,000, but is expected to bring an additional $24,000 of profit to the store every year for five years. Would this project be worthwhile if evaluated using a payback period of two years or less and if the cost of capital is 10%?
No, since the value of the cash flows over the first two years are less than the initial investment.
If WiseGuy Inc. uses payback period rule to choose projects, which of the projects (Project A or Project B) will rank highest?
Project A
If WiseGuy Inc. uses IRR rule to choose projects, which of the projects (Project A or Project B) will rank highest?
Project B
Mary is in contract negotiations with a publishing house for her new novel. She has two options. She may be paid $100,000 up front, and receive royalties that are expected to total $26,000 at the end of each of the next five years. Alternatively, she can receive $200,000 up front and no royalties. Which of the following investment rules would indicate that she should take the former deal, given a discount rate of 8%? Rule I: The Net Present Value rule Rule II: The Payback Rule with a payback period of two years Rule III: The internal rate of return (IRR) Rule
Rule I only
Net present value (NPV) is the difference between the present value (PV) of the benefits and the present value (PV) of the costs of a project or investment.
TRUE
Net present value (NPV) is usefully supplemented by internal rate of return (IRR), since IRR gives a good indication of the sensitivity of any decision made to changes in the discount rate.
TRUE
The Net Present Value rule implies that we should compare a projectʹs net present value (NPV) to zero.
TRUE
The payback rule is based on the idea that an opportunity that pays back its initial investment quickly is a worthwhile opportunity.
TRUE
The profitability index can break down completely when dealing with multiple resource restraints.
TRUE
When an alternative decision rule disagrees with the net present value (NPV), the NPV should be followed.
TRUE
When comparing mutually exclusive projects which have different scales, you must know the dollar impact of each investment rather than percentage returns.
TRUE
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.
TRUE
You can evaluate alternative projects with different lives by calculating and comparing their equivalent annual annuity.
TRUE
Which of the following best describes the Net Present Value rule?
Take any investment opportunity where the net present value (NPV) is not negative; turn down any opportunity when it is negative.
Tanner is choosing between two investment options. He can invest $500 now and get (guaranteed) $550 in one year, or invest $500 now and get (guaranteed) $531.40 back later today. The risk-free rate is 3.5%. Which investment should Tanner prefer?
Tanner should be indifferent between the two investments, since both are equivalent to the same amount of cash today.
A lawn maintenance company compares two ride-on mowersthe Excelsior, which has an expected working-life of six years, and the Grassassinator, which has a working life of four years. After examining the equivalent annual annuities of each mower, the company decides to purchase the Excelsior. Which of the following, if true, would be most likely to make them change that decision?
The mower is only expected to be needed for three years.
Which of the following statements is FALSE?
The payback rule is reliable because it considers the time value of money and depends on the cost of capital.
Which of the following is NOT a valid method of modifying cash flows to produce a MIRR?
Turn multiple negative cash flows into a single negative cash flow by summing all negative cash flows over the projectʹs lifetime.
A lottery winner can take $6 million now or be paid $600,000 at the end of each of the next 16 years. The winner calculates the internal rate of return (IRR) of taking the money at the end of each year and, estimating that the discount rate across this period will be 4%, decides to take the money at the end of each year. Was her decision correct?
Yes, because it agrees with the Net Present Value rule.
Peter has a business opportunity that requires him to invest $10,000 today, and receive $12,000 in one year. He can either use $10,000 that he already has for this investment or borrow the money from his bank at an interest rate of 10%. However, the $10,000 he has right now is needed for urgent repairs to his home, repairs that will cost at least $15,000 if he delays them for a year. What is the best alternative for Peter out of the following choices?
Yes, since he can borrow the $10,000 from a bank, repair his home, invest $10,000 in the business opportunity, which, since it has a NPV > 0 will mean he will still come out ahead after repaying the loan.
The present value (PV) of an investment is ________.
he amount that an investment would yield if the benefit were realized today
A firm is considering several mutually exclusive investment opportunities. The best way to choose between them is which of the following?
net present value (NPV)
You are trying to decide between three mutually exclusive investment opportunities. The most appropriate tool for identifying the correct decision is ________.
net present value (NPV)
Which of the following decision rules is best defined as the amount of time it takes to pay back the initial investment?
payback period
Which of the following decision rules might best be used as a supplement to net present value (NPV) by a firm that favors liquidity?
payback period
Most corporations measure the value of a project in terms of which of the following?
present value (PV)
Assuming that your capital is constrained, which investment tool should you use to determine the correct investment decisions?
profitability Index
You are opening up a brand new retail strip mall. You presently have more potential retail outlets wanting to locate in your mall than you have space available. What is the most appropriate tool to use if you are trying to determine the optimal allocation of your retail space?
profitability index
Which of the following is a disadvantage of the Net Present Value rule?
relies on accurate estimate of the discount rate
When comparing two projects with different lives, why do you compute an annuity with an equivalent present value (PV) to the net present value (NPV)?
so that the projects can be compared on their cost or value created per year
