Chapter 8 test questions

Which one of the following statements is correct?

If the internal rate of return equals the required return, the net present value will equal zero.

Which one of the following is most closely related to the net present value profile?

Internal rate of return

The profitability index reflects the value created per dollar:

invested.

The average accounting return:

measures profitability rather than cash flow.

The payback period is the length of time it takes an investment to generate sufficient cash flows to enable the project to:

recoup its initial cost.

The modified internal rate of return is specifically designed to address the problems associated with:

unconventional cash flows.

The net present value profile illustrates how the net present value of an investment is affected by which one of the following?

Discount rate

Net present value involves discounting an investment's:

future cash flows.

The Nifty Fifty is considering opening a new store at a start-up cost of $628,000. The initial investment will be depreciated straight-line to zero over the 15-year life of the project. What is the average accounting rate of return given the following net income projections? (chart)

16.35 percent

You are considering an equipment purchase costing $167,000. This equipment will be depreciated straight-line to zero over its three-year life. What is the average accounting return if this equipment produces the following net income?

AAR = [($15,600 + 14,200 + 13,500)/3]/[($167,000 + 0)/2] = .1729, or 17.29 percent

Delta Mu Delta is considering purchasing some new equipment costing $393,000. The equipment will be depreciated on a straight-line basis to a zero book value over the four-year life of the project. Projected net income for the four years is $16,900, $25,300, $27,700, and $18,400. What is the average accounting rate of return?

AAR = [($16,900 + 25,300 + 27,700 + 18,400)/4]/[($393,000 + 0)/2] = .1123, or 11.23 percent

Woodcrafters requires an average accounting return (AAR) of at least 17.5 percent on all fixed asset purchases. Currently, it is considering some new equipment costing $169,700. This equipment will have a four-year life over which time it will be depreciated on a straight-line basis to a zero book value. The annual net income from this equipment is estimated at $7,100, $13,300, $18,600, and $19,200 for the four years. Should this purchase occur based on the accounting rate of return? Why or why not?

AAR = [($7,100 + 13,300 + 18,600 + 19,200)/4]/[($169,700 + 0)/2] = .1715, or 17.15 percent Because the AAR is less than the required rate, the equipment should not be purchased.

Which one of the following methods of analysis ignores cash flows?

Average accounting return

Which one of the following is the primary advantage of payback analysis?

Ease of use

What is the net present value of the following cash flows if the relevant discount rate is 7 percent? (chart in question)

NPV = -$11,520 + $81 / 1.07 + $650 / 1.072 + $880 / 1.073 + $2,300 / 1.074 + $15,800 / 1.075 NPV = $2,861.62

You are making an investment of $110,000 and require a rate of return of14.6 percent. You expect to receive $48,000 in the first year, $52,500 in the second year, and $55,000 in the third year. There will be a cash outflow of $900 in the fourth year to close out the investment. What is the net present value of this investment?

NPV = -$110,000 + $48,000 / 1.146 + $52,500 / 1.1462 + $55,000 / 1.1463 + (-$900 / 1.1464) NPV = $7,881.55

Molly is considering a project with cash inflows of $811, $924, $638, and $510 over the next four years, respectively. The relevant discount rate is 11.2 percent. What is the net present value of this project if it the start-up cost is $2,700?c

NPV = -$2,700 + $811 / 1.112 + $924 / 1.1122 + $638 / 1.1123 + $510 / 1.1124 NPV = -$425.91

Professional Properties is considering remodeling the office building it leases to Heartland Insurance. The remodeling costs are estimated at $2.8 million. If the building is remodeled, Heartland Insurance has agreed to pay an additional $820,000 a year in rent for the next five years. The discount rate is 12.5 percent. What is the benefit of the remodeling project to Professional Properties?

NPV = -$2,800,000 + $820,000 ×{1 - [1 / (1 + .125)5]} / .125 NPV = $119,666.04

What is the net present value of a project that has an initial cost of $42,700 and produces cash inflows of $9,250 a year for 9 years if the discount rate is 14.65 percent?

NPV = -$42,700 + $9,250 ×{1 - [1 / (1 + .1465)9]} / .1465 NPV = $1,992.43

The Steel Factory is considering a project that will produce annual cash flows of $43,800, $40,200, $46,200, and $41,800 over the next four years, respectively. What is the internal rate of return if the initial cost of the project is $127,900?

NPV = 0 = -$127,900 + $43,800 / (1 + IRR) + $40,200 / (1 + IRR)2 + $46,200 / (1 + IRR)3 + $41,800 / (1 + IRR)4 IRR = 13.00 percent

Chasteen, Inc., is considering an investment with an initial cost of $145,000 that would be depreciated straight-line to a zero book value over the life of the project. The cash inflows generated by the project are estimated at $76,000 for the first two years and $30,000 for the following two years. What is the internal rate of return?

NPV = 0 = -$145,000 + $76,000 / (1 + IRR) + $76,000 / (1 + IRR)2 + $30,000 / (1 + IRR)3 +$30,000 / (1 + IRR)4 IRR = 21.29 percent

You are considering an investment for which you require a rate of return of 8.5 percent. The investment costs $67,400 and will produce cash inflows of $25,720 for three years. Should you accept this project based on its internal rate of return? Why or why not?

NPV = 0 = -$67,400 + $25,720 / (1 + IRR) + $25,720 / (1 + IRR)2 + $25,720 / (1 + IRR)3 IRR = 7.08 percent The project should be rejected because the IRR is less than the required rate.

The Black Horse is currently considering a project that will produce cash inflows of $11,000 a year for three years followed by $6,500 in Year 4. The cost of the project is $38,000. What is the profitability index if the discount rate is 9 percent?

PI = ($11,000 / 1.09 + $11,000 / 1.092 + $11,000 / 1.093 + $6,500 / 1.094) / $38,000 PI= .85

A firm is reviewing a project that has an initial cost of $67,000. The project will produce annual cash inflows, starting with Year 1, of $8,000, $13,400, $18,600, $24,100, and finally in Year 5, $37,900. What is the profitability index if the discount rate is 11 percent?

PI = ($8,000 / 1.11 + $13,400 / 1.112 + $18,600 / 1.113 + $24,100 / 1.114 + $37,900 / 1.115) / $67,000 PI = 1.05

The net present value of a project's cash inflows is $2,716 at a discount rate of 12 percent. The profitability index is 1.09 and the firm's tax rate is 34 percent. What is the initial cost of the project?

PI = 1.09 = $2,716 / Initial cost Initial cost = $2,491.74

China Importers would like to spend $215,000 to expand its warehouse. However, the company has a loan outstanding that must be repaid in 2.5 years and thus will need the $215,000 at that time. The warehouse expansion project is expected to increase the cash inflows by $60,000 in the first year, $140,000 in the second year, and $150,000 a year for the following 2 years. Should the firm expand at this time? Why or why not?

Payback = 2 + ($215,000 -60,000 -140,000)/$150,000 = 2.10 years Yes, the company should accept the expansion project because it pays back within the required 2.5 years.

A project has the following cash flows. What is the payback period? (chart)

Payback = 3 + ($14,500-2,200 -4,800- 6,500)/$7,500 =3.13years References

What is the payback period for a project with the following cash flows? (chart)

Payback = 3 + ($75,000 -15,000 -23,000 -35,000)/$25,000 = 3.08 years

Which one of the following indicates that a project is expected to create value for its owners?

Positive net present value

You were recently hired by a firm as a project analyst. The owner of the firm is unfamiliar with financial analysis and wants to know only what the expected dollar return is per dollar spent on a given project. Which financial method of analysis will provide the information that the owner requests?

Profitability index

Which one of the following indicates that an independent project is definitely acceptable?

Profitability index greater than 1.0

The net present value of each new project is zero.

The firm should increase in value each time it accepts a new project

An investment has conventional cash flows and a profitability index of 1.0. Given this, which one of the following must be true?

The net present value is equal to zero.

Which one of the following will occur when the internal rate of return equals the required return?

The profitability index will equal 1.0.

The payback method of analysis ignores which one of the following?

Time value of money

Which one of the following statements is correct? Assume cash flows are conventional.

When the internal rate of return is greater than the required return, the net present value is positive.

The net present value of an investment represents the difference between the investment's:

cost and its market value.

The net present value:

decreases as the required rate of return increases.

The internal rate of return is the:

discount rate that results in a zero net present value for the project.