Financial Policies MIDTERM Ch 5

What does value additivity mean for a firm?

- The value of a firm is simply the combined value of a firm's projects, divisions, and entities owned by the firm - The NPV values of individual projects can be added together

Which of the following are true for a project with a negative initial cash flow followed by positive cash flows?

- accept if npv is greater than 0 - reject if irr is less than market rate of financing

The discounted payback has which of these weaknesses?

- arbitrary cut-off date - exclusion of some cash flows - loss of Simplicity as compared to the payback method

Which of the following is the best tool for ranking projects in the presence of capital rationing? PI or NPV

PI; ranking by NPV does not take into account the initial cost of the project, so sometimes ranks wrong when there is capital rationing

True or false: The crossover rate is the rate at which the npv of two projects are equal

TRUE

True or False: The MIRR method eliminate multiple IRR problems and it is an alternative to the NPV method.

True

True or false: Two challenges with the irr approach When comparing two mutually exclusive projects are scale and cash flow timing

True

The property of value ______ implies that the contribution of any project to a firm's value is simply the NPV of the project.

additivity

The payback period method allows upper management to evaluate the _______ abilities of lower management.

decision-making

IRR must be compared to the ___________ rate in order to determine the acceptability of a project.

discount

An _______ project does not rely on the acceptance or rejection of another project.

independent

The net present value of a project's cash flows is divided by the ________ to calculate the profitability index.

initial investment

A project with a cash outflow followed by three cash inflows will always have _________ internal rate of return.

one

The _________ method is best suited for decisions on small projects while the _________ method is most appropriate for large, complex projects.

payback; NPV

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

$5.94

Which of the following are weaknesses of the payback method?

- Cash flows received after the payback are ignored - time value of money principles are ignored - the cutoff date is arbitrary

What are the steps involved in the discounted payback period in order starting with the first step?

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

A project with a cash inflow of $200 followed by a cash outflow of -$250 1 year later we'll have an IRR of _____ percent. (25, 30, -20, or 20)

25 Explanation: 0 = +200 - $250/1 + IRR IRR = $250/200 - 1 = 25%

NPV ________ cash flows properly. a. discounts b. compounds

a. discounts

For a project with a positive initial cash flow followed by negative cash flows we should _______.

accept if the IRR is less than R

Accept a project if its NPV is _______ zero.

greater than

Higher cash flows earlier in a project's life are _______valuable than cash flows later on.

more

In capital budgeting the net _________ is the value of a project to the company

present value

The discount rate is determined by the ________ of a project.

risk

When evaluating mutually exclusive projects the profitability index has a problem with ________.

scale

Where are is the discount rate that makes the npv of a project equal to ______.

zero

A small project has cash flows of -$10 and $45, and a large project has cash flows of -$30 and $70. What is the incremental NPV at a discount rate of 10%?

$2.73

In general, NPV is ______.

- Negative for discount rates above the irr - positive for discount rates below the irr - equal to zero when the discount rate equals the irr

Two mutually exclusive projects can be correctly evaluated by _________.

- comparing the NPVs of the two projects - examining the NPV of the incremental cash flows - comparing the incremental irr to the discount rate

The discount rate assigned to a project reflects the _________.

- opportunity cost to the investor - risk of the project

Which of the following is true about projects with a negative cash flow followed by positive cash flow and then another negative?

- the npv decision rule is accept if npv is greater than 0 - npv can be used to make the correct accept/reject decision

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

-The payback period method is easy to use - it allows lower-level managers to make small decisions effectively - the payback period method is ideal for minor projects *** the payback period DOES NOT adjust for the discount rate***

What is the PI for a project with an initial cash outflow of $30 and subsequent cash inflows of $80 in year 1 and $20 in year 2 if the discount rate is 12%?

= 2.91 CF 0 = -30, CF 1 = 80, CF 2 = 20 ; r = 12% PV = 80/1.12 + 20/1.12^2 = 87.37 PI = 87.37/30 = 2.91

The spreadsheet function for calculating Net Present Value is:

=NPV()

True or false the scale of a project is never a concern when using irr.

False

You must know the discount rate to compute _______, while the discount rate is necessary to apply ________. (IRR or NPV)

NPV, IRR

The Incremental irr is used to account for the problem of __________ when evaluating project cash flows. a. scale b. risk c. uncertainty d. financial loss

a. scale

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

about 9.71%; use trial and error until both sides equal zero when plugging in IRR

The PI rule for an independent project is to _________ the project if the PI is greater than 1. (delay, accept, or reject)

accept

Jimbo Bobcat has a book deal. He will receive $50,000 in advance to write a book about his life. It will take two years to write. In order to write it, he'll have to quit a second job, where he earns $26,000 per year, so his cash flow for each of those two years is -$26,000. What is the IRR decision rule for this investment if his opportunity cost of capital is 8%?

accept if IRR <8%, reject otherwise; because initial CF is positive and subsequent CFs are negative

The payback period rule ______ a project if it has a payback period that is less than or equal to a particular cut off date. (accepts or rejects)

accepts

According to the basic IRR rule, we should ______ a project if the IRR is ______ than the discount rate. a. reject; greater b. accept; greater c. reject; less d. accept; less

b. accept; greater c. reject; less

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

budgeting

Which capital budgeting decision method finds the present value of each cash flow before calculating a payback period?

discounted payback period

The movie industry frowned upon NPV analysis because their cash flows are _______ to predict (hard or easy)

hard

The problems with scale in the profitability index can be corrected by using ________ analysis.

incremental

A dollar received one year from today has ______ value than a dollar received today.

less

A project with an initial cash outflow followed by a cash inflow and then a cash outflow_________.

may have multiple rates of return

When cash flows are conventional NPV is _________ if the discount rate is above the IRR (positive, negative, or zero).

negative

The ________ method is ideal for companies with limited funds that need a quick turnover of their capital.

payback

A firm evaluating two mutually exclusive projects can _______________.

-reject both projects -accept one of the projects - reject of the projects

According to the basic investment rule for NPV, a firm should ____________.

1. accept a project if the NPV is greater than zero 2. be indifferent towards accepting a project if NPV is equal to zero 3. reject a project if NPV is less than zero

The most important alternative to npv is the _______ method

IRR

According to Graham and Harvey's 1999 survey of 392 CFO's, which of the following two Capital budgeting methods are most used by firms in the U.S. And Canada?

IRR and NPV

The dollar difference in value between mutually exclusive projects can be found by calculating the ________ of the incremental cash flows.

NPV

True or false: Some projects, such as mines, have cash outflows followed by cash inflows, which are then followed by cash outflows, giving a project multiple rates of return.

True

True or false: A project with an initial cash outflow followed by a cash inflow has an NPV that is negatively related to the discount rate.

True; NPV will decrease as discount rate increases

The decision rule for a project for which the first cash flow is an inflow and subsequent cash flows are negative states that we should _________ the project when the irr is ________ than the discount rate

reject; greater accept; less