Unit 4 Chapter 5

Which of the following statements regarding the discounted payback period rule is true?

The discounted payback rule uses the time value of money concept.

The following are disadvantages of using the payback rule EXCEPT the rule:

is easy to calculate and use.

The internal rate of return is the discount rate that makes the PV of a project's cash inflows equal to zero.

False

What are some rules used by firms when making capital budgeting decisions?

- Payback period - IRR - NPV

What are some shortcomings of the IRR method

- Projects can have multiple IRRs. - IRR cannot distinguish between a borrowing project and a lending project - It is very cumbersome to evaluate mutually exclusive projects using the IRR method.

What are some disadvantages of using the payback rule

- ignores all cash flow after the cutoff date. - does not use the time value of money. - does not have the value additivity property

Which of the following methods of evaluating capital investment projects incorporates the time value of money concept? I) payback period; II) discounted payback period; III) net present value (NPV); IV) internal rate of return

2,3,4

The survey of CFOs indicates that the IRR method is used for evaluating investment projects by approximately:

75% of firms

The survey of CFOs indicates that the NPV method is always, or almost always, used for evaluating investment projects by approximately:

75% of firms

A project's "book value" represents, essentially, the market valuation of the project.

False

A project's internal rate of return depends on its level of risk.

False

The following are some of the shortcomings of the IRR method except:

IRR is conceptually easy to communicate

The benefit-cost ratio is defined as the ratio of:

present value of cash flows to initial investment

The payback period rule:

requires an arbitrary choice of a cut-off point.

The internal rate of return (IRR) method could also be called the:

discounted cash-flow (DCF) rate of return method.

If the sign of the cash flows for a project changes two times, then the project likely has:

two IRRs. SINCE THE IRR RULE BREAKS DOWN WHENEVER THE CASH FLOWS ARE NOT CONVENTIONAL, YOU SHOULD NEVER USE THE RULE IN THIS CASE. SO THIS QUESTION IS BEST PUT IN THE CATEGORY OF "INTERESTING TO KNOW" BUT DEFINITELY NOT CRITICAL TO KNOW.

One can use the profitability index most usefully for which situation?

when capital rationing exists

If an investment project ("normal" project with conventional cash flows) has an IRR equal to the cost of capital, the NPV for that project is:

zero

Accounting earnings from a firm's income statement, prepared according to generally accepted accounting principles (GAAP), are typically the best data source for calculating a project's NPV.

False

Decommissioning and clean-up costs for any project is always insignificant and should typically be ignored.

False

In the case of a loan project (borrowing), one should accept the project if the IRR is more than the cost of capital.

False

The discounted payback rule calculates the payback period and then discounts the payback period at the opportunity cost of capital.

False

The profitability index is always less than 1.0.

False

There can never be more than one value of the IRR for any sequence of cash flows.

False

How does modified internal rate of return (MIRR) differ from IRR?

MIRR reduces the number of sign changes in a cash-flow sequence.

The profitability index is the ratio of the:

NPV of cash flows to investment

Project X has the following cash flows: C0 = +2,000, C1 = -1,300,and C2 = -1,500. If the IRR of the project is 25% and if the cost of capital is 18%. Would you accept or reject this project?

Reject the project because this is a loan. (original investment is positive so its a loan) with an IRR greater than cost of capital is rejected.

Which of the following investment rules does NOT use the time value of money concept?

The payback period

Present values have the value additivity property.

True

Soft rationing may be used to control managerial behavior.

True

The IRR rule states that firms should accept any project offering an internal rate of return in excess of the cost of capital.

True

The benefit-cost ratio is equal to the profitability index plus one.

True

The denominator of the profitability index is the present value of the investment.

True

The discounted payback technique discounts cash flows at the opportunity cost of capital and then calculates the payback period.

True

The internal rate of return is the discount rate that makes the NPV of a project's cash flows equal to zero.

True

The payback rule ignores all cash flows after the cutoff date.

True

The profitability index of a positive NPV project is always positive.

True

Project X has the following cash flows: C0 = +2,000, C1 = -1,150, and C2 = -1,150. If the IRR of the project is 9.85% and if the cost of capital is 12%. Would you accept or reject this project?

You would accept this projectt. This loan (original investment is position) has an IRR that is lower than cost of capital, so you accept it.

Which investment analysis technique is used the least by CFOs?

book rate of return

The payback period rule accepts all projects for which the payback period is:

less than the cut-off value

The following rules are used by firms when making capital budgeting decisions EXCEPT:

p/e ratio

Which of the following investment rules may not use all possible cash flows in its calculations?

payback period

The net present value of a project depends upon the:

project's cash flows and opportunity cost of capital.

The main advantage of the payback rule is:

simple to use.

The IRR is defined as:

the discount rate that makes a project's NPV equal to zero.

Which of the following investment rules has the value additivity property?

the net present value method

A project will have only one internal rate of return if:

there is a one-sign change in the cash flows (conventional cash flows)