Ch 8 Smartbook

______ is a measure of how much value is created or added by undertaking an investment.

Net present value

The payback period can lead to foolish decisions if it is used too literally because:

it ignores cash flows after the cutoff date.

The spreadsheet function for calculating net present value is

=NPV(rate,CF1, ..., CFn) + CF0

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

MIRR NPV

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

budgeting

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 IRR is the discount rate that makes NPV equal to

0

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

initial cost

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

initial investment

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

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

net present value

True or false: A disadvantage of the AAR is that it does not take into account the time value of money.

True

The profitability index is also called the ______ ratio.

cost-benefit.

True or false: An advantage of the AAR is that it is based on book values, not market values.

false A disadvantage of the AAR is that it is based on book values, not market values.

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

Which of the following is a disadvantage of the payback period rule? adjusts for uncertainty of later cash flows requires an arbitrary cutoff point biased toward liquidity easy to understand

requires an arbitrary cutoff point

Which of the following are methods of calculating the MIRR of a project? the combination approach the present value approach the reinvestment approach the discounting approach

the combination approach the reinvestment approach the discounting approach

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

The internal rate of return is a function of

a project's cash flows

According to the average accounting return rule, a project is acceptable if its average accounting return exceeds:

a target average accounting return.

The average accounting return is defined as:

average net income/average book value

Capital budgeting is probably the most important of the three key areas of concern to the financial manager because

it defines the business of the firm

If the IRR is greater than the ______, we should accept the project.

required return

Which of the following are weaknesses of the payback method? The cutoff date is arbitrary. Cash flows received after the payback period are ignored. Time value of money principles is ignored. All cash flows are included in the payback period.

The cutoff date is arbitrary. Cash flows received after the payback period are ignored. Time value of money principles is ignored.

Internal rate of return (IRR) must be compared to the ______ in order to determine the acceptability of a project.

Required Return.

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 basic NPV investment rule is:

-accept a project if the NPV is greater than zero -reject a project if its NPV is less than zero -if the NPV is equal to zero, acceptance or rejection of the project is a matter of indifference

The combination MIRR method is used by the Excel MIRR function and uses which of the following? discounting all cash outflows to time 0 discounting ALL cash inflows to time 0 compounding cash inflows to the end of the project a reinvestment rate for compounding compounding ALL cash flows to the end of the project a financing rate for discounting a single discount rate for both discounting and compounding

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

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

False One drawback of the payback period rule is that it does not take into consideration the time value of money.

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

False The PI may lead to incorrect decisions in comparisons of mutually exclusive investments.

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

False There are various ways to correctly calculate the modified IRR.

What is the primary concern of the payback period rule?

How long it takes to recover the initial investment

Which of the following are reasons why IRR continues to be used in practice? The IRR of a proposal can be calculated without knowing the appropriate discount rate. It is easier to communicate information about a proposal with an IRR. Businesspeople prefer to talk about rates of return. The IRR allows the correct ranking of projects.

The IRR of a proposal can be calculated without knowing the appropriate discount rate. It is easier to communicate information about a proposal with an IRR. Business people 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. There are no significant differences between variable entry in Excel and in a financial calculator.

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.

True or false: A project with nonconventional cash flows will produce two or more IRRs.

True

True or false: The measure of average accounting profit is in the numerator of the average accounting return (AAR) formula.

True

The profitability index (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

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

accepted

The payback period rule ______ a project if it has a payback period that is less than or equal to a particular cutoff date.

accepts

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

Which of the following present problems when using the IRR method? a high discount rate nonconventional cash flows mutually exclusive projects larger cash flows later in the project

nonconventional cash flows mutually exclusive projects

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

payback

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

According to the basic IRR rule, we should:

reject a project if the IRR is less than the required return

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: The discounted cash flow (DCF) valuation estimates future value as the difference between the market price and the cost of the investment.

False The discounted (DCF) valuation estimates the NPV as the difference between the present value of the future cash flows and the cost of the investment.

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

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 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 larger than the initial investment.

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

False You need the discount rate to calculate the NPV, but it is not required for the IRR calculation.

A(n) ______ project does not rely on the acceptance or rejection of another project

independent

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 United States and Canada? internal rate of return payback method profitability index accounting rate of return net present value

internal rate of return net present value

Which of the following is a disadvantage of the profitability index? It is useful when capital is rationed. It is easy to understand. It is closely related to NPV. It cannot rank mutually exclusive projects.

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 United States and Canada.

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