Chapter 5 Net Present Value and Other Investment Rules

According to the basic IRR rule, we should ____ a project if the IRR is ____ than the discount rate.

• Accept; greater • Reject; less

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

• Net present value • Internal Rate of Return

What does value additivity mean for a firm?

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

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

9.70%

The internal rate of return is a function of ____.

A project's cash flow

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.

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

Discounted payback period

True or false: A firm evaluating two mutually exclusive projects can accept both projects.

False

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 value of a firm is simply the combined value of the firm's projects, divisions, and entities owned by the firm is due to the property called value

additivity

One of the weaknesses of the payback period is that the cutoff date is a(n) ______ standard.

arbitrary

Using ____ cash flows corrects the problems of scale in the profitability index.

incremental

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

less than

The payback method works well for companies with ______ cash.

limited

The discount rate is often referred to as an ______ cost.

opportunity

The ______ method is ideal for companies with limited funds that have a need for a quick turn-around of their capital.

payback

If a firm has a payback period of 3 years and a project has a payback period of 3.5 years, the project should be:

rejected

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

scale

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

• It allows lower level managers to make small decision effectively • The payback period method is ideal for minor projects • The payback period is easy to use

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 percent?

(80/1.12)+(20/1.12^2))/30=2.91

The PI rule for an independent project is to ______ the project if the PI is greater than 1.

accept

NPV ______ cash flows properly.

discounts

The discounted payback period ______ account for time value of money and the payback period ______ account for time value of money.

does; does not

Accept a project if its NPV is ______ zero.

greater than

For "normal" cash flows (the outflows occur before the inflows), the NPV is ______ if the discount rate is less than the IRR, and it is ______ if the discount rate is greater than the IRR.

positive;negative

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

risk

Arrange the steps involved in the discounted payback period in order starting with the first step.

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

What is the PI for a project with an initial cash outflow of $50 and a present value of all future cash flows of $150?

3

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

Additive

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

Discount

IRR refers to:

Internal Rate of Return

The most important alternative to NPV is the ______ method.

Internal rate of return

A project with a positive NPV should be

accepted

This capital budgeting method allows lower management to make smaller, everyday financial decisions easily is:

Payback method

The discounted payback period method requires ______ steps than the payback period method.

more

A dollar today is worth ______ a dollar in the future because it can be reinvested.

more than

According to Graham and Harvey's 1999 survey of 392 CFOs, which of the following capital budgeting techniques is least used.

profitability method

A firm evaluating two mutually exclusive projects can ___.

Accept one. Reject one of the projects Reject both projects

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

Be indifferent towards accepting a project if NPC is equal to zero Reject a project if NPV is less than zero Accept a project if the NPV is greater than zero

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

accepted

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

budgeting

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

initial investment

The PI rule for an independent project is to decline the project if the PI is _____ than 1.

less

In capital budgeting, the net ______ is the value of a project to the company.

present value

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

decision-making

When calculating NPV, the present value of the nth cash flow is found by dividing the nth cash flow by 1 plus the ______ rate raised to the nth power.

discount

Net present value is the ______ between the sum of the present value of all future cash flows and the ______ cost.

difference; initial

Which of the following allows management to know if a correct decision was made sooner?

payback method

With mutually exclusive projects, the profitability index suffers from the same problem that the IRR rule does in that it fails to consider ____.

the size or scale of projects

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

The three attributes of NPV are that it:

• Uses cash flows• Uses all the cash flows of a project• Discounts the cash flows properly

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 percent?

NPC=-$95(107/1.06)= 5.94

The discount rate assigned to a project reflects the ____.

Risk of the project Opportunity cost to the investor

When computing the IRR, alternatives to the guess and check method is to use which of the following:

spreadsheet software Financial calculator

The NPV _____ the initial investment while the profitability index _____ the initial investment from the present value of all future cash flows.

subtract;divide