Chapter 8 - Corporate Finance

Which of the following are methods of calculating the MIRR of a project? The Present Value Approach The Discounting Approach The Reinvestment Approach The Combination Approach

- The Reinvestment Approach - The Discounting Approach - The Combination Approach

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? Year 1-4: 58000, Years 6-10: 52000, Years 11-15: 44000

AAR = {[($58,000 ×5) + ($52,000 ×5) + ($44,000 ×5)]/15}/[($628,000 + 0)/2] = .1635, or 16.35 percent

Which one of the following is the primary advantage of payback analysis? Incorporation of the time value of money concept Ease of use Research and development bias Arbitrary cutoff point Long-term bias

Ease of use

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

MIRR, NPV

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

Payback

Which one of the following methods of analysis has the greatest bias toward short-term projects? Net present value Internal rate of return Average accounting return Profitability index Payback

Payback

A project has the following cash flows. What is the payback period? Year 0: $-14,500, Year 1: 2,200, Year 2: 4,800, Year 3: 6,500, Year 4: 7,500

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

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

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:Whenever subsequent cash flows are both negative and positive, multiple internal rates of return may occur.

Which one of the following statements is correct? Assume cash flows are conventional. *If the IRR exceeds the required return, the profitability index will be less than 1.0. *The profitability index will be greater than 1.0 when the net present value is negative. *When the internal rate of return is greater than the required return, the net present value is positive. *Projects with conventional cash flows have multiple internal rates of return. *If two projects are mutually exclusive, you should select the project with the shortest payback period.

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

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.

If a project with conventional cash flows has a profitability index of 1.0, the project will:

have an internal rate of return that equals the required return.

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

independent

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

it ignores cash flows after the cutoff date

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

The IRR is the discount rate that makes NPV equal to ______.

zero

In general, NPV is ____.

-Equal to zero when the discount rate equals the IRR -Negative for Discount Rates above the IRR -Positive for Discount Rates below the IRR

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.

Which of the following present problems when using the IRR method?

-mutually exclusive projects -non-conventional cash flows

The basic NPV investment rule is:

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

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

Net Present Value

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 project has expected cash inflows, starting with Year 1, of $900, $1,200, $1,500, and finally in Year 4, $2,000. The profitability index is 1.11 and the discount rate is 12 percent. What is the initial cost of the project?

PI = 1.11 = ($900 / 1.12 + $1,200 / 1.12^2 + $1,500 / 1.12^3 + $2,000 / 1.12^4) / Initial cost Initial cost = $3,692.71

Which of the following is a disadvantage of the payback period rule?

Requires an arbitrary cutoff point

Today, Sweet Snacks is investing $491,000 in a new oven. As a result, the company expects its cash flows to increase by $64,000 a year for the next two years and by $98,000 a year for the following three years. How long must the firm wait until it recovers all of its initial investment?

The project never pays back because the total cash inflow is only $422,000.

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

accept

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

arbitrary

The Average Accounting Return is defined as:

average net income/average book value

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

net present value

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 US and Canada?

net present value internal rate of return

The __________ is best suited for decisions on relatively small, minor projects while ______ is more appropriate for large complex projects.

payback period; NPV

According to the basic IRR rule, we should:

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

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

required return

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

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

true

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 ____.

zero

The spreadsheet function for calculating net present value is ______.

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

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

False, this is a disadvantage

The internal rate of return is a function of ___

a project's cash flows

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

accepted

The Profitability Index is also called the __________ ratio.

cost-benefit

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

false

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

required return

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

true

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

True or false: A project with non-conventional cash flows will produce two or more IRRs.

true

The Combination MIRR method is used by the Excel MIRR function and uses which of the following?

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

Which of the following is a disadvantage of the Profitability Index?

It cannot rank mutually exclusive projects.

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 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 PI always results in the correct decision in comparisons of mutually exclusive investments.

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

The profitability index is calculated by dividing the PV of the _________ cash inflows by the initial investment.

future

One of the flaws of the payback period method is that cash flows after the cutoff date are ___.

not considered in the analysis

The Tool Box needs to purchase a new machine costing $1.46 million. Management is estimating the machine will generate cash inflows of $223,000 the first year and $600,000 for the following three years. If management requires a minimum 12 percent rate of return, should the firm purchase this particular machine based on its IRR? Why or why not?

Yes, because the IRR is 12.74 percent NPV = 0 = -$1,460,000 + $223,000 / (1 + IRR) + $600,000 / (1 + IRR)2 + $600,000 / (1 + IRR)3 + $600,000 / (1 + IRR)4 IRR = 12.74 percent The project should be accepted because the IRR is greater than the required rate.

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.

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.

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

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

An investment has an initial cost of $462,000 and will generate the net income amounts shown below. This investment will be depreciated straight-line to zero over the four-year life of the project. Should this project be accepted based on the average accounting rate of return if the required rate is 14.75 percent? Why or why not? Year 1: 27000, Year 2: 24800, Year 3: 37500, Year 4: 45000

AAR = [($27,000 + 24,800 + 37,500 + 45,000)/4]/[($462,000 + 0)/2] = .1453, or 14.53 percent Because the AAR is less than the required rate, the project should be rejected.

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 Reason: 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.

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

Empire Industries is considering adding a new product to its lineup. This product is expected to generate sales for four years after which time the product will be discontinued. What is the project's net present value at a required rate of return of 14.8 percent? Year 0: -62,000, Year 1: $16,500,Year 2: $23,800, Year 3: $27,100, Year 4: $23,300

NPV = -$62,000 + $16,500 / 1.148 + $23,800 / 1.1482 + $27,100 / 1.1483 + $23,300 / 1.1484 NPV = $1,758.71

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

Joe and Rich are both considering investing in a project that costs $25,500 and is expected to produce cash inflows of $15,800 in Year 1 and $15,300 in Year 2. Joe has a required return of 8.5 percent but Rich demands a return of 12.5 percent. Who, if either, should accept this project?

NPVJoe = - $25,500 + $15,800 / 1.085 + $15,300 / 1.085^2 NPVJoe = $2,058.88 NPVRich = -$25,500 + $15,800 / 1.125 + $15,300 / 1.125^2 NPVRich = $633.33Both Joe and Rich should accept the project as both NPVs are positive.

Mary has just been asked to analyze an investment to determine if it is acceptable. Unfortunately, she is not being given sufficient time to analyze the project using various methods. She must select one method of analysis and provide an answer based solely on that method. Which method do you suggest she use in this situation?

Net present value

Which one of the following indicators offers the best assurance that a project will produce value for its owners? PI equal to zero Negative rate of return Positive AAR Positive IRR Positive NPV

Positive NPV

You are considering the following two mutually exclusive projects. The required return on each project is 14 percent. Which project should you accept and what is the best reason for that decision? Year 0, Project A: -24000, Project B: -21000: Year 1, Project A: 9500, Project B: 6500, Year 2, Project A: 16200, Project B: 9800, Year 3, Project A: 8700, Project B: 15200

Project A; because it has the higher net present value NPVA = -$24,000 + $9,500 / 1.14 + $16,200 / 1.14^2 + $8,700 / 1.14^3 NPVA = $2,670.96 NPVB = -$21,000 + $6,500 / 1.14 + $9,800 / 1.14^2 + $15,200 / 1.14^3 NPVB = $2,502.10 Payback has several flaws and is not the best method of comparison. The profitability index should not be used to evaluate mutually exclusive projects of varying sizes. The decision should be made based on net present value.

Which one of the following is true if the managers of a firm accept only projects that have a profitability index greater than 1.5?

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.

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

a target average accounting return

Based on the average accounting return rule, a project is _____ if its average accounting return exceeds a target average accounting return.

acceptable

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

accepts