FIN611 Chapter 10 Test Review

International Advertising Services has two projects that are mutually exclusive and have normal cash flows. Project A has an IRR of 15% and Project B's IRR is 20%. International's WACC is 12%, and at that rate, Project A has the higher NPV. Which of the following statements is correct? Assuming the two projects have the same scale, Project B probably has a faster payback than Project A. The crossover rate for the two projects must be less than 12%. As Project B has the higher IRR, then it must also have the higher NPV if the crossover rate is less than the WACC of 12%. Assuming the timing pattern of the two projects' cash flows is the same, Project B probably has a higher cost (and larger scale). The crossover rate for the two projects must be 12%.

Assuming the two projects have the same scale, Project B probably has a faster payback than Project A.

Mathematically, the NPV, IRR, MIRR, and PI methods will always lead to the same accept/reject decisions for mutually exclusive projects that differ in size or timing of cash flows. True False

False These methods will always lead to the same accept/reject decisions for normal, independent projects, but can give conflicting rankings for mutually exclusive projects if the projects differ in size or in the timing of cash flows.

If a project would lead to an increase in a firm's cost of capital (its WACC), it should NOT be accepted. True False

False A firm should accept all positive NPV projects. Even with the higher cost of capital, the company should go ahead and raise external equity and accept the project.

If the NPV ranking conflicts with the PI ranking, then the PI ranking should be used. True False

False If the PI ranking conflicts with the NPV, then the NPV ranking should be used.

Projects with nonnormal cash flows sometimes have multiple MIRRs. True False

False Multiple IRRs occur in projects with nonnormal cash flows, but there is only one MIRR for each project.

The NPV and MIRR methods lead to the same decision for mutually exclusive projects regardless of the projects' relative sizes. True False

False NPV and MIRR criteria may not lead to the same decision when the projects differ in scale (project size or timing of cash flows).

If a firm has zero cost of capital and two mutually exclusive projects, the payback method and NPV method would always lead to the same decision on which project to undertake. True False

False One project might have cash flows that extend well past the payback year, leading to different rankings.

Other things held constant, a decrease in the cost of capital (discount rate) will cause an increase in a project's IRR. True False

False The IRR calculation is independent of the project's cost of capital.

Which of the following statements is correct? If a project has an IRR greater than zero, then taking on the project will increase the value of the company's common stock because the project will make a positive contribution to net income. If a project has an NPV greater than zero, then taking on the project will increase the value of the firm's stock. Assume that you plot the How to Use the Different Capital Budgeting Methods of two mutually exclusive projects with normal cash flows and that the cost of capital is greater than the rate at which the profiles cross one another. In this case, the NPV and IRR methods will lead to contradictory rankings of the two projects. For independent (as opposed to mutually exclusive) normal projects, the NPV and IRR methods will generally lead to conflicting accept/reject decisions. Statements b, c, and d are true.

If a project has an NPV greater than zero, then taking on the project will increase the value of the firm's stock.

Assuming that a project being considered has normal cash flows, with one outflow followed by a series of inflows, which of the following statements is accurate? If Project A has a higher IRR than Project B, then Project A must also have a higher NPV. If Project A has a higher IRR than Project B, then Project A must have the lower NPV. The IRR calculation implicitly assumes that all cash flows are reinvested at the WACC. If a project has normal cash flows and its IRR exceeds its WACC, then the project's NPV must be positive. The IRR calculation implicitly assumes that cash flows are withdrawn from the business rather than being reinvested in the business.

If a project has normal cash flows and its IRR exceeds its WACC, then the project's NPV must be positive.

Which of the following statements regarding mutually exclusive projects with unequal lives is NOT accurate? To apply the equivalent annual annuity (EAA) method, find the constant payment streams that the projects' NPVs would provide over their respective lives. The key to the replacement chain (common life) approach for projects that will have to be repeated in the future is to analyze both projects over an equal life. It is appropriate to extend the analysis to a common life even if the probability that a project will actually be repeated at the end of its initial life is low. When choosing between two mutually exclusive alternatives with significantly different lives, an adjustment is necessary. Serious weaknesses in the replacement chain (common life) approach include that it does not account for inflation and new technology that could affect future replacements and change the cash flows.

It is appropriate to extend the analysis to a common life even if the probability that a project will actually be repeated at the end of its initial life is low.

Which of the following statements regarding IRR and WACC is accurate? Multiple IRRs can only occur if the direction of the cash flows changes more than once. A project cannot have multiple IRRs if it is independent. If a project has two IRRs, then the smaller one is the one that is most relevant, and it should be accepted and relied upon. Two projects are likely to have multiple IRRs if they are mutually exclusive. For a project to have more than one IRR, then both IRRs must be greater than the WACC.

Multiple IRRs can only occur if the direction of the cash flows changes more than once.

Which of the following measures established for screening projects is considered the best single measure? Modified internal rate of return (MIRR) Internal rate of return (IRR) Profitability index (PI) Net present value (NPV) Discounted payback

Net present value (NPV) The NPV is the best single measure, primarily because it directly relates to the firm's central goal of maximizing intrinsic value.

Which of the following project evaluation measures determines how much value a project creates for each dollar of the project's cost? MIRR IRR PI NPV RPP

PI The profitability index (PI) measures how much value a project creates for each dollar of the project's cost.

Which of the following is NOT a project evaluation measure? Modified internal rate of return (MIRR) Internal rate of return (IRR) Profitability payback Net present value (NPV) Discounted payback

Profitability payback Profitability payback is not a project evaluation measure. The six project evaluation measures are (1) net present value, (2) internal rate of return (IRR), (3) modified internal rate of return (MIRR), (4) profitability index, (5) regular payback, and (6) discounted payback.

Which of the following statements regarding IRR and NPV is accurate? The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate. The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR. The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.

The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.

If a project being considered has normal cash flows, with one outflow followed by a series of inflows, which of the following statements is accurate? The higher the WACC used to calculate the NPV, the lower the calculated NPV will be. A project's NPV is generally found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting the TV at the IRR to find its PV. If a project's NPV is greater than zero, then its IRR must be less than zero. The NPVs of relatively risky projects should be found using relatively low WACCs. If a project's NPV is greater than zero, then its IRR must be less than the WACC.

The higher the WACC used to calculate the NPV, the lower the calculated NPV will be.

A project is described as having normal cash flows, meaning one outflow followed by a series of inflows. Which of the following statements regarding normal cash flows is accurate? A project's regular IRR is found by discounting the cash inflows at the WACC to find the present value (PV), then compounding this PV to find the IRR. To find a project's IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project's costs. If a project's IRR is greater than the WACC, then its NPV must be negative. A project's regular IRR is found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting this TV at the WACC. To find a project's IRR, we must find a discount rate that is equal to the WACC.

To find a project's IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project's costs.

Assume that a project has one initial cash outflow followed by a series of positive cash inflows. To use the modified internal rate of return (MIRR) method, you would compound the cash inflows out to the end of the project's life, sum those compounded cash flows to form a terminal value (TV), and then find the discount rate that causes the PV of the TV to equal the project's cost. True False

True

In general, small businesses use DCF capital budgeting techniques less often than large businesses do. This may reflect a lack of knowledge on the part of small firms' managers, but it may also reflect a rational conclusion that the costs of using DCF analysis outweigh the benefits of these methods for very small firms. True False

True

The IRR method can be used in place of the NPV method for all independent projects. True False

True

In theory, capital budgeting decisions should depend solely on forecasted cash flows and the opportunity cost of capital. Managers' tastes, choice of accounting method, or the profitability of other independent projects should not be considered. True False

True A firm should accept all positive NPV projects, regardless of other considerations.

Among the conditions that may cause a project to have more than one IRR, one might be the situation in which a negative cash flow (or cost) occurs at the end of the project's life in addition to the initial investment at time = 0. True False

True More than one negative cash flow will cause a project to have multiple IRRs.

The NPV method is preferred over the IRR method because the NPV method's reinvestment rate assumption is better. True False

True Project cash flows are substitutes for outside capital. Thus, the opportunity cost of these cash flows is the firm's cost of capital, adjusted for risk. The NPV method uses this cost as the reinvestment rate, while the IRR method assumes reinvestment at the IRR.

The second step in project analysis is to: calculate net present value. perform a risk assessment. calculate the evaluation measures. estimate the project's expected cash flows. determine the cost of financing.

calculate the evaluation measures.

Armbrister Pyrotechnics Inc. has imposed a limit of $50 million for capital expenditures, causing it to forgo a number of value-adding projects. This is an example of: capital rationing. a marginal cost of capital. linear programming. an optimal capital budget. a post-audit program.

capital rationing. Sometimes firms set an upper limit on the size of their capital budgets, which is known as capital rationing.

Which of the following types of decisions would most likely be made at the board level? replacement needed to continue profitable operations replacement to reduce costs expansion of existing products or markets contraction decisions all of these decisions

contraction decisions Downsizing decisions are made at the board level.

The first step in project analysis is to: calculate net present value. perform a risk assessment. estimate the payback period. estimate the project's expected cash flows. determine the cost of financing.

estimate the project's expected cash flows.

The time period in which a project is maximizing NPV and thus shareholder wealth is called the project's: economic life. physical life. golden life. engineering life. optimal life.

golden life.

A project is acceptable if its PI is: greater than 0.5; the higher the better. less than 0.5; the lower the better. less than 1.0; the lower the better. equal to 0. greater than 1.0; the higher the better.

less than 1.0; the lower the better. A project is acceptable if its PI is greater than 1.0. Projects with higher PIs should be ranked above projects with lower PIs.

To overcome estimation bias, some firms: limit the size of the capital budget. require managers to use an unrealistically short economic life. use post-audit programs that link the accuracy of forecasts to the compensation of the managers who initiate the projects. require managers to use an unrealistically high cost of capital. require managers to use an unrealistically high cost of capital, limit the size of the capital budget, and/or use post-audit programs that link accuracy to compensation.

require managers to use an unrealistically high cost of capital, limit the size of the capital budget, and/or use post-audit programs that link accuracy to compensation.

Which of the following types of decisions might be made in order to comply with the terms of an insurance policy? expansion of existing products or markets replacement to reduce costs contraction decisions replacement needed to continue profitable operations safety and/or environmental projects

safety and/or environmental projects