Finance Chapter 9

8) Lincoln Industries Inc. is considering a project that has an initial after-tax outlay or after-tax cost of $350,000. The respective future cash inflows from its five-year project for years 1 through 5 are $75,000 each year. Lincoln expects an additional cash flow of $50,000 in the fifth year. The firm uses the net present value method and has a discount rate of 10%. Will Lincoln accept the project? A) Lincoln accepts the project because it has an IRR greater than 10%. B) Lincoln rejects the project because it has an IRR less than 10%. C) Lincoln accepts the project because it has an IRR greater than 5%. D) There is not enough information to answer this question.

B

Thus, Dweller accepts the project because it has a positive NPV. 12) Lincoln Industries Inc. is considering a project that has an initial after-tax outlay or after-tax cost of $350,000. The respective future cash inflows from its five-year project for years 1 through 5 are $75,000 each year. Lincoln expects an additional cash flow of $50,000 in the fifth year. The firm uses the net present value method and has a discount rate of 10%. Will Lincoln accept the project? A) Lincoln accepts the project because it has an NPV greater than $5,000. B) Lincoln rejects the project because it has an NPV less than $0. C) Lincoln accepts the project because it has an NPV greater than $18,000. D) There is not enough information to make a decision.

B

10) Lennon, Inc. is considering a five-year project that has an initial outlay or cost of $80,000. The respective future cash inflows from its project for years 1, 2, 3, 4 and 5 are: $15,000, $25,000, $35,000, $45,000, and $55,000. Lennon uses the internal rate of return method to evaluate projects. What is Lennon's IRR? A) The IRR is less than 22.50%. B) The IRR is about 24.16%. C) The IRR is about 26.16%. D) The IRR is over 26.50%.

C

5) ________ corrects for most, but not all, of the problems of IRR and gives the solution in terms of a return. A) Profitability Index B) Discounted Payback Period C) Net Present Value D) MIRR

D

2) The net present value of an investment is ________. A) the present value of all benefits (cash inflows) B) the present value of all benefits (cash inflows) minus the present value of all costs (cash outflows) of the project C) the present value of all costs (cash outflows) of the project D) the present value of all costs (cash outflow) minus the present value of all benefits (cash inflow) of the project

B

24) To be considered acceptable, a project must have an NPV greater than 1.0

B

5) Which of the statements below is FALSE? A) The NPV decision criterion is true when all projects are independent and the company has a sufficient source of funds to accept all positive NPV projects. B) Two projects are mutually exclusive if the accepting of one project has no bearing on the accepting or rejecting of the other project. C) Projects are mutually exclusive if picking one project eliminates the ability to pick the other project. D) If a company has constrained capital, then it can only take on a limited number of projects.

B

Thus, Lennon accepts the project since it has a positive NPV. 15) Dice, Inc. is considering a five-year project that has an initial after-tax outlay or after-tax cost of $70,000. The future after-tax cash inflows from its project for years 1, 2, 3, 4 and 5 are all the same at $35,000. Dice uses the net present value method and has a discount rate of 10%. Will Dice accept the project? A) Dice accepts the project because the NPV is about $69,455. B) Dice accepts the project because the NPV is about $62,678. C) Dice rejects the project because the NPV is about -$13,382. D) Dice rejects the project because the NPV is less than -$33,021.

B

2) The IRR is the discount rate that produces a zero NPV or the specific discount rate at which the present value of the cost equals ________. A) the future value of the present cash outflows B) the present value of the future benefits or cash inflows C) the present value of the cash outflow D) the investment

B

2) The ________ model is usually considered the best of the capital budgeting decision-making models. A) Internal Rate of Return (IRR) B) Net Present Value (NPV) C) Profitability Index (PI) D) Discounted Payback Period

B

15) The crossover rate is the discount rate where both projects have the same ________. A) IRR B) PI C) NPV D) length to completion

C

3) Without a computer and special calculator, ________. A) computing the payback period is much more difficult than computing the IRR B) finding the IRR will typically be a very easy process C) finding the IRR may be a very tedious process only if the NPV is negative D) finding the IRR may be a very tedious process since it is an iterative process

D

22) The IRR decision criterion is to accept a project if the IRR exceeds the desired or required return rate and to reject the project if the IRR is less than the desired or required rate of return.

A

23) Finding the equivalent annual annuity (EAA) is a good way to deal with projects with unequal lives and should only be used with mutually exclusive projects.

A

24) One problem with the decision criterion of IRR is that if cash flow is not standard, there is a possibility of multiple IRRs for a single project.

A

25) One of the underlying assumptions of the IRR model is that all cash inflow can be reinvested at the individual project's internal rate of return (IRR) over the remaining life of the project.

A

4) Because money is limited, companies must be careful to choose projects that are feasible and profitable.

A

3) The ________ method is economically sound and properly ranks projects across various sizes, time horizons, and levels of risk, without exception for all independent projects. A) NPV B) Discounted Payback Period C) Profitability Index D) Modified IRR

A

3) We can separate short-term and long-term decisions into three dimensions. Which of the below is NOT one of these? A) Degree of information gathering prior to the decision B) Cost C) Personality of CEO making the decisions D) Length of impact

C

11) When the Profitability Index (PI) is greater than 1, the benefits exceed the costs.

A

7) Calculating IRR, NPV, or MIRR is easy and efficient using a spreadsheet once you know the relevant cash flow, the timing of the cash flow, the cost of capital, and the reinvestment rate.

A

8) According to an academic survey of large and small U.S. businesses, the IRR method of capital budgeting is slightly preferred over NPV by the survey respondents.

A

9.3 Net Present Value 1) The capital budgeting decision model that utilizes all the discounted cash flow of a project is the ________ model, which is one of the single most important models in finance. A) net present value (NPV) B) internal rate of return (IRR) C) profitability index (PI) D) discounted payback period

A

NPV = -CF0 + (PMT × ). Inserting in the given values gives: NPV = -$180,000 + ($35,000 × ) = -$180,000 + ($35,000 × 4.967640)= -$180,000 + $173,867.39 = -$6,132.61. Thus, Morgan rejects the project since it has a negative NPV. 18) Opie, Inc. is considering an eight-year project that has an initial after-tax outlay or after-tax cost of $180,000. The future after-tax cash inflows from its project for years 1 through 8 are the same at $38,000. Opie uses the net present value method and has a discount rate of 11.50%. Will Opie accept the project? A) Opie accepts the project because the NPV is greater than$12,000. B) Opie accepts the project because the NPV is about $11,114. C) Opie rejects the project because the NPV is about -$11,114. D) Opie rejects the project because the NPV is less than -$12,000.

A

22) To determine the current value of a project, discount all future cash flows to the present and add up all cash inflow and outflow.

B

5) The hurdle rate should be set so that it reflects the proper risk level for the project. If we have to choose between two projects with similar risk and therefore similar hurdle rates, we would select the project that ________. A) has a higher internal rate of return B) has a lower internal rate of return C) has a hurdle rate that is consistent with the payback period method D) has a hurdle rate that is consistent with the discounted payback period model

A

23) The IRR is an unpopular capital budgeting decision model because even with the advent of calculators and spreadsheets, the cumbersome calculation remains.

B

Step One. Find the future values of all the cash inflow by reinvesting the cash inflow at the appropriate cost of capital. FV = $15,000 × (1.1050)4 + $16,000 × (1.1050)3 + $17,000 × (1.1050)2 + $17,500 × (1.1050)1 + $18,000 × (1.1050)0 = $22,363.53 + $21,587.72 + $20,757.43 + $19,337.50 + $18,000.00. Summing these we get: FV = $102,046.18. Step Two. Find the present value of the cash outflow by discounting at the appropriate cost of capital.This is the initial cash outflow of $75,000 because all investment is made at the start of the project. Expressing the cash outflow in absolute terms: PV= $75,000. Step Three. Find the interest rate that equates the present value of the cash outflow with the future value of the cash inflow given as: MIRR = (FV / PV)n - 1 = ($102,046.18 / $75,000)1/5 - 1 = (1.852084)1/5 - 1 = 1.063524 - 1 = 0.063524 or about 6.35%. 21) Corbett and Sullivan Enterprises (CSE) use the Modified Internal Rate of Return (MIRR) when evaluating projects. CSE's cost of capital is 9.5%. What is the MIRR of a project if the initial costs are $10,200,000 and the project lasts seven years, with each year producing the same after-tax cash inflows of $1,900,000? A) About 7.95% B) About 8.01% C) About 8.24% D) About 8.88%

C

Thus, Geronimo rejects the project since it has a negative NPV. 14) Lennon, Inc. is considering a five-year project that has an initial after-tax outlay or after-tax cost of $80,000. The respective future cash inflows from its project for years 1, 2, 3, 4 and 5 are: $15,000, $25,000, $35,000, $45,000 and $55,000. Lennon uses the net present value method and has a discount rate of 9%. Will Lennon accept the project? A) Lennon accepts the project because the NPV is $129,455.25. B) Lennon accepts the project because the NPV is 79,455.25. C) Lennon accepts the project because the NPV is $49,455.25. D) Lennon accepts the project because the NPV is less than zero.

C

5) Capital budgeting decisions are typically long-term decisions.

A

11) Dice, Inc. is considering a very risky five-year project that has an initial outlay or cost of $70,000. The future cash inflows from its project for years 1, 2, 3, 4, and 5 are all the same at $35,000. Dice uses the internal rate of return method to evaluate projects. Will Dice accept the project if its hurdle rate is 41.00%? A) Dice will probably reject this project because its IRR is about 39.74%, which is slightly below its hurdle rate. B) Dice will probably accept this project because its IRR is about 41.04%, which is slightly above its hurdle rate. C) Dice will accept this project because its IRR is about 41.50%. D) Dice will accept this project because its IRR is over 45.50%.

B

12) The Internal Rate of Return (IRR) Model suffers from three problems. Which of the below is NOT one of these problems? A) Comparing mutually exclusive projects B) Cumbersome computations not resolvable by the latest technology C) Incorporates the IRR as the reinvestment rate for the future cash flows D) Multiple IRRs

B

6) Which of the statements below is TRUE? A) The hurdle rate is the cost of debt needed to fund a project. B) If the IRR exceeds a project's hurdle rate, the project should be rejected. C) If the IRR clears the hurdle rate, the project is rejected. D) The hurdle rate should be set so that it reflects the proper risk level for the project.

D

1) Which method is designed to give the dollar amount of return for every $1.00 invested in the project in terms of current dollars? A) Profitability Index Method B) Internal Rate of Return Method C) Net Present Value Method D) Discounted Payback Period Method

;A

). Inserting in the given values, we have: NPV = -$180,000 + ($38,000 × ) = -$180,000 + ($38,000 × 5.055637) = -$180,000 + $192,114.20 = $12,114.20. The EAA is the NPV divided by the PVIFA. We have: EAA (Project A) = = $2,396.18. For Project B, the NPV = -CF0 + (PMT × ) = -$160,000 + ($36,000 × ) = -$160,000 + ($36,000 × 4.170294) = -$160,000 + $150,130.59 = -$9,869.41. The EAA is the NPV divided by the PVIFA. We have: EAA (Project B) = = -$2,366.60. George will take Project A not only because its EAA is positive and superior to Project B's, but because the NPV for Project B is negative. Thus, we can really only consider one project, and that is Project A. 20) Trudeau, Inc. is considering Project A and Project B, which are two mutually exclusively projects with unequal lives. Project A is an eight-year project that has an initial outlay or cost of $140,000. Its future cash inflows for years 1 through 8 are the same at $36,500. Project B is a six-year project that has an initial outlay or cost of $160,000. Its future cash inflows for years 1 through 6 are the same at $48,000. Trudeau uses the equivalent annual annuity (EAA) method and has a discount rate of 13%. Which project(s), if any, will Trudeau accept? A) Trudeau will take Project B because it has a positive NPV and its EAA is greater than that for Project A. B) Trudeau rejects both projects because both have a negative NPV (and thus negative EAA). C) Trudeau accepts both projects because both have a positive NPV (and thus positive EAA). D) Trudeau accepts Project A because its EAA of about $7,975 is greater than Project B's EAA of about $6,440.

A

1) The ________ method is simple and fast but economically unsound as it ignores all cash flow after the cutoff date and ignores the time-value of money. A) Payback Period B) MIRR C) Net Present Value D) IRR

A

1) The ________ model answers one basic question: How soon will I recover my initial investment? A) Payback Period B) IRR C) NPV D) Profitability Index

A

1) The most popular alternative to NPV for capital budgeting decisions is the ________ method. A) internal rate of return (IRR) B) payback period C) discounted payback period D) profitability index

A

1) ________ is at the heart of corporate finance, because it is concerned with making the best choices about project selection. A) Capital budgeting B) Capital structure C) Payback period D) Short-term budgeting

A

10) The present value of the benefits and costs needed to calculate Profitability Index (PI) is the same information one finds when computing the NPV.

A

14) Two projects intersect, in terms of NPV, at a discount rate labeled the ________. A) crossover rate B) internal rate of return C) discount rate D) yield to maturity

A

17) Which of the statements below is TRUE? A) A problem with IRR as a decision rule is that if the cash flow is not standard, there is a possibility of multiple IRRs for a single project. B) When we talk about standard cash flow for a project, we assume an initial cash outflow at the beginning of the project and negative cash flows in the future. C) When we apply IRR to standard cash flow, we have the potential for more than one IRR solution. D) For every period that the cash flow has a change of sign (negative to positive or positive to negative), the NPV profile could cross the y-axis, generating a MIRR.

A

18) Suppose you have an investment that costs $80,000 at the beginning of the project, and it generates $30,000 a year for four years in positive cash flows. The cost of capital is 12%. The IRR of the project is 18.45% and the NPV is about $11,120. The IRR model assumes that at the end of the first year you can invest the $30,000 at ________. A) 18.45% B) 12.00% C) a rate less than the cost of capital D) a rate greater than the IRR

A

20) Find the Modified Internal Rate of Return (MIRR) for the following annual series of cash flows, given a discount rate of 10.50%: Year 0: -$75,000 Year 1: $15,000; Year 2: $16,000; Year 3: $17,000; Year 4: $17,500; and, Year 5: $18,000. A) About 6.35% B) About 6.88% C) About 7.35% D) About 7.88% ;

A

6) Projects are mutually exclusive if picking one project eliminates the ability to pick the other project. This mutually exclusive situation can arise for different reasons. Which of the statements below is NOT one of these reasons? A) One project will always have a negative NPV. B) There is a scarce resource that both projects would need. C) There is need for only one project, and both projects can fulfill that current need. D) By using funds for one project, there are not enough funds available for the other project.

A

6) The discounted payback method, net present value method (NPV), internal rate of return (IRR), modified internal rate of return (MIRR), and profitability index (PI) are all consistent with the the time value of money.

A

NPV = -CF0 + (PMT × ). Inserting in the given values, we have: NPV = -$140,000 + ($36,500 × ) = -$140,000 + ($36,500 × 4.79877)= -$140,000 + $175,155.12 = $35,155.12. The EAA is the NPV divided by the PVIFA. We have: EAA (Project A) = = $7,325.86. For Project B, the NPV = -CF0 + (PMT × ) = -$160,000 + ($48,000 x ) = -$160,000 + ($48,000 x 3.997550) = -$160,000 + $191,882.39 = $31,882.39. The EAA is the NPV divided by the PVIFA. We have: EAA (Project A) = = $7,975.48. Trudeau will take Project B because it has a positive NPV and its EAA is greater than that for Project A. 21) The assignment of a discount rate to each project is an integral part of the NPV process.

A

13) Geronimo, Inc. is considering a project that has an initial after-tax outlay or after-tax cost of $220,000. The respective future cash inflows from its four-year project for years 1 through 4 are: $50,000, $60,000, $70,000 and $80,000. Geronimo uses the net present value method and has a discount rate of 11%. Will Geronimo accept the project? A) Geronimo accepts the project because the NPV is greater than $10,000.00. B) Geronimo rejects the project because the NPV is about -$22,375.73. C) Geronimo rejects the project because the NPV is about -$12,375.60. D) Geronimo rejects the project because the NPV is about -$2,375.60.

B

13) Which of the following in NOT a potential problem suffered by the IRR method of capital budgeting? A) Multiple IRRs B) Disagreement with the NPV as to whether a project with ordinary cash flows is profitable or not. C) Incorporates the IRR as the reinvestment rate for the future cash flows D) Comparing mutually exclusive projects

B

4) The ________ model provides a single measure (return) but must apply risk outside the model, thus allowing for errors in rankings of projects. A) Payback Period B) IRR C) Net Present Value D) Profitability Index

B

3) In the NPV Model, all cash flows are stated ________. A) in future value dollars, and the total inflow is "netted" against the outflow to see if the net amount is positive or negative B) in present value or current dollars, and the outflow is "netted" against the total inflow to see if the gross amount is positive or negative C) in present value or current dollars, and the total inflow is "netted" against the initial outflow to see if the net amount is positive or negative D) in future dollars, and the initial outflow is "netted" against the total inflow to see if the net amount is positive

C

4) Which of the statements below describes the IRR decision criterion? A) The decision criterion is to accept a project if the IRR falls below the desired or required return rate. B) The decision criterion is to reject a project if the IRR exceeds the desired or required return rate. C) The decision criterion is to accept a project if the IRR exceeds the desired or required return rate. D) The decision criterion is to accept a project if the NPV is positive.

C

8) Which of the statements below is FALSE? A) The net present value decision model is an economically sound model when comparing different projects across a wide variety of products, services, and activities under capital constraint. B) The greater the NPV of a project, the greater the "bag of money" for doing the project, and more money is better. If a company is short of capital, it would choose those projects that provide the largest "bag of money." C) Despite all of the advantages of using the NPV Model, it is inconsistent with the concept of the time-value-of-money. D) By discounting all future cash flows to the present, adding up all inflows, and subtracting all outflows, we are determining the current value of the project.

C

9) Geronimo, Inc. is considering a project that has an initial outlay or cost of $220,000. The respective future cash inflows from its four-year project for years 1 through 4 are: $50,000, $60,000, $70,000, and $80,000, respectively. Geronimo uses the internal rate of return method to evaluate projects. Will Geronimo accept the project if its hurdle rate is 10%? A) Geronimo will not accept this project because its IRR is about 9.70%. B) Geronimo will not accept this project because its IRR is about 8.70%. C) Geronimo will not accept this project because its IRR is about 6.50%. D) Geronimo will not accept this project because its IRR is about 4.60%.

C

Thus, we can use: NPV = -CF0 + (PMT × ). Inserting in the given values gives: NPV = -$170,000 + ($45,000 × ) = -$170,000 + ($45,000 × 3.672771)= -$170,000 + $165,274.71 = -$4,725.29. Thus, Fox rejects the project since it has a negative NPV. 17) Morgan, Inc. is considering an eight-year project that has an initial after-tax outlay or after-tax cost of $180,000. The future after-tax cash inflows from its project for years 1 through 8 are the same at $35,000. Morgan uses the net present value method and has a discount rate of 12%. Will Morgan accept the project? A) Morgan accepts the project because the NPV is over $10,000. B) Morgan accepts the project because the NPV is about $6,141. C) Morgan rejects the project because the NPV is about -$6,133. D) Morgan rejects the project because the NPV is below -$7,000.

C

Thus, we can use: NPV = -CF0 + (PMT × ). Inserting in the given values gives: NPV = -$70,000 + ($35,000 × ) = -$70,000 + ($35,000 × 3.790787) = -$70,000 + $132,677.54 = $62,677.54. Thus, Dice accepts the project since it has a positive NPV. 16) Fox, Inc. is considering a five-year project that has initial after-tax outlay or after-tax cost of $170,000. The future after-tax cash inflows from its project for years 1 through 5 are $45,000 for each year. Fox uses the net present value method and has a discount rate of 11.25%. Will Fox accept the project? A) Fox accepts the project because the NPV is about $5,455. B) Fox accepts the project because the NPV is about $165,275. C) Fox rejects the project because the NPV is about -$4,725. D) Fox rejects the project because the NPV is about -$154,725.

C

10) Which of the statements below is FALSE? A) We calculate the equivalent annual annuity by taking the NPV of the project and find the annuity stream that equates to the NPV, using the appropriate discount rate for the project and life of the project. B) In dealing with mutually exclusive projects of unequal lives, we can compute the EAA for the NPV of the project over the life of the project. C) One of the advantages of NPV over other decision models is that we can select the appropriate discount rate for each individual project and still compare the resulting NPVs across different projects. D) By using the EAA approach for mutually exclusive projects, we overcome all potential problems.

D

11) Dweller, Inc. is considering a four-year project that has an initial after-tax outlay or after-tax cost of $80,000. The future cash inflows from its project are $40,000, $40,000, $30,000 and $30,000 for years 1, 2, 3 and 4, respectively. Dweller uses the net present value method and has a discount rate of 12%. Will Dweller accept the project? A) Dweller accepts the project because the NPV is greater than $30,000. B) Dweller rejects the project because the NPV is less than -$4,000. C) Dweller rejects the project because the NPV is -$3,021. D) Dweller accepts the project because the NPV is greater than $28,000.

D

16) Which of the statements below is FALSE? A) Project A has a higher y-axis intercept for its NPV profile than mutually exclusive Project B. As long as the profile of Project A is above the profile of Project B, Project A will have a higher NPV value for that particular discount rate. B) Project A and Project B are mutually exclusive. The two projects intersect in terms of NPV at a discount rate labeled the crossover rate. C) Project A has a higher y-axis intercept for its NPV profile than mutually exclusive Project B. As we proceed past the crossover rate to the right on the x-axis, Project B's profile will be above Project A's profile. D) Project A has a higher y-axis intercept for its NPV profile than mutually exclusive Project B. This means that Project A has a lower NPV than Project B when the discount rate is zero.

D

19) Find the Modified Internal Rate of Return (MIRR) for the following series of future cash flows, given a discount rate of 11%: Year 0: -$22,000 Year 1: $5,000; Year 2: $6,000; Year 3: $7,000; Year 4: $7,500; and, Year 5: $8,000. A) About 12.13% B) About 12.88% C) About 13.04% D) About 13.12%

D

4) In regard to the NPV method, which of the statements below is TRUE? A) In the NPV Model, if two projects are being compared, the one with the highest IRR is selected. B) In the NPV Model, the present cash flows are discounted at the rate r, the cost of capital. C) In the NPV Model, most future cash flows are stated in present value or current dollars and the inflow is "netted" against the outflow to see if the net amount is positive or negative. D) In the NPV Model, the net present value of an investment is the present value of all benefits (cash inflow) minus the present value of all costs (cash outflow) of the project.

D

7) Flynn, Inc. is considering a four-year project that has an initial outlay or cost of $80,000. The future cash inflows from its project are $40,000, $40,000, $30,000, and $30,000 for years 1, 2, 3 and 4, respectively. Flynn uses the internal rate of return method to evaluate projects. What is the approximate IRR for this project? A) The IRR is less than 12%. B) The IRR is between 12% and 20%. C) The IRR is about 24.55%. D) The IRR is about 28.89%.

D

7) Which of the following may be TRUE regarding mutually exclusive capital budgeting projects? A) There is need for only one project, and both projects can fulfill that current need. B) By using funds for one project, there are not enough funds available for the other project. C) There is a scarce resource that both projects would need. D) All of the above

D

9) There are two ways to correct for projects with unequal lives when using the NPV approach. Which of the answers below is one of these ways? A) One way is to find a common life, without the need to extend the projects to the least common multiple of their lives. B) One way is to find the present value factors and then compare them. C) One way is to compare the lengths of the projects and take the project with the shortest life. D) One way is to find a common life by extending the projects to the least common multiple of their lives.

D

Thus, we can use: NPV = -CF0 + (PMT × ). Inserting in the given values gives: NPV = -$180,000 + ($38,000 × ) = -$180,000 + ($38,000 × 5.055637)= -$180,000 + $192,114.20 = $12,114.20. Thus, Opie accepts the project since it has a positive NPV. 19) George, Inc. is considering Project A and Project B, which are two mutually exclusively projects with unequal lives. Project A is an eight-year project that has an initial outlay or cost of $180,000. Its future cash inflows for years 1 through 8 are $38,000.Project B is a six-year project that has an initial outlay or cost of $160,000. Its future cash inflows for years 1 through 6 are the same at $36,000. George uses the equivalent annual annuity (EAA) method and has a discount rate of 11.50%. Will George accept the project? A) George accepts Project B because it has a more positive EAA. B) George rejects both projects because both have a negative NPV (and thus negative EAA). C) George accepts Project A because its EAA is about $2,396 and Project B's EAA is only about $1,097. D) George accepts Project A because its NPV (and thus EAA) is positive and Project B's NPV (and thus EAA) is negative.

D