FIN 600 - Smart Book Chp. 5

Select all that apply Which of the following are true for a project with a negative initial cash flow followed by positive cash flows? Accept if NPV is greater than zero. Accept if IRR is less than the market rate of financing Reject if IRR is less than market rate of financing.

-Accept if NPV is greater than zero. -Reject if IRR is less than market rate of financing.

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. -Receiving cash inflows sooner will decrease the payback period. -A delay in receiving cash inflows will increase the payback period. -Both the timing and the size of the cash flows can affect the payback period.

Which of the following are weaknesses of the payback method? -Cash flows received after the payback period are ignored. -All cash flows are included in the payback period. -It gives equal weight to all cash flows before the cutoff date.

-Cash flows received after the payback period are ignored. -It gives equal weight to all cash flows before the cutoff date.

Select all that apply A firm evaluating two mutually exclusive projects can ___. accept one of the projects accept both projects reject one of the projects reject both projects

-accept one of the projects -reject one of the projects -reject both projects

Select all that apply When an initial cash outflow is followed by cash inflows, NPV is: -negative when the opportunity cost of capital is greater than the IRR. -equal to zero when the opportunity cost of capital equals the IRR. -positive when the opportunity cost of capital is less than the IRR. -positive when the opportunity cost of capital is greater than the IRR.

-negative when the opportunity cost of capital is greater than the IRR. -equal to zero when the opportunity cost of capital equals the IRR. -positive when the opportunity cost of capital is less than the IRR.

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% Use CF C0=-250 C1=100 C2=100 C3=100 CPT IRR = 9.70%

Which of the following is true for a project with a negative initial cash flow followed by positive cash flows?

Accept if NPV is greater than zero. Accept if IRR is greater than the market rate of financing.

Which of the following are weaknesses of the payback method?

Cash flows received after the payback period are ignored.

For a project with a positive initial cash flow followed by negative cash flows, we should:

accept if the IRR is less than R The IRR decision rule of accepting an investment project if the opportunity cost of capital is less than the IRR does not work in this case. If you plot out this example of a positive initial cash flow followed by negative cash flows, you will see that you need to look for an IRR LESS than the opportunity cost of capital.

If the IRR is greater than the opportunity cost of capital, we should ___.

accept the project

According to the basic IRR rule, we should ____ a project if the IRR is ____ than the opportunity cost of capital.

accept; greater reject; less

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

accepts

Mutually exclusive projects are defined as _________.

alternative capital investments, any one of which will substantially satisfy the same need or purpose

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

cash flows

Two mutually exclusive projects can be evaluated by:

comparing the NPVs of the two projects comparing the incremental IRR to the discount rate.

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

discount

NPV ______ cash flows properly.

discounts

The profitability index is calculated by _________.

dividing the PV of the future cash flows by the initial investment

Which type of rationing occurs when a firm can't raise more money from the capital markets?

hard; Soft rationing occurs when management adopts limits as an aid to financial control.

The payback period can lead to incorrect decisions because it ____.

ignores cash flows after the cutoff date

The payback period can lead to _____________ because it ignores cash flows after the cutoff date.

incorrect decisions

The accounting rate of return method focuses on ______.

incremental accounting income

The most important alternative to NPV is the ______ method.

internal rate of return

Higher cash flows earlier in a project's life are ______ valuable than higher cash flows later on.

more; Reason: Present value is inversely related to time. Cash flows earlier in the project life are more valuable as they can be reinvested.

When an initial cash outflow is followed by cash inflows, NPV is ______ if the opportunity cost of capital is greater than the IRR.

negative

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

not considered in the analysis

The ______ method differs from NPV because it evaluates a project by determining the time needed to recoup the initial investment.

payback

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

present value

The profitability index is the _________.

present value of cash flows, exclusive of the initial investment, divided by the initial investment

Select all that apply The accounting rate of return ______. -is calculated using the same rules as the internal rate of return -parallels financial statement accounting -is a simple way to screen investment proposals -considers the time value of money

-parallels financial statement accounting -is a simple way to screen investment proposals

Two challenges with the IRR approach when comparing two projects are:

-scale -differing cash flow patterns over time.

Three attributes of NPV are that it:

-uses cash flow. -uses all the cash flows of the project. -discounts the cash flows properly.

A project with a cash inflow of $200 followed by a cash outflow of (-$250) one year later will have an IRR of ___ percent.

25 Reason: IRR is the interest rate that makes the NPV = 0: 0 = +$200 - ($250/1+IRR) Solving for IRR: → IRR = ($250/$200) - 1 = 25%

A project with a cash inflow of $185 followed by a cash outflow of (-$250) one year later will have an IRR of ___ percent.

35 Reason: IRR is the interest rate that makes the NPV = 0: 0 = +$185 - ($250/1+IRR) Solving for IRR: → IRR = ($250/$185) -1 = 35%

True or false: A project with an initial cash outflow followed by a cash inflow has an NPV that is positively related to the discount rate.

False NPV and the discount rate (rate of return) are inversely related. Reason: A project with an initial cash outflow followed by a cash inflow will have an NPV that will decrease as discount rates increase.

True or false: The scale of a project is never a concern when using IRR.

False; Reason: The scale of a project can be an issue with IRR when choosing between mutually exclusive projects.

______ cash flows earlier in a project's life are more valuable than higher cash flows later on.

Higher

The payback method differs from ______ because it evaluates a project by determining the time needed to recoup the initial investment.

NPV

True or false: A project with an initial cash outflow followed by a cash inflow has an NPV that is negatively related to the discount rate.

True

True or false: The scale of a project can be an issue with IRR when choosing between mutually exclusive projects.

True

The internal rate of return is a function of ____.

a project's cash flows

Select all that apply The decision rule for a project for which the first cash flow is an inflow and subsequent cash flows are negative states that we should ____ the project when the IRR is ____ than the discount rate. -reject; greater -reject; less -accept; greater -accept; less

reject; greater accept; less Reason: The IRR decision rule of accepting an investment project if the opportunity cost of capital is less than the IRR does not work in this case. If you plot out this example of a positive initial cash flow followed by negative cash flows, you will see that you need to look for an IRR LESS than the opportunity cost of capital.

The payback rule ______ a project if it has a payback period that is greater than a particular cutoff date.

rejects