FIN POLICIES AND STATEGIES EXAM 1 -VALSARTI
When evaluating a project with an initial cash inflow followed by cash outflows, the NPV will _____ as the discount rate rise.
INCREASE
The (IRR/NPV) rule summarizes the information about a project in a single rate of return. This single rate gives people a simple way of discussing the rate of return of projects. (Enter abbreviation only.)
IRR
What is the equation for estimating operating cash flows using the top-down approach?
OCF = Sales - Cash costs - Taxes
Investment in net working capital arises when ___. Multiple select question.
inventory is purchased -cash is kept for unexpected expenditures -credit sales are made
A small project has cash flows of -$10 and $45, and a large project has cash flows of -$30 and $70. What is the incremental NPV at a discount rate of 10%?
$2.73 Reason: The answer is the NPV of the difference in cash flows between the two projects. In this case, the time 0 cash flow difference is (-$30-(-$10)=-$20) and the second cash flow difference is $70-$45 = 25. NPV = -$20+ (25/1.10) = $2.73. You can also take the difference in the NPVs of the two projects.
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 of the following is the equation for estimating operating cash flows using the tax shield approach?
OCF = (Sales - Costs) × (1 - Tax rate) + Depreciation × Tax rate
The IRR rule summarizes the information about the project in: Multiple choice question.
a single rate of return
The three attributes of NPV are that it:
discounts the cash flows properly. uses cash flows. uses all the cash flows of a project.
NPV ______ cash flows properly.
discounts. Reason: To calculate an NPV, future cash flows are discounted to the present.
The net present value technique does not discount earnings because earnings ___.
do not represent real money
The equation for determining the real interest rate has the nominal interest rate in the _____ and the inflation rate in the ______. Multiple choice question.
numerator; denominator
According to Graham and Harvey's 1999 survey of 392 CFOs, which of the following capital budgeting techniques is least used. Multiple choice question.
profitability index
According to the bottom-up approach, what is the OCF if EBIT is $600, depreciation is $1,800, and the tax rate is 30 percent?
$2,220 OCF = EBIT - taxes + depreciation, or EBIT(1-t) + depreciation$600 × (1−.30) 1- 0.30 + $1,800 = $2,220
A small project has cash flows of -$10 and $45, and a large project has cash flows of -$30 and $70. What is the incremental NPV at a discount rate of 10%? Multiple choice question.
$2.73 The answer is the NPV of the difference in cash flows between the two projects. In this case, the time 0 cash flow difference is (-$30-(-$10)=-$20) and the second cash flow difference is $70-$45 = 25. NPV = -$20+ (25/1.10) = $2.73. You can also take the difference in the NPVs of the two projects.
According to the top-down approach, what is the operating cash flow if sales are $200,000, total cash costs are $190,636, and the tax bill is $1,144?
$8,220 $200,000 - 190,636 - 1,144 = $8,220
Which of the following correctly describes the relationship between depreciation, income, taxes, and investment cash flows? Multiple choice question.
As depreciation expense increases, net income and taxes will decrease, while investment cash flows will increase.
Which capital budgeting decision method finds the present value of each cash flow before calculating a payback period?
Discounted payback period
True or false: The scale of a project is never a concern when using IRR.
False
A project that results in the firm receiving funds first and pays out funds later should not be accepted.
False Reason: A project that results in the firm receiving funds first and pays out funds later should be accepted when the IRR is less than the discount rate.
True or false: Opportunity costs can be ignored when determining the financial feasibility of a project.
False Reason: Opportunity costs are relevant cash flows and should be included when determining the financial feasibility of a project.
The shareholders' books in the US follow the rules of the ____.
Financial Accounting Standards Board (FASB)
If the inflation rate increases, the nominal rate of interest will ______.
INCREASE
A way to evaluate mutually exclusive projects is to analyze the Incremental cash flows.
Incremental
expenses incurred on debt financing are ignored when computing cash flows from a project.
Interest
The PI rule for an independent project is to decline the project if the PI is _____ then 1.
LESS
According to the basic investment rule for NPV, a firm should :
accept a project if the NPV is greater than zero. reject a project if NPV is less than zero. be indifferent towards accepting a project if NPV is equal to zero
A firm evaluating two mutually exclusive projects can reject both projects
accept one of the projects reject one of the projects
Allocated costs arise when a specific expenditure
benefits more than one project or division
Accept a project if its NPV is ______ zero.
greater than
A dollar received one year from today has ______ value than a dollar received today.
less
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
In capital budgeting, the net ______ is the value of a project to the company
present value
According to the basic IRR rule, we should ____ a project if the IRR is ____ than the discount rate.
reject; less accept; greater
The IRR is ______ to account for the scale of the project.
unable
The computation of equivalent annual costs is useful when comparing projects with unequal
lives The computation of equivalent annual costs is useful when comparing projects with unequal lives. NPV adjusts for differing annual cash flows.
Among the three main sources of cash flow, which source of cash flow is the most important and also the most difficult to forecast? Multiple choice question.
The operating cash flows from net sales over the life of the project
What are the advantages of the payback period method for management?
The payback period method is ideal for minor projects. The payback period method is easy to use. It allows lower level managers to make small decisions effectively.
The NPV _____ the initial investment while the profitability index _____ the initial investment from the present value of all future cash flows.
subtracts; divides
When a firm evaluates a proposal to make an existing facility more cost effective, the cost savings must be large enough to justify:
the necessary capital expenditure The annual depreciation allowances will increase with the new cost-cutting project.
The IRR is ______ to account for the scale of the project. Multiple choice question.
unable
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?
2.91
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
An increase in depreciation expense will ____ cash flows from operations.
increase Because depreciation is not a cash expense, its only effect is to decrease taxes paid, thereby increasing cash flows from operations.
Synergy will ______ the sales of existing products.
increase. Synergy is the case in which a new product's sales will increase the sales of existing products.
Buying new cost-cutting equipment affects operating cash flows by: Multiple select question.
increasing taxes increasing pretax income increasing the depreciation deduction
Two mutually exclusive projects can be correctly evaluated by comparing the
incremental IRR to the discount rate.
Erosion will ______ the sales of existing products
reduce Erosion is the case in which a new product's sales will reduce the sales of existing products.
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
What is the depreciation tax shield if EBIT is $600, depreciation is $1,800, and the tax rate is 30 percent? Multiple choice question.
$540 Tax shield = $1,800 × .3 = $540
Discounting is the process of _____. Multiple choice question.
Calculating the present value of either a lump sum or a series of cash flows. REASON: Discounting is the process of calculating the present value of either a lump sum or a series of cash flows. It does not remove risk, though it does attempt to adjust project value to account for it.
Which of the following is given greater importance in capital budgeting problems in corporate finance?
Cash flows
This capital budgeting method allows lower management to make smaller, everyday financial decisions easily is:
Payback method Reason: Accounting rate of return is harder to calculate, so it is often not used for small financial decisions.
Which of the following are true for a project with a negative initial cash flow followed by positive cash flows?
Reject if IRR is less than market rate of financing. Accept if NPV is greater than zero. Reason: In this case, you should accept if IRR is greater than the market rate of financing.
What are the two sets of accounting books? Multiple select question.
Tax books Shareholders' books
Which of the following are weaknesses of the payback method?
The cutoff date is arbitrary. Cash flows received after the payback period are ignored. Time value of money principles 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 Reason: For a project with a positive initial cash flow followed by negative cash flows, we should accept if the IRR is less than R.
If the IRR is greater than the discount rate, we should ___
accept the project Reason: If the IRR is greater than the discount rate, we should accept the project.
If the IRR is greater than the discount rate, we should
accept the project Reason: If the IRR is greater than the discount rate, we should accept the
A project with a positive NPV should be:
accepted Because A project or investment's NPV equals the present value of net cash inflows the project is expected to generate, minus the initial capital required for the project. ... If a project's NPV is positive (> 0), the company can expect a profit and should consider moving forward with the investment.
Internal rate of return (IRR) must be compared to the ______ rate in order to determine the acceptability of a project.
discount Reason: Internal rate of return (IRR) must be compared to the discount rate in order to determine the acceptability of a project.
If the tax rate increases, the value of the depreciation tax shield will ____
increase
Identify the three main sources of cash flows over the life of a typical project.
A) cash outflows from investment in plant and equipment at the inception of the project B) net cash flows are sales and expenses over the life of the project. D) net cash flows from salvage value at the end of the project.
The PI rule for an independent project is to ______ the project if the PI is greater than 1
ACCEPT
An investment opportunity has an initial cash inflow of $75,000 and a cash outflow of $30,000 for the following 3 years. What is the IRR decision rule for this investment if his opportunity cost of capital is 11%?
Accept if IRR < 11%, reject otherwise.
Jimbo Bobcat has a book deal. He will receive $50,000 in advance to write a book about his life. It will take two years to write. In order to write it, he'll have to quit his second job, where he earns $26,000 per year, so his cash flow for each of those two years is -$26,000. What is the IRR decision rule for this investment if his opportunity cost of capital is 8%?
Accept if IRR < 8%, reject otherwise. Reason: This is never the decision rule. In "normal" cash flows, where you spend money before you receive it, the rule is "Accept if IRR > opportunity cost of capital." In this case the NPV profile is upward sloping, because he receives his cash inflow before his cash outflows, so the rule is "Accept if IRR < opportunity cost of capital." Reason: In this case the NPV profile is upward sloping, because he receives his cash inflow before his cash outflows, so the rule is "Accept if IRR < 8%."
Jimbo Bobcat has a book deal. He will receive $50,000 in advance to write a book about his life. It will take two years to write. In order to write it, he'll have to quit his second job, where he earns $26,000 per year, so his cash flow for each of those two years is -$26,000. What is the IRR decision rule for this investment if his opportunity cost of capital is 8%?
Accept if IRR < 8%, reject otherwise. accept if IRR <8%, reject otherwise; because initial CF is positive and subsequent CFs are negative This is never the decision rule. In "normal" cash flows, where you spend money before you receive it, the rule is "Accept if IRR > opportunity cost of capital." In this case the NPV profile is upward sloping, because he receives his cash inflow before his cash outflows, so the rule is "Accept if IRR < opportunity cost of capital.
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?
NPV = -$95 + ($107/1.06) = $5.94
Interest on municipal bonds is
ignored for tax purposes but included as income for FASB accounting Reason: Interest on municipal bonds is ignored for tax purposes but included as income for FASB accounting.
You must know the discount rate to compute ____, while the discount rate is necessary to apply ___. Multiple choice question.
NPV, IRR Reason: You must know the discount rate to compute NPV, while the discount rate is necessary to apply IRR (because you need it for the decision rule)
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
A project with a negative NPV should be:
Rejected BECAUSE: If the calculated NPV of a project is negative (< 0), the project is expected to result in a net loss for the company. As a result, and according to the rule, the company should not pursue the project.
When evaluating mutually exclusive projects, the profitability index has a problem with __
SCALE
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.
True or false: Two challenges with the IRR approach when comparing two mutually exclusive projects are scale and cash flow timing.
True
True or false: The crossover rate is the rate at which the NPVs of two projects are equal.
True Reason: By definition, the crossover rate occurs when the NPVs of two mutually exclusive projects are equal.
he internal rate of return is a function of .
a project's cash flows. The internal rate of return is a function of only a project's cash flows. It does not require the market interest rate.
The incremental IRR is the rate that causes the incremental cash flows to have:
a zero NPV Reason: The incremental IRR is the rate that causes the incremental cash flows to have an NPV of 0 (both IRRs are the same).
The PI rule for an independent project is to ______ the project if the PI is greater than 1.
accept because If the PI is greater than 1, the present value of the cash flows generated by a project exceed the project's initial cost.
The payback period rule ______ a project if it has a payback period that is less than or equal to a particular cutoff date.
accepts Reason: The payback period rule accepts a project if it has a payback period that is less than or equal to a particular cutoff period
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
When analyzing a project, sunk costs ____ incremental cash outflows. Multiple choice question.
are not. Reason: When analyzing a project, sunk costs are not incremental cash outflows, because they will not be recovered if the project is rejected.
What is the decision-making process for accepting or rejecting projects?
capital budgeting
Corporate finance emphasizes _____ while financial accounting emphasizes ______
cash flows; earnings
Two mutually exclusive projects can be correctly evaluated by
comparing the incremental IRR to the discount rate examining the NPV of the incremental cash flows comparing the NPVs of the two projects
Net present value is the ______ between the sum of the present value of all future cash flows and the ______ cost.Net present value is the ______ between the sum of the present value of all future cash flows and the ______ cost
difference; initial
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
The net present value technique does not discount earnings because earnings ___.
do not represent real money The net present value technique does not discount earnings because earnings do not represent real money, as they are accrual based. They are reported on a quarterly basis.
The discounted payback period ______ account for time value of money and the payback period ______ account for time value of money.
does; does not
In general, NPV is ___
equal to zero when the discount rate equals the IRR. positive for discount rates below the IRR. negative for discount rates above the IRR. True or false: A firm evaluating two mutually exclusive projects can accept both projects FALSE Reason: The firm can reject both projects, but it can accept only one mutually exclusive project.
Sunk costs are costs that ___
have already occurred and are not affected by accepting or rejecting a project. Reason: Sunk costs are costs that have already occurred and are not affected by accepting or rejecting a project.
Interest expenses incurred on debt financing are ______ when computing cash flows from a project. Multiple choice question.
ignored In order to separate the investment from the financing of that investment, you must ignore any costs associated with financing. Cash flows from the project should be completed without taking into account the costs associated with the financing of the project.
If sales are made on credit, net working capital will
increase
The net present value of a project's cash flows is divided by the ______ to calculate the profitability index.
initial investment Reason: The discount rate is used when determining a project's net present value. The formula for profitability index is present value of cash flows after the initial investment/initial investment.
The IRR ______ to distinguish between investing or financing.
is unable 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.
When comparing projects with different lives, one should choose the project with the ______ equivalent annual cost.
lower
When bidding for a job, a competing firm can use the NPV approach to determine their bid. Once the bid is submitted, the firm will win the contract for the project if their bid is the:
lowest
A dollar today is worth ______ a dollar in the future because it can be reinvested.
more than
When cash flows are conventional, NPV is ______ if the discount rate is above the IRR.
negative
When computing the IRR, the discount rate is:
not needed
Depreciation × Tax rate represent the depreciation tax
shield
With mutually exclusive projects, the profitability index suffers from the same problem that the IRR rule does in that it fails to consider ____. Multiple choice question.
the size or scale of projects
Which of the following cause issues when comparing two mutually exclusive projects using IRR?
timing of cash flows scale of cash flows
