FIN3080C - Chapter 9 Terms
Net Present Value Profile
A graphical representation of the relationship between an investment's NPVs and various discount rates.
Mutually Exclusive Investment Decisions
A situation in which taking one investment prevents the taking of another.
Payback Period - Decision Rule
Accept the project if it pays back on a discounted basis within the specified time.
IRR - Decision Rule
Accept the project if the IRR is greater than the required return.
One advantage of the payback method of project analysis is the method's A) application of a discount rate to each separate cash flow. B) simplicity. C) difficulty of use. D) arbitrary cutoff point. E) consideration of all relevant cash flows.
Answer: B
The discount rate that makes the net present value of an investment exactly equal to zero is called the A) profitable rate of return. B) internal rate of return. C) average accounting return. D) profitability index. E) risk-free rate.
Answer: B
Which methods of project analysis are most biased towards short-term projects? A) Net present value and internal rate of return B) Payback and discounted payback C) Accounting rate of return and internal rate of return D) Payback and accounting rate of return E) Internal rate of return and discounted payback
Answer: B
A firm should accept projects with positive net present values primarily because those projects will A) produce cash inflows that exceed the cash outflows. B) return the firm's initial cash outlay within 1 year. C) create value for the firm's current stockholders. D) produce only positive cash flows after the initial investment period. E) increase the current liquidity of the firm.
Answer: C
Assume a project has normal cash flows. According to the accept/reject rules, the project should be accepted if the A) PI is less than 1. B) AAR is less than the required AAR. C) IRR exceeds the required return. D) payback period is less than the life of the project. E) discounted payback period is less than the life of the project.
Answer: C
Assume a project has normal cash flows. Given this, you should accept the project A) if, and only if, the NPV is exactly equal to zero. B) only if the NPV is equal to the initial cash flow. C) if the NPV is positive and reject it if the NPV is negative. D) if the total cash inflows exceed the initial cash outflow. E) because it has positive cash flows for every time period after the initial investment.
Answer: C
The discounted payback period of a project will decrease whenever the A) initial cash outlay for the project is increased. B) amount of each projected cash inflow is decreased. C) discount rate applied to the project is decreased. D) time period of the project is increased. E) costs of the fixed assets utilized in the project increase.
Answer: C
All else constant, the net present value of a typical investment project increases when A) the discount rate increases. B) each cash inflow is delayed by one year. C) the initial cost of a project increases. D) the rate of return decreases. E) all cash inflows are moved to the last year of the project.
Answer: D
The discounted payback method A) discounts a project's initial cost. B) is simpler and more reliable than the payback period. C) is as reliable as NPV because both methods use discounted cash flo. D) uses an arbitrary cutoff period. E) ignores a project's initial costs.
Answer: D
The internal rate of return: A) is more reliable as a decision making tool than net present value when considering mutually exclusive projects. B) is the discount rate that makes the net present value of a project equal to one. C) is easier to apply than net present value when cash flows are unconventional. D) will provide the same accept/reject decision as NPV when cash flows are conventional and projects are independent. E) is influenced by daily changes in the market rate of interest.
Answer: D
Uptown Developers is considering two projects. Project A consists of building a wholesale book outlet on the firm's downtown lot. Project B consists of building a sit-down restaurant on that same lot. The lot can only accommodate one of the projects. When trying to decide whether to build the book outlet or the restaurant, management should rely most heavily on the analysis results from which one of these methods? A) Profitability index B) Internal rate of return C) Payback D) Net present value E) Accounting rate of return
Answer: D
1. The net present value of a project is projected at $210. How should this amount be interpreted? A) The project's cash inflows exceed its outflows by $210. B) The project will return an accounting profit of $210. C) The project's discounted cash flows are $210 less than its undiscounted cash flows. D) The project will increase the firm's cash account by $210 when the project is started. E) The project is earning $210 in addition to the project's required rate of return.
Answer: E
You are considering a project with conventional cash flows. The IRR is 12.6 percent, NPV is -$198, and the payback period is 2.87 years. Which one of the following statements is correct given this information? A) The discount rate used in computing the net present value was less than 12.6 percent. B) The discounted payback period will have to be less than 2.87 years. C) The project life must be 2.87 years. D) This project should be accepted based on the internal rate of return. E) The required rate of return must be greater than 12.6 percent.
Answer: E
Average Accounting Return (AAR)
An investment's average net income divided by its average book value.
An investment is acceptable if the profitability index (PI) of the investment is A) greater than one. B) less than one. C) greater than the internal rate of return (IRR). D) less than the net present value (NPV). E) greater than a prespecified rate of return.
Answer: A
An investment: A) is acceptable if its calculated payback period is less than some prespecified period of time. B) should be accepted if the payback is positive and rejected if it is negative. C) should be rejected if the payback is positive and accepted if it is negative. D) is acceptable if its calculated payback period is greater than some prespecified period of time. E) should be accepted any time the payback period is less than the discounted payback period, given a positive discount rate.
Answer: A
The payback method is a convenient and useful tool because A) it provides a quick estimate of how rapidly an initial investment will be recouped. B) it considers all of a project's relevant cash flows. C) it considers the time value of money. D) the required payback period for all of a firm's projects must be identical. E) it only considers the cash flows within the current period of 12 months.
Answer: A
The two most commonly used methods of capital budgeting analysis are the A) internal rate of return and net present value methods. B) net present value and payback methods. C) profitability index and the internal rate of return methods. D) net present value and discounted payback methods. E) average accounting return and discounted payback methods.
Answer: A
What is the key reason why a positive NPV project should be accepted? A) The project is expected to increase shareholder value. B) The present value of the expected cash flows equals the project's cost. C) The project will produce positive cash flows in the future. D) The project's payback will be positive during its life. E) The project's PI will be less than 1, which indicates acceptance.
Answer: A
All else equal, the payback period for a project will decrease whenever the A) duration of a project is lengthened. B) cash inflows are moved earlier in time. C) assigned discount rate decreases. D) required return for a project increases. E) initial cost increases.
Answer: B
Assume a project has normal cash flows and a positive (non-zero) net present value. The project's A) profitability index will be less than 1. B) internal rate of return will exceed its required rate of return. C) costs exceed its benefits. D) discounted payback period will exceed the life of the project. E) payback period must equal the life of the project.
Answer: B
If the discounted payback method is preferable to the payback method, then why is the payback method ever used? A) The discounted payback requires an arbitrary cutoff point while payback does not. B) Payback is easier to compute than discounted payback. C) Payback considers all of a project's cash flows but discounted payback does not. D) Payback requires the initial investment be recovered during a project's life while the required discounted payback period may be shorter. E) Payback can be used with mutually exclusive projects but discounted payback cannot.
Answer: B
NPV - Decision Rule
If the NPV is positive, accept the project.
Payback Period
The amount of time required for an investment to generate cash flows sufficient to recover its initial cost. Advantages -easy to understand -adjusts for uncertainty of later cash flows -biased toward liquidity Disadvantages -ignores the time value of money -requires an arbitrary cutoff point -ignores cash flows beyond the cutoff date -biased against long-term projects, such as research and development, and new projects
Net Present Value (NPV)
The difference between an investment's market value and its cost.
Internal Rate of Return (IRR)
The discount rate that makes the NPV of an investment zero.
Discounted Payback Period
The length of time required for an investment's discounted cash flows to equal its initial cost. Advantages -includes time value of money -easy to understand -does not accept negative estimated NPV investments when all future cash flows are positive -biased towards liquidity Disadvantages -may reject positive NPV investments -requires an arbitrary cutoff point -ignores cash flows beyond the cutoff point -biased against long-term projects, such as R&D and new products
Multiple Rates of Return
The possibility that more than one discount rate will make the NPV of an investment zero.
Profitability Index (PI)
The present value of an investment's future cash flows divided by its initial cost. Also called the benefit-cost ratio. Advantages -closely related to NPV, generally leading to identical decisions -easy to understand and communicate -may be useful when available investment funds are limited Disadvantages -may lead to incorrect decisions in comparisons of mutually exclusive investments
Discounted Cash Flow (DCF) Valuation
The process of valuing an investment by discounting its future cash flows.