Exam 3

Which of the following present problems when using the IRR method?

-mutually exclusive projects -non-conventional cash flows

Which of the following is true relative to capital rationing?

-soft rationing is typically internal in that the firm allocates funds to divisions for capital projects -hard rationing implies the firm is unable to raise funds for projects

What is the total number of inputs that change at a given time while doing sensitivity analysis?

1

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 a disadvantage of the Profitability Index?

It cannot rank mutually exclusive projects.

Given a level of investment in net working capital, that same investment must be ______ at some time in the future.

recovered

According to the basic IRR rule, we should:

reject a project if the IRR is less than the required return

Opportunity costs are classified as ____ costs in project analysis.

relevant

The first step in estimating cash flow is to determine the _________ cash flows.

relevant

If the IRR is greater than the _______ ________, we should accept the project.

required return

__________ analysis is useful in pinpointing variables that deserve the most attention.

sensitivity

To investigate the impact on NPV of a change in one variable, you would employ ________.

sensitivity analysis

When calculating NPV, the present value of the nth cash flow is found by dividing the nth cash flow by 1 plus ______ rate raised to the nth power

the discount

The IRR is the discount rate that makes NPV equal to ______.

zero

The basic NPV investment rule is:

-if the NPV is equal to zero, acceptance or rejection of the project is a matter of indifference -accept a project if the NPV is greater than zero. -reject a project if its NPV is less than zero.

If a firm's sales estimate used in its base case analysis is 1,000 units per year and they anticipate the upper and lower bounds to be +/- 15%, What is the "best case" for units sold per year?

1,150 (Reason: 1.15 × 1,000 = 1,150)

If we find that our estimated NPV is sensitive to a variable that is difficult to forecast, then the degree of forecasting risk is _____.

High

Once cash flows have been estimated, which of the following investment criteria can be applied to them?

NPV IRR payback period

Which of the following is a disadvantage of the payback period rule?

Requires an arbitrary cutoff point

What is scenario analysis?

Scenario analysis determines the impact on NPV of a set of events relating to a specific scenario.

True or false: Net working capital will be recovered at the end of a project.

TRUE

True or false: A project with non-conventional cash flows will produce two or more IRRs.

True

True or false: Investment in net working capital may arise from the need to cover credit sales.

True

The internal rate of return is a function of ____.

a project's cash flows

We underestimate NPV because of the option(s) to ______.

abandon expand

The PI rule for an independent project is to ______ the project if the PI is greater than 1.

accept

Side effects from investing in a project refer to cash flows from:

erosion effects beneficial spillover effects

True or false: In calculating cash flows, you should consider all financing costs.

false

True or false: The PI always results in the correct decision in comparisons of mutually exclusive investments.

false

Synergy will _____ the sales of existing products.

increase

Investment in net working capital arises when ___.

inventory is purchased credit sales are made cash is kept for unexpected expenditures

The payback period can lead to foolish decisions if it is used too literally because:

it ignores cash flows after the cutoff date

The ______ method evaluates a project by determining the time needed to recoup the initial investment.

payback

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

required return

When we estimate the best-case, worst-case, and base-case cash flows and calculate the corresponding NPVs, we are engaging in:

scenario analysis asking what if

Estimates of which of the following are needed to prepare pro forma income statements?

selling price per unit variable costs unit sales

Scenario analysis considers a combination of factors for each scenario while _________ analysis focuses on only one variable at a time

sensitivity

Capital rationing exists when a company has identified positive NPV projects but cannot (or will not) find:

the necessary financing

True or false: If analysts are overly optimistic about the future, then they may accept a project that realistically has a negative NPV.

true

In a competitive market, positive NPV projects are:

uncommon

In order to analyze the risk of a project's NPV estimate, we should establish ___________ for each important estimate variable.

upper and lower bounds

The multiple rates of return problem is the possibility that more than one discount rate may make the net present value of an investment equal to

zero

Operating cash flow is a function of:

Earnings Before Interest and Taxes Taxes Depreciation

True or false: Sensitivity analysis is helpful because it indicates what we should do regarding forecasting errors.

False

Which of the following are methods of calculating the MIRR of a project?

-The Combination Approach -The Reinvestment Approach -The Discounting Approach

What are the advantages of the payback period method for management?

-The payback period method is easy to use. -The payback period method is ideal for minor projects. -It allows lower level managers to make small decisions effectively.

Which of the following are components of project cash flow?

Change in net working capital Capital spending Operating cash flow

What are the two main benefits of performing sensitivity analysis?

It reduces a false sense of security by giving a range of values for NPV instead of a single value. It identifies the variable that has the most effect on NPV.

If a project has multiple internal rates of return, which of the following methods should be used?

NPV MIRR

One of the weaknesses of the payback period is that the cutoff date is a(n) ______ standard.

arbitrary

A positive NPV exists when the market value of a project exceeds its cost. Unfortunately, most of the time the market value of a project:

cannot be observed

Cash flows used in project estimation should always reflect:

cash flows when they occur after-tax cash flows

Managerial options are taken into consideration in __________ planning

contingency

The Profitability Index is also called the __________ ratio.

cost-benefit

Incremental cash flows come about as a(n) ________ consequence of taking a project under consideration.

direct

True or false: The depreciation tax shield is the depreciation deduction divided by the tax rate.

false

True or false: The profitability index (PI) is calculated by dividing the present value of an investment's future cash flows by its future cost.

false

Sunk costs are costs that ____.

have already occurred and are not affected by accepting or rejecting a project

What is the primary concern of the payback period rule?

how long it takes to recover initial investment

A positive NPV exists when the market value of a project exceeds its cost. Which of these two values is the most difficult to establish?

market value

In capital budgeting, ______ determines the dollar value of a project to the company

net present value

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

not considered in analysis

The NPV is ______ if the required return is less than the IRR, and it is ______ if the required return is greater than the IRR.

positive, negative

An option on a real asset rather than a financial asset is known as a:

real option managerial option

When using _______________, all of the variables except one are frozen in order to determine how sensitive the NPV estimate is to changes in that particular variable.

sensitivity analysis

According to the _________ principle, once the incremental cash flows from a project have been identified, the project can be viewed as a "minifirm."

stand-alone

Cash flows should always be considered on a(n) ___________ basis.

after tax

The number of positive NPV projects is unlimited for any given firm.

false

True or false: The profitability index rule for an independent project states that, if a project has a positive NPV, then the present value of the future cash flows must be smaller than the initial investment.

false

Interest expenses incurred on debt financing are ______ when computing cash flows from a project.

ignored

The discounted cash flow valuation shows that higher cash flows earlier in a project's life are ______ valuable than higher cash flows later on. (more or less)

more

Which of the following are reasons why NPV is considered a superior capital budgeting technique?

It considers all the cash flows. It considers time value of money. It considers the riskiness of the project. It properly chooses among mutually exclusive projects

If a firm's variable cost per unit estimate used in its base case analysis is $50 per unit and they anticipate the upper and lower bounds to be +/- 10%, What is the "worst case" for variable cost per unit?

$55 (Reason: 1.10 × $50 = $55; The worst case for costs is the higher value.)

True or false: The discounted cash flow (DCF) valuation estimates future value as the difference between the market price and the cost of the investment.

False

True or false: The value of managerial options is taken into account when performing conventional NPV analysis.

False

True or false: There is only one way to calculate the modified IRR.

False

Which of the following are reasons why IRR continues to be used in practice?

-Businesspeople prefer to talk about rates of return. -The IRR of a proposal can be calculated without knowing the appropriate discount rate. -It is easier to communicate information about a proposal with an IRR.

What is an important drawback of traditional NPV analysis?

It ignores managerial options in investment decisions.

The Combination MIRR method is used by the Excel MIRR function and uses which of the following?

-Discounting all cash outflows to time 0 -A financing rate for discounting -Compounding cash inflows to the end of the project -A reinvestment rate for compounding

Specifying variables in the Excel NPV function differs from the manner in which they are entered in a financial calculator in which of the following ways?

-The range of cash flows specified in Excel begins with Cashflow 1, not Cashflow 0. -The discount rate in Excel is entered as a decimal, or as a percentage with a percent sign. -With the Excel NPV function, Cashflow 0 must be handled outside the NPV function. -The Excel NPV function is actually a PV function.

True or false: The IRR is easy to use because you only need to know the appropriate discount rate.

False

True or false: The payback period takes into consideration the time value of money.

False

What are the two main drawbacks of sensitivity analysis?

It does not consider interaction among variables. It may increase the false sense of security among managers if all pessimistic estimates of NPV are positive.

In the context of capital budgeting, what does sensitivity analysis do?

It examines how sensitive a particular NPV calculation is to changes in underlying assumptions.

_______ is a measure of how much value is created or added by undertaking an investment.

Net present value

The possibility that errors in projected cash flows will lead to incorrect decisions is known as:

forecasting risk estimation risk

True or false: Some projects, such as mines, have cash outflows followed by cash inflows and cash outflows again, giving the project multiple internal rates of return.

True

True or false: While performing sensitivity analysis, we recompute NPV several times by changing one input variable at a time.

True

A project should be __________ if its NPV is greater than zero

accepted

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

accepts

The profitability index is calculated by dividing the PV of the _________ cash inflows by the initial investment.

future

The goals of risk analysis in capital budgeting include:

identifying critical components assessing the degree of financing risk

The difference between a firm's cash flows with a project versus without the project is called ________________.

incremental cash flows

The profitability index (PI) is calculated by dividing the present value of an investment's future cash flows by its _____ _____.

initial cost

The present value of the future cash inflows are divided by the ______ to calculate the profitability index.

initial investment

If a firm is evaluating two possible projects, both of which require the use of the same production facilities, and taking one project means that we cannot take the other, these projects would be considered _______________.

mutually exclusive

West Corporation estimated cash flows for a project, evaluated those cash flows using NPV, and determined that the project was acceptable. Unfortunately West Corporation lost money on the project. This may have been avoided had they assessed the ______ of the cash flow estimates.

reliability

True or false: According to Graham and Harvey's 1999 survey of 392 CFOs (published in 2001), the internal rate of return and the NPV are the two most popular capital budgeting methods used by firms in the US and Canada.

true