FIN 3214: Chapter 7: Net Present Value and Other Investment Rules

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%

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

Accept

The problems with scale in the profitability index can be corrected by using ______ analysis.

Incremental

NPV, but not IRR, can be used in which of these situations?

Multiple IRR AND Multiple changes in cash flow signs

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

Present Value

With mutually exclusive projects, the profitability index suffers from the same problem that the IRR rule does in that it fails to consider _____.

The size or scale of projects.

Why is a dollar received today worth more than a dollar received in the future?

Today's dollar can be invested, yielding a greater amount in the future.

The IRR is the discount rate that makes the NPV of a project equal to _____.

Zero

Which of these sets of cash flows may have multiple internal rates of return?

$20, -$5, $10, -$40 AND -$50, $40, $30, -$5

A project requires $240 of equipment that will be depreciated straight-line over the 3-year project life. What is the average investment for AAR purposes?

($240+$160+$80+$0)/4 = $120

The internal rate of return is a function of ____.

A project's cash flows

For a project with a positive intial cash flow followed by negative cash flows, we should ____.

Accept if the IRR is less than R.

The discount rate is often referred to as ______.

An opportunity cost

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

Arbitrary

Which of these are weaknesses of the AAR method of project analysis?

Arbitrary target rate, No account of timing, AND Use of accounting values rather than cash flows

The average accounting return is calculated as the average net income from a project divided by the _____.

Average book value of the investment.

The net present value of a project's cash flows is divided by the _____ to calculate the profitability index.

Initial Investment

The most important alternative to NPV is the _____ method.

Internal Rate of Return

The discounted payback period has which of these weaknesses?

Loss of simplicity as compared to the payback method, Arbitrary cutoff date, AND Exclusion of some cash flows

The _____ method is ideal for companies with limited funds that have a need for a quick turn-around of their capital.

Payback

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 OR Accept;Less

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?

IRR and NPV

A(n) _____ project does not rely on the acceptance or rejection of another project.

Independent

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

More

The IRR allows a manager to summarize the information about a project in a _______ rate of return.

Single

When using the spreadsheet function NPV, the cash outflow at Time 0 must be _____.

Subtracted from the PV of the other cash flows.

The spreadsheet function for calculating net present value is _____.

=NPV()

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

Payback

The capital budgeting method allows lower management to make smaller, everyday financial decisions easily is:

Payback Method

Accepting a positive NPV project will _____ the stockholders by ______ the value of the firm.

Benefit; Increasing

Capital ____ is the decision-making process for accepting and rejecting projects.

Budgeting

Two mutually exclusive projects can be correctly evaluated by _____.

Comparing the NPVs of the two projects, Examining the NPV of the incremental cash flows, AND 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

Accept a project if its NPV is _____ zero.

Greater Than

The movie industry frowns upon NPV analysis because their cash flows are ____ to predict.

Hard

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

IRR = ($250/$200) - 1 = 25%

The payback period can lead to incorrect decisions if it is used too literally because it ____.

Ignores cash flows after the cutoff date

A dollar received one year from today has _____ value than a dollar received today.

Less

Capital rationing requires a company to ____.

Limit their investments.

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

MIRR and NPV

The dollar difference in vale between mutually exclusive projects can be found by calculating the _____ of the incremental cash flows.

NPV

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%?

NPV = -$95 + ($107/1.06) = $5.94

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%?

PI = (($80/1.12)+($20/1.12^2))/ $30 PI = 2.91

The _____ method is best suited for decisions on small projects while the _____ method is most appropriate for large, complex projects.

Payback; NPV

In general, NPV is ____.

Positive for discount rates below the IRR, Equal to zero when the discount rate equals the IRR, AND Negative for discount rates above the IRR.

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

Capital ____ occurs when a firm doesn't have enough capital to fund all its positive NPV projects.

Rationing

According to the basic investment rule for NPV, a firm should ______.

Reject a project if NPV is less than zero, Accept a project if the NPV is greater than zero, AND Be indifferent towards accepting a project if NPV is equal to zero.

A firm evaluating two mutually excusive projects can ____.

Rejects one of the projects, Reject both projects, AND Accept one of the projects.

The discount rate is determined by the _______ of a project.

Risk

The incremental IRR is used to account for the problem of _____ when evaluating project cash flows.

Scale

The three attributes of NPV are that it:

Uses cash flows AND Uses all the cash flows of a project AND Discounts the cash flows properly

Arrange the steps involved in the discounted payback period in order starting with the first step.

1) Discount the cash flows using the discount rate, 2) Add the discounted cash flows, AND 3) Accept if the discounted payback period is less than some pre-specified number of years.

If the IRR of a project is greater than the discount rate, we should ____.

Accept the project.

According to the basic IRR rule, we should _____ a project if the IRR is _____ than the discount rate.

Accept; Greater AND Reject; Less

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 property of value _____ implies that the contribution of any project to a firm's value is simply the NPV of the project.

Additivity

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.

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

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 AND Accept if NPV is greater than zero.

The discount rate assigned to a project reflects the ____.

Risk of the project AND Opportunity cost to the investor

NPV accounts for the size of the project, and eliminating the effects of _____.

Scale

When evaluating mutually exclusive projects, the profitability index has a problem with ____.

Scale

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, AND It allows lower level manager to make small decisions effectively.

What does value additivity mean for a firm?

The value of a firm is simply the combined value of the firm's projects, divisions, and entities owned by the firm AND The NPV values of individual projects can be added together.

Which of the following are weaknesses of the payback method?

Time value of money principles are ignored, The cutoff date is arbitrary, AND Cash flows received after the payback period are ignored.