Finance 3003Chapter 8

A project with an initial investment of $5 million and cash flows for 6 years of $1.5 million per year. What is the project's internal rate of return (IRR)?

19.9%

The discount rate used to value capital investments is often referred to as ________.

Opportunity Cost of Capital

In simple cases of capital rationing, the _____________ can tell a firm which projects to accept

Profitability index (PI)

Capital rationing that is imposed by top management of a firm is called ___________ rationing. _____________ rationing occurs when a firm cannot raise the money it needs from outside sources.

Soft, Hard

International Rate of Return

The discount rate at which NPV equals zero

True or false: when choosing among mutually exclusive projects, choose the one that offers the highest NPV

True

What are problems that managers may encounter when deciding between mutually exclusive projects?

When equipment should be replaced The choice between short and long-lived equipment The timing of investments

The NPV rule states that managers increase shareholder wealth by:

accepting all projects with a positive NPV

A positive NPV investment _______________ which a negative NPV investment ____________________

builds shareholder value; destroys shareholder value

The limit set on the amount of funds available for investment is referred to as:

capital rationing

Since a risky dollar is worth less than a safe one, returns for risky projects must be ____________ than those of a risk-free investment.

higher

The IRR rule specifies that a firm should select any project whose IRR is ___________ the firm's ____________

higher than; opportunity cost of capital

When choosing mutually exclusive projects, choose the one that offers the ____________________

highest NPV

When the firm's budget is limited, then the firm should select the project with the ______________

highest PI ratio

If two projects (investments) A and B are said to be mutually exclusive then we know that the firm ______________

must choose to invest in either A or B, but not both

The rate of return rule states that a firm should invest in any project offering a rate of return that is higher than the:

opportunity cost of capital

A projects IRR measures the _________ whereas the opportunity cost of capital is equal to the _________________.

profitability of a project; return offered by equivalent-risk investment in the capital market.

When comparing investments in assets with different lives you should:

select the project with the lowest equivalent annual annuity of costs

When evaluating a single project for acceptance, the NPV and IRR decision rules will give the same result when ______________

the graph of NPV versus discount rate declines smoothly as discount rate increases

The payback period for a project can best be defined as:

the length of time before you can recover you initial investment

True or False: the payback rule states that a project should be accepted if its payback period is greater than a specified cutoff period

False: payback period is LESS than a specified cutoff period

What are three limitations of the Payback Rule for accepting projects?

Gives equal weight to all cash flows arriving before the cutoff period Biases the firm against long-term projects in favor of short-term ones Does not consider cash flows after the payback period

Under which situations should the IRR decision rule be avoided?

Mutually Exclusive Projects Multiple Rates of Return A project NPV does not decline smoothly as discount rate increases

Which of the following is the capital investment decision criterion that will always lead management to make the value-maximizing choice?

NPV

what are the Investment criterion methods most used by firms

NPV IRR

Profitability Index (PI) Formula

NPV/Initial Investment

A machine that costs $20,000 today has annual operating costs of $1,500, $1,600, $1,700, and $1,800 in each of the next four years. The discount rate is 10 percent. The PV of costs is _________ and the equivalent annual annuity is __________.

$25,192.61; $7,947.53

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%? (Be sure to record initial investment as a negative number.)

$5.94

Equivalent annual annuity formula

(PV of costs)/(# of years annuity factor)

A project has an initial investment of $125,000 and cash flows of $50,000 per year for 3 years. What is the project's internal rate of return (IRR)?

9.7%

Making the choice to invest today or to postpone that investment to a future date is a choice between mutually exclusive projects. When making this choice, what is the correct criterion to use?

Choose the investment date that produces the highest NPV today

What capital budgeting decision method finds the present value of each cash flow before calculating a payback period?

Discounted payback period

The cash flow per period with the same present value as the cost of buying and operating a machine is called the:

Equivalent annual annuity