Finance 342 Chapter 8 Concept Questions
A firm plans to invest $10,000,000 in a new factory that will generate annual cash flows to the firm of $3,000,000 for 5 years, then will be scrapped. If the appropriate opportunity cost of capital for this investment is 8.0 percent, what is its NPV?
$1,978,130
A project has 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)? Hint: use your financial calculator or financial spreadsheet to answer this question. Or, use trial and error to see which discount rate below offers an NPV closest to zero.
19.9%
In simple cases of capital rationing, the _________ can tell a firm which projects to accept.
Profitability Index (PI)
A company has the opportunity to invest in one of two mutually exclusive projects. Project A has an initial cost of $1.2 million and cash flows with a present value of $4.5 million. Project B has an initial cost of $2 million and cash flows with a present value of $5 million. Which project should the firm choose to invest in?
Project A because it has a higher Net Present Value
The opportunity cost of capital is determined by the ______ of a project.
Risk
A positive NPV investment _________ while a negative NPV investment __________.
builds shareholder value; destroys shareholder value
The internal rate of return (IRR) is also called the:
discounted cash flow (DCF) rate of return
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
The IRR rule specifies that a firm should select any project whose IRR is __________ the firm's ___________.
higher than; opportunity cost of capital
If choices you make today do not affect future investment opportunities, then
it is enough simply to compare the NPV of the projects.
Under which of the following situations should the IRR decision rule be avoided?
selection of mutually exclusive projects project NPV does not decline smoothly as discount rate increases a project with multiple rates of return
The opportunity cost of capital can best be described as:
the expected rate of return given up by investing in a project rather than in the capital market
True or false: IRR is essentially the same as the opportunity cost of capital.
False
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
Which of the three limitations of the Payback Rule can be overcome with a modification to it?
Gives equal weight to all cash flows arriving before the cutoff period
Which two investment criterion methods are most used by firms?
Internal Rate of Return / Net Present Value
Which mutually exclusive project should a manager select?
NPV = $1,800, Total Cash Flow = $9,000
The correct equation for the Profitability Index (PI) is given by:
NPV/Initial Investment
The single variable of interest for the investment timing problem is
Net Present Value
Machines A and B are mutually exclusive and have the following investment and operating costs. Machine A has a life of 3 years while Machine B has a 2 year life. Year: 0 1 2 3 A $5,000 $800 $900 $1,000 B $6,000 $850 $900 -- Assume the discount rate is 9 percent. The equivalent annual annuity of machine A is ______. The equivalent annual annuity of machine B is ______.
$2,869.53; $4,284.74
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 the initial investment as a negative number.)
$5.94
A firm plans to invest $300,000 in a new high-efficiency furnace that will reduce it's energy bill by $100,000 in years 1 and 2, $75,000 in years 3,4,5 and $50,000 in year 6. If the appropriate discount rate is 7.5%, the NPV of this project is ________.
$80,729
When considering mutually exclusive projects, the project that adds most to shareholder wealth is the one with:
- Biases the firm against long-term projects in favor of short-term ones - Gives equal weight to all cash flows arriving before the cutoff period - Does not consider cash flows after the payback period
Which of the following are problems that managers may encounter when deciding between mutually exclusive projects?
- when equipment should be replaced - the timing of investments - the choice between short and long-lived equipment
Project A has an initial investment of $10,000 and an NPV of $15,000. Project B has an initial investment of $100,000 and an NPV of $101,000. Based on the PI (Profitability Index), project _______ would be selected. Based on the NPV, project _______ would be accepted. Selecting project ______ will actually maximize shareholder value.
A B B
Which of the following is the correct definition of the Equivalent Annual Annuity (EAA)?
A stream of cash flows or payments that have the same present value as a project or investment's cash flows.
Select which of the following relationships is correct: A) if the opportunity cost of capital is greater than a project's rate of return, then the NPV of the project is positive B) if the opportunity cost of capital is less than a project's rate of return, then the NPV of the project is positive C)if the opportunity cost of capital is equal to a project's rate of return, then the NPV of the project is positive
B) if the opportunity cost of capital is less than a project's rate of return, then the NPV of the project is positive
The relationship between the NPV profile and the discount rate is
Declining
Which capital budgeting decision method finds the present value of each cash flow before calculating a payback period?
Discounted Payback Period
When comparing investments in assets with different lives, which project is best?
EAA = -$3,000; NPV = -$10,000
