Finance Exam 5

NPV Decision Rule

If the computed NPV is greater than zero, accept.

Internal Rate of Return

the discount rate that will make the NPV = 0. (Popular Method)

Profitability Index

the present value of an investment's future cash flows divided by its initial cost

A. Mutually Exclusive

If a firm accepts Project A it will not be feasible to also accept Project B because both projects would require the simultaneous and exclusive use of the same piece of machinery. These projects are considered to be: A. Mutually Exclusive B. Economically Scaled C. Independent D. Interdependent

C. The project's internal rate of return is exactly equal to the discount rate

If a project has a net present value equal to zero, then: A. A decrease in the project's initial cost will cause the project to have a negative NPV. B. The total of the cash inflows must equal the initial cost of the project. C. The project's internal rate of return is exactly equal to the discount rate D. The project's profitability index must also be equal to zero

B) Payback is easier to compute than discounted payback.

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.

B) simplicity.

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.

Advantages of IRR

- Knowing a return is intuitively appealing - It is a simple way to communicate the value of a project to someone who doesn't know all the estimation details - If the IRR is high enough, you may not need to estimate a required return, which is often a difficult task

Disadvantages of Payback Period

-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

Advantages of Discounted Payback Period

-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 of Discounted Payback Period

-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

C) create value for the firm's current stockholders.

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.

PI disadvantages

May lead to incorrect decisions in comparisons of mutually exclusive investments

Net Present Value

The difference between the market value of a project and its cost (best method)

B) internal rate of return.

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.

D) uses an arbitrary cutoff period.

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.

D) Net present value

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

E) The required rate of return must be greater than 12.6 percent.

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.

Advantages of Payback Period

-easy to understand -adjusts for uncertainty of later cash flows -biased toward liquidity

Payback Period

the amount of time required for an investment to generate cash flows sufficient to recover its initial cost

Shortcomings IRR

-Non conventional(cash flow sign changes more than once) cash flows -Mutually Exclusive

Payback period Decision Criteria

Accept if the payback period is less than the policy payback time

PI decision criteria

Accept project when PI>1

Discounted Payback Period Decision Criteria

Accept the project if it pays back on a discounted basis within the specified time

IRR decision criteria

Accept the project if the IRR is greater than the required return

D) the rate of return decreases.

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.

PI Advantages

-Closely related to NPV, generally leading to identical decisions -Easy to understand and communicate -May be useful when available investment funds are limited

D. The discount rate used to in computing the net present value was less than 11.63 percent

You are considering a project with conventional cash flows, an IRR of 11.63 percent, a PI of 1.04, an NPV of $987, and a payback period of 2.98 years. Which one of the following statements is correct given this information? A. The project must be rejected based on its PI value B. The breakeven discount rate is less than 11.63 percent C. The discounted payback period must be less than 2.98 years D. The discount rate used to in computing the net present value was less than 11.63 percent

B) cash inflows are moved earlier in time.

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.

A) is acceptable if its calculated payback period is less than some pre-specified period of time.

An investment A) is acceptable if its calculated payback period is less than some pre-specified 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.

A) greater than one.

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 pre-specified rate of return.

B) internal rate of return will exceed its required rate of return.

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.

C) IRR exceeds the required return.

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.

C) if the NPV is positive and reject it if the NPV is negative.

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.

C) discount rate applied to the project is decreased.

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.

5 Capital Budgeting Methods

Payback Period, Discounted payback period, NPV, Profitability Index, Internal Rate of Return

D) will provide the same accept/reject decision as NPV when cash flows are conventional and projects are independent.

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.

E) The project is earning $210 in addition to the project's required rate of return.

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.

A) it provides a quick estimate of how rapidly an initial investment will be recouped.

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.

A) internal rate of return and net present value methods.

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.

A) The project is expected to increase shareholder value.

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.

A. Accepted because the profitability index is greater than 1.

When the present value of the cash inflows exceeds the initial cost of a project, then the project should be: A. Accepted because the profitability index is greater than 1. B. Rejected because the internal rate of return is negative. C. Rejected because the net present value is positive. D. Accepted because the payback period is less than the required time period.

B) Payback and discounted payback

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

B. The IRR is equal to the required return when the net present value is equal to zero.

Which of the following statements related to the internal rate of return (IRR) is correct? A. A project with an IRR equal to the required return would reduce the value of a firm if accepted. B. The IRR is equal to the required return when the net present value is equal to zero. C. The payback period is a better method of analysis than the IRR from a financial point of view. D.The IRR yields the same accept and eject decisions as the net present value method given mutually exclusive projects.