Finance Module 10
The owner of a hair salon spends $1,000,000 to renovate its premises, believing that this will increase her future cash flow. She constructs the graph below, which shows the net present value (NPV) as a function of the discount rate. At what discount rate does her decision to renovate become untenable?
3.3%
Which of the following situations can lead to IRR giving a different decision than NPV for mutually exclusive projects?
All of the above can lead to IRR giving a different decision than NPV
A decrease in the firm's discount rate (r, or WACC) will increase NPV of a project with normal cash flows, which could change the accept/reject decision for any independent project under the NPV method. However, since such a change would have no impact on the project's IRR, the accept/reject decision of the independent project under the IRR method does not depend on the cost of capital.
False
All else constant, an increase in the cost of capital will result in a decrease in a project's IRR.
False
Assuming that their NPVs based on the firm's cost of capital are equal, the NPV of a project whose cash flows accrue relatively rapidly will be more sensitive to changes in the discount rate than the NPV of a project whose cash flows come in later in its life.
False
Internal rate of return (IRR) can reliably be used to choose between mutually exclusive projects.
False
Suppose there are two mutually exclusive projects - Project X and Project Y - with normal cash flows. If the IRR of Project X is greater than the IRR of Project Y, we can conclude that the firm should select X rather than Y if X has NPV > 0.
False
The IRR of normal Project X is greater than the IRR of normal Project Y, and both IRRs are greater than zero. Also, the NPV of X is greater than the NPV of Y at the cost of capital of 10%. If the two projects are mutually exclusive, Project X will be selected over Project Y at all discount rates (at which NPV of X is positive).
False
The internal rate of return (IRR) rule will agree with the Net Present Value rule even when positive cash flows precede negative cash flows.
False
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
If a project has normal cash flows and its IRR exceeds its WACC, then the project's NPV must be positive.
Which of the following statements is FALSE for normal projects (i.e., projects with normal cash flows)?
If the cost of capital estimate is more than the internal rate of return (IRR), the net present value (NPV) will be positive.
Which of the following is NOT a limitation of the payback period rule?
It is difficult to calculate.
Which of the following is NOT a limitation of the payback rule?
It is difficult to calculate.
Which of the following statements is CORRECT?
Multiple IRRs can only occur if the signs of the cash flows change more than once.
A firm is considering several mutually exclusive investment opportunities. The best way to choose between them is which of the following?
Net Present Value (NPV)
The cash flows for three projects are shown below. The cost of capital is 7.5%. If an investor decided to take projects with a payback period two years or less, which of these projects would he take?
None of these investments
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
One drawback of the payback criterion for evaluating projects is that this method does not properly account for the time value of money.
Which of the following decision rules is best defined as the amount of time it takes to pay back the initial investment?
Payback period
Which of the following statements is CORRECT?
Projects with "normal" cash flows can have only one IRR.
Which of the following statements is CORRECT?
The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
Which of the following statements is FALSE?
The payback rule is reliable because it considers the time value of money and depends on the cost of capital.
Which of the following statements is FALSE?
There is always one internal rate of return (IRR) for an investment opportunity.
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
To find a project's IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project's costs.
One advantage of the payback method for evaluating potential investments is that it provides some information about a project's liquidity and risk.
True
The NPV method's assumption that cash inflows are reinvested at the cost of capital is more reasonable than the IRR's assumption that cash flows are reinvested at the IRR.
True
The payback rule is based on the idea that an opportunity that pays back its initial investment quickly is a worthwhile opportunity.
True
Under certain conditions, a project may have more than one IRR. One such condition is when, in addition to the initial investment at time = 0, a negative cash flow (or cost) occurs at the end of the project's life.
True
When different investment rules give conflicting answers, then decisions should be based on the Net Present Value rule, as it is the most reliable and accurate decision rule.
True
