MGF Chapter 8

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 Rationale: $1,978,130 = -10,000,000 + 3M/(1.08) + 3M/(1.08)2 + 3M/(1.08)3 + 3M/(1.08)4 + 3M/(1.08)5

A project has an initial investment of $1.4 million and a present value of cash flows totaling $4 million. What is the project's net present value (NPV)?

$2.6 million Rationale: NPV=initial investment + PV of cash flows= -$1.4 million + 4 million = $2.6 million

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 NPV = -$95 + ($107/1.06) = $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 Rationale: 50000/(1.075)6 + 75000/(1.075)5 + 75000/(1.075)4 + 75000/(1.075)3 + 100000/(1.075)2 + 100000/(1.075) - 300000

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% Rationale: An IRR of 19.9% gives an NPV of $673.16, which is the closest figure to zero.

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)? 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.

9.7% Rationale: A discount rate of 9.7% gives an NPV of $2.27, which is the closest to zero.

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.

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

Discounted payback period

True or false: IRR is essentially the same as the opportunity cost of capital.

F

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

F

The single variable of interest for the investment timing problem is

NPV

Which mutually exclusive project should a manager select?

NPV = $1,800, Total Cash Flow = $9,000

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 Rationale: Project A has a higher NPV and is the correct choice: $4.5 million - $1.2 million = $3.3 million. The NPV for Project B is only $5 million - $2 million = $3 million

Under which of the following situations should the IRR decision rule be avoided?

a project with multiple rates of return selection of mutually exclusive projects project NPV does not decline smoothly as discount rate increases

The net present value rule states that managers increase shareholder wealth by:

accepting all projects with a positive NPV.

A positive NPV investment _________ while 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

The relationship between the NPV profile and the discount rate is

declining

The internal rate of return (IRR) is also called the:

discounted cash flow (DCF) rate of return

The ___________ method of project selection asks, "How long must the project last in order to offer a positive net present value?"

discounted-payback

The rate of return rule states that the rate of return is the discount rate at which NPV:

equals 0

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

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

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

profitability index (PI)

A project's IRR measures the _________ whereas the opportunity cost of capital is equal to the ____________.

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

The opportunity cost of capital is determined by the ______ of a project.

risk

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

When considering mutually exclusive projects, the project that adds most to shareholder wealth is the one with:

the highest NPV

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

the length of time before you recover your initial investment

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

the opportunity cost of capital

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

The NPV formula can be defined as:

PV - required investment

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

T

Select which of the following relationships is correct:

if the opportunity cost of capital is less than a project's rate of return, then the NPV of the project is positive

If choices you make today do not affect future investment opportunities, then

it is enough simply to compare the NPV of the projects.

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 Internal Rate of Return (IRR) can best be defined as:

the discount rate at which the NPV equals zero

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