Conceptual questions from Chapter 8

Which of the following best describes the Net Present Value rule? A) Take any investment opportunity where the net present value (NPV) is not negative; turn down any opportunity when it is negative. B) Take any investment opportunity where the net present value (NPV) exceeds the opportunity cost of capital; turn down any opportunity where the cost of capital exceeds the net present value (NPV). C) When choosing among any list of investment opportunities where resources are limited, always choose those projects with the highest net present value (NPV). D) If the difference between the present cost of an investment and the present value (PV) of its benefits after a fixed number of years is positive the investment should be taken, otherwise it should be rejected.

A) Take any investment opportunity where the net present value (NPV) is not negative; turn down any opportunity when it is negative.

You are trying to decide between three mutually exclusive investment opportunities. The most appropriate tool for identifying the correct decision is ________. A) net present value (NPV) B) profitability index C) internal rate of return (IRR) D) incremental internal rate of return (IRR)

A) net present value (NPV)

Assuming that your capital is constrained, which investment tool should you use to determine the correct investment decisions? A) profitability Index B) incremental IRR C) net present value (NPV) D) internal rate of return (IRR)

A) profitability Index

The present value (PV) of an investment is ________. A) the amount that an investment would yield if the benefit were realized today B) the difference between the cost of the investment and the benefit of the investment in dollars today C) the amount you need to invest at the current interest rate to re-create the cash flow from the investment D) the amount by which the cash flow of an investment exceeds or falls short of the cash flow generated by the same amount of money invested at market rate

A) the amount that an investment would yield if the benefit were realized today

Which of the following statements is FALSE? A) The payback investment rule is based on the notion that an opportunity that pays back its initial investments quickly is a good idea. B) An internal rate of return (IRR) will always exist for an investment opportunity. C) A net present value (NPV) will always exist for an investment opportunity. D) In general, there can be as many internal rates of return (IRRs) as the number of times the project's cash flows change sign over time.

B) An internal rate of return (IRR) will always exist for an investment opportunity.

Which of the following is NOT a limitation of the payback period rule? A) It does not account for the time value of money. B) It is difficult to calculate. C) It ignores cash flows after payback. D) It does not account for changes in the discount rate.

B) It is difficult to calculate.

The owner of a hair salon spends $1,000,000 to renovate its premises, estimating that this will increase her cash flow by $220,000 per year. She constructs the above graph, which shows the net present value (NPV) as a function of the discount rate. If her discount rate is 6%, should she accept the project? A) Yes, because the NPV is positive at that rate. B) No, because the NPV is negative at that rate. C) No, because the NPV is positive at that rate. D) Cannot be determined from the information given.

B) No, because the NPV is negative at that rate.

A lawn maintenance company compares two ride-on mowers—the Excelsior, which has an expected working-life of six years, and the Grassassinator, which has a working life of four years. After examining the equivalent annual annuities of each mower, the company decides to purchase the Excelsior. Which of the following, if true, would be most likely to make them change that decision? A) Fuel prices are expected to rise and raise the annual running costs of all mowers. B) The mower is only expected to be needed for three years. C) The prices of equivalent mowers are expected to grow in the future as lawnmower manufacturers consolidate. D) The number of customers requiring lawn-mowing services is expected to sharply increase in the near future.

B) The mower is only expected to be needed for three years.

Which of the following statements is FALSE? A) The payback rule is useful in cases where the cost of making an incorrect decision might not be large enough to justify the time required for calculating the net present value (NPV). B) The payback rule is reliable because it considers the time value of money and depends on the cost of capital. C) For most investment opportunities, expenses occur initially and cash is received later. D) Fifty percent of firms surveyed reported using the payback rule for making decisions.

B) The payback rule is reliable because it considers the time value of money and depends on the cost of capital.

When comparing two projects with different lives, why do you compute an annuity with an equivalent present value (PV) to the net present value (NPV)? A) so that you can see which project has the greatest net present value (NPV) B) so that the projects can be compared on their cost or value created per year C) to reduce the danger that changes in the estimate of the discount rate will lead to choosing the project with a shorter timeframe D) to ensure that cash flows from the project with a longer life that occur after the project with the shorter life has ended are considered

B) so that the projects can be compared on their cost or value created per year

Which of the following is true regarding the profitability index? A) It does not use the net present value (NPV) to assess benefits. B) It is very simple to compute. C) Attention must be taken when using it to make sure that all of the constrained resource is utilized. D) It is unreliable when used for choosing between different projects.

C) Attention must be taken when using it to make sure that all of the constrained resource is utilized.

According to Graham and Harvey's 2001 survey (Figure 8.2 in the text), the most popular decision rules for capital budgeting used by CFOs are ________. A) NPV, IRR, MIRR B) MIRR, IRR, Payback period C) IRR, NPV, Payback period D) Profitability index, NPV, IRR

C) IRR, NPV, Payback period

Which of the following is NOT a limitation of the payback rule? A) It does not consider the time value of money. B) Lacks a decision criterion that is economically based. C) It is difficult to calculate. D) It does not consider cash flows occurring after the payback period.

C) It is difficult to calculate.

A firm is considering several mutually exclusive investment opportunities. The best way to choose between them is which of the following? A) profitability index B) payback period C) net present value (NPV) D) internal rate of return (IRR)

C) net present value (NPV)

Which of the following situations can lead to IRR giving a different decision than NPV? A) delayed investment B) multiple IRRs C) differences in project scale D) All of the above can lead to IRR giving a different decision than NPV.

D) All of the above can lead to IRR giving a different decision than NPV.

Which of the following statements is FALSE? A) In general, the difference between the cost of capital and the internal rate of return (IRR) is the maximum amount of estimation error in the cost of capital estimate that can exist without altering the original decision. B) The internal rate of return (IRR) can provide information on how sensitive your analysis is to errors in the estimate of your cost of capital. C) If you are unsure of your cost of capital estimate, it is important to determine how sensitive your analysis is to errors in this estimate. D) If the cost of capital estimate is more than the internal rate of return (IRR), the net present value (NPV) will be positive.

D) If the cost of capital estimate is more than the internal rate of return (IRR), the net present value (NPV) will be positive.

Tanner is choosing between two investment options. He can invest $500 now and get (guaranteed) $550 in one year, or invest $500 now and get (guaranteed) $531.40 back later today. The risk-free rate is 3.5%. Which investment should Tanner prefer? A) $531.40 later today, since $1 today is worth more than $1 in one year. B) $550 in one year, since it is $50 more than he invested rather than $31.40 more than he invested. C) Neither - both investments have a negative NPV. D) Tanner should be indifferent between the two investments, since both are equivalent to the same amount of cash today.

D) Tanner should be indifferent between the two investments, since both are equivalent to the same amount of cash today.

The owner of a hair salon spends $1,000,000 to renovate its premises, estimating that this will increase her cash flow by $220,000 per year. She constructs the above graph, which shows the net present value (NPV) as a function of the discount rate. At what dollar value should the NPV profile cross the vertical axis? A) $780,000 B) $1,000,000 C) Cannot be determined because inadequate information is given. D) The vertical axis crossing point cannot be calculated since the cash inflows are in perpetuity.

D) The vertical axis crossing point cannot be calculated since the cash inflows are in perpetuity.

Which of the following is NOT a valid method of modifying cash flows to produce a MIRR? A) Discount all of the negative cash flows to time 0 and leave the positive cash flows alone. B) Leave the initial cash flow alone and compound all of the remaining cash flows to the final period of the project. C) Discount all of the negative cash flows to the present and compound all of the positive cash flows to the end of the project. D) Turn multiple negative cash flows into a single negative cash flow by summing all negative cash flows over the project's lifetime.

D) Turn multiple negative cash flows into a single negative cash flow by summing all negative cash flows over the project's lifetime.

Which of the following decision rules is best defined as the amount of time it takes to pay back the initial investment? A) internal rate of return (IRR) B) profitability index C) net present value (NPV) D) payback period

D) payback period

Which of the following decision rules might best be used as a supplement to net present value (NPV) by a firm that favors liquidity? A) profitability index B) MIRR C) equivalent annual annuity D) payback period

D) payback period

Most corporations measure the value of a project in terms of which of the following? A) discount value B) discount factor C) future value (FV) D) present value (PV)

D) present value (PV)

You are opening up a brand new retail strip mall. You presently have more potential retail outlets wanting to locate in your mall than you have space available. What is the most appropriate tool to use if you are trying to determine the optimal allocation of your retail space? A) internal rate of return (IRR) B) payback period C) net present value (NPV) D) profitability index

D) profitability index

Which of the following is a disadvantage of the Net Present Value rule? A) can be misleading if inflows come before outflows B) not necessarily consistent with maximizing shareholder wealth C) ignores cash flows after the cutoff point D) relies on accurate estimate of the discount rate

D) relies on accurate estimate of the discount rate