Finance 450, Exam 3, Chapters 8

Based upon the following data: calculate the Average Accounting Return Net Income: Year 1: $ 1,500,000 Year 2: $ 1,200,000 Year 3: $ 1,050,000 Year 4: -$ 1,400,000 Year 5: $ 1,350,000 The starting book value is $11,840,000, which will end with $0, at the end of five years. A. 6.25% B. 10% C. 12.5% D. 20% E. 25%

C. 12.5% Average net income = ($1,500,000 + $1,200,000 + $1,050,000 - $1,400,000 + $1,350,000) / 5 = $740,000 Average book value = (11,840,000 + 0) / 2 = 5,920,000 AAR = 740,000 / 5,920,000 = 12.50%

According to the video, which of the following are disadvantages of the Average Accounting Return (AAR)? A. Time value of money is ignored. B. An arbitrary benchmark cutoff rate is established. C. Market values are not considered. D. All of the above. E. A & C only.

D. All of above All of the above are disadvantages. Time value of money is ignored, an arbitrary benchmark cutoff rate is established, and market values are not considered.

All of the following are disadvantages of the Payback Period, except: A. The method ignores the time value of money. B. All projects are considered based upon cash flows alone. C. Cash flows that extend beyond the cutoff date are not considered. D. The company must select a specified number of years to compare projects. E. The method incorporates the time value of money.

E. The method incorporates the Time Value of Money All of the items are disadvantages except that The method incorporates the time value of money.

What are non-conventional cash flows? A. A combination of cash outflows and inflows. B. Low cash flows followed by much higher cash flows. C. High cash flows followed by much lower cash flows. D. Small initial investments and much larger returns. F. A zero return on an investment.

A. A combo of cash inflows and outflows Non-conventional cash flows are defined as a combination of cash outflows, followed by inflows, and returning to outflows. This commonly occurs because companies will invest a small amount into a project, monitor the inflows, and then anticipate investing additional funds later assuming the project is successful.

The Average Accounting Return (AAR) Rule states that a company will accept a project that has an average account return that: A. exceeds a pre-determined target average accounting return. B. is less than a pre-determined target average accounting return. C. exceeds the net present value for the company. D. is less than the net present value for the company. E. Is equal to the increase of the net income over the past year.

A. Exceeds a pre determined target average accounting return

According the video, one of the biggest challenges for the Net Present Value method is: A. Identifying the appropriate discount rate to use. B. Choosing good quality projects to invest in. C. Comparing the cost of the investment to the future cash flows. D. Choosing a method to calculate the Net Present Value. E. Not taking on too many new projects at one time.

A. Identifying the appropriate discount rate to use. According the video, one of the biggest challenges for the Net Present Value method is identifying the appropriate discount rate to use.

All of the following are advantages of the Profitability Index, except: A.) It is useful for comparing mutually exclusive investments. B.) It is closely related to the Net Present Value calculation. C.) It is typically leads to the same decision as the Net Present Value. D.) It is easy to understand and communicate. E.) It is useful to identify the "bang for the buck".

A. It is useful for comparing mutually exclusive investments. The main disadvantage with the profitability index is the you may incorrectly choose projects when considering mutually exclusive investments.

The Payback Period Rule states that a company will accept a project if: A. The calculated payback is less than three years for all projects. B. The calculated payback is less than a pre-specified number of years. C. We can recover the costs in a reasonable amount of time. D. The project stays within budget. E. The project increases shareholder value.

B. The calculated payback is less than a pre-specified number of years. The Payback Period Rule states that a company will accept a project if the calculated payback is less than a pre-specified number of years.

The Internal Rate of Return (IRR) represents which of the following: A. The discount rate that must be lower than the required rate of return. B. The discount rate that makes the net present value equal to zero. C. The discount rate that makes the net present value positive. D. The discount rate that makes the net present value negative. E. The discount rate that is affected by the cash flows external to the project.

B. The discount rate that makes the net present value equal to zero

What is the first step in the Net Present Value (NPV) process? A. Identify the appropriate discount rate to use. B. Compare the cost of the investment to the future cash flows. C. Estimate the future cash flows. D. Use a financial calculator to calculate the NPV. E. Find the present value of the cash flows.

C. Estimate the future cash flows. step 1- estimate future cash flows step 2- calc pv of cash flows step 3- estimate/calc NPV

What does the Modified Internal Rate of Return (MIRR) assume? A. The MIRR assumes only conventional cash flow models are used. B. The MIRR assumes that all cash inflows are paid out as dividends. C. The MIRR assumes that cash flows will be reinvested at the cost of capital. D. The MIRR assumes that cash flows will be reinvested at the MIRR. E. The MIRR assumes that cash flows will be reinvested at the IRR.

C. The MIRR assumes that cash flows will be reinvested at the cost of capital. The MIRR assumes that cash flows will be reinvested at the cost of capital. This is the purpose of the MIRR calculation, to assume that when cash inflows occur, they will be reinvested at the cost of capital, not a much higher rate that may not be attainable by the company.

When choosing between mutually exclusive projects, what is the best method to use? A. The highest IRR is always the best option. B. The lowest IRR is always the best option. C. The highest NPV is always the best option. D. The lowest NPV is always the best option. E. The lowest initial investment is always the best option.

C. The highest NPV is always the best option. When choosing between mutually exclusive projects, the highest NPV is always the best option.

Based upon the following data, which of the following mutually exclusive projects should you choose if your required return is 10%? Year Investment A Investment B 0 −$ 150 −$ 150 1 80 40 2 40 50 3 40 60 4 30 55 A. Investment A with an NPV of 6.33% B. Investment B with an NPV of 6.33% C. Investment A with an NPV of 10.33% D. Investment B with an NPV of 10.33% E. Both projects since they have positive NPV's.

D. Investment B with an NPV of 10.33% -$150 + (40/1.1) + (50/1.12) + (60/1.13) + (55/1.14) = 10.33%

Last Question of chap 8 All of the following are useful for understanding Profitability Index, except: A. A profitability index greater than 1 equals a positive NPV. B. A profitability index less than 1 equals a negative NPV. C. The initial investment is excluded when calculating the present value of the future cash flows. D. The initial investment is included when calculating the present value of the future cash flows. E. The denominator for the profitability index is the cost of the project.

D. The initial investment is included when calculating the present value of the future cash flows. The initial investment is not included when calculating the present value of the future cash flows.

Using the method of your choice, calculate the Net Present Value of the following cash flows. Assume that the required return on this project is 15% Project A Initial Cost -$ 150 Year 1 $ 175 Year 2 $ 100 A. $15 B. $35 C. $55 D. $70 E. $78

E. $78 Project A Discounted Inflows (@ 15%) Initial Cost -$ 150 Year 1 $ 175 $175/1.15 = $152 Year 2 $ 100 $100 / (1.152) = $76 Compare to the $150 estimated cost: NPV = -$150 + ($152 + $76) = $78 Remember: The Net Present Value represents the amount of value that will be added (positive NPV) or subtracted (negative NPV) if the project is taken on.

Based upon the following data: calculate the Profitability Index. Cost = $325 Present value of future cash flows = $350 A.) .93 B.) .97 C.) 1.00 D.) 1.05 E.) 1.08

E. 1.08 Profitability Index = Present value of future cash flows / Cost = $350/$325 = 1.08

Based upon the following data: calculate the Payback Period. Project A Initial Cost -$ 50,000 Year 1 $ 20,000 Year 2 $ 15,000 Year 3 $ 20,000 A. 1.5 years B. 2.0 years C. 2.25 years D. 2.5 years E. 2.75 years

E. 2.75 Payback period Initial cost = $50,000 - $20,000 (year 1) - $15,000 (year 2) =$15,000 remaining after year 2 $15,000/$20,000 (Year 3) = .75 2.75 years

All of the following are commonly cited reasons for using the Internal Rate of Return, except: A. Rates of return are commonly used when considered positive projects being considered. B. Internal rate of return is an easy way to provide information about a proposal. C. The IRR does need a discount rate to complete the calculation. D. A high IRR can be assumed to be a positive project to consider. E. Multiple IRR's allow the company to choose the best one when evaluating projects.

E. Multiple IRR's allows the company to choose the best one when evaluating alternatives Multiple IRR's create confusion and are commonly associated with non-conventional cash flows are would not be a reason for using the Internal Rate of Return

What does mutually exclusive mean? A. Independent projects are also mutually exclusive. B. We must choose all the high NPV projects that are exclusive for our company. C. Each project must be mutually beneficial for other projects in the company. D. The highest IRR is always the best option, which is mutually exclusive. E. Taking one project means that we cannot take the other.

E. Taking one project means that we cannot take the other. Mutually Exclusive means we must make a choice between projects and that we can only accept one project.