Chapter 5.pdf

Chapter 05 - Net Present Value and Other Investment Criteria

Chapter 05 Net Present Value and Other Investment Criteria Multiple Choice Questions

1. Which of the following investment rules does not use the time value of the money concept? A. Net present value B. Internal rate of return C. The payback period D. All of the above use the time value concept

2. Suppose a firm has a $100 million in excess cash. It could: A. Invest the funds in projects with positive NPVs B. Pay high dividends to the shareholders C. Buy another firm D. All of the above

3. The following are measures used by firms when making capital budgeting decisions except: A. Payback period B. Internal rate of return C. P/E ratio D. Net present value

4. The survey of CFOs indicates that NPV method is always, or almost always, used for evaluating investment projects by: A. 12% of firms B. 20% of firms C. 57% of firms D. 75% of firms

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Chapter 05 - Net Present Value and Other Investment Criteria

5. The survey of CFOs indicates that IRR method is used for evaluating investment projects by: A. 12% of firms B. 20% of firms C. 76% of firms D. 57% of firms

6. Which of the following investment rules has value adding-up property? A. The payback period method B. Net present value method C. The book rate of return method D. The internal rate of return method

7. If the net present value (NPV) of project A is + $100, and that of project B is + $60, then the net present value of the combined project is: A. +$100 B. +$60 C. +$160 D. None of the above

8. If the NPV of project A is + $30 and that of project B is + $60, then the NPV of the combined project is: A. +$30 B. -$60 C. -$30 D. None of the above.

9. You are given a job to make a decision on project X, which is composed of three independent projects A, B, and C which have NPVs of + $70, -$40 and + $100, respectively. How would you go about making the decision about whether to accept or reject the project? A. Accept the firm's joint project as it has a positive NPV B. Reject the joint project C. Break up the project into its components: accept A and C and reject B D. None of the above

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Chapter 05 - Net Present Value and Other Investment Criteria

10. If the NPV of project A is + $120, and that of project B is -$40 and that of project C is + $40, what is the NPV of the combined project? A. +$100 B. -$40 C. +$70 D. +$120

11. The net present value of a project depends upon: A. company's choice of accounting method B. manager's tastes and preferences C. project's cash flows and opportunity cost of capital D. all of the above

12. Which of the following investment rules may not use all possible cash flows in its calculations? A. NPV B. Payback period C. IRR D. All of the above

13. The payback period rule: A. Varies the cut-off point with the interest rate. B. Determines a cut-off point so that all projects accepted by the NPV rule will be accepted by the payback period rule. C. Requires an arbitrary choice of a cut-off point. D. Both A and C.

14. The payback period rule accepts all projects for which the payback period is: A. Greater than the cut-off value B. Less than the cut-off value C. Is positive D. An integer

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Chapter 05 - Net Present Value and Other Investment Criteria

15. The main advantage of the payback rule is: A. Adjustment for uncertainty of early cash flows B. It is simple to use C. Does not discount cash flows D. Both A and C

16. The following are disadvantages of using the payback rule except: A. The payback rule ignores all cash flow after the cutoff date B. The payback rule does not use the time value of money C. The payback period is easy to calculate and use D. The payback rule does not have the value additive property

17. Which of the following statements regarding the discounted payback period rule is true? A. The discounted payback rule uses the time value of money concept. B. The discounted payback rule is better than the NPV rule. C. The discounted payback rule considers all cash flows. D. The discounted payback rule exhibits the value additive property.

18. Given the following cash flows for project A: C0 = -1000, C1 = +600 ,C2 = +400, and C3 = +1500, calculate the payback period. A. One year B. Two years C. Three years D. None of the above

19. The cost of a new machine is $250,000. The machine has a 3-year life and no salvage value. If the cash flow each year is equal to 40% of the cost of the machine, calculate the payback period for the project: A. 2 years B. 2.5 years C. 3 years D. Cannot be determined because of insufficient data

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Chapter 05 - Net Present Value and Other Investment Criteria

20. Given the following cash flows for project Z: C0 = -1,000, C1 = 600, C2 = 720 and C3 = 2000, calculate the discounted payback period for the project at a discount rate of 20%. A. 1 year B. 2 years C. 3 years D. None of the above

21. Internal rate of return (IRR) method is also called: A. Discounted payback period method B. Discounted cash-flow (DCF) rate of return method C. Modified internal rate of return (MIRR) method D. None of the above

22. The quickest way to calculate the internal rate of return (IRR) of a project is by: A. Trial and error method B. Using the graphical method C. Using a financial calculator D. Guessing the IRR

23. If an investment project (normal project) has IRR equal to the cost of capital, the NPV for that project is: A. Positive B. Negative C. Zero D. Unable to determine

24. Given the following cash flows for Project M: C0 = -1,000, C1 = +200, C2 = +700, C3 = +698, calculate the IRR for the project. A. 23% B. 21% C. 19% D. None of the above

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Chapter 05 - Net Present Value and Other Investment Criteria

25. The IRR is defined as: A. The discount rate that makes the NPV equal to zero B. The difference between the cost of capital and the present value of the cash flows C. The discount rate used in the NPV method D. The discount rate used in the discounted payback period method

26. Which of the following methods of evaluating capital investment projects incorporates the time value of money concept? I) Payback Period, II) Discounted Payback Period, III) Net Present Value (NPV), IV) Internal Rate of Return A. I, II, and III only B. II, III, and IV only C. III and IV only D. I, II, III, and IV

27. Driscoll Company is considering investing in a new project. The project will need an initial investment of $2,400,000 and will generate $1,200,000 (after-tax) cash flows for three years. Calculate the IRR for the project. A. 14.5% B. 18.6% C. 20.2% D. 23.4%

28. The following are some of the shortcomings of the IRR method except: A. IRR is conceptually easy to communicate B. Projects can have multiple IRRs C. IRR method cannot distinguish between a borrowing project and a lending project D. It is very cumbersome to evaluate mutually exclusive projects using the IRR method

29. Project X has the following cash flows: C0 = +2000, C1 = -1,300 and C2 = -1,500. If the IRR of the project is 25% and if the cost of capital is 18%, you would: A. Accept the project B. Reject the project

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Chapter 05 - Net Present Value and Other Investment Criteria

30. Project X has the following cash flows: C0 = +2000, C1 = -1,150 and C2 = -1,150. If the IRR of the project is 9.85% and if the cost of capital is 12%, you would: A. Accept the project B. Reject the project

31. If the sign of the cash flows for a project changes two times then the project has: A. one IRR B. two IRRs C. three IRRs D. None of the above

32. Project Y has following cash flows: C0 = -800; C1 = +5,000; C2 = -5,000; Calculate the IRRs for the project: A. 25% & 400% B. 125% & 500% C. -44% & 11.6% D. None of the above

33. Music Company is considering investing in a new project. The project will need an initial investment of $2,400,000 and will generate $1,200,000 (after-tax) cash flows for three years. Calculate the NPV for the project if the cost of capital is 15%. A. $169, 935 B. $1,200,000 C. $339,870 D. $125,846

34. Muscle Company is investing in a giant crane. It is expected to cost 6.5 million in initial investment and it is expected to generate an end of year cash flow of 3.0 million each year for three years. Calculate the IRR approximately. A. 14.6 % B. 16.4 % C. 18.2 % D. 22.1%

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Chapter 05 - Net Present Value and Other Investment Criteria

35. A project will have only one internal rate of return if: A. The net present value is positive B. The net present value is negative C. The cash flows decline over the life of the project D. There is a one sign change in the cash flows

36. Story Company is investing in a giant crane. It is expected to cost 6.0 million in initial investment and it is expected to generate an end of year cash flow of 3.0 million each year for three years. Calculate the NPV at 12% (approximately). A. 2.4 million B. 1.2. million C. 0.80 million D. 0.20 million

37. Dry-Sand Company is considering investing in a new project. The project will need an initial investment of $1,200,000 and will generate $600,000 (after-tax) cash flows for three years. Calculate the MIRR (modified internal rate of return) for the project if the cost of capital is 15%. A. 14.5% B. 18.6% C. 20.2% D. 23.4%

38. Mass Company is investing in a giant crane. It is expected to cost 6.6 million in initial investment and it is expected to generate an end of year cash flow of 3.0 million each year for three years. Calculate the MIRR for the project if the cost of capital is 12% APR. A. 17.3% B. 15.3% C. 23.8% D. 22.1%

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Chapter 05 - Net Present Value and Other Investment Criteria

39. Given the following cash flow for project A: C0 = -3,000, C1 = +500, C2 = +1,500 and C3 = +5,000, calculate the NPV of the project using a 15% discount rate. A. $5,000 B. $2,352 C. $3,201 D. $1,857

40. Profitability index is useful under: A. Capital rationing B. Mutually exclusive projects C. Non-normal projects D. None of the above

41. Profitability index is the ratio of: A. Future value of cash flows to investment B. Net present value of cash flows to investment C. Net present value of cash flows to IRR D. Present value of cash flows to IRR

42. The following table gives the available projects for a firm.

If the firm has a limit of 210 million to invest, what is the maximum NPV the company can obtain? A. 200 B. 283 C. 307 D. None of the above

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Chapter 05 - Net Present Value and Other Investment Criteria

43. The firm has only twenty million to invest. What is the maximum NPV that the company can obtain? A. 3.5 B. 4.0 C. 4.5 D. None of the above

44. Benefit-cost ratio is defined as the ratio of: A. Net present value cash flow to initial investment B. Present value of cash flow to initial investment C. Net present value of cash flow to IRR D. Present value of cash flow to IRR

45. The profitability index can be used for ranking projects under: A. Soft capital rationing B. Hard capital rationing C. Capital rationing at t = 0 D. Both A and B

46. What would be the weighted average profitability index of the following two investments, given the firm only has $250 to invest? Project A: Cost = $120, NPV = 80 Project B: Cost = $100, NPV = 75 A. .62 B. .67 C. .75 D. .79

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Chapter 05 - Net Present Value and Other Investment Criteria

47. What is the profitability index of an investment with cash flows in years zero thru 4 of 340, 120, 130, 153, and 166, respectively and a discount rate of 16%? A. .15 B. .22 C. .35 D. .42

True / False Questions

48. The profitability index will always be below 1. True False

49. A positive NPV will always generate a profitability index above 0. True False

50. Present values have value adding-up property. True False

51. The payback rule ignores all cash flows after the cutoff date. True False

52. The discounted payback rule calculates the payback period and then discounts it at the opportunity cost of capital. True False

53. The internal rate of return is the discount rate that makes the PV of a project's cash inflows equal to zero. True False

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Chapter 05 - Net Present Value and Other Investment Criteria

54. The IRR rule states that firms should accept any project offering an internal rate of return in excess of the cost of capital. True False

55. In case of a loan project, one should accept the project if the IRR is more than the cost of capital. True False

56. There can never be more than one value of IRR for any cash flow. True False

57. Decommissioning and clean-up cost for any project is always insignificant and should always be ignored. True False

58. The benefit-cost ratio is equal to profitability index plus one. True False

59. Soft rationing may be used to control managerial behavior. True False

Essay Questions

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Chapter 05 - Net Present Value and Other Investment Criteria

60. Briefly explain the value adding-up property.

61. Discuss some of the advantages of using the payback method.

62. Discuss some of the disadvantages of the payback rule.

63. What are some of the disadvantages of using the IRR method?

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Chapter 05 - Net Present Value and Other Investment Criteria

64. What are some of the advantages of using the IRR method?

65. In what way is the modified internal rate of return (MIRR) method better than the IRR method?

66. Briefly discuss capital rationing.

67. Briefly explain the term "soft rationing".

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Chapter 05 - Net Present Value and Other Investment Criteria

68. Briefly explain the term "hard rationing."

69. When calculating a weighted average profitability index should you apply an index of 0 to left over money?

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Chapter 05 - Net Present Value and Other Investment Criteria

Chapter 05 Net Present Value and Other Investment Criteria Answer Key

Multiple Choice Questions

1. Which of the following investment rules does not use the time value of the money concept? A. Net present value B. Internal rate of return C. The payback period D. All of the above use the time value concept

Type: Easy

2. Suppose a firm has a $100 million in excess cash. It could: A. Invest the funds in projects with positive NPVs B. Pay high dividends to the shareholders C. Buy another firm D. All of the above

Type: Easy

3. The following are measures used by firms when making capital budgeting decisions except: A. Payback period B. Internal rate of return C. P/E ratio D. Net present value

Type: Easy

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Chapter 05 - Net Present Value and Other Investment Criteria

4. The survey of CFOs indicates that NPV method is always, or almost always, used for evaluating investment projects by: A. 12% of firms B. 20% of firms C. 57% of firms D. 75% of firms

Type: Medium

5. The survey of CFOs indicates that IRR method is used for evaluating investment projects by: A. 12% of firms B. 20% of firms C. 76% of firms D. 57% of firms

Type: Medium

6. Which of the following investment rules has value adding-up property? A. The payback period method B. Net present value method C. The book rate of return method D. The internal rate of return method

Type: Difficult

7. If the net present value (NPV) of project A is + $100, and that of project B is + $60, then the net present value of the combined project is: A. +$100 B. +$60 C. +$160 D. None of the above NPV(A + B) = NPV(A) + NPV(B) = 100 + 60 = 160

Type: Easy

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Chapter 05 - Net Present Value and Other Investment Criteria

8. If the NPV of project A is + $30 and that of project B is + $60, then the NPV of the combined project is: A. +$30 B. -$60 C. -$30 D. None of the above. NPV(A + B) = 30 - 60 = -30

Type: Easy

9. You are given a job to make a decision on project X, which is composed of three independent projects A, B, and C which have NPVs of + $70, -$40 and + $100, respectively. How would you go about making the decision about whether to accept or reject the project? A. Accept the firm's joint project as it has a positive NPV B. Reject the joint project C. Break up the project into its components: accept A and C and reject B D. None of the above

Type: Difficult

10. If the NPV of project A is + $120, and that of project B is -$40 and that of project C is + $40, what is the NPV of the combined project? A. +$100 B. -$40 C. +$70 D. +$120 NPV(A + B + C) = 120 + 40 - 40 = 120

Type: Easy

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Chapter 05 - Net Present Value and Other Investment Criteria

11. The net present value of a project depends upon: A. company's choice of accounting method B. manager's tastes and preferences C. project's cash flows and opportunity cost of capital D. all of the above

Type: Medium

12. Which of the following investment rules may not use all possible cash flows in its calculations? A. NPV B. Payback period C. IRR D. All of the above

Type: Medium

13. The payback period rule: A. Varies the cut-off point with the interest rate. B. Determines a cut-off point so that all projects accepted by the NPV rule will be accepted by the payback period rule. C. Requires an arbitrary choice of a cut-off point. D. Both A and C.

Type: Medium

14. The payback period rule accepts all projects for which the payback period is: A. Greater than the cut-off value B. Less than the cut-off value C. Is positive D. An integer

Type: Easy

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Chapter 05 - Net Present Value and Other Investment Criteria

15. The main advantage of the payback rule is: A. Adjustment for uncertainty of early cash flows B. It is simple to use C. Does not discount cash flows D. Both A and C

Type: Medium

16. The following are disadvantages of using the payback rule except: A. The payback rule ignores all cash flow after the cutoff date B. The payback rule does not use the time value of money C. The payback period is easy to calculate and use D. The payback rule does not have the value additive property

Type: Medium

17. Which of the following statements regarding the discounted payback period rule is true? A. The discounted payback rule uses the time value of money concept. B. The discounted payback rule is better than the NPV rule. C. The discounted payback rule considers all cash flows. D. The discounted payback rule exhibits the value additive property.

Type: Easy

18. Given the following cash flows for project A: C0 = -1000, C1 = +600 ,C2 = +400, and C3 = +1500, calculate the payback period. A. One year B. Two years C. Three years D. None of the above Initial investment: 1000 = CF1 + CF2 = 600 + 400; Payback period = 2 years

Type: Medium

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Chapter 05 - Net Present Value and Other Investment Criteria

19. The cost of a new machine is $250,000. The machine has a 3-year life and no salvage value. If the cash flow each year is equal to 40% of the cost of the machine, calculate the payback period for the project: A. 2 years B. 2.5 years C. 3 years D. Cannot be determined because of insufficient data Cash flow each year = (0.4)(250,000) = 100,000; Payback period = 2.5 years

Type: Medium

20. Given the following cash flows for project Z: C0 = -1,000, C1 = 600, C2 = 720 and C3 = 2000, calculate the discounted payback period for the project at a discount rate of 20%. A. 1 year B. 2 years C. 3 years D. None of the above 1000 = (600/1.2) + (720/1.2^2); the discounted payback = 2 years

Type: Difficult

21. Internal rate of return (IRR) method is also called: A. Discounted payback period method B. Discounted cash-flow (DCF) rate of return method C. Modified internal rate of return (MIRR) method D. None of the above

Type: Medium

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Chapter 05 - Net Present Value and Other Investment Criteria

22. The quickest way to calculate the internal rate of return (IRR) of a project is by: A. Trial and error method B. Using the graphical method C. Using a financial calculator D. Guessing the IRR

Type: Easy

23. If an investment project (normal project) has IRR equal to the cost of capital, the NPV for that project is: A. Positive B. Negative C. Zero D. Unable to determine

Type: Easy

24. Given the following cash flows for Project M: C0 = -1,000, C1 = +200, C2 = +700, C3 = +698, calculate the IRR for the project. A. 23% B. 21% C. 19% D. None of the above -1000 + [200/(1 + IRR)] + [700/(1 + IRR)^2] + [698/(1 + IRR)^3] = 0; IRR = 23%

Type: Difficult

25. The IRR is defined as: A. The discount rate that makes the NPV equal to zero B. The difference between the cost of capital and the present value of the cash flows C. The discount rate used in the NPV method D. The discount rate used in the discounted payback period method

Type: Easy

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Chapter 05 - Net Present Value and Other Investment Criteria

26. Which of the following methods of evaluating capital investment projects incorporates the time value of money concept? I) Payback Period, II) Discounted Payback Period, III) Net Present Value (NPV), IV) Internal Rate of Return A. I, II, and III only B. II, III, and IV only C. III and IV only D. I, II, III, and IV

Type: Medium

27. Driscoll Company is considering investing in a new project. The project will need an initial investment of $2,400,000 and will generate $1,200,000 (after-tax) cash flows for three years. Calculate the IRR for the project. A. 14.5% B. 18.6% C. 20.2% D. 23.4% -2,400,000 + [1,200,000/(1 + IRR)] + [1,200,000/(1 + IRR)^2] + [1,200,000/(1 + IRR)^3] = 0; IRR = 23.4%.

Type: Difficult

28. The following are some of the shortcomings of the IRR method except: A. IRR is conceptually easy to communicate B. Projects can have multiple IRRs C. IRR method cannot distinguish between a borrowing project and a lending project D. It is very cumbersome to evaluate mutually exclusive projects using the IRR method

Type: Difficult

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Chapter 05 - Net Present Value and Other Investment Criteria

29. Project X has the following cash flows: C0 = +2000, C1 = -1,300 and C2 = -1,500. If the IRR of the project is 25% and if the cost of capital is 18%, you would: A. Accept the project B. Reject the project This is a loan project therefore reject.

Type: Difficult

30. Project X has the following cash flows: C0 = +2000, C1 = -1,150 and C2 = -1,150. If the IRR of the project is 9.85% and if the cost of capital is 12%, you would: A. Accept the project B. Reject the project This is a loan project therefore accept.

Type: Difficult

31. If the sign of the cash flows for a project changes two times then the project has: A. one IRR B. two IRRs C. three IRRs D. None of the above

Type: Difficult

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Chapter 05 - Net Present Value and Other Investment Criteria

32. Project Y has following cash flows: C0 = -800; C1 = +5,000; C2 = -5,000; Calculate the IRRs for the project: A. 25% & 400% B. 125% & 500% C. -44% & 11.6% D. None of the above -800 + [5000/(1 + IRR)] - [5000/(1 + IRR)^2] = 0 or 800[(1 + IRR)^2] - 5000(1 + IRR) + 5000 = 0 This is a quadratic equation and has two roots. 1 + IRR = [5000 + SQRT{ 5000^2 - (4) * (800) * (5000)}]/(2 * 800) = 5; IRR = 4 = 400% 1 + IRR = [5000 + SQRT{ 5000^2 - (4) * (800) * (5000)}]/(2 * 800) = 1.25; IRR = 0.25 = 25%

Type: Difficult

33. Music Company is considering investing in a new project. The project will need an initial investment of $2,400,000 and will generate $1,200,000 (after-tax) cash flows for three years. Calculate the NPV for the project if the cost of capital is 15%. A. $169, 935 B. $1,200,000 C. $339,870 D. $125,846 NPV = -2,400,000 + [(1,200,000)/(1.15)] + [(1,200,000/(1.15)^2] + [1,200,000/(1.15)^3] = 339,1870

Type: Medium

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Chapter 05 - Net Present Value and Other Investment Criteria

34. Muscle Company is investing in a giant crane. It is expected to cost 6.5 million in initial investment and it is expected to generate an end of year cash flow of 3.0 million each year for three years. Calculate the IRR approximately. A. 14.6 % B. 16.4 % C. 18.2 % D. 22.1% 0 = -6.5 + ((3/(1 + IRR) + (3/((1 + IRR)^2)) + (3/((1 + IRR)^3))); IRR = 18.2% (by trial & error)

Type: Medium

35. A project will have only one internal rate of return if: A. The net present value is positive B. The net present value is negative C. The cash flows decline over the life of the project D. There is a one sign change in the cash flows

Type: Medium

36. Story Company is investing in a giant crane. It is expected to cost 6.0 million in initial investment and it is expected to generate an end of year cash flow of 3.0 million each year for three years. Calculate the NPV at 12% (approximately). A. 2.4 million B. 1.2. million C. 0.80 million D. 0.20 million NPV = -6.0 + 3/1.12 + 3/(1.12^2) + 3/(1.12^3) = 1. 2

Type: Medium

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Chapter 05 - Net Present Value and Other Investment Criteria

37. Dry-Sand Company is considering investing in a new project. The project will need an initial investment of $1,200,000 and will generate $600,000 (after-tax) cash flows for three years. Calculate the MIRR (modified internal rate of return) for the project if the cost of capital is 15%. A. 14.5% B. 18.6% C. 20.2% D. 23.4% - 1.2[(0.6 * (1.15)^2) + (0.6 * (1.15)) + 0.6]/[(1 + MIRR)^3] = 0; MIRR = 20.2%

Type: Difficult

38. Mass Company is investing in a giant crane. It is expected to cost 6.6 million in initial investment and it is expected to generate an end of year cash flow of 3.0 million each year for three years. Calculate the MIRR for the project if the cost of capital is 12% APR. A. 17.3% B. 15.3% C. 23.8% D. 22.1% Year 0 = -6.6, Year 3 = 10.1232; (1 + MIRR) = (10.1232/ 6.6)^0.3333 = 15.3%

Type: Difficult

39. Given the following cash flow for project A: C0 = -3,000, C1 = +500, C2 = +1,500 and C3 = +5,000, calculate the NPV of the project using a 15% discount rate. A. $5,000 B. $2,352 C. $3,201 D. $1,857 NPV = -3000 + (500/1.15) + (1500/1.15^2) + (5000/1.15^3) = 1857

Type: Medium

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Chapter 05 - Net Present Value and Other Investment Criteria

40. Profitability index is useful under: A. Capital rationing B. Mutually exclusive projects C. Non-normal projects D. None of the above

Type: Medium

41. Profitability index is the ratio of: A. Future value of cash flows to investment B. Net present value of cash flows to investment C. Net present value of cash flows to IRR D. Present value of cash flows to IRR

Type: Medium

42. The following table gives the available projects for a firm.

If the firm has a limit of 210 million to invest, what is the maximum NPV the company can obtain? A. 200 B. 283 C. 307 D. None of the above A + B + C + F = 140 + 70 + 65 + 32 = 307; Total Investment = 90 + 20 + 60 + 40 = 210

Type: Difficult

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Chapter 05 - Net Present Value and Other Investment Criteria

43. The firm has only twenty million to invest. What is the maximum NPV that the company can obtain? A. 3.5 B. 4.0 C. 4.5 D. None of the above A + C + D + E + F = 4.5; Total Investment = 5 + 5 + 1 + 2 + 7 = $20 Million

Type: Difficult

44. (p. 136) Benefit-cost ratio is defined as the ratio of: A. Net present value cash flow to initial investment B. Present value of cash flow to initial investment C. Net present value of cash flow to IRR D. Present value of cash flow to IRR

Type: Medium

45. The profitability index can be used for ranking projects under: A. Soft capital rationing B. Hard capital rationing C. Capital rationing at t = 0 D. Both A and B

Type: Difficult

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Chapter 05 - Net Present Value and Other Investment Criteria

46. What would be the weighted average profitability index of the following two investments, given the firm only has $250 to invest? Project A: Cost = $120, NPV = 80 Project B: Cost = $100, NPV = 75 A. .62 B. .67 C. .75 D. .79 (80/120) × (120/250) + (75/100) × (100/250)

Type: Difficult

47. What is the profitability index of an investment with cash flows in years zero thru 4 of 340, 120, 130, 153, and 166, respectively and a discount rate of 16%? A. .15 B. .22 C. .35 D. .42 NPV = 49.7 PI = 49.7/340 = .15

Type: Difficult

True / False Questions

48. The profitability index will always be below 1. FALSE

Type: Medium

49. A positive NPV will always generate a profitability index above 0. TRUE

Type: Medium

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Chapter 05 - Net Present Value and Other Investment Criteria

50. Present values have value adding-up property. TRUE

Type: Difficult

51. The payback rule ignores all cash flows after the cutoff date. TRUE

Type: Medium

52. The discounted payback rule calculates the payback period and then discounts it at the opportunity cost of capital. FALSE

Type: Medium

53. The internal rate of return is the discount rate that makes the PV of a project's cash inflows equal to zero. FALSE

Type: Difficult

54. The IRR rule states that firms should accept any project offering an internal rate of return in excess of the cost of capital. TRUE

Type: Medium

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Chapter 05 - Net Present Value and Other Investment Criteria

55. In case of a loan project, one should accept the project if the IRR is more than the cost of capital. FALSE

Type: Difficult

56. There can never be more than one value of IRR for any cash flow. FALSE

Type: Difficult

57. Decommissioning and clean-up cost for any project is always insignificant and should always be ignored. FALSE

Type: Medium

58. The benefit-cost ratio is equal to profitability index plus one. TRUE

Type: Difficult

59. (p. 138) Soft rationing may be used to control managerial behavior. TRUE

Type: Easy

Essay Questions

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Chapter 05 - Net Present Value and Other Investment Criteria

60. Briefly explain the value adding-up property. For example, the net present value (NPV) of the combined project say A and B is equal to the NPV(A) and NPV(B). This property holds good for the present values also. This property is not shared by IRR. IRR of the combined project is not the sum of the individual IRRs. The value adding-up property is very useful when making decisions about numerous projects.

Type: Medium

61. Discuss some of the advantages of using the payback method. It tells you how quickly you can recover your investment. The main advantage is that it is easy to calculate and use.

Type: Easy

62. Discuss some of the disadvantages of the payback rule. The disadvantages are that it does not take the time value of money into account and also does not use all the cash flow. It has limited applications such as small projects.

Type: Easy

63. What are some of the disadvantages of using the IRR method? There are several disadvantages to IRR method. It is difficult to intuitively explain the concept of internal rate of return. It is not useful in evaluating complex projects, mutually exclusive projects and dependent projects. For projects with high IRRs, reinvestment rate assumption implicit in the method may be unrealistic. It is also more complicated to calculate. You can also get multiple rates of return in case of projects where the cash flows have more than change in sign. One way to eliminate this problem is by using the modified internal rate of return method. Also, IRR cannot distinguish between borrowing and lending projects. In most cases it may be easier to use the NPV method.

Type: Difficult

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Chapter 05 - Net Present Value and Other Investment Criteria

64. What are some of the advantages of using the IRR method? The main advantage of IRR is that it is easy to communicate.

Type: Medium

65. In what way is the modified internal rate of return (MIRR) method better than the IRR method? With the modified internal rate of return method, cash flows from the project are explicitly reinvested at the cost of capital, thus eliminating the reinvestment rate assumption problem. This eliminates the multiple IRR problems inherent in complex projects. Also reinvesting the cash flows from the project at the cost of capital is more realistic. But using NPV method is much better.

Type: Medium

66. Briefly discuss capital rationing. There are two types of capital rationing; soft rationing imposed by the company and hard rationing imposed by the capital markets. Capital rationing results in the firm foregoing some positive NPV projects thereby reducing a firm's value.

Type: Medium

67. Briefly explain the term "soft rationing". Management uses soft rationing to get better financial control over investment decisions. Soft rationing is imposed by the management on a temporary basis and not by capital markets.

Type: Medium

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Chapter 05 - Net Present Value and Other Investment Criteria

68. Briefly explain the term "hard rationing." A firm faces hard rationing when it cannot raise more money in the capital markets. It is also be indicative of market imperfections. Market imperfections do not invalidate the NPV rule as long as the shareholders of the firm have access to well-functioning capital markets so that their portfolio choice is not restricted. The NPV rule is undermined when imperfections restrict shareholders' portfolio choice. Generally, hard rationing is rare for corporations in the U.S.A.

Type: Medium

69. When calculating a weighted average profitability index should you apply an index of 0 to left over money? The NPV of money that is not invested is zero. If the NPV is zero the profitability index is zero. Thus, the math leads to a PI of zero for left over money. Additionally, money not invested cannot be assumed to have created value.

Type: Difficult

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