Deck 10: Capital-Budgeting Techniques and Practice

Question 1

Advantages of the payback period include that it is easy to calculate,easy to understand,and that it is based on cash flows rather than on accounting profits.

Answer 1

True

Question 2

The required rate of return reflects the costs of funds needed to finance a project.

Answer 2

True

Question 3

One of the disadvantages of the payback method is that it ignores time value of money.

Answer 3

True

Question 4

The net present value profile clearly demonstrates that the NPV of a project increases as the discount rate increases.

Question 5

An acceptable project should have a net present value greater than or equal to zero and a profitability index greater than or equal to one.

Question 6

The most critical aspect in determining the acceptability of a capital budgeting project is the impact the project will have on the company's net income over the projects entire useful life.

Question 7

The profitability index provides an advantage over the net present value method by reporting the present value of benefits per dollar invested.

Question 8

Two projects that have the same cost and the same expected cash flows will have the same net present value.

Question 9

Free cash flows represent the benefits generated from accepting a capital-budgeting proposal.

Question 10

One drawback of the payback method is that some cash flows may be ignored.

Question 11

When several sign reversals in the cash flow stream occur,a project can have more than one IRR.

Question 12

If project A generates $10 million of free cash flow over its five year useful life and project B generates $8 million of free cash flow over its useful life,then Project A will have a shorter payback period than Project B,assuming both projects require the same initial investment.

Question 13

The profitability index is the ratio of the company's net income (or profits)to the initial outlay or cost of a capital budgeting project.

Question 14

If a project is acceptable using the net present value criteria,then it will also be acceptable under the less stringent criteria of the payback period.

Question 15

A project with a payback period of four years is acceptable as long as the company's target payback period is greater than or equal to four years.

Question 16

If a project's internal rate of return is greater than the project's required return,then the project's profitability index will be greater than one.

Question 17

The modified internal rate of return represents the project's internal rate of return assuming that intermediate cash flows from the project can be reinvested at the project's required return.

Question 18

Whenever the internal rate of return on a project equals that project's required rate of return,the net present value equals zero.

Question 19

The net present value of a project will increase as the required rate of return is decreased (assume only one sign reversal).

Question 20

The capital budgeting decision-making process involves measuring the incremental cash flows of an investment proposal and evaluating the attractiveness of these cash flows relative to the project's cost.

Question 21

If the net present value of a project is zero,then the profitability index will equal one.

Question 22

The main disadvantage of the NPV method is the need for detailed,long-term forecasts of free cash flows generated by prospective projects.

Question 23

A project's net present value profile shows how sensitive the project is to the choice of a discount rate.

Question 24

NPV assumes reinvestment of intermediate free cash flows at the cost of capital,while IRR assumes reinvestment of intermediate free cash flows at the IRR.

Question 25

For any individual project,if the project is acceptable based on its internal rate of return,then the project will also be acceptable based on its modified internal rate of return.

Question 26

Mutually exclusive projects have more than one IRR.

Question 27

Marketing is crucial to capital budgeting success because the goal of a good capital budgeting project is to maximize the company's sales.

Question 28

One positive feature of the payback period is it emphasizes the earliest forecasted free cash flows,which are less uncertain than later cash flows and provide for the liquidity needs of the firm.

Question 29

If a project has multiple internal rates of return,the lowest rate should be used for decision making purposes.

Question 30

Because the NPV and PI methods both yield the same accept/reject decision,a company attempting to rank capital budgeting projects for funding consideration can use either method and get the same results.

Question 31

The internal rate of return will equal the discount rate when the net present value equals zero.

Question 32

The internal rate of return is the discount rate that equates the present value of the project's future free cash flows with the project's initial outlay.

Question 33

For a project with multiple sign reversals in its cash flows,the net present value can be the same for two entirely different discount rates.

Question 34

Many firms today continue to use the payback method but also employ the NPV or IRR methods especially when large projects are being analyzed.

Question 35

NPV is the most theoretically correct capital budgeting decision tool examined in the text.

Question 36

A project's IRR is analogous to the concept of the yield to maturity for bonds.

Question 37

If a project is acceptable using the NPV criteria,it will also be acceptable when using the profitability index and IRR criteria.

Question 38

The profitability index is the ratio of the present value of the future free cash flows to the initial investment.

Question 39

If a project's profitability index is less than one then the project should be rejected.

Question 40

If a firm imposes a capital constraint on investment projects,the appropriate decision criterion is to select the set of projects that has the highest positive net present value subject to the capital constraint.

Question 41

NPV may be calculated on an Excel spreadsheet simply by entering the project's free cash flows into Excel's NPV function.

Question 42

A project that is very sensitive to the selection of a discount rate will have a steep net present value profile.

Question 43

Project W requires a net investment of $1,000,000 and has a payback period of 5.6 years.You analyze Project W and decide that Year 1 free cash flow is $100,000 too low,and Year 3 free cash flow is $100,000 too high.After making the necessary adjustments

A)the payback period for Project W will be longer than 5.6 years.
B)the payback period for Project W will be shorter than 5.6 years.
C)the IRR of Project W will increase.
D)the NPV of Project W will decrease.

Question 44

Project Alpha has an internal rate of return (IRR)of 15 percent.Project Beta has an IRR of 14 percent.Both projects have a required return of 12 percent.Which of the following statements is MOST correct?

A)Both projects have a positive net present value (NPV).
B)Project Alpha must have a higher NPV than Project Beta.
C)If the required return were less than 12 percent,Project Beta would have a higher IRR than Project Alpha.
D)Project Beta has a higher profitability index than Project Alpha.

Question 45

Any project deemed acceptable using the discounted payback period will also be acceptable if using the traditional payback period.

Question 46

DYI Construction Co.is considering a new inventory system that will cost $750,000.The system is expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one,$325,000 in year two,$150,000 in year three,and $180,000 in year four.DYI's required rate of return is 8%.What is the net present value of this project?

A)$104,089
B)$100,328
C)$96,320
D)$87,417

Question 47

A project with a NPV of zero should be rejected since even the returns on U.S.Treasury bill are greater than zero.

Question 48

Because the MIRR assumes reinvestment at the cost of capital while IRR assumes reinvestment at the project's IRR,the MIRR will always be less than the IRR.

Question 49

Calculating the modified internal rate of return on an Excel spreadsheet involves the use of the IRR function multiple times,once using the financing rate,and once using the reinvestment rate.

Question 50

DYI Construction Co.is considering a new inventory system that will cost $750,000.The system is expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one,$325,000 in year two,$150,000 in year three,and $180,000 in year four.DYI's required rate of return is 8%.What is the modified internal rate of return of this project?

A)10.87%
B)11.57%
C)13.68%
D)15.13%

Question 51

The capital budgeting manager for XYZ Corporation,a very profitable high technology company,completed her analysis of Project A assuming 5-year depreciation.Her accountant reviews the analysis and changes the depreciation method to 3-year depreciation.This change will

A)increase the present value of the NCFs.
B)decrease the present value of the NCFs.
C)have no effect on the NCFs because depreciation is a non-cash expense.
D)only change the NCFs if the useful life of the depreciable asset is greater than 5 years.

Question 52

Which of the following statements is MOST correct?

A)If a project's internal rate of return (IRR)exceeds the required return,then the project's net present value (NPV)must be negative.
B)If Project A has a higher IRR than Project B,then Project A must also have a higher NPV.
C)The IRR calculation implicitly assumes that all cash flows are reinvested at a rate of return equal to the IRR.
D)A project with a NPV = 0 is not acceptable.

Question 53

A major disadvantage of the discounted payback period is the arbitrariness of the process used to select the maximum desired payback period.

Question 54

The discounted payback period takes the time value of money into account in that it uses discounted free cash flows rather than actual undiscounted free cash flows in calculating the payback period.

Question 55

The payback period ignores the time value of money and therefore should not be used as a screening device for the selection of capital budgeting projects.

Question 56

Many financial managers believe the payback period is of limited usefulness because it ignores the time value of money; hence,it is referred to as the discounted payback period.

Question 57

DYI Construction Co.is considering a new inventory system that will cost $750,000.The system is expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one,$325,000 in year two,$150,000 in year three,and $180,000 in year four.DYI's required rate of return is 8%.What is the payback period of this project?

A)4.00 years
B)3.09 years
C)2.91 years
D)2.50 years

Question 58

The internal rate of return is the discount rate that equates the present value of the project's free cash flows with the project's initial cash outlay.

Question 59

DYI Construction Co.is considering a new inventory system that will cost $750,000.The system is expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one,$325,000 in year two,$150,000 in year three,and $180,000 in year four.DYI's required rate of return is 8%.What is the internal rate of return of this project?

A)10.87%
B)11.57%
C)13.68%
D)15.13%

Question 60

Project LMK requires an initial outlay of $400,000 and has a profitability index of 1.5.The project is expected to generate equal annual cash flows over the next twelve years.The required return for this project is 20%.What is project LMK's net present value?

A)$600,000
B)$150,000
C)$120,000
D)$80,000

Question 61

Lithium,Inc.is considering two mutually exclusive projects,A and B.Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two.Project B costs $120,000 and is expected to generate $64,000 in year one,$67,000 in year two,$56,000 in year three,and $45,000 in year four.Lithium,Inc.'s required rate of return for these projects is 10%.The net present value for Project B is

A)$58,097.
B)$66,363.
C)$74,538.
D)$112,000.

Question 62

Lithium,Inc.is considering two mutually exclusive projects,A and B.Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two.Project B costs $120,000 and is expected to generate $64,000 in year one,$67,000 in year two,$56,000 in year three,and $45,000 in year four.Lithium,Inc.'s required rate of return for these projects is 10%.The profitability index for Project B is

A)1.55.
B)1.48.
C)1.39.
D)1.33.

Question 63

All of the following are sufficient indications to accept a project EXCEPT (assume that there is no capital rationing constraint,and no consideration is given to payback as a decision tool)

A)the net present value of an independent project is positive.
B)the profitability index of an independent project exceeds one.
C)the IRR of a mutually exclusive project exceeds the required rate of return.
D)the NPV of a mutually exclusive project is positive and exceeds that of all other projects.

Question 64

Given the following annual net cash flows,determine the internal rate of return to the nearest whole percent of a project with an initial outlay of $750,000.

A)9%
B)11%
C)13%
D)15%

Question 65

Lithium,Inc.is considering two mutually exclusive projects,A and B.Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two.Project B costs $120,000 and is expected to generate $64,000 in year one,$67,000 in year two,$56,000 in year three,and $45,000 in year four.The firm's required rate of return for these projects is 10%.The net present value for Project A is

A)$12,358.
B)$16,947.
C)$19,458.
D)$26,074.

Question 66

Raindrip Corp.can purchase a new machine for $1,875,000 that will provide an annual net cash flow of $650,000 per year for five years.The machine will be sold for $120,000 after taxes at the end of year five.What is the net present value of the machine if the required rate of return is 13.5%.

A)$558,378
B)$513,859
C)$473,498
D)$447,292

Question 67

A project requires an initial investment of $389,600.The project generates free cash flow of $540,000 at the end of year 4.What is the internal rate of return for the project?

A)138.6%
B)38.6%
C)8.5%
D)6.9%

Question 68

Lithium,Inc.is considering two mutually exclusive projects,A and B.Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two.Project B costs $120,000 and is expected to generate $64,000 in year one,$67,000 in year two,$56,000 in year three,and $45,000 in year four.Lithium,Inc.'s required rate of return for these projects is 10%.The modified internal rate of return for Project B is

A)17.84%.
B)18.52%.
C)19.75%.
D)22.80%.

Question 69

Lithium,Inc.is considering two mutually exclusive projects,A and B.Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two.Project B costs $120,000 and is expected to generate $64,000 in year one,$67,000 in year two,$56,000 in year three,and $45,000 in year four.Lithium,Inc.'s required rate of return for these projects is 10%.The internal rate of return for Project B is

A)29.74%.
B)30.79%.
C)35.27%.
D)36.77%.

Question 70

A machine that costs $1,500,000 has a 3-year life.It will generate after tax annual cash flows of $700,000 at the end of each year.It will be salvaged for $200,000 at the end of year 3.If your required rate of return for the project is 13%,what is the NPV of this investment?

A)$291,417
B)$400,000
C)$600,000
D)$338,395

Question 71

Lithium,Inc.is considering two mutually exclusive projects,A and B.Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two.Project B costs $120,000 and is expected to generate $64,000 in year one,$67,000 in year two,$56,000 in year three,and $45,000 in year four.Lithium,Inc.'s required rate of return for these projects is 10%.The modified internal rate of return for Project A is

A)19.19%.
B)24.18%.
C)26.89%.
D)29.63%.

Question 72

Project LMK requires an initial outlay of $500,000 and has a profitability index of 1.4.The project is expected to generate equal annual cash flows over the next ten years.The required return for this project is 16%.What is project LMK's internal rate of return?

A)19.88%
B)22.69%
C)24.78%
D)26.12%

Question 73

Lithium,Inc.is considering two mutually exclusive projects,A and B.Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two.Project B costs $120,000 and is expected to generate $64,000 in year one,$67,000 in year two,$56,000 in year three,and $45,000 in year four.Lithium,Inc.'s required rate of return for these projects is 10%.The profitability index for Project A is

A)1.27.
B)1.22.
C)1.17.
D)1.12.

Question 74

Lithium,Inc.is considering two mutually exclusive projects,A and B.Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two.Project B costs $120,000 and is expected to generate $64,000 in year one,$67,000 in year two,$56,000 in year three,and $45,000 in year four.Lithium,Inc.'s required rate of return for these projects is 10%.The internal rate of return for Project A is

A)31.43%.
B)29.42%.
C)25.88%.
D)19.45%.

Question 75

Arguments against using the net present value and internal rate of return methods include that

A)they fail to use accounting profits.
B)they require detailed long-term forecasts of the incremental benefits and costs.
C)they fail to consider how the investment project is to be financed.
D)they fail to use the cash flow of the project.

Question 76

The net present value method

A)is consistent with the goal of shareholder wealth maximization.
B)recognizes the time value of money.
C)uses all of a project's cash flows.
D)all of the above.

Question 77

When reviewing the net present profile for a project

A)the higher the discount rate,the higher the NPV.
B)the higher the discount rate,the higher the IRR.
C)the IRR will always be a point on the horizontal axis line where NPV = 0.
D)the IRR will always be a point on the horizontal axis equal to the required return.

Question 78

Lithium,Inc.is considering two mutually exclusive projects,A and B.Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two.Project B costs $120,000 and is expected to generate $64,000 in year one,$67,000 in year two,$56,000 in year three,and $45,000 in year four.Lithium,Inc.'s required rate of return for these projects is 10%.Which project would you recommend using the replacement chain method to evaluate the projects with different lives?

A)Project B because its NPV is higher than Project A's replacement chain NPV of $47,623
B)Project A because its replacement chain NPV is $76,652,which exceeds the NPV for Project B
C)Project A because its replacement chain NPV is $45,642,which is less than the NPV for Project B
D)Both projects will be valued the same since they are now both four year projects.

Question 79

Lithium,Inc.is considering two mutually exclusive projects,A and B.Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two.Project B costs $120,000 and is expected to generate $64,000 in year one,$67,000 in year two,$56,000 in year three,and $45,000 in year four.Lithium,Inc.'s required rate of return for these projects is 10%.The equivalent annual annuity amount for project B,rounded to the nearest dollar,is

A)$17,385.
B)$20,936.
C)$22,789.
D)$26,551.

Question 80

A capital budgeting project has a net present value of $30,000 and a modified internal rate of return of 15%.The project's required rate of return is 13%.The internal rate of return is

A)greater than $30,000.
B)less than 13%.
C)between 13% and 15%.
D)greater than 15%