Question 1

Your company is planning to open a new gold mine which will cost $3 million to build, with the expenditure occurring at the end of the year three years from today. The mine will bring year-end after-tax cash inflows of $2 million at the end of the two succeeding years, and then it will cost $.5 million to close down the mine at the end of the 3rd year of operation. What is the project's IRR?

Accepted Answer

Using a financial calculator: IRR = CF0 = -3,000,000, C01 = 2,000,000, F01 = 2, C02 = -500,000 F02 = 1, IRR CPT = 12.70%

Question 2

According to the internal rate of return method, a firm should accept a project if the ________.

Accepted Answer

According to the internal rate of return method, a project should be accepted if the internal rate of return is greater than the cost of capital. This is because the internal rate of return represents the rate at which the project will generate positive cash flows, and if it exceeds the cost of capital, the project will generate excess returns for the firm. Therefore, choice B is the correct answer.

Question 3

The New Watch Times is considering a new printing press to increase its productive capacity. If the cost of the press is $500,000 and the relevant cash flows from the project are $75,000 per year over the next ten years, what is the payback period?

Accepted Answer

To calculate the payback period, we need to divide the initial cost of the investment by the expected annual cash inflows.

Payback period = Cost of investment / Annual cash inflows

Payback period = $500,000 / $75,000 = 6.67 years

Therefore, the payback period for the printing press is 6.67 years, which is closest to option D) 6.67 years.

Question 4

Perhaps the greatest disadvantage of using the IRR method to evaluate investment opportunities is:

Accepted Answer

The greatest disadvantage of using the IRR method to evaluate investment opportunities is the assumption that all cash flows from the project will be reinvested at the IRR.

Question 5

An insurance firm agrees to pay you $3,310 at the end of 20 years if you pay a premium of $100 per year at the end of each year of the 20 years. Find the internal rate of return to the nearest whole percentage point.

Accepted Answer

Using a financial calculator:
CF0 = 0, C01 = -100, F01 = 20, C02 = 3,310, F02 = 1, IRR CPT = 4.58% or 5%

Question 6

Genuine Products Inc. requires a new machine. Two companies have submitted bids, and you have been assigned to the task of choosing one of the machines. Cash flow analysis indicates the following: $$\begin{array} { | c | c | c | } 
\hline \text { Year } & \text { Machine A } & \text { Machine B } \
\hline 0 & - \$ 2,000 & - \$ 2,000 \
\hline 1 & \$ 0 & \$ 832 \
\hline 2 & \$ 0 & \$ 832 \
\hline 3 & \$ 0 & \$ 832 \
\hline 4 & \$ 3,877 & \$ 832 \
\hline
\end{array}$$ What is the internal rate of return for each machine?

Accepted Answer

The IRR for Machine A is 18% and for Machine B is 24%, calculated by finding the discount rate that makes the net present value of cash flows equal to zero for each machine.

Question 7

A project requires an investment outlay of $100 immediately. The project will generate after-tax cash flows of $50 one year from now and $60 two years from now. What is the IRR of the project?

Accepted Answer

Using a financial calculator:
CF0 = -100, C01 = 50, F01 = 1, C02 = 60, F02 = 1, IRR CPT = 6.39%

Question 8

What is the payback period for the Boeing 787 Dreamliner project? The Boeing 787-8 can carry 230 passengers up to 8,200 nautical miles at a cruising speed of mach 0.85. The Dreamliner is more comfortable for passengers because of higher cabin humidity. Boeing completed construction of its final assembly plant in Everett Washington in December 2007 at a total cost of $7B. Boeing has secured sales of 865 aircraft over the period 2008-2012 for total proceeds of $138.4B ($160M per aircraft). The cost of building each plane is $140M. Assume that sales (and costs)occur in December of each year. Assume that sales are spread evenly across the five years from 2008-2012. The project cash flows are shown in the table, below. What is the payback period for the project? Ignore taxes. $$\begin{array} { | c | c | c | c | c | c | } 
\hline \text { Year } & \begin{array} { c } 
\text { Capital } \
\text { Investment }
\end{array} & \text { Annual Sales } & \begin{array} { c } 
\text { Annual } \
\text { Revenues }
\end{array} & \text { Annual Costs } & \text { Cash Flows } \
\hline 2007 & - \$ 7,000 \mathrm { M } & & & & - \$ 7,000 \
\hline 2008 & & 173 & \$ 27,680 & \$ 24,220 & \$ 3,460 \
\hline 2009 & & 173 & \$ 27,680 & \$ 24,220 & \$ 3,460 \
\hline 2010 & & 173 & \$ 27,680 & \$ 24,220 & \$ 3,460 \
\hline 2011 & & 173 & \$ 27,680 & \$ 24,220 & \$ 3,460 \
\hline 2012 & & 173 & \$ 27,680 & \$ 24,220 & \$ 3,460 \
\hline
\end{array}$$

Accepted Answer

The payback period is the amount of time it takes for the project to generate enough cash flow to cover the initial investment. In this case, the initial investment is $7 billion. The project generates $3.46 billion in cash flow each year, so the payback period is $7 billion / $3.46 billion = 2.02 years.

Question 9

A project requires a current expenditure of $300 and expects to generate $100 cash inflows at the end of each of the next 5 years. What conclusion can be drawn from examining an NPV profile for this project?

Accepted Answer

Using a financial calculator:
CF0 = -300, C01 = 100, F01 = 5, IRR CPT = 19.86% or 20%

Question 10

A firm is evaluating a proposal which has an initial investment of $35,000 and has cash flows of $10,000 in year 1, $20,000 in year 2, and $10,000 in year 3. The payback period of the project is:

Accepted Answer

The payback period is the time it takes for the cash inflows to cover the initial investment. Here, by the end of year 2, the total cash inflow is $30,000 ($10,000 in year 1 + $20,000 in year 2), which does not cover the initial investment of $35,000. By the end of year 3, with an additional $10,000, the total inflow is $40,000, covering the investment. Thus, the payback period is between 2 and 3 years.

Question 11

All of the following are weaknesses of the payback period EXCEPT:

Accepted Answer

This statement is incorrect as using cash flows instead of accounting profits is not a weakness of the payback period, but rather a characteristic of it. The weaknesses of the payback period are noted in choices A, B, and C.

Question 12

The underlying cause of ranking conflicts between the NPV and IRR methods is differing:

Accepted Answer

The ranking conflicts between NPV and IRR methods arise due to the differences in the reinvestment rate assumption. The IRR assumes that cash inflows can be reinvested at the same rate as the IRR, while the NPV assumes that cash inflows can be reinvested at the firm's cost of capital. This can lead to conflicts in ranking projects, especially when the IRR method leads to the selection of a project, but the NPV method shows that the project actually results in lower wealth for the firm. Therefore, option B is the correct answer.

Question 13

Among the reasons many firms DON'T use the payback period as a guideline in capital investment decisions are all of the following EXCEPT:

Accepted Answer

Being easy to calculate is not a reason firms choose not to use the payback period technique.

Question 14

If the ________ is greater than or equal to the ________, the project should be accepted.

Accepted Answer

We accept the project if the IRR is greater than or equal to our cost of capital.

Question 15

In comparing the internal rate of return and net present value methods of evaluation,

Accepted Answer

Net Present Value is preferred by financial managers because it takes into account the time value of money and measures benefits relative to the costs. It also provides a dollar value of the project's profitability, rather than just a rate of return like Internal Rate of Return. While Internal Rate of Return is a valuable tool in project evaluation, it may not always provide a clear picture of the project's profitability.

Question 16

The internal rate of return may be defined as the:

Accepted Answer

The internal rate of return (IRR) is the discount rate at which a project's NPV equals zero. In other words, it is the return that an investor expects to earn from a project over its useful life. It is used as a tool to evaluate the financial feasibility of a project or investment opportunity.

Question 17

What is the IRR for a project with a current cost of $7,000 that is expected to produce cash inflows of $1,000 at the end of each of the next 10 years? Round answer to the nearest whole percent.

Accepted Answer

Using a financial calculator:IRR = CF0 = -7,000, C01 = 1,000, F01 = 10, IRR CPT = 7.07%

Question 18

Some firms use the payback period as a decision criterion or as a supplement to sophisticated decision techniques, because:

Accepted Answer

The payback period is not a reliable measure of a project's profitability or risk exposure. It simply tells us how long it takes to recoup the initial investment in a project. Therefore, the best choice is B, as it is the only option that is true. Some firms may use payback as a supplement to more sophisticated techniques, but not as a replacement for them.

Question 19

What is the internal rate of return for a project that requires a current cash outlay of $15,187 and is expected to generate cash inflows of $5,000 at the end of each of the next four years?

Accepted Answer

Using a financial calculator:IRR = CF0 = -15,187, C01 = 5,000, F01 = 4, IRR CPT = 12%

Question 20

Comparing net present value and internal rate of return analysis:

Accepted Answer

NPV and IRR will always result in the same accept/reject decision.

Quiz 9: Capital Budgeting Techniques