Question 1

Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the higher NPV.

Accepted Answer

The NPV method is considered to be more reliable than the IRR method as it takes into account the time value of money and uses a more realistic discount rate. Therefore, conflicts between these methods should be resolved in favor of the project with the higher NPV.

Question 2

Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the higher IRR.

Accepted Answer

This statement is false. Conflicts between NPV and IRR rankings cannot be resolved by simply choosing the project with higher IRR. NPV is generally considered to be the more reliable method for evaluating projects, as it takes into account the time value of money, and provides a clear measure of the expected total value of a project. In cases where NPV and IRR rankings conflict, it is important to consider other factors, such as project size, risk, and strategic importance, to make an informed decision.

Question 3

Assuming that their NPVs based on the firm's cost of capital are equal, the NPV of a project whose cash flows accrue relatively rapidly will be more sensitive to changes in the discount rate than the NPV of a project whose cash flows come in later in its life.

Accepted Answer

The NPV of a project whose cash flows come in later in its life is more sensitive to changes in the discount rate because the present value of future cash flows is more heavily impacted by the rate at which those cash flows are discounted back to the present.

Question 4

The phenomenon called “multiple internal rates of return” arises when two or more mutually exclusive projects that have different lives are being compared.

Accepted Answer

The phenomenon of multiple internal rates of return arises in a single project with non-conventional cash flows, not when comparing projects with different lives.

Question 5

The NPV and IRR methods, when used to evaluate two independent and equally risky projects, will lead to different accept/reject decisions and thus capital budgets if the projects' IRRs are greater than their costs of capital.

Accepted Answer

The answer of The NPV and IRR methods, when used...

Question 6

A basic rule in capital budgeting is that if a project's NPV exceeds its IRR, then the project should be accepted.

Accepted Answer

The decision to accept a project in capital budgeting is based on whether the Net Present Value (NPV) is positive, not on whether it exceeds the Internal Rate of Return (IRR). The IRR is a rate of return; comparing its magnitude directly to the NPV, which is a dollar amount, is not meaningful for decision-making.

Question 7

The primary reason that the NPV method is conceptually superior to the IRR method for evaluating mutually exclusive investments is that

Accepted Answer

The answer of The primary reason that the NPV method...

Question 8

When evaluating mutually exclusive projects, the modified IRR (MIRR) always leads to the same capital budgeting decisions as the NPV method, regardless of the relative lives or sizes of the projects being evaluated.

Accepted Answer

MIRR and NPV can lead to different capital budgeting decisions because MIRR assumes reinvestment at the project's own rate of return, while NPV assumes reinvestment at the firm's cost of capital, potentially leading to different preferences for projects, especially when they have different sizes or lives.

Question 9

The NPV method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital.

Accepted Answer

This assumption is central to the NPV method and is based on the fact that the cost of capital reflects the opportunity cost of investing in a project, and any cash flows generated by the project should be reinvested at this rate to maximize shareholder value.

Question 10

The IRR method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital.

Accepted Answer

The IRR method assumes that the projects' cash flows are reinvested at the internal rate of return itself, not at the project's risk-adjusted cost of capital.

Question 11

When considering two mutually exclusive projects, the firm should always select the project whose internal rate of return is the highest, provided the projects have the same initial cost. This statement is true regardless of whether the projects can be repeated or not.

Accepted Answer

The answer of When considering two mutually exclusive projects, the...

Question 12

Other things held constant, an increase in the cost of capital will result in a decrease in a project's IRR.

Accepted Answer

The IRR (Internal Rate of Return) is a metric used to evaluate the profitability of a project and is not directly affected by changes in the cost of capital. The cost of capital influences the project's NPV (Net Present Value) and its acceptability, not its IRR.

Question 13

Under certain conditions, a project may have more than one IRR. One such condition is when, in addition to the initial investment at time = 0, a negative cash flow (or cost) occurs at the end of the project's life.

Accepted Answer

The answer of Under certain conditions, a project may have...

Question 14

The NPV method's assumption that cash inflows are reinvested at the cost of capital is generally more reasonable than the IRR's assumption that cash flows are reinvested at the IRR. This is an important reason why the NPV method is generally preferred over the IRR method.

Accepted Answer

The NPV method's assumption is more realistic as it assumes that cash inflows are reinvested at the cost of capital, which is a more accurate reflection of market conditions. The IRR method's assumption that cash flows are reinvested at the IRR can lead to unrealistic returns and may not accurately reflect the true profitability of a project. Therefore, the NPV method is generally preferred over the IRR method.

Question 15

Both the regular and the modified IRR (MIRR) methods have wide appeal to professors, but most business executives prefer the NPV method to either of the IRR methods.

Accepted Answer

The answer of Both the regular and the modified IRR...

Question 16

For a project with one initial cash outflow followed by a series of positive cash inflows, the modified IRR (MIRR) method involves compounding the cash inflows out to the end of the project's life, summing those compounded cash flows to form a terminal value (TV), and then finding the discount rate that causes the PV of the TV to equal the project's cost.

Accepted Answer

This is the correct definition of the MIRR method.

Question 17

One advantage of the payback method for evaluating potential investments is that it provides information about a project's liquidity and risk.

Accepted Answer

The payback method calculates how long it takes for a project to recoup its initial investment, which gives insight into the project's liquidity (ability to generate cash) and risk (the longer the payback period, the higher the risk).

Question 18

The internal rate of return is that discount rate that equates the present value of the cash outflows (or costs) with the present value of the cash inflows.

Accepted Answer

The statement is true.

Question 19

Because "present value" refers to the value of cash flows that occur at different points in time, a series of present values of cash flows should not be summed to determine the value of a capital budgeting project.

Accepted Answer

A series of present values of cash flows should be summed to determine the value of a capital budgeting project, which is known as the net present value (NPV). NPV is calculated by subtracting the initial investment from the sum of present values of all future cash flows.

Question 20

A firm should never accept a project if its acceptance would lead to an increase in the firm's cost of capital (its WACC).

Accepted Answer

The statement is not always true. It depends on the specific project and its potential impact on the firm's future cash flows. If the project has a high enough return on investment to outweigh the increased cost of capital, then accepting the project would still be beneficial for the firm. However, if the project's return is not sufficient to cover the increased cost of capital, then the firm should reject it.

Quiz 12: Capital Budgeting Mc Problems