Question 1

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

False

Question 2

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

When a project has a negative cash flow at the end of its life, it can create multiple changes in sign in the cash flow stream, leading to multiple IRRs.

Question 3

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 cost of capital.

Accepted Answer

Both NPV (Net Present Value) and IRR (Internal Rate of Return) methods will lead to the same accept/reject decision for independent projects if the projects' IRRs are greater than the cost of capital. This is because both methods will indicate that the projects are expected to generate returns above the required threshold, making them acceptable investments.

Question 4

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

The NPV method discounts each project's cash flows to the present value using the project's risk-adjusted cost of capital. This assumes that cash flows are reinvested at the same cost of capital to generate returns equal to the required rate of return for the project.

Question 5

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 6

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 7

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

The present value of cash flows can be summed to determine the value of a capital budgeting project, using techniques such as net present value (NPV) or internal rate of return (IRR).

Question 8

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

Accepting a project may increase or decrease the firm's cost of capital (WACC) depending on the nature of the project and its impact on the risk profile of the company. Therefore, the decision to accept or reject a project should not be based solely on its potential impact on WACC.

Question 9

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 an accurate description of the MIRR method.

Question 10

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 answer of The phenomenon called "multiple internal rates of...

Question 11

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 assumes that cash inflows are reinvested at the cost of capital, which is a more realistic assumption than the IRR method's assumption that cash flows are reinvested at the IRR. This is because the cost of capital represents the required return on a new investment, while the IRR assumes that the investor can reinvest at the same rate in future projects, which may not be realistic. Therefore, the NPV method is generally preferred over the IRR method.

Question 12

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 13

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 definition of internal rate of return provided in the statement is accurate, making the answer true.

Question 14

The primary reason that the NPV method is conceptually superior to the IRR method for evaluating mutually exclusive investments is that multiple IRRs may exist, and when that happens, we don't know which IRR is relevant.

Accepted Answer

The primary reason the NPV method is considered conceptually superior is that it directly measures the increase in value to the firm, taking into account the scale of the investment and the time value of money, ensuring decisions align with maximizing shareholder wealth. Multiple IRRs can be an issue, but it's not the primary reason for NPV's superiority.

Question 15

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 16

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 17

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. In reality, conflicts between NPV and IRR can occur due to a variety of factors, such as differences in cash flow patterns and project sizes. Therefore, neither method should be used exclusively to make investment decisions. Rather, both should be used in conjunction with other financial analysis tools to determine the feasibility and profitability of a project.

Question 18

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 answer of A basic rule in capital budgeting is...

Question 19

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 more reliable and accurate than the IRR method in evaluating project profitability. Therefore, conflicts should be resolved in favor of the project with the higher NPV.

Question 20

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 the amount of time it takes for an investment to generate enough cash flow to recover the initial investment. This information can be helpful in assessing a project's liquidity and risk, as a shorter payback period implies faster recovery of the initial investment and less risk.

Quiz 11: The Basics of Capital Budgeting