Question 1

Normal Projects S and L have the same NPV when the discount rate is zero.However, Project S's cash flows come in faster than those of L.Therefore, we know that at any discount rate greater than zero, L will have the higher NPV.

Accepted Answer

Project S, with faster incoming cash flows, will have a higher NPV at any positive discount rate because earlier cash flows are more valuable when discounted back to the present value.

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 (or cost) at the end of its life, it is possible for the project to have more than one IRR. This is because the negative cash flow can create multiple sign changes in the cash flows, leading to multiple possible discount rates that result in a net present value of zero.

Question 3

Which of the following statements is CORRECT?
A) One defect of the IRR method versus the NPV is that the IRR does not take account of the time value of money.
B) One defect of the IRR method versus the NPV is that the IRR does not take account of the cost of capital.
C) One defect of the IRR method versus the NPV is that the IRR values a dollar received today the same as a dollar that will not be received until sometime in the future.
D) One defect of the IRR method versus the NPV is that the IRR does not take proper account of differences in the sizes of projects.
E) One defect of the IRR method versus the NPV is that the IRR does not take account of cash flows over a project's full life.

Accepted Answer

The IRR method does consider the time value of money, similar to NPV, and it does account for cash flows over a project's full life. However, it may not properly reflect differences in project sizes, which is a limitation compared to NPV.

Question 4

Which of the following statements is CORRECT?
A) One defect of the IRR method is that it does not take account of the time value of money.
B) One defect of the IRR method is that it does not take account of the cost of capital.
C) One defect of the IRR method is that it values a dollar received today the same as a dollar that will not be received until sometime in the future.
D) One defect of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid.
E) One defect of the IRR method is that it does not take account of cash flows over a project's full life.

Accepted Answer

One defect of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid. This is known as the reinvestment rate assumption, and it can lead to overestimating the true profitability of a project.

Question 5

Which of the following statements is CORRECT?
A) If a project has "normal" cash flows, then its MIRR must be positive.
B) If a project has "normal" cash flows, then it will have exactly two real IRRs.
C) The definition of "normal" cash flows is that the cash flow stream has one or more negative cash flows followed by a stream of positive cash flows and then one negative cash flow at the end of the project's life.
D) If a project has "normal" cash flows, then it can have only one real IRR, whereas a project with "nonnormal" cash flows might have more than one real IRR.
E) If a project has "normal" cash flows, then its IRR must be positive.

Accepted Answer

A project with "normal" cash flows has one or more negative cash flows at the beginning followed by a series of positive cash flows and then one negative cash flow at the end. Such projects can have only one real IRR. Projects with "nonnormal" cash flows, on the other hand, may have more than one real IRR. The MIRR (Modified Internal Rate of Return) can be positive, negative or zero depending on the cash flows and the required rate of return used to compute it.

Question 6

A project's IRR is independent of the firm's cost of capital.In other words, a project's IRR doesn't change with a change in the firm's cost of capital.

Accepted Answer

The project's IRR is based solely on the project's cash flows and is not affected by the firm's cost of capital. Therefore, changes in the firm's cost of capital will not impact the project's IRR.

Question 7

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
A) A project's regular IRR is found by discounting the cash inflows at the cost of capital to find the present value (PV), then compounding this PV to find the IRR.
B) If a project's IRR is greater than the WACC, then its NPV must be negative.
C) To find a project's IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project's costs.
D) To find a project's IRR, we must find a discount rate that is equal to the cost of capital.
E) A project's regular IRR is found by compounding the cash inflows at the cost of capital to find the terminal value (TV), then discounting this TV at the cost of capital.

Accepted Answer

The IRR is the discount rate that makes the net present value of a project's cash inflows equal to zero. In other words, we must solve for the discount rate that causes the present value of the inflows to equal the present value of the project's costs. Choices A, B, D, and E are incorrect because they do not accurately describe how IRR is calculated.

Question 8

Project S has a pattern of high cash flows in its early life, while Project L has a longer life, with large cash flows late in its life.Neither has negative cash flows after Year 0, and at the current cost of capital, the two projects have identical NPVs.Now suppose interest rates and money costs decline.Other things held constant, this change will cause L to become preferred to S.

Accepted Answer

As the interest rates and money costs decline, the present value of the larger cash flows in the later years of Project L will increase more than the present value of the earlier cash flows in Project S. Therefore, Project L will become more profitable and preferred over Project S.

Question 9

Which of the following statements is CORRECT?
A) The NPV profile graph for a normal project will generally have a positive (upward) slope as the life of the project increases.
B) An NPV profile graph is designed to give decision makers an idea about how a project's risk varies with its life.
C) An NPV profile graph is designed to give decision makers an idea about how a project's contribution to the firm's value varies with the cost of capital.
D) We cannot draw a project's NPV profile unless we know the appropriate cost of capital for use in evaluating the project's NPV.
E) An NPV profile graph shows how a project's payback varies as the cost of capital changes.

Accepted Answer

An NPV profile graph is designed to give decision makers an idea about how a project's contribution to the firm's value varies with the cost of capital. The graph shows the relationship between NPV and the discount rate or cost of capital. The slope of the graph (upward or downward) indicates the project's sensitivity to changes in the cost of capital, while the intersection of the graph with the horizontal axis represents the internal rate of return (IRR) of the project. The NPV profile graph can help decision makers to identify the range of discount rates at which the project will have positive NPV and hence be acceptable for investment.

Question 10

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
A) A project's regular IRR is found by compounding the cash inflows at the cost of capital to find the present value (PV), then discounting the TV to find the IRR.
B) If a project's IRR is smaller than the cost of capital, then its NPV will be positive.
C) A project's IRR is the discount rate that causes the PV of the inflows to equal the project's cost.
D) If a project's IRR is positive, then its NPV must also be positive.
E) A project's regular IRR is found by compounding the initial cost at the cost of capital to find the terminal value (TV), then discounting the TV at the cost of capital.

Accepted Answer

The Internal Rate of Return (IRR) is the discount rate at which the net present value (NPV) of a project is equal to zero. In other words, it is the discount rate at which the present value of future cash inflows equals the initial cost of the project. Therefore, statement C is correct. Statement A is incorrect because it describes the formula for calculating the Modified IRR (MIRR), which involves compounding the cash inflows and outflows separately. Statement B is incorrect because a project's NPV will be negative if its IRR is smaller than the cost of capital. Statement D is incorrect because a project's NPV can be positive, negative, or zero at any given IRR. Statement E is incorrect because it describes the formula for calculating the Terminal Value (TV), which is not used in the calculation of the IRR.

Question 11

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
A) If Project A has a higher IRR than Project B, then Project A must also have a higher NPV.
B) The IRR calculation implicitly assumes that all cash flows are reinvested at the cost of capital.
C) The IRR calculation implicitly assumes that cash flows are withdrawn from the business rather than being reinvested in the business.
D) If a project has normal cash flows and its IRR exceeds its cost of capital, then the project's NPV must be positive.
E) If Project A has a higher IRR than Project B, then Project A must have the lower NPV.

Accepted Answer

If a project has normal cash flows and its IRR exceeds its cost of capital, then the project's NPV must be positive. This is because the IRR represents the discount rate that would make the NPV of the project equal to zero. Therefore, if the IRR is higher than the cost of capital, the NPV will be positive. Choices A and E are incorrect because the relationship between IRR and NPV depends on the size and timing of the cash flows, and a higher IRR does not necessarily imply a higher or lower NPV. Choice B is incorrect because the IRR only assumes that the cash flows are reinvested at the IRR itself, not at the cost of capital. Choice C is incorrect because the IRR calculation assumes that all cash flows generated by the project are reinvested in the project, not withdrawn from the business.

Question 12

An increase in the firm's cost of capital will decrease projects' NPVs, which could change the accept/reject decision for any potential project.However, such a change would have no impact on projects' IRRs.Therefore, the accept/reject decision under the IRR method is independent of the cost of capital.

Accepted Answer

An increase in the firm's cost of capital will not necessarily have an impact on the accept/reject decision for potential projects under the IRR method. The IRR method compares the project's IRR to the cost of capital, and if the IRR is greater than the cost of capital, the project is accepted. Therefore, the decision is not independent of the cost of capital.

Question 13

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 takes into account the time value of money and discounts future cash flows at the project's risk-adjusted cost of capital. This assumes that any cash flows generated from the project are reinvested at the same rate of return as the project itself.

Question 14

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 15

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 reasonable assumption than the IRR method's assumption that cash flows are reinvested at the IRR. This is because the cost of capital represents the opportunity cost of investing in a project, while the IRR only measures the return on investment. Therefore, the NPV method is generally preferred over the IRR method.

Question 16

The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects that have different lives are compared to one another.

Accepted Answer

The phenomenon of "multiple internal rates of return" occurs when a project has unconventional cash flows (i.e., cash flow signs change more than once throughout the project's life), not specifically when comparing mutually exclusive projects with different lives.

Question 17

Which of the following statements is CORRECT?
A) If two projects are mutually exclusive, then they are likely to have multiple IRRs.
B) If a project is independent, then it cannot have multiple IRRs.
C) Multiple IRRs can occur only if the signs of the cash flows change more than once.
D) If a project has two IRRs, then the smaller one is the one that is most relevant, and it should be accepted and relied upon.
E) For a project to have more than one IRR, then both IRRs must be greater than the cost of capital.

Accepted Answer

C) Multiple IRRs can occur only if the signs of the cash flows change more than once. This is because the existence of multiple IRRs is associated with non-normal cash flows, where the cash flow pattern includes more than one change in the sign (from positive to negative or vice versa), leading to the possibility of calculating more than one IRR.

Question 18

If the IRR of normal Project X is greater than the IRR of mutually exclusive (and also normal) Project Y, we can conclude that the firm should always select X rather than Y if X has NPV > 0.

Accepted Answer

The decision to select a project based on IRR when comparing mutually exclusive projects can be misleading. The correct approach is to compare the NPVs of the projects. A project with a higher IRR might have a lower NPV, and since NPV is the direct measure of how much value a project adds to the firm, the project with the higher NPV should be selected, regardless of the IRR comparison.

Question 19

Which of the following statements is CORRECT?
A) If the cost of capital declines, this lowers a project's NPV.
B) The NPV method is regarded by most academics as being the best indicator of a project's profitability; hence, most academics recommend that firms use only this one method.
C) A project's NPV depends on the total amount of cash flows the project produces, but because the cash flows are discounted at the cost of capital, it does not matter if the cash flows occur early or late in the project's life.
D) The NPV and IRR methods may give different recommendations regarding which of two mutually exclusive projects should be accepted, but they always give the same recommendation regarding the acceptability of a normal, independent project.
E) The NPV method was once the favorite of academics and business executives, but today most authorities regard the MIRR as being the best indicator of a project's profitability.

Accepted Answer

The NPV and IRR methods may give different recommendations for mutually exclusive projects due to differences in cash flow timing and scale, but for independent projects, both methods generally agree on acceptability.

Question 20

The IRR of normal Project X is greater than the IRR of normal Project Y, and both IRRs are greater than zero.Also, the NPV of X is greater than the NPV of Y at the cost of capital.If the two projects are mutually exclusive, Project X should definitely be selected, and the investment made, provided we have confidence in the data.Put another way, it is impossible to draw NPV profiles that would suggest not accepting Project X.

Accepted Answer

While Project X has a higher IRR and NPV at a specific cost of capital, NPV profiles could intersect, meaning that the relative attractiveness of the projects could change at different discount rates. If the cost of capital changes, it might make Project Y more attractive under certain conditions.

Quiz 10: The Basics of Capital Budgeting: Evaluating Cash Flows

Normal Projects S and L have the same NPV when the discount rate is zero.However, Project S's cash flows come in faster than those of L.Therefore, we know that at any discount rate greater than zero, L will have the higher NPV.

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.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

A project's IRR is independent of the firm's cost of capital.In other words, a project's IRR doesn't change with a change in the firm's cost of capital.

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.

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

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

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.

The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects that have different lives are compared to one another.

Which of the following statements is CORRECT?

If the IRR of normal Project X is greater than the IRR of mutually exclusive (and also normal) Project Y, we can conclude that the firm should always select X rather than Y if X has NPV > 0.

Which of the following statements is CORRECT?