Question 1

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 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 NPV.

Accepted Answer

The NPV method is considered more reliable in evaluating mutually exclusive projects because it takes into account the time value of money and measures absolute dollar value. The IRR method can result in misleading conclusions if the cash flow patterns of the projects differ significantly. Therefore, conflicts should be resolved in favor of the project with the higher NPV.

Question 3

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 reinvestment of cash inflows at the cost of capital, which is a more reasonable assumption compared to the IRR method's assumption of reinvestment at the IRR. Hence, the NPV method is generally preferred over the IRR method.

Question 4

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

This statement is false. Accepting a project may actually lower the firm's cost of capital by diversifying the firm's investments or increasing the firm's cash flows. The decision to accept a project should be based on its expected return and its contribution to the firm's overall strategy and objectives.

Question 5

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 6

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 7

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 8

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 internal rate of return (IRR) is indeed the discount rate at which the net present value of an investment's cash inflows equals the net present value of its cash outflows or costs.

Question 9

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 10

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 11

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 simply by favoring the project with a higher IRR. It is important to carefully consider the assumptions and limitations of each method and potentially use additional analysis, such as the payback period or profitability index, to make a decision.

Question 12

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 13

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. This is known as the net present value (NPV) calculation.

Question 14

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 15

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 16

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 17

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 modified IRR (MIRR) method.

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 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 19

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 will take for the investment to generate enough cash flow to recover the initial investment cost. This information can indicate the project's liquidity, as it demonstrates how quickly the investment can generate cash. It can also provide an indication of risk, as longer payback periods may indicate greater uncertainty or risk in the investment.

Question 20

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 net present value (NPV) method assumes that cash flows generated by a project are reinvested at the project's risk-adjusted cost of capital, which is the minimum rate of return that investors require to compensate them for the level of risk involved in the project. This allows the NPV method to account for the time value of money and the opportunity cost of investing in a particular project.

Quiz 11: The Basics of Capital Budgeting