Question 1

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

This is the correct definition of internal rate of return (IRR).

Question 2

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 3

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 4

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 5

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 accurately describes the method for calculating the MIRR for a project with one initial cash outflow and a series of positive cash inflows. The MIRR considers the time value of money and assumes that cash inflows are reinvested at a specified rate of return until the end of the project's life. The discount rate that equates the PV of the TV to the project's cost is the MIRR.

Question 6

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 will take to recoup the initial investment, which provides information about the project's liquidity and risk. A shorter payback period indicates lower risk and greater liquidity, while a longer payback period indicates higher risk and lower liquidity. Therefore, the statement is true.

Question 7

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

This is known as the "multiple IRR problem" and occurs when there is a change in the sign of the cash flows, resulting in more than one possible rate of return that satisfies the cash flow equation.

Question 8

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

Accepted Answer

Conflicts between NPV and IRR can occur due to differences in cash flow timing and size. However, the NPV method is considered superior and should be used to make investment decisions. This is because NPV considers the time value of money and provides a clear estimate of the project's value in terms of dollars, whereas IRR only provides a percentage return and assumes the reinvestment of cash inflows at the same rate. Therefore, conflicts should be resolved in favor of the project with the higher NPV, not the higher IRR.

Question 9

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, using techniques such as net present value (NPV) or internal rate of return (IRR).

Question 10

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

Accepted Answer

This is because the NPV method is considered to be a more reliable method for evaluating investment projects as it takes into account the time value of money and provides a clear measure of the project's profitability over a given time period. The IRR method, on the other hand, assumes reinvestment of cash flows at the IRR rate, which may not always be a realistic assumption. Therefore, conflicts between the two methods should be resolved in favor of the project with the higher positive NPV.

Question 11

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 in a single project with non-conventional cash flows, not when comparing different projects.

Question 12

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 future cash flows to their present value using the project's risk-adjusted cost of capital. This assumes that any cash inflows generated by the project will be reinvested at this rate, taking into account the project's level of risk.

Question 13

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 actually decrease a firm's cost of capital by diversifying its portfolio or increasing its future cash flows. However, the project's expected return should always exceed the firm's cost of capital in order to create value for the shareholders.

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 assumption that cash inflows are reinvested at the cost of capital is more realistic as it represents the opportunity cost of investing in a project. On the other hand, the assumption that cash flows are reinvested at the IRR is often impractical as it assumes that the investor can find future projects with the same rate of return as the original investment, which is unlikely. Therefore, the NPV method is generally preferred over the IRR method.

Question 15

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 rule is that if a project's NPV (Net Present Value) is positive, the project should be accepted. The IRR (Internal Rate of Return) is a separate measure, and the comparison between NPV and IRR is not a standard decision criterion.

Question 16

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 17

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 18

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 IRR is based on the project's cash flows and is independent of the firm's cost of capital. Changing the firm's cost of capital only affects the net present value of the project, not the IRR.

Question 19

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 20

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.

Quiz 10: The Basics of Capital Budgeting