Question 1

A project's terminal value is the _____.

Accepted Answer

Terminal value is the sum of the future values of the cash inflows compounded at the firm's required rate of return. This represents the value of the project at the end of its useful life or when it is sold or liquidated. Options A, B, D, and E are all incorrect as they do not accurately define terminal value.

Question 2

Tangerine Inc. is evaluating a capital project for investment. The initial cash outflow in Year 0 is $1,500 followed by cash inflow of $500 each year for four years. Which of the following is the terminal value of the project? Assume the required rate of return is 12 percent.

Accepted Answer

The terminal value is calculated by finding the future value of the cash inflows at the end of the project. Using the formula for future value of an annuity: FV = C * [(1 + r)^n - 1] / r, where C = $500, r = 0.12, and n = 4, the terminal value is approximately $2,389.66.

Question 3

A project should be accepted if _____.

Accepted Answer

The internal rate of return (IRR) is a metric used to evaluate the profitability of a project. If the IRR exceeds the firm's required rate of return, it means the project is expected to generate a return higher than the minimum the firm would accept for investing, making it a viable and attractive investment.

Question 4

Suppose a capital budgeting project generates its largest cash flows in the early years of its life?(i.e., up front) rather than near the end of its life. In this situation. Which of the following statements about the project must be correct?

Accepted Answer

Projects that generate larger cash flows early in their life are less sensitive to changes in the discount rate (or the firm's required rate of return) because the bulk of their value is realized earlier when the discounting effect is less pronounced. This contrasts with projects that generate larger cash flows later, where future cash flows are more heavily discounted, making their net present value more sensitive to changes in the discount rate.

Question 5

Project A, which costs of $1,000 to purchase, will generate net cash inflows equal to $500 at the end of each of the next three years. The project's required rate of return is 10 percent. What are the project's internal rate of return (IRR) and modified internal rate of return (MIRR)?

Accepted Answer

To calculate IRR, we need to find the discount rate at which the present value of future cash inflows equals the initial investment. Using a financial calculator, we find that the IRR for this project is 23.4%.

To calculate the MIRR, we need to find the discount rate that equates the present value of future cash inflows with the terminal value of all cash outflows, assuming that all intermediate cash flows are reinvested at the cost of capital. Using a financial calculator, we find that the MIRR for this project is 18.3%.

Therefore, the best choice is C.

Question 6

Smart Solutions Inc. is evaluating a capital project for expansion. The project costs $10,000, and it is expected to generate $5,000 per year for three years. If the firm's required rate of return is 10 percent, what is the project's terminal value?

Accepted Answer

To find the terminal value of the project, we need to calculate the present value of the cash flows generated by the project in Year 4 and beyond. Since the cash flows beyond Year 3 are not given, we can assume that the project ends after three years and there are no cash flows beyond that. In that case, the project's terminal value is just the salvage value of the project at the end of Year 3. The salvage value is the value of the project's assets at the end of its useful life.

To calculate the salvage value, we need to find the present value of the cash flows generated by the project in Year 3. The cash flow in Year 3 is $5,000. We can find the present value of this cash flow using the formula:

PV = CF / (1 + r)^n
where PV is the present value, CF is the future cash flow, r is the required rate of return, and n is the number of periods.

PV = $5,000 / (1 + 0.10)^3
PV = $3,695.50

Therefore, the project's salvage value at the end of Year 3 is $3,695.50. This is the terminal value of the project.

To find the total value of the project, we need to add up the present value of the cash flows generated by the project in Years 1, 2, and 3, as well as the salvage value at the end of Year 3. The present value of the cash flows in Years 1, 2, and 3 is:

PV = $5,000 / (1 + 0.10)^1 + $5,000 / (1 + 0.10)^2 + $5,000 / (1 + 0.10)^3
PV = $4,545.45 + $4,132.23 + $3,759.19
PV = $12,436.87

Adding the salvage value of $3,695.50 to this gives a total project value of:

Total project value = $12,436.87 + $3,695.50 = $16,132.37

Therefore, the best choice is B, $16,550, which is closest to $16,132.37.

Question 7

Which of the following is a reason the modified internal rate of return (MIRR) measure is a better indicator of a project's true profitability than the internal rate of return (IRR) measure?

Accepted Answer

The modified internal rate of return (MIRR) assumes that the project's cash flows are reinvested at the firm's required rate of return, which is a better assumption than the IRR assumption that the cash flows are reinvested at its IRR. This is because the required rate of return represents the opportunity cost of capital for the firm, whereas the IRR only reflects the project's own potential return. Therefore, using the required rate of return provides a more realistic measure of the project's profitability. The other options are either incorrect or incomplete in their explanation of why MIRR is a better indicator of profitability than IRR.

Question 8

Suppose a firm has evaluated four capital budgeting projects and, using one of the time value of money capital budgeting techniques, has determined that all of the projects are acceptable. If the projects are mutually exclusive, which of the following capital budgeting techniques should be used to make the purchasing decision to ensure the firm's value is maximized?

Accepted Answer

The net present value (NPV) method should be used to make the purchasing decision. This is because NPV considers the time value of money and provides the total value of the project in dollar terms. It also allows comparison of the projects to determine which one will add the most value to the firm. In this case, since the projects are mutually exclusive, choosing the project with the highest positive NPV will maximize the firm's value. The other methods, such as traditional payback period (PB), internal rate of return (IRR), modified internal rate of return (MIRR), and discounted payback period (DPB), only consider certain aspects of the projects and may not necessarily result in the best purchasing decision.

Question 9

Which of the following cash flow patterns would produce multiple internal rates of return (IRRs) for a project?

Accepted Answer

Only option D has a large cash outflow followed by cash inflows and then another large cash outflow before more cash inflows. This pattern can produce multiple IRRs.

Question 10

The modified internal rate of return (MIRR) is the discount rate that forces the ______.

Accepted Answer

The modified internal rate of return (MIRR) is used to overcome some of the limitations of the traditional internal rate of return (IRR). The MIRR assumes that all cash flows are reinvested at the discount rate, while the traditional IRR assumes all cash flows are reinvested at the project's rate of return. The MIRR calculates the discount rate that makes the present value of the project's terminal value equal to the present value of its costs (cash outflows). Therefore, the correct choice is B.

Question 11

Los Angeles Lumber Company (LALC) is considering a project with a cost of $1,000 at Year 0 and inflows of $300 at the end of Years 1-5. LALC's cost of capital is 10 percent. What is the project's modified IRR (MIRR)?

Accepted Answer

To calculate the MIRR, we need to find the terminal value of the cash inflows first. Using 10% as the discount rate, the terminal value of the cash inflows at the end of Year 5 is $300/(0.10-0.05) = $6,000. Then we calculate the future value of the initial cost using the same discount rate: $1,000 * (1+0.10)^5 = $1,610.51. The MIRR is then the discount rate that equates the present value of the terminal value and the future value of the cost, which is (6,000/1+x)^5 = 1,610.51/(1+x)^5. Solving for x, we get 12.87%. Therefore, the answer is B.

Question 12

Which of the following capital budgeting assumes that any cash flows generated by a project can be reinvested at its internal rate of return (IRR)?

Accepted Answer

The internal rate of return (IRR) method assumes that any cash flows generated by a project can be reinvested at its internal rate of return. This is because IRR is defined as the discount rate at which the NPV of cash flows is equal to zero, implying that all cash flows are being reinvested at the same rate as the project's return.

Question 13

If a capital budgeting project has a negative net present value (NPV),

Accepted Answer

A negative NPV means the project's cash outflows exceed its cash inflows, resulting in a loss for the firm. This also implies that the project does not generate returns that exceed the firm's required rate of return or discount rate. Therefore, the project's IRR must be lower than the discount rate. However, we cannot determine whether the IRR is negative or positive based on this information alone. The DPB is the number of years it takes to recover the initial investment in present value terms. If the DPB is longer than the project's economic life, it means that the project does not generate enough cash flows to recover the initial investment within its lifetime, which is undesirable. Therefore, the best choice is B. Option A, C, D, and E are not accurate in this context.

Question 14

Suppose a firm uses both the net present value (NPV) technique and the internal rate of return (IRR) technique to evaluate two mutually exclusive capital budgeting projects. If a ranking conflict exists between NPV and IRR, which of the following criteria should be used to make the final investment decision?

Accepted Answer

The NPV technique is generally considered to be more reliable than the IRR technique because it takes into account the time value of money and the cost of capital. Therefore, if there is a ranking conflict between NPV and IRR, the project with the higher NPV should be selected.

Question 15

Modified internal rate of return (MIRR) is the discount rate that forces the present value of a project's terminal value to equal the _____.

Accepted Answer

MIRR is calculated by equating the present value of cash outflows to the present value of cash inflows, adjusted for the cost of capital and reinvestment rate.

Question 16

Which of the following statements is correct?

Accepted Answer

The NPV and IRR methods can indeed lead to conflicting decisions for mutually exclusive projects due to differences in how they handle reinvestment of cash flows and the scale of projects.

Question 17

Which of the following capital budgeting techniques makes the assumption that the project's cash flows are reinvested at the firms required rate of return?

Accepted Answer

The answer of Which of the following capital budgeting techniques...

Question 18

When determining a project's true profitability, it is normally better to compute the project's modified internal rate of return (MIRR) rather than its internal rate of return (IRR) because the MIRR technique:

Accepted Answer

MIRR assumes that the project's cash flows are reinvested at the firm's required rate of return, whereas IRR assumes that the cash flows are reinvested at the project's IRR. This makes MIRR a more realistic reflection of the project's profitability over time. Additionally, MIRR has a decision rule that is easier to apply than the IRR decision rule, making it a better choice overall when determining a project's true profitability.

Question 19

The traditional payback period technique that is used in capital budgeting analyses:

Accepted Answer

The traditional payback period is the simplest and oldest formal method used in capital budgeting analyses.

Question 20

The internal rate of return (IRR) technique assumes that cash flows are reinvested at the _____.

Accepted Answer

The IRR technique assumes that cash flows generated by the project is reinvested at the same rate as the project's internal rate of return (IRR). This assumption leads to a single rate of return, which is the IRR, that makes the present value of cash inflows equal to the initial investment.

Quiz 9: Capital Budgeting Techniques