Question 1

________ corrects for most, but not all, of the problems of IRR and gives the solution in terms of a return.

Accepted Answer

MIRR (Modified Internal Rate of Return) corrects for the problems of IRR by assuming a reinvestment rate for cash flows, which can be more realistic than assuming the same rate as the initial investment. MIRR also gives the solution in terms of a return, making it a comprehensive measure of project profitability that overcomes the limitations of IRR.

Question 2

Pigeon, Inc. is currently considering an eight-year project that has an initial outlay or cost of $80,000. The future cash inflows from its project for years 1 through 8 are the same at $30,000. Pigeon has a discount rate of 13%. Because of concerns about funds being short to finance all good projects, Pigeon wants to compute the profitability index (PI) for each project. What is the PI for Pigeon's current project?

Accepted Answer

The answer of Pigeon, Inc. is currently considering an eight-year...

Question 3

The ________ model provides a single measure (return) but must apply risk outside the model, thus allowing for errors in rankings of projects.

Accepted Answer

The Internal Rate of Return (IRR) model focuses on finding a single rate of return that makes the net present value of all cash flows from a particular project equal to zero. However, it does not inherently account for the risk associated with the project's cash flows, requiring risk considerations to be applied externally to the model. This can lead to potential errors in project rankings, especially when comparing projects with different risk profiles.

Question 4

When the Profitability Index (PI) is greater than 1, the benefits exceed the costs.

Accepted Answer

This is because the Profitability Index (PI) is calculated by dividing the present value of cash inflows by the initial investment. If the result is greater than 1, it means that the present value of cash inflows is greater than the initial investment or cost, indicating that the benefits exceed the costs.

Question 5

Berra, Inc. is currently considering an eight-year project that has an initial outlay or cost of $120,000. The future cash inflows from its project for years 1 through 8 are the same at $30,000. Berra has a discount rate of 11%. Because of capital rationing (shortage of funds for financing), Berra wants to compute the profitability index (PI) for each project. What is the PI for Berra's current project?

Accepted Answer

The profitability index (PI) is calculated as the present value of future cash inflows divided by the initial investment. Using the discount rate of 11%, the present value of the annuity of $30,000 for 8 years is approximately $154,800. The PI is then $154,800 / $120,000 = 1.29.

Question 6

The ________ method of capital budgeting is a ratio of the present value of cash inflows divided by the initial investment.

Accepted Answer

The profitability index method is calculated as the ratio of the present value of future cash flows to the initial investment. It measures the amount of value created per dollar invested, making it a useful tool for comparing different projects of varying sizes. The higher the index, the more attractive the investment. The other options, payback period, net present value, and internal rate of return, do not involve a ratio of present value to initial investment.

Question 7

________ is a modification of NPV to produce the ratio of the present value of the benefits (future cash inflow) to the present value of the costs (initial investment).

Accepted Answer

The option described is the Profitability Index (PI). It helps in ranking investments and choosing the projects that maximize the value of the firm. It is calculated by dividing the present value of future cash inflows by the initial investment. A PI greater than 1 indicates that the investment is profitable.

Question 8

According to an academic survey of large and small U.S. businesses, the IRR method of capital budgeting is slightly preferred over NPV by the survey respondents.

Accepted Answer

According to the statement, the IRR method is slightly preferred over NPV by the survey respondents.

Question 9

The ________ method is economically sound and properly ranks projects across various sizes, time horizons, and levels of risk, without exception for all independent projects.

Accepted Answer

NPV (Net Present Value) method is widely accepted as the most economically sound method for evaluating the feasibility of investment projects. It considers the time value of money, incorporates all relevant cash flows, and discounts them to their present value using a discount rate that reflects the risk of the project. It properly ranks projects across various sizes, time horizons and levels of risk, making it the preferred method for investment decision making. Discounted Payback Period and Profitability Index are also popular methods, but they have limitations in terms of their ability to deal with varying levels of risk and time horizons. Modified IRR, on the other hand, is used for projects with non-conventional cash flows and it may produce multiple IRRs, making it less reliable for ranking projects.

Question 10

Describe three of the six decision models used in capital budgeting decision-making and briefly evaluate their effectiveness.

Accepted Answer

The answer of Describe three of the six decision models...

Question 11

The ________ model incorporates the time-value of money but still ignores cash flows after the cutoff date.

Accepted Answer

The Discounted Payback Period model incorporates the time-value of money by discounting cash flows, but it still ignores any cash flows after the cutoff date. The Payback Period model ignores the time-value of money altogether, while the IRR and Modified Internal Rate of Return models both take into account all cash flows over the entire life of the project.

Question 12

The present value of the benefits and costs needed to calculate Profitability Index (PI) is the same information one finds when computing the NPV.

Accepted Answer

PI is calculated by dividing the present value of expected cash inflows by the present value of expected cash outflows (costs), which is the same method used to calculate NPV. Therefore, the present value of benefits and costs needed to compute PI is identical to the information used to calculate NPV.

Question 13

The ________ method is simple and fast but economically unsound as it ignores all cash flow after the cutoff date and ignores the time-value of money.

Accepted Answer

The Payback Period method is simple and fast, but it does not take into account the time-value of money and all cash flows after the cutoff date, making it economically unsound. The Net Present Value and Internal Rate of Return methods are more accurate and widely used for investment appraisal. The Modified Internal Rate of Return method overcomes some of the limitations of the IRR method, and the Net Present Value method considers the time-value of money and all cash flows over the project's life.

Question 14

Project A has an NPV of $20,000 and a PI of 1.2. Project B has an NPV of $10,000 and a PI of 1.3. Both projects have equal lives. Which project should be preferred if we are NOT concerned with capital rationing (that is, we are NOT concerned with being short of funds)?

Accepted Answer

When comparing two projects, it is best to use the NPV as the primary decision criteria because it shows the actual amount of dollars that will be generated by the project. In this case, Project A has a higher NPV than Project B, so it should be preferred. The PI is useful as a secondary decision criteria to compare the efficiency of investments, but it does not provide as much information as the NPV. Additionally, computing the EAA is not necessary since we are comparing projects of equal lives. The IRR is also not a relevant factor in this case.

Question 15

The discounted payback method, net present value method (NPV), internal rate of return (IRR), modified internal rate of return (MIRR), and profitability index (PI) are all consistent with the the time value of money.

Accepted Answer

All of these methods take into consideration the time value of money, which is the idea that money today is worth more than money received in the future due to inflation and the opportunity cost of not having that money available to invest or earn interest. The methods involve discounted cash flows and calculate the present value of future cash flows to determine the profitability of an investment.

Question 16

A firm is considering four projects with the following PIs, NPVs, and Costs. Project A: PI of 1.3, NPV of $3,600, and cost of $12,000; Project B: PI of 1.4, NPV of $5,600, and cost of $14,000; Project C: PI of 1.5, NPV of $5,000, and cost of $10,000; Project D: PI of 2.1, NPV of $8,800, and cost of $8,000. Rank the projects from best to worst in terms of their NPVs. Now rank the projects from best to worst in terms of their PIs.

Accepted Answer

The answer of A firm is considering four projects with...

Question 17

Calculating IRR, NPV, or MIRR is easy and efficient using a spreadsheet once you know the relevant cash flow, the timing of the cash flow, the cost of capital, and the reinvestment rate.

Accepted Answer

This statement is true. Spreadsheet software like Microsoft Excel or Google Sheets have built-in functions to calculate IRR, NPV, and MIRR. As long as the necessary information like cash flow, timing, discount rate, and reinvestment rate are entered correctly, the calculations can be done quickly and accurately.

Question 18

Which of the statements below is TRUE?

Accepted Answer

A PI greater than 1 indicates that the benefits exceed the costs. A PI of 1.50 means for every $1 invested, the firm gets back $1.50, indicating a positive return.

Question 19

Which of the statements below is FALSE?

Accepted Answer

The answer of Which of the statements below is FALSE?
...

Question 20

Mulligan, Inc. is currently considering an eight-year project that has an initial outlay or cost of $140,000. The cash inflows from its project for years 1 through 8 are the same at $35,000. Mulligan has a discount rate of 12%. Because there is a shortage of funds to finance all good projects, Mulligan wants to compute the profitability index (PI) for each project. That way Mulligan can get an idea as to which project might be a better choice. What is the PI for Mulligan's current project?

Accepted Answer

The answer of Mulligan, Inc. is currently considering an eight-year...

Quiz 9: Capital Budgeting Decision Models