Question 1

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 2

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

This statement is false. Conflicts between NPV and IRR can arise due to differences in project size, timing, and cash flows. In such cases, the NPV method should be used as it takes into account the time value of money and provides a more accurate picture of the project's profitability. The IRR method has its limitations and can sometimes lead to incorrect investment decisions.

Question 3

Patterson Co. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that a project's expected NPV can be negative, in which case it will be rejected. $\begin{array}{lcccc}
r & 10.00 \% \
\text { Year } & 0 & 1 & 2 & 3 \
\text { Cash flows } & -\$ 950 & \$ 500 & \$ 400 & \$ 300
\end{array}$

Accepted Answer

$\begin{array}{lcccc}
\text { WACC: } & 10.00 \% \
\text { Year } & 0 & 1 & 2 & 3 \
\text { Cash flows } & -\$ 950 & \$ 500 & \$ 400 & \$ 300
\end{array}$ 
NPV = $60.52

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 can actually lower a firm's cost of capital if the project has a lower cost of capital than the firm's overall cost of capital. Additionally, other factors such as diversification benefits and increased cash flows can also lower a firm's cost of capital.

Question 5

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

The correct statement is that 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) method. Summing the present values accounts for the time value of money and allows for a more accurate analysis of the project's profitability.

Question 6

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 7

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 8

Last month, Standard Systems analyzed the project whose cash flows are shown below. However, before the decision to accept or reject the project took place, the Federal Reserve changed interest rates and therefore the firm's cost of capital (r). The Fed's action did not affect the forecasted cash flows. By how much did the change in the r affect the project's forecasted NPV? Note that a project's expected NPV can be negative, in which case it should be rejected. $\begin{array} { l c c c c } 
\text { Old r: } & 10.00 \% & \text { New r: } & 11.25 \% \
\text { Year } & 0 & 1 & 2 & 3 \
\text { Cash flows } & - \$ 1,000 & \$ 410 & \$ 410 & \$ 410
\end{array}$

Accepted Answer

$\begin{array} { l c c c c } 
\text { Old r: } & 10.00 \% & \text { New r: } & 11.25 \% \
\text { Year } & 0 & 1 & 2 & 3 \
\text { Cash flows } & - \$ 1,000 & \$ 410 & \$ 410 & \$ 410
\end{array}$ 
Old NPV = $19.61 New NPV = σ$2.42 Change = σ$22.03

Question 9

Ellmann Systems is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that if a project's expected NPV is negative, it should be rejected. $\begin{array}{lccc}
r& 9.00\%\
\text { Year: } &0& 1 & 2 & 3 \
 \text { FCF: } & -\$ 1000 & \$ 500 & \$ 500& \$ 500
\end{array}$

Accepted Answer

$$\begin{array} { l c c c c } 
\text { WACC: } & 9.00 \% & & &  \
\text { Cear } & 0 & 1 & 2 & 3 \
\text { Cash flows } & - \$ 1,000 & \$ 500 & \$ 500 & \$ 500
\end{array}$$ 
NPV = $265.65

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 ranks the other one first. In theory, such conflicts should be resolved in favor of the project with the higher positive NPV.

Accepted Answer

The NPV method is considered more reliable and consistent than the IRR method in evaluating and ranking projects. Therefore, conflicts between the two methods should be resolved in favor of the project with the higher positive NPV.

Question 12

Robbins Inc. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that if a project's expected NPV is negative, it should be rejected. $\begin{array} { l c c c c c c c } 
\text { Year } & 10.25 \%\ & 0 & 1 & 2 & 3 & 4 & 5 \
\text { Cash FlowS } & - 1,000 & 300 & 300 & 300 & 300 & 300
\end{array}$

Accepted Answer

$\begin{array} { l c c c c c c } 
WACC:&10.25 \%\
\text { Year } & 0 & 1 & 2 & 3 & 4 & 5 \
 \text { Cash flows } & - \$ 1,000 & \$ 300 & \$ 300 & \$ 300 & \$ 300 & \$ 300
\end{array}$ 
NPV = $130.01

Question 13

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.

Accepted Answer

The NPV calculation involves discounting future cash flows, so the higher the discount rate (cost of capital), the lower the calculated present value of those cash flows will be.

Question 14

Dickson Co. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that a project's expected NPV can be negative, in which case it will be rejected. $\begin{array}{lcccccc}
r & 12.00 \% & & & & & \
\text { Year }  & 0 & 1 & 2 & 3 & 4 & 5 \
 \text { Cash flows }& -\$ 1,100 & \$ 400 & \$ 390 & \$ 380 & \$ 370 & \$ 360
\end{array}$

Accepted Answer

$\begin{array}{lcccccc}
WACC: & 12.00 \% & & & & & \
\text { Year }  & 0 & 1 & 2 & 3 & 4 & 5 \
 \text { Cash flows }& -\$ 1,100 & \$ 400 & \$ 390 & \$ 380 & \$ 370 & \$ 360
\end{array}$ 
NPV = $277.94

Question 15

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.

Accepted Answer

If a project's NPV is less than zero, it means that the initial outflow of cash exceeds the present value of the expected inflows, discounted at the cost of capital. To find the IRR, we need to find the discount rate at which the project's NPV is zero. Since the NPV is negative, the IRR must be less than the cost of capital. Therefore, statement B is correct. The other statements are not correct. Statement A is incorrect because the opposite is true - the lower the cost of capital, the higher the calculated NPV. Statement C is incorrect because if the NPV is greater than zero, it means that the project is generating positive value, and the IRR must be greater than the cost of capital. Statement D is incorrect because a low-risk project should be discounted at a low cost of capital, which reflects the low risk. Statement E is incorrect because it is a confusing and convoluted way of computing the NPV - the correct way is to discount the expected cash inflows at the cost of capital and subtract the initial outflow.

Question 16

Yoga Center Inc. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that a project's expected NPV can be negative, in which case it will be rejected.
 $\begin{array} { l c c c c c } 
r& 14.00 \% \
\text { Year } &0& 1 & 2 & 3 & 4 \
 \text { Cash flowr } & - \$ 1,200 & 400 & 425 & 450 & 475
\end{array}$

Accepted Answer

$\begin{array} { l c c c c c } 
WACC:& 14.00 \% \
\text { Year } &0& 1 & 2 & 3 & 4 \
 \text { Cash flowr } & - \$ 1,200 & 400 & 425 & 450 & 475
\end{array}$ 
NPV = $62.88

Question 17

Scott Enterprises is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that if a project's expected NPV is negative, it should be rejected. $\begin{array}{lccc}
r& 11.00\%\
\text { Year: } &0& 1 & 2 & 3&4 \
 \text { Cash flows } & -\$ 1000 & \$ 350 & \$  350& \$  350& \$  350
\end{array}$

Accepted Answer

$\begin{array}{lccc}
r& 11.00\%\
\text { Year: } &0& 1 & 2 & 3&4 \
 \text { Cash flows } & -\$ 1000 & \$ 350 & \$  350& \$  350& \$  350
\end{array}$
 
NPV = $85.86

Question 18

Reed Enterprises is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that a project's expected NPV can be negative, in which case it will be rejected. $\begin{array}{lcccc}
r & 10.00 \% \
\text { Year }  & 0 & 1 & 2 & 3 \
 \text { Cash flows }& -\$ 1,050 & \$ 450 & \$ 460 & \$ 470
\end{array}$

Accepted Answer

$\begin{array} { l c c c c } 
\text { WACC: } & 10.00 \% & & &  \
 \text { Cear } & 0 & 1 & 2 & 3 \
 \text { Cash flows } & - \$ 1,050 & \$ 450 & \$ 460 & \$ 470
\end{array}$ 
NPV = $92.37

Question 19

When considering two mutually exclusive projects, the firm should always select the project whose internal rate of return is the highest, . This statement is true regardless of whether the projects can be repeated or not.

Accepted Answer

Think about the following equally risky projects. The cost of capital is WACC = 10%
 $\begin{array}{llllllll}
&0&1&2&3&4&5&6\
S&-1,000&1,400\
L & -1.000 & 378.34 & 378.34 & 378.34 & 378.34 & 378.34 & 378.34
\end{array}$ 
 $\begin{array} { l l } 
\mathrm { IRR } _ { \mathrm { S } } = 40.0 \% & \mathrm { NP } \mathrm {V  } _ { \mathrm { s } } = \$ 272.73 \
\mathrm { IRR } _ { \mathrm { L } } = 30.0 \% & \mathrm { NP } \mathrm { V } _ { L } = \$ 647.77
\end{array}$ 
S has the higher IRR, but L has a much higher NPV and is therefore preferable. If the project could be repeated, though, S would turn out to be better-it would have both a higher NPV and IRR.

Question 20

Corner Jewelers, Inc. recently analyzed the project whose cash flows are shown below. However, before the company decided to accept or reject the project, the Federal Reserve changed interest rates and therefore the firm's cost of capital (r). The Fed's action did not affect the forecasted cash flows. By how much did the change in the r affect the project's forecasted NPV? Note that a project's expected NPV can be negative, in which case it should be rejected.
 $\begin{array} { l c c c c } 
\text { Old r: } &8.00 \% & \text { New r: } & 11.25 \% \
\text { Year } & 0 & 1 & 2 & 3 \
\text { Cash flows } & - \$ 1,000 & \$ 410 & \$ 410 & \$ 410
\end{array}$

Accepted Answer

$\begin{array} { l c c c c } 
\text { Old r: } & 8.00 \% & \text { New r: } & 11.25 \% \
\text { Year } & 0 & 1 & 2 & 3 \
\text { Cash flows } & - \$ 1,000 & \$ 410 & \$ 410 & \$ 410
\end{array}$ 
Old NPV = $56.61 New NPV = σ$2.42 Change = σ$59.03

Quiz 12: Capital Budgeting: Decision Criteria