Question 1

The IRR of normal Project X is greater than the IRR of normal Project Y, and both IRRs are greater than zero. Also, the NPV of X is greater than the NPV of Y at the cost of capital. If the two projects are mutually exclusive, Project X should definitely be selected, and the investment made, provided we have confidence in the data. Put another way, it is impossible to draw NPV profiles that would suggest not accepting Project X.

Accepted Answer

Project X may have a negative NPV if r > IRR. The NPV profile line crosses the horizontal axis, and the NPV at the cost of capital is in the lower right quadrant.

Question 2

Which of the following statements is CORRECT?

Accepted Answer

The IRR would rank a project that cost $100 and had a 100% IRR ahead of a project that cost $1,000,000 and had an IRR of 90%. The larger project would increase the firm's value more, as the NPV would demonstrate.

Question 3

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 internal rate of return (IRR) is the rate at which the present value of future cash inflows equals the initial cost of the project. Therefore, option C is the correct statement. Options A and E are incorrect as they do not consider the initial cost of the project. Option B is incorrect as if the IRR is smaller than the cost of capital, then the NPV will be negative. Option D is incorrect as a positive IRR does not guarantee a positive NPV, it depends on the cost of capital and the size of the initial investment.

Question 4

Which of the following statements is CORRECT?

Accepted Answer

A project with "normal" cash flows typically has one initial negative cash flow followed by a series of positive cash flows, leading to only one real IRR. "Nonnormal" cash flows can result in multiple IRRs.

Question 5

Which of the following statements is CORRECT?

Accepted Answer

Projects with "normal" cash flows, which involve one initial outflow followed by a series of inflows, typically have only one real IRR.

Question 6

Which of the following statements is CORRECT?

Accepted Answer

Statement e is correct. The others are false. If you draw an NPV profile for one project, you will see that if the WACC is less than the IRR, the NPV will be positive.

Question 7

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 when a project has unconventional cash flows (i.e., cash flow signs change more than once throughout the project's life), not specifically when comparing mutually exclusive projects with different lives.

Question 8

If the IRR of normal Project X is greater than the IRR of mutually exclusive (and also normal) Project Y, we can conclude that the firm should always select X rather than Y if X has NPV > 0.

Accepted Answer

We do not know if the cost of capital is to the right or left of the crossover point. Therefore, NPVX may be either higher or lower than NPVY.

Question 9

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 has normal cash flows and its IRR exceeds its cost of capital, then the project's NPV must be positive. This is because a project's IRR represents the discount rate at which the project's NPV equals zero. If the IRR exceeds the cost of capital, then the project's cash inflows are earning more than the cost of capital, resulting in a positive NPV.

Question 10

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 of a project is based solely on the project's cash flows and the timing of those cash flows, independent of the firm's cost of capital. Therefore, a change in the firm's cost of capital should not affect the project's IRR.

Question 11

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 internal rate of return (IRR) is the discount rate that will make the present value of the project's cash inflows equal to the present value of its cash outflows. Therefore, to find the IRR of a project we must solve for the discount rate that sets the net present value (NPV) equal to zero.

Question 12

Which of the following statements is CORRECT?

Accepted Answer

The IRR assumes reinvestment at the IRR, and that is generally not as valid as assuming reinvestment at the WACC, as with the NPV.

Question 13

Normal Projects S and L have the same NPV when the discount rate is zero. However, Project S's cash flows come in faster than those of L. Therefore, we know that at any discount rate greater than zero, L will have the higher NPV.

Accepted Answer

We can see from the graph that S has the higher NPV if r > 0.

Question 14

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 15

Project S has a pattern of high cash flows in its early life, while Project L has a longer life, with large cash flows late in its life. Neither has negative cash flows after Year 0, and at the current cost of capital, the two projects have identical NPVs. Now suppose interest rates and money costs decline. Other things held constant, this change will cause L to become preferred to S.

Accepted Answer

A decline in interest rates and money costs will lower the discount rate used to calculate the NPV of future cash flows, which would benefit longer-term projects like L with large cash flows late in its life. As a result, L would become more attractive and preferred over S.

Question 16

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

When a negative cash flow occurs at the end of the project's life, it can cause the project to have more than one IRR. This is because the IRR calculation involves finding the discount rate that sets the present value of all cash inflows equal to the initial investment. If there is a negative cash flow at the end of the project, it can cause the present value of cash inflows to cross the x-axis multiple times, resulting in multiple discount rates that could be considered the IRR.

Question 17

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 a more realistic reinvestment rate of the cost of capital, while the IRR method assumes that cash flows are reinvested at the returns generated by the project itself. This makes the NPV method more reliable and generally preferred over the IRR method.

Question 18

Which of the following statements is CORRECT?

Accepted Answer

An NPV profile graph is designed to give decision makers an idea about how a project's contribution to the firm's value varies with the cost of capital. It plots project NPV on the y-axis and the cost of capital on the x-axis, allowing decision makers to see the relationship between the two variables. The slope of the graph will depend on the project's cash flows and the cost of capital, but it is not necessarily always positive or always negative. Knowing the appropriate cost of capital is necessary for calculating the project's NPV, but it is not necessary for drawing the NPV profile graph. Furthermore, the NPV profile graph does not show how a project's payback varies with changes in the cost of capital.

Question 19

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 the cash flows generated by a project are reinvested at the project's risk-adjusted cost of capital over the entire life of the project. This is a fundamental assumption of the NPV method, which allows for comparison of different investment options that have varying cash flow timing and risk profiles.

Question 20

An increase in the firm's cost of capital will decrease projects' NPVs, which could change the accept/reject decision for any potential project. However, such a change would have no impact on projects' IRRs. Therefore, the accept/reject decision under the IRR method is independent of the cost of capital.

Accepted Answer

An increase in the firm's cost of capital will increase the required rate of return, which could cause projects' IRRs to fall below the required rate of return and result in projects being rejected. Therefore, the accept/reject decision under the IRR method is not independent of the cost of capital.

Quiz 12: Capital Budgeting: Decision Criteria

Which of the following statements is CORRECT?

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.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

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.

If the IRR of normal Project X is greater than the IRR of mutually exclusive (and also normal) Project Y, we can conclude that the firm should always select X rather than Y if X has NPV > 0.

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.

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.

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.

Which of the following statements is CORRECT?

Normal Projects S and L have the same NPV when the discount rate is zero. However, Project S's cash flows come in faster than those of L. Therefore, we know that at any discount rate greater than zero, L will have the higher NPV.

The IRR method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital.

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.

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.

Which of the following statements is CORRECT?

The NPV method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital.