Question 1

When NPV < 0 the IRR:&#10;A)is less than the cost of capital.&#10;B)equals the cost of capital.&#10;C)exceeds the cost of capital.&#10;D)none of these.

Accepted Answer

When NPV < 0, it means that the project's cash outflows exceed its cash inflows. In this case, the IRR must be less than the cost of capital, as the project's expected return is lower than the cost of financing the project. Therefore, choice A is the correct answer. When NPV is negative, it means the cost of the investment exceeds the present value of the expected future cash flows. Therefore, the IRR is expected to be lower than the cost of capital.

Question 2

Firms should reject a capital budgeting project only if its profitability index is:&#10;A)less than zero.&#10;B)greater than one.&#10;C)less than one.&#10;D)greater than the cost of capital.

Accepted Answer

The profitability index is calculated as the present value of future cash flows divided by the initial investment. If the profitability index is less than one, it indicates that the present value of future cash flows is less than the initial investment, resulting in a negative net present value (NPV). Therefore, rejecting a project with a profitability index less than one would result in a higher NPV for the firm. A profitability index greater than one indicates that the present value of future cash flows is higher than the initial investment, resulting in a positive NPV. Therefore, accepting a project with a profitability index greater than one would result in a higher NPV for the firm. The profitability index (PI) is the present value of future cash flows divided by the initial investment. Therefore, if the PI is less than one, it means that the present value of the expected cash flows is lower than the initial investment, and the project will not generate enough cash flows to cover the cost of the investment. Therefore, firms should reject a capital budgeting project only if its profitability index is less than one.

Question 3

Holding all else equal, the profitability index will rise following a decrease in the:&#10;A)cost of capital.&#10;B)benefit-cost ratio.&#10;C)IRR.&#10;D)NPV.

Accepted Answer

The profitability index is calculated as the present value of cash inflows divided by the initial investment. A decrease in the cost of capital means a lower discount rate, which increases the present value of cash inflows and thus the profitability index. The profitability index (PI) is calculated by dividing the present value of the future cash flows by the initial investment. Therefore, if the cost of capital decreases, the discounted cash flows will increase, leading to a higher PI.

Question 4

The cost of capital is always the marginal cost of a euro of:&#10;A)equity financing.&#10;B)debt financing.&#10;C)incremental financing.&#10;D)stockholders' equity.

Accepted Answer

The cost of capital represents the cost of obtaining additional funds for a project, also known as incremental financing. The cost of equity or debt financing may be considered when obtaining these funds, but the cost of capital should take into account all sources of financing, not just one or the other. Stockholders' equity may be a component of the cost of capital, but it is not the only factor. Therefore, the best choice is C, incremental financing.

Question 5

The PI method is preferred to the NPV criterion whenever:&#10;A)capital is abundant and attractive investment projects are relatively scarce.&#10;B)capital is scarce and attractive investment projects are relatively abundant.&#10;C)the MCC is falling.&#10;D)the MCC is rising.

Accepted Answer

The PI (Profitability Index) method is preferred over the NPV (Net Present Value) criterion when capital is scarce and attractive investment projects are relatively abundant. This is because PI, which is calculated as the present value of future cash flows divided by the initial investment, helps in ranking projects in terms of their efficiency in utilizing the limited capital.

Question 6

The crossover discount rate equates the:&#10;A)NPV for two investment projects.&#10;B)IRR for two investment projects.&#10;C)payback period for two investment projects.&#10;D)present value payback period for two investment projects.

Accepted Answer

The crossover discount rate is the rate at which the net present values (NPV) of two different projects are equal. This concept is used to compare the attractiveness of different projects at various discount rates.

Question 7

Beta is:&#10;A)the slope coefficient in a simple regression where the return on the market index is the dependent Y variable, and the return on a given stock is the independent X variable.&#10;B)the slope coefficient in a simple regression where the price of a given stock is the in dependent X variable, and the value of the market index is the dependent Y variable.&#10;C)greater than one for stocks preferred by risk averse investors.&#10;D)a relative measure of stock-price variability.

Accepted Answer

Beta is a relative measure of stock-price variability, indicating how much a stock's price moves in relation to the market.

Question 8

Acceptance of investment projects where IRR < MCC will:&#10;A)increase the value of the firm.&#10;B)decrease the value of the firm.&#10;C)have no impact on the value of the firm.&#10;D)none of these.

Accepted Answer

Accepting investment projects where the Internal Rate of Return (IRR) is less than the Minimum Acceptable Rate of Return (MCC) will decrease the value of the firm as it indicates that the project is not generating a return that meets its cost of capital. This results in a reduction in the overall profitability of the firm and lower shareholder returns. Therefore, such projects should be rejected. If the IRR (Internal Rate of Return) of a project is less than the MCC (Minimum acceptable rate of return), it means that the project is not generating enough return to cover the cost of capital. By accepting such projects, the firm will be investing in projects that will not generate enough return to cover the cost of capital. This will decrease the overall profitability of the firm and hamper its growth. Hence, the acceptance of such projects will decrease the value of the firm.

Question 9

The value of the firm will rise following adoption of capital budgeting projects when:&#10;A)IRR > k.&#10;B)IRR = k.&#10;C)IRR < k.&#10;D)none of these.

Accepted Answer

When the IRR (internal rate of return) is greater than the discount rate (k), it means that the project is generating a return that is greater than the cost of capital. This leads to an increase in the value of the firm, making option A the correct answer. If the IRR is equal to the discount rate (k), there is no net gain or loss in value, and if the IRR is less than the discount rate (k), the project is not generating enough return to cover the cost of capital, leading to a decrease in the value of the firm. If the Internal Rate of Return (IRR) of a capital budgeting project is greater than the cost of capital (k), then the project will generate positive net present value and increase the value of the firm. Therefore, Option A is the correct choice.

Question 10

The internal rate of return (IRR) is the:&#10;A)component cost of capital.&#10;B)rate of return on stockholders' equity.&#10;C)after-tax weighted average cost of capital.&#10;D)discount rate that equates the present value of cash inflows and outflows.

Accepted Answer

The IRR is the discount rate that makes the net present value (NPV) of a project equal to zero. In other words, it is the rate at which the present value of expected cash inflows equals the present value of expected cash outflows. Therefore, choice D is the correct answer. Choices A, B and C are incorrect because they do not accurately describe the IRR. The component cost of capital is the cost of each individual type of financing used to fund a project, such as debt or equity. The rate of return on stockholders' equity is the amount of profit generated from the investment in a company's stock. The after-tax weighted average cost of capital is the average cost of all of the types of financing used to fund a project, taking into account tax deductions. IRR is the discount rate that sets the present value of cash inflows equal to the present value of cash outflows. It is a measure of the profitability of an investment and is commonly used in capital budgeting to evaluate investment opportunities. A, B, and C are not correct because they refer to different concepts.

Deck 17: Capital Budgeting