Deck 7: Net Present Value and Other Investment Rules

Question 1

The internal rate of return for a project will increase if:

A) the initial cost of the project can be reduced.
B) the total amount of the cash inflows is reduced.
C) each cash inflow is moved such that it occurs one year later than originally projected.
D) the required rate of return is reduced.

Answer 1

the initial cost of the project can be reduced.

Question 2

The payback period rule accepts all investment projects in which the payback period for the cash flows is:

A) equal to the cutoff point.
B) greater than the cutoff point.
C) less than the cutoff point.
D) positive.

Answer 2

less than the cutoff point.

Question 3

A $25 investment produces $27.50 at the end of the year with no risk. Which of the following is not true?

A) NPV is positive if the interest rate is less than 10%.
B) NPV is negative if the interest rate is less than 10%.
C) NPV is zero if the interest rate is equal to 10%.

Answer 3

NPV is negative if the interest rate is less than 10%.

Question 4

Payback is frequently used to analyze independent projects because:

A) nit considers the time value of money.
B) all relevant cash flows are included in the analysis.
C) it is easy and quick to calculate.
D) it is the most desirable of all the available analytical methods from a financial perspective.

Question 5

An investment project is most likely to be accepted by the payback period rule and not accepted by the NPV rule if the project has:

A) a large initial investment with moderate positive cash flows over a very long period of time.
B) a very large negative cash flow at the termination of the project.
C) most of the cash flow at the beginning of the project.
D) All projects approved by the payback period rule will be accepted by the NPV rule.
E) The payback period rule and the NPV rule cannot be used to evaluate the same type of projects.

Question 6

An investment that requires initial cash outlay of $100,000 has a useful life of 3 years. In each of these years the before-tax cash flow is $40,000. If the tax rate is 34% and straight-line depreciation is used, the average accounting return is:

A) 40%.
B) 26.4%.
C) 13.34%.
D) 8.8%.

Question 7

The discounted payback rule states that you should accept projects:

A) which have a discounted payback period that is greater than some pre-specified period of time.
B) if the discounted payback is positive and rejected if it is negative.
C) only if the discounted payback period equals some pre-specified period of time.
D) if the discounted payback period is less than some pre-specified period of time.

Question 8

If a project is assigned a required rate of return equal to zero, then:

A) the timing of the project's cash flows has no bearing on the value of the project.
B) the project will always be accepted.
C) the project will always be rejected.
D) whether the project is accepted or rejected will depend on the timing of the cash flows.

Question 9

The investment decision rule that relates average net income to average investment is the:

A) discounted cash flow rule.
B) average accounting rate of return method.
C) average payback rule.
D) average profitability index.

Question 10

The internal rate of return tends to be:

A) easier for managers to comprehend than the net present value.
B) extremely accurate even when cash flow estimates are faulty.
C) ignored by most financial analysts.
D) used primarily to differentiate between mutually exclusive projects.

Question 11

Accepting positive NPV projects benefits the stockholders because:

A) it most easily understood valuation process.
B) the value of the expected cashflows are equal to the cost.
C) the value of the expected cashflows are greater than the cost.
D) it is the most easily calculated.

Question 12

A mutually exclusive project is a project whose:

A) acceptance or rejection has no effect on other projects.
B) NPV is always negative.
C) IRR is always negative.
D) acceptance or rejection effects other projects.

Question 13

An investment project has the cashflow stream of -250, 75, 125, 100, and 50. The cost of capital is 12%. What is the discount payback period?

A) 2.5 years.
B) 2.7 years.
C) 3.38 years.
D) 1.40 years.
E) 1.25 years.

Question 14

Consider an investment with an initial cost of $20,000 and is expected to last for 5 years. The expected cash flow in years 1 and 2 are $5000, in years 3 and 4 are $5,500 and in year 5 is $1,000. The total cash inflow is expected to be $22,000 or an average of $4,400 per year. Compute the payback period in years.

A) 3.18
B) 3.82
C) 4.55
D) 4.00

Question 15

The average accounting rate of return is determined by:

A) dividing the yearly cashflows by the investment.
B) dividing the average cashflows by the investment.
C) dividing the average net income by the average investment.
D) dividing the average net income by the initial investment.
E) dividing the net income by the cashflow.

Question 16

The discounted payback period rule:

A) considers the time value of money.
B) discounts the cutoff point.
C) ignores uncertain cash flows.
D) is preferred to the NPV rule.

Question 17

An investment with an initial cost of $16,000 produces cash flows of $5000 annually. If the cash flow is evenly spread out over the year and the firm can borrow at 10%, the discounted payback period is _____ years.

A) 4.55
B) 4.05
C) 3.20
D) 3.52

Question 18

The payback period rule:

A) determines a cutoff point so that all projects accepted by the NPV rule will be accepted by the payback period rule.
B) determines a cutoff point so that depreciation is just equal to positive cash flows in the payback year.
C) requires an arbitrary choice of a cutoff point.
D) varies the cutoff point with the interest rate.

Question 19

Which of the following does not characterize NPV?

A) NPV is the simplest of all investment rules.
B) NPV incorporates all relevant information.
C) NPV uses all of the project's cash flows.
D) NPV discounts all future cash flows.

Question 20

The two fatal flaws of the internal rate of return rule are:

A) arbitrary determination of a discount rate and failure to consider initial expenditures.
B) arbitrary determination of a discount rate and failure to correctly analyze mutually exclusive investment projects.
C) arbitrary determination of a discount rate and the multiple rate of return problem.
D) failure to consider initial expenditures and failure to correctly analyze mutually exclusive investment projects.
E) failure to correctly analyze mutually exclusive investment projects and the multiple rate of return problem.

Question 21

Under capital rationing the profitability index is used to select investments because of limited capital by their:

A) excess profit to achieve the highest payoff.
B) reward per dollar cost to achieve the highest incremental NPV.
C) incremental IRR to maximize the total rate of return.
D) capital usage rate to stay within budget.

Question 22

Suppose that a project has a cash flow pattern (-$2,000, $25,000,- $25000). For its modified IRR at a discount rate of 10%, the relevant numbers are

A) (-$2,000, $25,000)
B) (-$2,000, $2129)
C) (-$5,000, $5000)
D) (-$2,000, $2192.23)

Question 23

The elements that cause problems with the use of the IRR in projects that are mutually exclusive are:

A) the discount rate and scale problems.
B) timing and scale problems.
C) the discount rate and timing problems.
D) scale and reversing flow problems.
E) timing and reversing flow problems.

Question 24

Explain the differences and similarities between net present value (NPV) and the profitability index (PI).

Question 25

The profitability index is the ratio of

A) average net income to average investment.
B) internal rate of return to current market interest rate.
C) net present value of cash flows to internal rate of return.
D) net present value of cash flows to average accounting return.
E) present value of cash flows to initial investment cost.

Question 26

The Carnation Chemical Company is investing in an incinerator to dispose of PCB waste. The incinerator costs $1.5 million and will generate end of year cash of $1 million for the next 3 years. At the end of 3 years the incinerator will be worthless and must be disposed of at the cost of $500,000. The internal rate of return for this project is:

A) between 10% and 20%.
B) between 20% and 30%.
C) between 30% and 40%.
D) more than 40%.

Question 27

A project will have only one internal rate of return if:

A) all cash flows after the initial expense are positive.
B) average accounting return is positive.
C) net present value is negative.
D) net present value is positive.
E) net present value is zero.

Question 28

If there is a conflict between mutually exclusive projects due to the IRR, one should:

A) drop the two projects immediately.
B) spend more money on gathering information.
C) depend on the NPV as it will always provide the most value.
D) depend on the AAR because it does not suffer from these same problems.

Question 29

The internal rate of return may be defined as:

A) the discount rate that makes the NPV cash flows equal to zero.
B) the difference between the market rate of interest and the NPV.
C) the market rate of interest less the risk-free rate.
D) the project acceptance rate set by management.

Question 30

Which of the following correctly orders the investment rules of average accounting return (AAR), internal rate of return (IRR), and net present value (NPV) from the most desirable to the least desirable?

A) AAR, IRR, NPV.
B) AAR, NPV, IRR.
C) IRR, AAR, NPV.
D) NPV, AAR, IRR.
E) NPV, IRR, AAR.

Question 31

You have a choice between two projects, Project1 pays $12,000 back at the end of 1 period on an investment of $10,000. Project 2 pays back $6,500 at the end of 1 period on an investment of $5,000. Which project should be chosen and what is the problem that you must be concerned with in this choice?

A) Project 1; discount rate
B) Project 2; discount rate
C) Project 1; project scales
D) Project 2; project scales
E) Project 1, cashflow timings

Question 32

The Ziggy Trim and Cut Company can purchase equipment on sale for $4,300. The asset has a three-year life, will produce a cashflow of $1,200 in the first and second year, and $3,000 in the third year. The interest rate is 12%. Calculate the project's discounted payback and Profitability Index assuming end of year cash flows. Should the project be taken? If the accounting rate of return was positive, how would this affect your decision?

Question 33

The IRR decision rule can be reversed because:

A) the NPV rule is not the same as the IRR.
B) the IRR iis based on a mutually exclusive investment.
C) instead of an investment project it is a financing project.
D) the IRR is greater than 100%.

Question 34

A project will have more than one IRR if:

A) the IRR is positive.
B) the IRR is negative.
C) the NPV is zero.
D) the cash flow pattern exhibits more than one sign change.
E) the cash flow pattern exhibits exactly one sign change.

Question 35

Using the internal rate of return rule, a conventional project should be accepted if the internal rate of return is:

A) equal to the current weighted average cost of capital.
B) greater than the current weighted average cost of capital.
C) less than the current weighted average cost of capital.
D) negative.
E) positive.

Question 36

Suppose that a project has a cash flow pattern (-$2,000, $25,000, -$25000) Its IRR is given by

A) 12%
B) 9% or 1040%
C) 25%or 250%
D) 4100%

Question 37

The Balistan Rug Company is considering investing in a new loom that will cost $12,000. The new loom will create positive end of year cash flow of $5,000 for the next 3 years. The internal rate of return for this project is:

A) between 10% and 15%.
B) between 15% and 20%.
C) between 20% and 25%.
D) between 25% and 30%.
E) less than 10%.

Question 38

The problem of multiple IRRs can occur when:

A) there is only one sign change in the cashflows.
B) the first cash flow is always positive.
C) the cash flows decline over the life of the project.
D) there is more than one sign change in the cashflows.

Question 39

The Walker Landscaping Company can purchase a piece of equipment for $3,600. The asset has a two-year life, will produce a cashflow of $600 in the first year and $4200 in the second year. The interest rate is 15%. Calculate the project's discounted payback and Profitability Index assuming steady cashflows. Should the project be taken? If the accounting rate of return was positive, how would this affect your decision?

Question 40

Suppose that a project has a cash flow pattern (-$2,000, $25,000, -$25000) Its modified IRR is given by

A) 12%
B) 25% or 400%
C) 25%or 250%
D) 9.61%

Question 41

The NPV rule and PI give the same results when there is no conflict. In the case of capital rationing, explain the potential conflict and the way it should be solved with supporting examples.

Question 42

The NPV rule and PI give the same results when there is no conflict. In the case of a mutually exclusive set of investments, explain the potential conflict and the way it should be solved with supporting examples.