Question 1

Lancaster Corp.is considering two equally risky, mutually exclusive projects, both of which have normal cash flows.Project A has an IRR of 11%, while Project B's IRR is 14%.When the cost of capital is 8%, the projects have the same NPV.Given this information, which of the following statements is CORRECT?
A) If the cost of capital is 9%, Project A's NPV will be higher than Project B's.
B) If the cost of capital is 6%, Project B's NPV will be higher than Project A's.
C) If the cost of capital is greater than 14%, Project A's IRR will exceed Project B's.
D) If the cost of capital is 9%, Project B's NPV will be higher than Project A's.
E) If the cost of capital is 13%, Project A's NPV will be higher than Project B's.

Accepted Answer

When the cost of capital increases, the NPV of projects decreases. However, since Project B has a higher IRR (14%) compared to Project A (11%), its NPV will decrease at a slower rate as the cost of capital increases from 8% to 9%. Therefore, at a cost of capital of 9%, Project B's NPV will be higher than Project A's.

Question 2

Which of the following statements is CORRECT? Assume that all projects being considered have normal cash flows and are equally risky.
A) If a project's IRR is equal to its cost of capital, then under all reasonable conditions, the project's IRR must be negative.
B) If a project's IRR is equal to its cost of capital, then under all reasonable conditions the project's NPV must be zero.
C) There is no necessary relationship between a project's IRR, its cost of capital, and its NPV.
D) When evaluating mutually exclusive projects, those projects with relatively long lives will tend to have relatively high NPVs when the cost of capital is relatively high.
E) If a project's IRR is equal to its cost of capital, then, under all reasonable conditions, the project's NPV must be negative.

Accepted Answer

When a project's Internal Rate of Return (IRR) equals its cost of capital, the Net Present Value (NPV) of that project is zero. This is because the NPV is calculated based on the difference between the cost of capital and the IRR; when they are equal, the NPV equals zero.

Question 3

You are on the staff of O'Hara Inc.The CFO believes project acceptance should be based on the NPV, but Andrew O'Hara, the president, insists that no project should be accepted unless its IRR exceeds the project's risk-adjusted cost of capital.Now you must make a recommendation on a project that has a cost of $15,000 and two cash flows: $110,000 at the end of Year 1 and −$100,000 at the end of Year 2.The president and the CFO both agree that the appropriate cost of capital for this project is 10%.At 10%, the NPV is $2,355.37, but you find two IRRs, one at 6.33% and one at 527%, and a MIRR of 11.32%.Which of the following statements best describes your optimal recommendation, i.e., the analysis and recommendation that is best for the company and least likely to get you in trouble with either the CFO or the president?
A) You should recommend that the project be rejected because, although its NPV is positive, it has an IRR that is less than the cost of capital.
B) You should recommend that the project be accepted because (1) its NPV is positive and (2) although it has two IRRs, in this case it would be better to focus on the MIRR, which exceeds the cost of capital.You should explain this to the president and tell him that the firm's value will increase if the project is accepted.
C) You should recommend that the project be rejected.Although its NPV is positive it has two IRRs, one of which is less than the cost of capital, which indicates that the firm's value will decline if the project is accepted.
D) You should recommend that the project be rejected because, although its NPV is positive, its MIRR is less than the cost of capital, and that indicates that the firm's value will decline if it is accepted.
E) You should recommend that the project be rejected because its NPV is negative and its IRR is less than the cost of capital.

Accepted Answer

The NPV is positive and the MIRR exceeds the cost of capital, which means the project will increase the firm's value. The issue with the multiple IRRs is not a concern in this case. It is best to focus on the MIRR in this situation.

Question 4

Clifford Company is choosing between two projects.The larger project has an initial cost of $100,000, annual cash flows of $30,000 for 5 years, and an IRR of 15.24%.The smaller project has an initial cost of $50,000, annual cash flows of $16,000 for 5 years, and an IRR of 16.63%.The projects are equally risky.Which of the following statements is CORRECT?
A) Since the smaller project has the higher IRR, the two projects' NPV profiles will cross, and the larger project will look better based on the NPV at all positive values of the cost of capital.
B) If the company uses the NPV method, it will tend to favor smaller, shorter-term projects over larger, longer-term projects, regardless of how high or low the cost of capital is.
C) Since the smaller project has the higher IRR but the larger project has the higher NPV at a zero discount rate, the two projects' NPV profiles will cross, and the larger project will have the higher NPV if the cost of capital is less than the crossover rate.
D) Since the smaller project has the higher IRR and the larger NPV at a zero discount rate, the two projects' NPV profiles will cross, and the smaller project will look better if the cost of capital is less than the crossover rate.
E) Since the smaller project has the higher IRR, the two projects' NPV profiles cannot cross, and the smaller project's NPV will be higher at all positive values of the cost of capital.

Accepted Answer

The NPV method assumes that all cash inflows are reinvested at the discount rate, which is not necessarily equal to the project's IRR. Therefore, the two projects' NPV profiles can cross, and the project with the higher NPV at a given cost of capital is the better choice. In this case, the larger project has the higher NPV at a zero discount rate, so the crossover rate must be greater than zero. Therefore, the larger project will have the higher NPV if the cost of capital is less than the crossover rate.

Question 5

Which of the following statements is CORRECT?
A) One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at the cost of capital, whereas IRR assumes that cash flows are reinvested at the IRR.The NPV assumption is generally more appropriate.
B) One advantage of the NPV over the MIRR method is that NPV takes account of cash flows over a project's full life whereas MIRR does not.
C) One advantage of the NPV over the MIRR method is that NPV discounts cash flows whereas the MIRR is based on undiscounted cash flows.
D) Since cash flows under the IRR and MIRR are both discounted at the same rate (the cost of capital), these two methods always rank mutually exclusive projects in the same order.
E) One advantage of the NPV over the IRR is that NPV takes account of cash flows over a project's full life whereas IRR does not.

Accepted Answer

The NPV method assumes reinvestment at the cost of capital, which is more realistic for most projects compared to the IRR's assumption of reinvestment at the IRR itself. This makes NPV a more appropriate method in many cases.

Question 6

Which of the following statements is CORRECT?
A) The payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
B) The discounted payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
C) The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
D) The modified internal rate of return method (MIRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
E) The internal rate of return method (IRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

Accepted Answer

The net present value method (NPV) is generally regarded by academics as the best single method for evaluating capital budgeting projects because it takes into account the time value of money and provides a clear indication of whether a project will increase the value of the firm. The payback method only considers the time it takes to recover the initial investment, while the discounted payback method is a slight improvement but still doesn't fully account for time value of money. The IRR and MIRR can result in multiple answers and can be misleading in certain situations.

Question 7

Consider projects S and L.Both have normal cash flows, and the projects have the same risk, hence both are evaluated with the same cost of capital, 10%.However, S has a higher IRR than L.Which of the following statements is CORRECT?
A) If Project S has a positive NPV, Project L must also have a positive NPV.
B) If the cost of capital falls, each project's IRR will increase.
C) If the cost of capital increases, each project's IRR will decrease.
D) If Projects S and L have the same NPV at the current cost of capital, 10%, then Project L, the one with the lower IRR, would have a higher NPV if the cost of capital used to evaluate the projects declined.
E) Project S must have a higher NPV than Project L.

Accepted Answer

The IRR is the discount rate that makes the NPV of a project zero. It does not change with changes in the cost of capital. If two projects have the same NPV at a certain cost of capital, the project with the lower IRR (Project L) will benefit more from a decrease in the cost of capital, resulting in a higher NPV for Project L if the cost of capital declines. This is because the NPV is more sensitive to changes in the discount rate when the rate is closer to the project's IRR.

Question 8

You are considering two mutually exclusive, equally risky, projects.Both have IRRs that exceed the cost of capital.Which of the following statements is CORRECT? Assume that the projects have normal cash flows, with one outflow followed by a series of inflows.
A) If the cost of capital is greater than the crossover rate, then the IRR and the NPV criteria will not result in a conflict between the projects.The same project will rank higher by both criteria.
B) If the cost of capital is less than the crossover rate, then the IRR and the NPV criteria will not result in a conflict between the projects.The same project will rank higher by both criteria.
C) For a conflict to exist between NPV and IRR, the initial investment cost of one project must exceed the cost of the other.
D) For a conflict to exist between NPV and IRR, one project must have an increasing stream of cash flows over time while the other has a decreasing stream.If both sets of cash flows are increasing or decreasing, then it would be impossible for a conflict to exist, even if one project is larger than the other.
E) If the two projects' NPV profiles do not cross, then there will be a sharp conflict as to which one should be selected.

Accepted Answer

BWhen the cost of capital is either greater than or less than the crossover rate, the IRR and NPV criteria will align, meaning there will be no conflict in choosing between the two projects. The crossover rate is the cost of capital at which the NPVs of the two projects are equal. If the cost of capital is above or below this rate, both IRR and NPV methods will recommend the same project.

Question 9

Consider two projects, X and Y.Project X's IRR is 19% and Project Y's IRR is 17%.The projects have the same risk and the same lives, and each has constant cash flows during each year of their lives.If the cost of capital is 10%, Project Y has a higher NPV than X.Given this information, which of the following statements is CORRECT?
A) The crossover rate must be greater than 10%.
B) If the cost of capital is 8%, Project X will have the higher NPV.
C) If the cost of capital is 18%, Project Y will have the higher NPV.
D) Project X is larger in the sense that it has the higher initial cost.
E) The crossover rate must be less than 10%.

Accepted Answer

The answer of Consider two projects, X and Y.Project X's...

Question 10

If you were evaluating two mutually exclusive projects for a firm with a zero cost of capital, the payback method and NPV method would always lead to the same decision on which project to undertake.

Accepted Answer

The payback method focuses on how quickly investment costs can be recovered, not accounting for the time value of money or cash flows beyond the payback period, whereas NPV considers the present value of all cash flows over the project's life, making it possible for the two methods to recommend different projects.

Question 11

Projects S and L are equally risky, mutually exclusive, and have normal cash flows.Project S has an IRR of 15%, while Project L's IRR is 12%.The two projects have the same NPV when the cost of capital is 7%.Which of the following statements is CORRECT?
A) If the cost of capital is 6%, Project S will have the higher NPV.
B) If the cost of capital is 13%, Project S will have the lower NPV.
C) If the cost of capital is 10%, both projects will have a negative NPV.
D) Project S's NPV is more sensitive to changes in cost of capital than Project L's.
E) If the cost of capital is 10%, both projects will have positive NPVs.

Accepted Answer

The answer of Projects S and L are equally risky,...

Question 12

Assume a project has normal cash flows.All else equal, which of the following statements is CORRECT?
A) A project's NPV increases as the cost of capital declines.
B) A project's MIRR is unaffected by changes in the cost of capital.
C) A project's regular payback increases as the cost of capital declines.
D) A project's discounted payback increases as the cost of capital declines.
E) A project's IRR increases as the cost of capital declines.

Accepted Answer

As the cost of capital declines, the present value of the project's cash flows increases, and thus the project's NPV increases. However, the MIRR, regular payback, and discounted payback do not necessarily change as the cost of capital declines. The IRR may increase or decrease depending on the specific project cash flows, but this is not always the case for all projects with normal cash flows.

Quiz 10: The Basics of Capital Budgeting: Evaluating Cash Flows

Which of the following statements is CORRECT? Assume that all projects being considered have normal cash flows and are equally risky.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Consider projects S and L.Both have normal cash flows, and the projects have the same risk, hence both are evaluated with the same cost of capital, 10%.However, S has a higher IRR than L.Which of the following statements is CORRECT?

You are considering two mutually exclusive, equally risky, projects.Both have IRRs that exceed the cost of capital.Which of the following statements is CORRECT? Assume that the projects have normal cash flows, with one outflow followed by a series of inflows.

If you were evaluating two mutually exclusive projects for a firm with a zero cost of capital, the payback method and NPV method would always lead to the same decision on which project to undertake.

Projects S and L are equally risky, mutually exclusive, and have normal cash flows.Project S has an IRR of 15%, while Project L's IRR is 12%.The two projects have the same NPV when the cost of capital is 7%.Which of the following statements is CORRECT?

Assume a project has normal cash flows.All else equal, which of the following statements is CORRECT?