Question 1

Which of the following statements is most correct?

Accepted Answer

The answer of Which of the following statements is most...

Question 2

Which of the following statements is most correct?

Accepted Answer

The NPV method assumes that cash flows will be reinvested at the cost of capital, while the IRR method assumes reinvestment at the IRR.

Question 3

Projects L and S each have an initial cost of $10,000, followed by a series of positive cash inflows. Project L has total, undiscounted cash inflows of $16,000, while S has total undiscounted inflows of $15,000. Further, at a discount rate of 10 percent, the two projects have identical NPVs. Which project's NPV will be more sensitive to changes in the discount rate? (Hint: Projects with steeper NPV profiles are more sensitive to discount rate changes.)

Accepted Answer

Since Projects L and S have the same NPV at a discount rate of 10%, we know that Project L must have a steeper NPV profile than Project S. This means that Project L's NPV will be more sensitive to changes in the discount rate compared to Project S, making Choice B the correct answer.

Question 4

Extending projects with different lives to a common life for comparison purposes, while theoretically appealing, should be done only if there is a high probability that the projects will actually be replicated beyond their initial lives.

Accepted Answer

Extending projects with different lives to a common life for comparison purposes can be useful, but only if there is a high likelihood that the projects will actually be replicated beyond their initial lives. If there is no intention or possibility of replication, comparing different project lives may not be relevant or meaningful.

Question 5

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

While Project X has a higher IRR and NPV at a specific cost of capital, NPV profiles could intersect, meaning that the relative attractiveness of the projects could change at different discount rates. If the cost of capital changes, it might make Project Y more attractive under certain conditions.

Question 6

Small businesses probably make less use of the DCF capital budgeting techniques than large businesses. This may reflect a lack of knowledge on the part of small firms' managers, but it may also reflect a rational conclusion that the costs of using DCF analysis outweigh the benefits of these methods for those firms.

Accepted Answer

Small businesses may not be as familiar with DCF capital budgeting techniques, but they may also decide that the benefits of using these methods do not outweigh the costs, such as the time and resources needed to gather data and perform the analysis.

Question 7

The main reason that the NPV method is regarded as being conceptually superior to the IRR method for evaluating mutually exclusive investments is that multiple IRRs may exist.

Accepted Answer

The answer of The main reason that the NPV method...

Question 8

The internal rate of return of a capital investment

Accepted Answer

The internal rate of return (IRR) is the discount rate at which the net present value of the investment is equal to zero. Therefore, it is dependent on the cost of capital since changing the discount rate changes the present value of future cash flows. Choice B is incorrect because the IRR formula is not just based on the annual net cash flows but rather the timing and magnitude of all cash flows. Choice C is correct because if the IRR is less than the cost of capital, the project is not generating enough return to cover the cost of funding it. Choice D is correct because the IRR is a measure of the return on the investment and is similar to the yield to maturity on a bond, which is a measure of the return on a bond based on its purchase price, coupon, and maturity.

Question 9

A company estimates that its weighted average cost of capital (WACC) is 10 percent. Which of the following independent projects should the company accept?

Accepted Answer

Project A generates a net present value of $3,200, which is positive and greater than the up-front expenditure of $1,000,000. Therefore, it generates a return greater than the cost of capital (10 percent), making it the best choice. Projects B, C, and D have rates of return that are lower than the cost of capital, so they should not be accepted.

Question 10

The post-audit is used to

Accepted Answer

The post-audit is used to improve cash flow forecasts and stimulate management to improve operations and bring results into line with forecasts. Therefore, options A and B are correct. Option C is incorrect as the post-audit may identify potentially profitable projects that were not forecasted properly. Option D is incorrect as option C is incorrect.

Question 11

Project A has an internal rate of return (IRR) of 15 percent. Project B has an IRR of 14 percent. Both projects have a cost of capital of 12 percent. Which of the following statements is most correct?

Accepted Answer

The IRR of a project is the discount rate at which the project's net present value (NPV) equals zero. If the cost of capital is less than the IRR, then the project has a positive NPV and is profitable. In this case, both Project A and Project B have IRRs that are greater than the cost of capital, so both projects have positive NPVs. However, we cannot conclude which project has a higher NPV without knowing the initial investment and cash flows of each project.

Option C is incorrect because the IRR is a function of the project's cash flows and does not depend on the cost of capital. If the cost of capital were less than the IRR, both projects would still have positive NPVs, but the difference between their IRRs and the cost of capital would be smaller.

Question 12

The NPV and IRR methods, when used to evaluate an independent project, will lead to different accept/reject decisions unless the IRR is greater than the cost of capital.

Accepted Answer

The NPV and IRR methods will generally lead to the same accept/reject decision for independent projects, as both methods consider the cost of capital. If the IRR is greater than the cost of capital, both methods will typically suggest accepting the project.

Question 13

Project A has an IRR of 15 percent. Project B has an IRR of 18 percent. Both projects have the same risk. Which of the following statements is most correct?

Accepted Answer

The answer of Project A has an IRR of 15...

Question 14

A major disadvantage of the payback period method is that it

Accepted Answer

The payback period method ignores cash flows beyond the payback period and does not account for the time value of money, making only options B and C correct.

Question 15

Although the replacement chain, or common life, approach is appealing for dealing with projects with different lives, it is not used in industry because there are no projects which meet the assumptions the method requires.

Accepted Answer

This statement is not entirely accurate. While it is true that the replacement chain approach has limitations and may not be applicable to all projects, there are some industries where it is commonly used. For example, in the oil and gas industry, this approach is often used for decision-making related to pipeline replacements and upgrades, where infrastructure has different lifespans.

Question 16

A project has an up-front cost of $100,000. The project's WACC is 12 percent and its net present value is $10,000. Which of the following statements is most correct?

Accepted Answer

The net present value of the project is positive, which indicates that the project will generate a return greater than the WACC. Therefore, the project should be accepted. Additionally, since the net present value is positive, the project's internal rate of return must be greater than the WACC. The modified internal rate of return is not relevant in this case.

Question 17

Assume a project has normal cash flows (i.e., the initial cash flow is negative, and all other cash flows are positive). Which of the following statements is most correct?

Accepted Answer

As the cost of capital declines, the discount rate used in NPV calculations decreases, leading to a higher NPV. IRR and MIRR are not directly affected by changes in the cost of capital.

Question 18

In capital budgeting analyses, it is possible that NPV and IRR will both involve an assumption of reinvestment of the project's cash flows at the same rate.

Accepted Answer

It is common practice in capital budgeting to assume that cash flows generated by a project are reinvested at the same rate as the project's required rate of return, which is used to calculate both the NPV and IRR. This assumption ensures consistency between the two methods and helps to avoid any inconsistencies or contradictions that may arise if different reinvestment rates are used for each method.

Question 19

Projects A and B have the same expected lives and initial cash outflows. However, one project's cash flows are larger in the early years, while the other project has larger cash flows in the later years. The two NPV profiles are given below: Which of the following statements is most correct?

Accepted Answer

The NPV profile for Project A is lower initially and then increases, indicating smaller cash flows in the early years and larger cash flows in the later years. Therefore, statement A is incorrect. The NPV profile for Project B is higher initially and then decreases, indicating larger cash flows in the early years and smaller cash flows in the later years. Therefore, statement B is correct. Statement C is incorrect because we can determine which project has larger early cash flows by analyzing the NPV profile. Statement D is incorrect because the NPV profile is consistent with the information given in the problem. Therefore, the correct answer is B.

Question 20

Any capital budgeting investment rule should depend solely on forecasted cash flows and the opportunity cost of capital. The rule itself should not be affected by managers' tastes, the choice of accounting method, or the profitability of other independent projects.

Accepted Answer

A capital budgeting investment rule should be based solely on objective factors such as forecasted cash flows and the opportunity cost of capital. It should not be influenced by subjective factors such as managers' tastes or accounting methods, or by the profitability of unrelated projects. This ensures that investment decisions are made based on their potential to create value for the company and maximize shareholder wealth.

Quiz 12: Capital Budgeting: Decision Criteria

Which of the following statements is most correct?

Which of the following statements is most correct?

Extending projects with different lives to a common life for comparison purposes, while theoretically appealing, should be done only if there is a high probability that the projects will actually be replicated beyond their initial lives.

The main reason that the NPV method is regarded as being conceptually superior to the IRR method for evaluating mutually exclusive investments is that multiple IRRs may exist.

The internal rate of return of a capital investment

A company estimates that its weighted average cost of capital (WACC) is 10 percent. Which of the following independent projects should the company accept?

The post-audit is used to

Project A has an internal rate of return (IRR) of 15 percent. Project B has an IRR of 14 percent. Both projects have a cost of capital of 12 percent. Which of the following statements is most correct?

The NPV and IRR methods, when used to evaluate an independent project, will lead to different accept/reject decisions unless the IRR is greater than the cost of capital.

Project A has an IRR of 15 percent. Project B has an IRR of 18 percent. Both projects have the same risk. Which of the following statements is most correct?

A major disadvantage of the payback period method is that it

Although the replacement chain, or common life, approach is appealing for dealing with projects with different lives, it is not used in industry because there are no projects which meet the assumptions the method requires.

A project has an up-front cost of $100,000. The project's WACC is 12 percent and its net present value is $10,000. Which of the following statements is most correct?

Assume a project has normal cash flows (i.e., the initial cash flow is negative, and all other cash flows are positive) . Which of the following statements is most correct?

In capital budgeting analyses, it is possible that NPV and IRR will both involve an assumption of reinvestment of the project's cash flows at the same rate.

Projects A and B have the same expected lives and initial cash outflows. However, one project's cash flows are larger in the early years, while the other project has larger cash flows in the later years. The two NPV profiles are given below: Which of the following statements is most correct?

Any capital budgeting investment rule should depend solely on forecasted cash flows and the opportunity cost of capital. The rule itself should not be affected by managers' tastes, the choice of accounting method, or the profitability of other independent projects.