Question 1

When evaluating mutually exclusive projects, the MIRR always leads to the same capital budgeting decisions as the NPV method, regardless of the relative lives or sizes of the projects being evaluated.

Accepted Answer

The MIRR (Modified Internal Rate of Return) and NPV (Net Present Value) methods can lead to different capital budgeting decisions, especially when evaluating mutually exclusive projects with different sizes or lifespans. This is because MIRR assumes reinvestment at the project's own rate, while NPV assumes reinvestment at the firm's cost of capital, potentially leading to different preferences between projects.

Question 2

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

Accepted Answer

The primary reason is that NPV directly measures the increase in value to the firm, taking into account the scale of the investment and the time value of money, whereas IRR does not always provide a clear measure of value addition, especially in cases of non-conventional cash flows or mutually exclusive projects with different scales and timing of cash flows.

Question 3

The NPV and IRR methods, when used to evaluate INDEPENDENT AND EQUALLY RISKY
projects, will lead to different accept/reject decisions if their IRRs are greater than the cost of capital.

Accepted Answer

When evaluating independent and equally risky projects, both NPV and IRR methods will lead to the same accept/reject decisions if the IRRs are greater than the cost of capital, as both methods will indicate that the projects are acceptable.

Question 4

The IRR is that discount rate that equates the present value of the cash outflows (or costs) with the present value of the cash inflows.

Accepted Answer

This statement accurately defines the internal rate of return (IRR).

Question 5

When considering two mutually exclusive projects, the firm should always select that project whose IRR is the highest PROVIDED THE PROJECTS HAVE THE SAME INITIAL COST. This statement is true regardless of whether the projects can be repeated or not.

Accepted Answer

The IRR rule can be misleading for mutually exclusive projects because it does not account for the scale of the projects or the timing of cash flows. The project with the highest IRR may not have the highest NPV, which is the more appropriate measure for value creation.

Question 6

If a project's NPV exceeds its IRR, then the project should be accepted.

Accepted Answer

This statement is not always true. It depends on the required rate of return and the cost of capital. If the required rate of return (or cost of capital) is higher than the IRR, then accepting a project with an NPV greater than the IRR could result in a negative net present value overall. It's important to consider all relevant financial factors when evaluating a project.

Question 7

One advantage of the payback method for evaluating potential investments is that it provides some information about a project's liquidity and risk.

Accepted Answer

The payback method shows how quickly an investment will generate cash flows to recover its initial cost. This provides some indication of the project's liquidity - i.e. its ability to generate cash - as well as its risk, since longer payback periods imply greater risks associated with the investment.

Question 8

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

Accepted Answer

The decision to select Project X over Project Y based solely on a higher IRR can be misleading if not considering the scale of investment, timing of cash flows, and cost of capital. NPV should be the primary criterion for project selection, especially for mutually exclusive projects, as it directly measures the value added to the firm. A project with a higher NPV is generally preferred, regardless of its IRR compared to another project.

Question 9

Because "present value" refers to the value of cash flows that occur at different points in time, a series of present values should not be summed to determine the value of a capital budgeting project.

Accepted Answer

A series of present values should be summed to determine the value of a capital budgeting project, using techniques such as net present value (NPV) or discounted cash flow (DCF) analysis.

Question 10

Small businesses make less use of 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 very small firms.

Accepted Answer

Small businesses may not have the resources or expertise to effectively use DCF capital budgeting techniques, and the benefits of using these methods may not outweigh the costs for very small firms.

Question 11

In theory, 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

Capital budgeting investment rules are based on the principles of finance and should be determined solely by the expected cash flows and the opportunity cost of capital, rather than managerial preferences, accounting practices or the profitability of other projects. This ensures objectivity and consistency in decision-making.

Question 12

The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects that have different lives are being compared.

Accepted Answer

The answer of The phenomenon called "multiple internal rates of...

Question 13

Assuming that their NPVs based on the firm's cost of capital are equal, the NPV of a project whose cash flows accrue relatively rapidly will be more sensitive to changes in the discount rate than the NPV of a project whose cash flows come in later in its life.

Accepted Answer

The NPV of a project whose cash flows come in later in its life is more sensitive to changes in the discount rate because the present value of future cash flows is more heavily impacted by the rate at which those cash flows are discounted back to the present.

Question 14

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

This is known as "multiple IRR problem" and occurs when there are two or more sign changes in the cash flow over the life of the project, resulting in the possibility of multiple IRRs.

Question 15

The NPV method's assumption that cash inflows are reinvested at the cost of capital is more reasonable than the IRR's assumption that cash flows are reinvested at the IRR. This is an important reason that the NPV method is generally preferred over the IRR method.

Accepted Answer

The NPV method's assumption that cash inflows are reinvested at the cost of capital is more realistic compared to the IRR assumption that cash flows are reinvested at the IRR. As a result, the NPV approach is generally preferred because it is theoretically sound and produces more accurate results.

Question 16

The MIRR method has wide appeal for professors, but most business executives prefer the NPV
method to either the regular or MIRR.

Accepted Answer

The answer of The MIRR method has wide appeal for...

Question 17

Financing pressure or liquidity can explains the popular use of payback period in project appraisals for small firms.

Accepted Answer

Small firms often face financing pressure or liquidity constraints, and therefore tend to prioritize shorter payback periods to ensure speedy recovery of their investments. This is because shorter payback periods require less time to generate positive cash flows, which can help alleviate financing pressure and ensure more liquid assets.

Question 18

A firm should never undertake an investment if accepting the project would lead to an increase in the firm's cost of capital.

Accepted Answer

This statement is false. Accepting a project may lead to an increase or decrease in a firm's cost of capital, depending on the specifics of the project and the firm's financing structure. The decision to undertake an investment should be based on whether the project's expected return exceeds the cost of capital, not solely on whether the cost of capital would increase.

Question 19

Other things held constant, an INCREASE in the cost of capital will result in a DECREASE in a project's IRR.

Accepted Answer

The Internal Rate of Return (IRR) is a measure of a project's profitability and is independent of the cost of capital. An increase in the cost of capital does not affect the IRR itself, but it may affect the decision to undertake the project if the IRR is compared to the cost of capital.

Question 20

Conflicts between two mutually exclusive projects, where the NPV method chooses one project but the IRR method chooses the other, should generally be resolved in favour of the project with the higher NPV.

Accepted Answer

The NPV method is considered more reliable than the IRR method in evaluating investment projects. This is because the IRR method assumes that cash flows generated by a project are reinvested at the same rate as the IRR, which may not be practical or realistic. On the other hand, the NPV method discounts cash flows at a predetermined rate, which is usually the cost of capital, to make sure that the cash flows generated by a project are properly adjusted for the time value of money. As a result, conflicts between these two methods should generally be resolved in favor of the project with the higher NPV.

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