Question 1

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:

Accepted Answer

The answer of The Carnation Chemical Company is investing in...

Question 2

The problem of multiple IRRs can occur when:

Accepted Answer

The problem of multiple IRRs arises when there is more than one sign change in the cash flows, as this creates the possibility of calculating more than one internal rate of return for the same project.

Question 3

The internal rate of return tends to be:

Accepted Answer

The internal rate of return (IRR) is often easier for managers to understand than the net present value (NPV) because it provides a single percentage rate that gauges the profitability of a project, making it more intuitive for decision-making.

Question 4

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:

Accepted Answer

The answer of An investment that requires initial cash outlay...

Question 5

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

Accepted Answer

The average accounting rate of return method relates average net income to average investment, providing a simple measure of a project's profitability without considering the time value of money.

Question 6

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:

Accepted Answer

The internal rate of return (IRR) is the discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. In this case, the cash flows are $5,000 for each of the next 3 years, and the initial investment is $12,000. Without calculating the exact IRR, we can estimate it by recognizing that the total cash inflow ($15,000 over 3 years) is more than the initial investment ($12,000), but not by a huge margin. The IRR must be positive but not extremely high, placing it in the range of between 10% and 15%.

Question 7

The IRR decision rule can be reversed because:

Accepted Answer

The IRR decision rule can be reversed for financing projects because the IRR represents the cost of financing. In such cases, a lower IRR is preferable as it indicates a lower cost of borrowing, contrasting with investment projects where a higher IRR is sought after.

Question 8

A project will have more than one IRR if:

Accepted Answer

A project will have more than one IRR if the cash flow pattern exhibits more than one sign change. This means that there are multiple points where the cash flows change from positive to negative or vice versa, resulting in multiple possible rates of return.

Question 9

A situation in which accepting one investment prevents the acceptance of another investment is called the:

Accepted Answer

A mutually exclusive investment decision is a situation where the acceptance of one investment precludes the acceptance of another competing investment. This may occur when there are limited resources and both investments cannot be undertaken simultaneously. The net present value profile, operational ambiguity decision, issues of scale problem, and multiple rates of return decision are not specifically related to mutually exclusive investment decisions.

Question 10

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?

Accepted Answer

NPV is generally considered the most reliable method because it accounts for the time value of money and provides a direct estimate of the added value from an investment. IRR is next, as it also considers the time value of money but can be misleading for non-conventional cash flows or multiple IRRs. AAR is the least desirable because it does not account for the time value of money and is based on accounting profits rather than cash flows.

Question 11

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

Accepted Answer

The internal rate of return (IRR) rule states that a conventional project should be accepted if its IRR exceeds the project's cost of capital, which is often represented by the weighted average cost of capital (WACC). If the IRR is greater than the WACC, it means the project is expected to generate a return higher than the cost of financing it, making it a worthwhile investment.

Question 12

The internal rate of return may be defined as:

Accepted Answer

The internal rate of return (IRR) is the discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. This means it is the rate at which the present value of the project's cash inflows equals the present value of its outflows.

Question 13

The profitability index is the ratio of:

Accepted Answer

The profitability index is calculated as the present value of future cash flows divided by the initial investment cost. This index helps in determining the relative profitability of an investment.

Question 14

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

Accepted Answer

The answer of The elements that cause problems with the...

Question 15

A mutually exclusive project is a project whose:

Accepted Answer

Mutually exclusive projects are those where the decision to invest in one project affects the decision on other projects, meaning if one project is chosen, the other cannot be chosen due to constraints like budget, resources, or project scope.

Question 16

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

Accepted Answer

Reducing the initial cost of the project increases the internal rate of return (IRR) because the IRR is the discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. Lower initial costs mean higher profitability relative to the investment, thus increasing the IRR.

Question 17

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?

Accepted Answer

Project 1 has a return of $2,000 on a $10,000 investment (20% return), and Project 2 has a return of $1,500 on a $5,000 investment (30% return). The issue is with project scales, as comparing absolute returns ignores the scale of the investment.

Question 18

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

Accepted Answer

Depending on the Net Present Value (NPV) is the most reliable method in this scenario because NPV directly measures the increase in value brought by the projects, taking into account the time value of money, which is a more comprehensive approach than the Internal Rate of Return (IRR) in cases of mutually exclusive projects.

Question 19

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

Accepted Answer

The internal rate of return (IRR) is unique for a project if all future cash flows following the initial investment are positive. This is because the project's cash flow pattern does not change sign more than once, avoiding the possibility of multiple IRRs.

Question 20

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

Accepted Answer

The two fatal flaws of the internal rate of return (IRR) rule are its failure to correctly analyze mutually exclusive investment projects and the multiple rate of return problem. This is because the IRR rule does not always provide a clear choice between projects that have different scales or timing of cash flows, and some projects may have cash flows that lead to more than one IRR, causing confusion in decision-making.

Quiz 7: Net Present Value and Other Investment Rules