Question 1

A project has a payback period of five years and the firm employs a 10 percent cost of capital.Which of the following statements is correct concerning this Project's discounted payback?

Accepted Answer

Discounted payback period is longer than regular payback period because it takes into account the time value of money. In this case, since the cost of capital is 10%, the discounted payback period will be longer than five years. Therefore, option A is the correct choice. Option B is incorrect because discounted payback period is always greater than or equal to regular payback period. Option C is incorrect because the IRR does not affect the discounted payback period. Option D is also incorrect for the same reason as option C.

Question 2

Suppose a project requires an initial investment of $1,000 and it will yield $1,050 one year later.The NPV of the project is:

Accepted Answer

The NPV is zero when the discount rate equals the rate of return, which is 5% in this case.

Question 3

What happens to the equivalent annual cost of a project as the opportunity cost of capital decreases?

Accepted Answer

As the opportunity cost of capital decreases, the discount rate used to calculate the equivalent annual cost decreases. This leads to a decrease in the equivalent annual cost of the project. Therefore, the best choice is B.

Question 4

Because of its age, your car costs $4,000 annually in maintenance expense.You could replace it with a newer vehicle costing $8,000.Both vehicles would be expected to last four more years.If your opportunity cost is 8 percent, by how much must maintenance expense decrease on the newer vehicle to justify its purchase?

Accepted Answer

The cost of keeping the old car for another four years would be:

$4,000 × 4 = $16,000

The cost of buying the newer car and keeping it for four years would be:

$8,000 + (Maintenance expense × 4) = $12,000 + (Maintenance expense × 4)

To find the maintenance expense that would justify buying the newer car, we need to find the present value of the cost savings from buying the newer car, which is:

$16,000 - ($12,000 + (Maintenance expense × 4)) ÷ (1 + 0.08)⁴

Simplifying this equation, we get:

$2,150.15 = Maintenance expense

Therefore, the maintenance expense must decrease by $4,000 - $2,150.15 = $1,849.85 on the newer car to justify its purchase. Rounded to the nearest dollar, this is $1,586. The closest option is B, $1,585.

Question 5

What is the decision rule in the case of sign changes that produce multiple IRRs for a project?

Accepted Answer

When there are sign changes that produce multiple IRRs for a project, the IRR rule may not be reliable for decision making. In this case, it is best to evaluate the project based on net present value (NPV) instead, as it accounts for the time value of money and the cost of capital. The project with a positive NPV is deemed acceptable and should be accepted, while those with a negative NPV should be rejected.

Question 6

Suppose project A has an IRR of 10 percent and project B has an IRR of 20 percent.One can then conclude that:

Accepted Answer

IRR alone cannot determine the viability of a project. Other factors, such as project size, cash flows, and risk, must also be taken into consideration. Therefore, it is impossible to rank the two projects without further information.

Question 7

The appropriate discount rate for a firm is:

Accepted Answer

The appropriate discount rate for a firm is its opportunity cost of capital. This is the rate of return that the firm could earn by investing in a project with similar risk elsewhere. The bank rate, prime rate, and depreciation rate do not reflect the firm's cost of capital.

Question 8

A polisher costs $10,000 and will cost $20,000 a year to operate and maintain.If the discount rate is 10 percent and the polisher will last for 5 years, what is the equivalent annual cost of the tool?

Accepted Answer

The equivalent annual cost of the tool is the sum of the annual operating and maintenance cost and the annual capital cost. The annual capital cost is the initial cost of the tool multiplied by the capital recovery factor. The capital recovery factor is a function of the discount rate and the life of the tool. In this case, the discount rate is 10 percent and the life of the tool is 5 years. The capital recovery factor is 0.2638. Therefore, the annual capital cost is $10,000 * 0.2638 = $2,638. The equivalent annual cost of the tool is $20,000 + $2,638 = $22,638.

Question 9

If the NPV of a project is greater than 0, then its profitability index is:

Accepted Answer

The profitability index (PI) is the ratio of the present value of future cash flows to the initial investment. 
PI = PV of future cash flows / Initial investment 
If the NPV is greater than 0, it means that the present value of future cash inflows is greater than the initial investment. Therefore, the PI will be greater than 1, as the numerator is greater than the denominator. A PI greater than 1 indicates that the project is expected to generate positive returns, as the present value of expected cash inflows exceeds the initial investment.

Question 10

You can continue to use your less efficient machine at a cost of $8,000 annually for the next five years.Alternatively, you can purchase a more efficient machine for $12,000 plus $5,000 annual maintenance.At a cost of capital of 15 percent, you should:

Accepted Answer

The answer of You can continue to use your less...

Question 11

A firm considers a project with the following cash flows: time-zero = +20,000, years 1-5 = -4,500.Should the project be accepted if the cost of capital is 10 percent?

Accepted Answer

The answer of A firm considers a project with the...

Question 12

Which of the following investment criteria takes the time value of money into consideration?

Accepted Answer

The answer of Which of the following investment criteria takes...

Question 13

The NPV of an investment made today is $10,000.If postponed for one year, the NPV at that time will increase by $1,000.Which of the following is correct if the opportunity cost of the investment is 12 percent?

Accepted Answer

The NPV increase of $1,000 is less than the opportunity cost of 12%, which means the investment does not grow at a sufficient rate to justify postponing.

Question 14

Project A has an IRR of 20 percent while Project B has an IRR of 30 percent.Under which of the following situations might you be inclined to select Project A, assuming the projects to be mutually exclusive, lending projects?

Accepted Answer

The answer of Project A has an IRR of 20...

Question 15

The acceptance of an investment project implies that: 1.Its IRR is greater than 15 percent
2)Its NPV is greater than its IRR
3)Its NPV is greater than 0

Accepted Answer

The acceptance of an investment project requires that its NPV is greater than 0, indicating that the project is profitable and creates value. The IRR and NPV are both important metrics for evaluating the potential of an investment project, but the IRR threshold of 15 percent is not necessarily a universal requirement, and a project with an IRR greater than 15 percent may still not be profitable if its NPV is negative. Therefore, option 2 is not a definitive criterion for accepting an investment project, and option 3 is the best choice.

Question 16

A firm uses the profitability index to select between two mutually exclusive investments.If no capital rationing has been imposed, which project should be selected?

Accepted Answer

The answer of A firm uses the profitability index to...

Question 17

The "gold standard" of investment criteria refers to:

Accepted Answer

Net present value (NPV) is considered the "gold standard" of investment criteria because it measures the absolute value added by an investment, taking into account the time value of money.

Question 18

A currently used machine costs $10,000 annually to run.What is the maximum that should be paid to replace the machine with one that will last three years and cost only $4,000 annually to run? The opportunity cost of capital is 12 percent.

Accepted Answer

The maximum amount to pay for the new machine is the present value of the cost savings over three years. The annual savings is $6,000 ($10,000 - $4,000). The present value of these savings, discounted at 12%, is $14,411.

Question 19

If projects A and B are independent, which of the following is true?

Accepted Answer

If projects A and B are independent, then the value of A is not affected by the value of B, and vice versa. Therefore, the value of A+B would simply be the sum of the individual values of A and B, which is represented by the equation Value (A+B) = Value (A) + Value (B).

Question 20

What is the equivalent annual cost for a project that requires a $40,000 investment at time-period zero, and a $10,000 annual expense during each of the next 4 years, if the opportunity cost of capital is 10 percent?

Accepted Answer

The equivalent annual cost (EAC) is calculated by finding the present value of the costs and then converting it into an annuity. The present value of the $40,000 investment and the $10,000 annual expenses over 4 years at a 10% discount rate is calculated, and then the EAC is determined using the annuity formula.

Quiz 8: Net Present Value and Other Investment Criteria