Question 1

Conflicts between two mutually exclusive projects occasionally occur,where the NPV method ranks one project higher but the IRR method ranks the other one first.In theory,such conflicts should be resolved in favor of the project with the higher positive IRR.

Accepted Answer

The conflicts between projects with different NPVs and IRRs cannot be resolved solely on the basis of one method. Other factors such as project size, timing, risk, and strategic fit must also be considered. Therefore, a comprehensive analysis that takes into account all relevant factors is necessary to make a sound investment decision.

Question 2

A basic rule in capital budgeting is that if a project's NPV exceeds its IRR,then the project should be accepted.

Accepted Answer

The decision to accept a project in capital budgeting is based on whether the NPV (Net Present Value) is positive, not on whether it exceeds the IRR (Internal Rate of Return). The IRR is a rate of return; comparing its magnitude directly to a dollar value like NPV is conceptually incorrect.

Question 3

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

Accepted Answer

The IRR (Internal Rate of Return) is a metric used to evaluate the profitability of a project and is not directly affected by changes in the cost of capital. The cost of capital influences the project's acceptability threshold, not its IRR.

Question 4

A firm should never accept a project if its acceptance would lead to an increase in the firm's cost of capital (its WACC).

Accepted Answer

Accepting a project may increase the firm's cost of capital, but it may still be beneficial if the project's return exceeds the cost of capital. The decision to accept or reject a project should be based on its impact on the firm's cash flows and overall value, not just the immediate effect on the cost of capital.

Question 5

The internal rate of return 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 is the definition of internal rate of return (IRR).

Question 6

For a project with one initial cash outflow followed by a series of positive cash inflows,the modified IRR (MIRR)method involves compounding the cash inflows out to the end of the project's life,summing those compounded cash flows to form a terminal value (TV),and then finding the discount rate that causes the PV of the TV to equal the project's cost.

Accepted Answer

This is an accurate description of the MIRR method.

Question 7

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

Accepted Answer

Present values of cash flows should be summed to determine the value of a capital budgeting project.

Question 8

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

Accepted Answer

The payback method focuses on the amount of time it takes for an investment to recoup its initial cost, which provides insight into the project's liquidity and risk. A shorter payback period indicates lower risk and better liquidity, while a longer payback period implies higher risk and weaker liquidity.

Question 9

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

Accepted Answer

The phenomenon of "multiple internal rates of return" occurs when a project has unconventional cash flows (i.e., cash flow signs change more than once throughout the project's life), not specifically when comparing mutually exclusive projects with different lives.

Question 10

The NPV method's assumption that cash inflows are reinvested at the cost of capital is generally more reasonable than the IRR's assumption that cash flows are reinvested at the IRR.This is an important reason why 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 generally a more realistic assumption than the IRR's assumption that cash flows are reinvested at the IRR. This is because the cost of capital is a more easily achievable rate of return that reflects the opportunity cost of investing in a project, whereas the IRR may be an unrealistic assumption about future investment opportunities. Therefore, the NPV method is generally preferred over the IRR method.

Question 11

The NPV method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital.

Accepted Answer

The NPV method takes into account the time value of money and discounts future cash flows to their present value using the project's risk-adjusted cost of capital. This assumes that any cash flows generated by the project are reinvested at the same risk-adjusted cost of capital.

Question 12

A project's IRR is independent of the firm's cost of capital.In other words,a project's IRR doesn't change with a change in the firm's cost of capital.

Accepted Answer

The IRR represents the discount rate at which the net present value of cash inflows equals the net present value of cash outflows. It is solely based on the cash flows generated by the project and is independent of the cost of capital of the firm. Therefore, a change in the firm's cost of capital will not affect the IRR of the project.

Question 13

When considering two mutually exclusive projects,the firm should always select the project whose internal rate of return 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 answer of When considering two mutually exclusive projects,the firm...

Question 14

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,and when that happens,we don't know which IRR is relevant.

Accepted Answer

The primary reason the NPV method is considered conceptually superior is that it directly measures the increase in value to the firm, taking into account the scale of the investment and the time value of money, ensuring decisions align with maximizing shareholder wealth. Multiple IRRs can be an issue, but it's not the primary reason for NPV's superiority.

Question 15

When evaluating mutually exclusive projects,the modified IRR (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

MIRR and NPV can lead to different capital budgeting decisions because they incorporate different reinvestment rate assumptions and handle non-conventional cash flows differently. MIRR assumes reinvestment at the project's own rate, while NPV assumes reinvestment at the cost of capital, potentially leading to different preferences for projects, especially when comparing projects of different sizes or durations.

Question 16

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

When a project has a negative cash flow at the end of its life, it can cause the project to have multiple IRRs. This occurs because the negative cash flow can cause the cash flow stream to have multiple sign changes, resulting in multiple possible discount rates that would make the net present value of the cash flows equal to zero.

Question 17

The IRR method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital.

Accepted Answer

The IRR method assumes that the projects' cash flows are reinvested at the internal rate of return itself, not at the project's risk-adjusted cost of capital.

Question 18

Both the regular and the modified IRR (MIRR)methods have wide appeal to professors,but most business executives prefer the NPV method to either of the IRR methods.

Accepted Answer

The answer of Both the regular and the modified IRR...

Question 19

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

Projects with cash flows that come in later in their life are more sensitive to changes in the discount rate because the present value of these future cash flows is more heavily impacted by the rate at which they are discounted.

Question 20

Conflicts between two mutually exclusive projects occasionally occur,where the NPV method ranks one project higher but the IRR method ranks the other one first.In theory,such conflicts should be resolved in favor of the project with the higher positive NPV.

Accepted Answer

The NPV method is considered to be a more reliable method for making capital budgeting decisions because it considers the absolute dollar value of cash flows and incorporates the time value of money. Therefore, conflicts between projects should be resolved in favor of the project with the higher positive NPV. The IRR method can lead to inconsistent results when cash flows are non-conventional or when comparing projects with different cash flow patterns.

Quiz 12: Capital Budgeting: Decision Rules