Question 1

Net present value (NPV) assumes that intermediate cash inflows are reinvested at the cost of capital, whereas internal rate of return (IRR) assumes that intermediate cash inflows can be reinvested at a rate equal to the project's IRR.

Accepted Answer

This statement is true. NPV assumes that intermediate cash inflows will be reinvested at the cost of capital, while IRR assumes that intermediate cash inflows will be reinvested at a rate equal to the project's IRR.

Question 2

Certain mathematical properties may cause a project with a nonconventional cash flow pattern to have multiple IRRs; this problem does not occur with the NPV approach.

Accepted Answer

This statement is true. The mathematical properties that cause multiple IRRs are related to the changing signs of cash flows and the possibility of multiple roots in the polynomial equation used to solve for IRR. NPV, on the other hand, uses a straightforward calculation to determine the present value of cash inflows and outflows and does not have the same mathematical complexities as IRR.

Question 3

Conflicting rankings in the case of mutually exclusive projects using NPV and IRR often results from differences in the magnitude and/or timing of cash flows.

Accepted Answer

Conflicting rankings in the case of mutually exclusive projects using NPV and IRR often result from differences in the magnitude and/or timing of cash flows. This is because NPV assumes a reinvestment rate while IRR assumes a constant rate of return, and differing cash flow patterns can affect these calculations differently.

Question 4

Projects having higher cash inflows in the early years tend to be less sensitive to changes in the cost of capital and are therefore often acceptable at higher discount rates compared to projects with higher cash inflows that occur in the later years.

Accepted Answer

Projects with higher cash inflows in the early years have a higher proportion of their cash flows occurring in the near future. As a result, they are less sensitive to changes in the cost of capital and are often acceptable at higher discount rates compared to projects with higher cash inflows that occur in the later years.

Question 5

Consider the following projects, X and Y, where the firm can only choose one. Project X costs $600 and has cash flows of $400 in each of the next 2 years. Project Y also costs $600, and generates cash flows of $500 and $275 for the next 2 years, respectively. Which investment should the firm choose if the cost of capital is 10 percent?

Accepted Answer

The answer of Consider the following projects, X and Y,...

Question 6

There is sometimes a ranking problem among NPV and IRR when selecting among mutually exclusive investments. This ranking problem only occurs when

Accepted Answer

The answer of There is sometimes a ranking problem among...

Question 7

Consider the following projects, X and Y where the firm can only choose one. Project X costs $600 and has cash flows of $400 in each of the next 2 years. Project B also costs $600, and generates cash flows of $500 and $275 for the next 2 years, respectively. Which investment should the firm choose if the cost of capital is 25 percent?

Accepted Answer

The answer of Consider the following projects, X and Y...

Question 8

A project's net present value profile is a graph that plots a project's IRR for various discount rates.

Accepted Answer

A project's net present value (NPV) profile is a graph that plots the NPV of a project for various discount rates, not the IRR. The IRR is the discount rate at which the NPV equals zero.

Question 9

What is the IRR for the following project if its initial after tax cost is $5,000,000 and it is expected to provide after-tax operating cash inflows of $1,800,000 in year 1, $1,900,000 in year 2, $1,700,000 in year 3 and $1,300,000 in year 4?

Accepted Answer

To calculate the IRR, we need to find the discount rate at which the present value of cash inflows equals the initial cost.

Using a financial calculator or spreadsheet software, we can input the cash flows and solve for the discount rate that results in a net present value (NPV) of zero. The IRR is this discount rate expressed as a percentage.

In this case, we get an IRR of 13.57%. Therefore, the best choice is C.

Question 10

A project's net present value profile is a graph that plots a project's NPV for various discount rates.

Accepted Answer

The NPV profile shows the relationship between a project's NPV and different discount rates.

Question 11

Net present value profiles are most useful when selecting among mutually exclusive projects.

Accepted Answer

Net present value profiles show the present value of cash inflows and outflows over time, which allows for comparison of the profitability of different projects over their respective lifetimes. This is especially useful when choosing between projects that cannot be pursued simultaneously, as it allows for a comprehensive assessment of the value and risks associated with each option.

Question 12

Tangshan Mining Company is considering investing in a new mining project. The firm's cost of capital is 12 percent and the project is expected to have an initial after tax cost of $5,000,000. Furthermore, the project is expected to provide after-tax operating cash flows of $2,500,000 in year 1, $2,300,000 in year 2, $2,200,000 in year 3 and ($1,300,000) in year 4?
(a) Calculate the project's NPV.
(b) Calculate the project's IRR.
(c) Should the firm make the investment?

Accepted Answer

The answer of Tangshan Mining Company is considering investing in...

Question 13

For conventional projects, both NPV and IRR techniques will always generate the same accept-reject decision, but differences in their underlying assumptions can cause them to rank mutually exclusive projects differently.

Accepted Answer

The answer of For conventional projects, both NPV and IRR...

Question 14

In general, projects with similar-sized investments and lower early-year cash inflows (lower cash inflows in the early years) tend to be preferred at higher discount rates.

Accepted Answer

The answer of In general, projects with similar-sized investments and...

Question 15

Net present value profiles are most useful when selecting among independent projects.

Accepted Answer

Net present value profiles are most useful for comparing mutually exclusive projects to understand how the value of each project changes with different discount rates, rather than for selecting among independent projects where each project can be evaluated on its own merits.

Question 16

What is the IRR for the following project if its initial after tax cost is $5,000,000 and it is expected to provide after-tax operating cash flows of ($1,800,000) in year 1, $2,900,000 in year 2, $2,700,000 in year 3 and $2,300,000 in year 4?

Accepted Answer

The answer of What is the IRR for the following...

Question 17

On a purely theoretical basis, NPV is the better approach to capital budgeting than IRR because IRR implicitly assumes that any intermediate cash inflows generated by an investment are reinvested at the firm's cost of capital.

Accepted Answer

The answer of On a purely theoretical basis, NPV is...

Question 18

On a purely theoretical basis, NPV is a better approach to capital budgeting than IRR because NPV implicitly assumes that any intermediate cash inflows generated by an investment are reinvested at the firm's cost of capital.

Accepted Answer

NPV takes into account the time value of money and assumes that cash inflows are reinvested at the firm's cost of capital, which is a more realistic assumption. IRR, on the other hand, assumes that all cash inflows are reinvested at the same rate of return as the project, which may not be accurate. Therefore, on a purely theoretical basis, NPV is a better approach to capital budgeting than IRR.

Question 19

Since the cost of capital tends to be a reasonable estimate of the rate at which the firm could actually reinvest intermediate cash inflows, the use of NPV is in theory preferable to IRR.

Accepted Answer

NPV takes into account the cost of capital, which provides a more accurate estimate of the rate of return on future investments. IRR does not consider the cost of capital and can sometimes provide misleading results. Therefore, in theory, NPV is preferable to IRR.

Question 20

The IRR method assumes the cash flows are reinvested at the internal rate of return rather than the required rate of return

Accepted Answer

The IRR method assumes that the cash flows are reinvested at the internal rate of return. This is one of the main assumptions of the method, which makes it different from other capital budgeting techniques that assume the cash flows are reinvested at the required rate of return.

Quiz 10: Capital Budgeting Techniques