Question 1

Mary is in contract negotiations with a publishing house for her new novel. She has two options. She may be paid $100,000 up front, and receive royalties that are expected to total $26,000 at the end of each of the next five years. Alternatively, she can receive $200,000 up front and no royalties. Which of the following investment rules would indicate that she should take the former deal, given a discount rate of 8%?
Rule I: The Net Present Value rule
Rule II: The Payback Rule with a payback period of two years
Rule III: The internal rate of return (IRR) Rule
A) Rule I only
B) Rule III only
C) Rule II and III
D) Rule I and II

Accepted Answer

A) Using a financial calculator, enter CF0 = 100,000, CF1 = 26,000, F1 = 5;
calculate NPV for I = 8 = $203,810, which is greater than $200,000.

Question 2

Use the information for the question(s) below.
 
-If WiseGuy Inc. uses payback period rule to choose projects, which of the projects (Project A or Project B) Project B
A) Project A
B) will WiseGuy Inc. prefer?
C) Project A and Project B have the same ranking.
D) Cannot calculate a payback period without a discount rate.

Accepted Answer

The payback period rule states that a project should be accepted if its payback period is less than a specified period. Project B has a shorter payback period than Project A, making it a better choice according to this rule. Adding a discount rate may change the rankings, but this information is not given in the question. Therefore, the best choice is Project B.

Question 3

Consider the following two projects:

The payback period for project B is closest to ________.
A) 3.2 years
B) 2.3 years
C) 2.6 years
D) 2.9 years

Accepted Answer

D) 11eaabab_c09e_a107_b90e_e5917a6e0cd7_TB5536_11

Question 4

The Sisyphean Company is planning on investing in a new project. This will involve the purchase of some new machinery costing $400,000. The Sisyphean Company expects cash inflows from this project as detailed below:

The appropriate discount rate for this project is 15%. The internal rate of return (IRR) for this project is closest to ________.
A) 13%
B) 16%
C) 21%
D) 24%

Accepted Answer

C) CF0 = -400,000
CF1 = 157,452.975
CF2 = 157,452.975
CF3 = 157,452.975
CF4 = 157,452.975
Compute IRR = 21%.

Question 5

Which of the following statements is FALSE?
A) The payback rule is useful in cases where the cost of making an incorrect decision might not be large enough to justify the time required for calculating the net present value (NPV).
B) The payback rule is reliable because it considers the time value of money and depends on the cost of capital.
C) For most investment opportunities, expenses occur initially and cash is received later.
D) Fifty percent of firms surveyed reported using the payback rule for making decisions.

Accepted Answer

The statement "The payback rule is reliable because it considers the time value of money and depends on the cost of capital" is false. The payback rule does not consider the time value of money as it does not discount cash flows, and it also does not depend on the cost of capital.

Question 6

Use the information for the question(s) below.
 
-If WiseGuy Inc. uses IRR rule to choose projects, which of the projects (Project A or Project B) Project B
A) Project A
B) will rank highest?
C) Project A and Project B have the same ranking.
D) Cannot calculate a payback period without a discount rate.

Accepted Answer

B) IRRA=10.7%, IRRB=26.4%

Question 7

You are considering investing in a zero-coupon bond that will pay you its face value of $1000 in twelve years. If the bond is currently selling for $496.97, then the internal rate of return (IRR) for investing in this bond is closest to ________.
A) 5.0%
B) 7.1%
C) 6.0%
D) 8.2%

Accepted Answer

C) PV = -496.97
FV = 1000
PMT = 0
N = 12
Compute I = 6.0%.

Question 8

A lottery winner can take $6 million now or be paid $600,000 at the end of each of the next 16 years. The winner calculates the internal rate of return (IRR) of taking the money at the end of each year and, estimating that the discount rate across this period will be 4%, decides to take the money at the end of each year. Was her decision correct?
A) Yes, because it agrees with the Net Present Value rule.
B) Yes, because it agrees with the payback rule.
C) Yes, because it agrees with both the Net Present Value rule and the payback rule.
D) Yes, because it disagrees with the Net Present Value rule.

Accepted Answer

A) Using a financial calculator, enter 11eaabab_c09d_b694_b90e_7ba712c7eaa4_TB5536_11 11eaabab_c09d_b695_b90e_83bc0fc45364_TB5536_11 11eaabab_c09d_b696_b90e_d196cea4c124_TB5536_11 calculate 11eaabab_c09d_b697_b90e_5992715365a0_TB5536_11 which is greater than $6,000,000.

Question 9

Which of the following statements is FALSE?
A) The payback investment rule is based on the notion that an opportunity that pays back its initial investments quickly is a good idea.
B) An internal rate of return (IRR) will always exist for an investment opportunity.
C) A net present value (NPV) will always exist for an investment opportunity.
D) In general, there can be as many internal rates of return (IRRs) as the number of times the project's cash flows change sign over time.

Accepted Answer

An internal rate of return (IRR) may not always exist for an investment opportunity if the project's cash flows have irregular patterns, such as multiple negative cash flows followed by positive ones. In such cases, the IRR calculation may not result in a meaningful percentage.

Question 10

A florist is buying a number of motorcycles to expand its delivery service. These will cost $78,000 but are expected to increase profits by $3000 per month over the next four years. What is the payback period in this case?
A) 10.40 months
B) 15.60 months
C) 19.50 months
D) 26.00 months

Accepted Answer

D) 11eaabab_c09d_8f83_b90e_7113f438f24d_TB5536_11

Question 11

What is the internal rate of return (IRR) of an investment that requires an initial investment of $11,000 today and pays $15,400 in one year's time?
A) 37%
B) 44%
C) 43%
D) 40%

Accepted Answer

D) Calculate interest rate using TVM keys: input 11eaabab_c09e_c819_b90e_bd3fba696454_TB5536_11 11eaabab_c09e_c81a_b90e_d76baec3094c_TB5536_11 and 11eaabab_c09e_c81b_b90e_c126f6d7db44_TB5536_11 interest 11eaabab_c09e_c81c_b90e_d90dc4b684c2_TB5536_11

Question 12

Which of the following is NOT a limitation of the payback rule?
A) It does not consider the time value of money.
B) Lacks a decision criterion that is economically based.
C) It is difficult to calculate.
D) It does not consider cash flows occurring after the payback period.

Accepted Answer

The payback rule is relatively easy to calculate compared to other capital budgeting tools. However, payback rule does not consider the time value of money, lacks a decision criterion that is economically based and does not take into account cash flows occurring after the payback period.

Question 13

A mining company plans to mine a beach for rutile. To do so will cost $14 million up front and then produce cash flows of $7 million per year for five years. At the end of the sixth year the company will incur shut-down and clean-up costs of $6 million. If the cost of capital is 13.0%, then what is the MIRR for this project?
A) -60.97%
B) -78.39%
C) -87.10%
D) -95.81%

Accepted Answer

C) Bring all negative cash flows to time 0;
thus, PV shut-down 11eaabab_c09e_04bc_b90e_41d51cbdd852_TB5536_11 11eaabab_c09e_04bd_b90e_49e4a1533d7c_TB5536_11 11eaabab_c09e_04be_b90e_bb8225e97206_TB5536_11

Question 14

A local government awards a landscaping company a contract worth $1.5 million per year for five years for maintaining public parks. The landscaping company will need to buy some new machinery before they can take on the contract. If the cost of capital is 6%, what is the most that this equipment could cost if the contract is to be worthwhile for the landscaping company?
A) $5.69 million
B) $6.00 million
C) $6.32 million
D) $6.63 million

Accepted Answer

C) Using a financial calculator, enter 11eaabab_c09d_dda8_b90e_ebaafcb90f63_TB5536_11 11eaabab_c09d_dda9_b90e_4720de38edd9_TB5536_11 11eaabab_c09d_ddaa_b90e_4323a5dcd556_TB5536_11 calculate 11eaabab_c09e_04bb_b90e_97826fdf7c52_TB5536_11

Question 15

A convenience store owner is contemplating putting a large neon sign over his store. It would cost $50,000, but is expected to bring an additional $24,000 of profit to the store every year for five years. Would this project be worthwhile if evaluated using a payback period of two years or less and if the cost of capital is 10%?
A) Yes, since it will pay back its initial investment in two years.
B) Yes, since the value of the cash flows into the store, in present dollars, are greater than the initial investment.
C) Yes, since the cash flows after two years are greater than the initial investment.
D) No, since the value of the cash flows over the first two years are less than the initial investment.

Accepted Answer

The payback period is calculated by dividing the initial investment by the annual cash inflow. Here, $50,000/$24,000 = 2.08 years, which is more than the required payback period of 2 years or less. Therefore, the project would not be considered worthwhile under this criterion.

Question 16

Consider a project with the following cash flows:

Assume the appropriate discount rate for this project is 13%. The payback period for this project is closest to ________.
A) 2.88 years
B) 2.40 years
C) 1.92 years
D) 3.60 years

Accepted Answer

B) 11eaabab_c09e_79f3_b90e_4da67bdd296f_TB5536_11 years

Question 17

Which of the following is NOT a valid method of modifying cash flows to produce a MIRR?
A) Discount all of the negative cash flows to time 0 and leave the positive cash flows alone.
B) Leave the initial cash flow alone and compound all of the remaining cash flows to the final period of the project.
C) Discount all of the negative cash flows to the present and compound all of the positive cash flows to the end of the project.
D) Turn multiple negative cash flows into a single negative cash flow by summing all negative cash flows over the project's lifetime.

Accepted Answer

Turning multiple negative cash flows into a single negative cash flow by summing all negative cash flows over the project's lifetime is not a valid method of modifying cash flows to produce a MIRR. All negative cash flows need to be discounted to the present and all positive cash flows need to be compounded to the end of the project. Choices A, B, and C are valid methods of modifying cash flows to produce a MIRR.

Question 18

An investor is considering a project that will generate $900,000 per year for four years. In addition to upfront costs, at the completion of the project at the end of the fifth year there will be shut-down costs of $400,000. If the cost of capital is 4.4%, based on the MIRR, at what upfront costs does this project cease to be worthwhile?
A) $2.62 million
B) $2.91 million
C) $3.21 million
D) $3.50 million

Accepted Answer

B) Bring all negative cash flows to time 0;
thus, PV shut-down 11eaabab_c09e_2bcf_b90e_5f8464438032_TB5536_11 FV positive cash flows at time 11eaabab_c09e_2bd0_b90e_03ca1c80bd77_TB5536_11 PV of positive cash flows at time 0 = $3,139,085; 11eaabab_c09e_2bd1_b90e_d1040a8d5ceb_TB5536_11

Question 19

Consider the following two projects:

The payback period for project A is closest to ________.
A) 1.9 years
B) 2.3 years
C) 2.6 years
D) 2.1 years

Accepted Answer

D) Payback period: It is clear that the project is not paid off after two years since we have only received 90 toward the 100 investment. To calculate the fraction of the third year, we take the $10 yet to be repaid 11eaabab_c09e_79f5_b90e_eb622d94e13a_TB5536_11 so, the payback is 2.1 years.

Question 20

According to Graham and Harvey's 2001 survey (Figure 8.2 in the text), the most popular decision rules for capital budgeting used by CFOs are ________.
A) NPV, IRR, MIRR
B) MIRR, IRR, Payback period
C) IRR, NPV, Payback period
D) Profitability index, NPV, IRR

Accepted Answer

According to Graham and Harvey's 2001 survey, the most popular decision rules for capital budgeting used by CFOs are IRR, NPV, and Payback period. Therefore, option C is the correct answer. Meanwhile, options A, B, and D are incorrect as they either do not include all three popular decision rules or include less popular decision rules.

Quiz 8: Investment Decision Rules

Use the information for the question(s) below. -If WiseGuy Inc. uses payback period rule to choose projects, which of the projects (Project A or Project B) Project B

Consider the following two projects: The payback period for project B is closest to ________.

Which of the following statements is FALSE?

Use the information for the question(s) below. -If WiseGuy Inc. uses IRR rule to choose projects, which of the projects (Project A or Project B) Project B

You are considering investing in a zero-coupon bond that will pay you its face value of $1000 in twelve years. If the bond is currently selling for $496.97, then the internal rate of return (IRR) for investing in this bond is closest to ________.

Which of the following statements is FALSE?

A florist is buying a number of motorcycles to expand its delivery service. These will cost $78,000 but are expected to increase profits by $3000 per month over the next four years. What is the payback period in this case?

What is the internal rate of return (IRR) of an investment that requires an initial investment of $11,000 today and pays $15,400 in one year's time?

Which of the following is NOT a limitation of the payback rule?

Consider a project with the following cash flows: Assume the appropriate discount rate for this project is 13%. The payback period for this project is closest to ________.

Which of the following is NOT a valid method of modifying cash flows to produce a MIRR?

Consider the following two projects: The payback period for project A is closest to ________.

According to Graham and Harvey's 2001 survey (Figure 8.2 in the text) , the most popular decision rules for capital budgeting used by CFOs are ________.