Question 1

The IRR 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 IRR.

Question 2

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

Accepted Answer

False

Question 3

Conflicts between two mutually exclusive projects, where the NPV method chooses one project but the IRR method chooses the other, should generally be resolved in favour of the project with the higher NPV.

Accepted Answer

The NPV method is considered to be a better method of capital budgeting than the IRR method because it takes into account the time-value of money and assumes that cash flows are reinvested at a certain rate. Therefore, if there is a conflict between two projects, where the NPV method chooses one project and the IRR method chooses the other, it is generally recommended to choose the project with the higher NPV. This is because the NPV method provides a more accurate assessment of the profitability of a project and reflects its true economic value.

Question 4

A firm should never undertake an investment if accepting the project would lead to an increase in the firm's cost of capital.

Accepted Answer

This statement is not entirely true. Accepting a project can lead to an increase in a firm's cost of capital in the short run, but can also lead to a decrease in the long run if the project is successful and creates value for the firm. Therefore, the decision to accept or reject a project should be based on the net present value (NPV) of the project, which takes into account both the initial investment and the expected future cash flows.

Question 5

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 NPV (Net Present Value) and its acceptability, not its IRR.

Question 6

A decision to undertake significant downsizing to control fixed costs is usually made by senior management, with the decision reported to the firm's board of directors.

Accepted Answer

The answer of A decision to undertake significant downsizing to...

Question 7

The NPV method's assumption that cash inflows are reinvested at the cost of capital is more reasonable than the IRR's assumption that cash flows are reinvested at the IRR. This is an important reason that 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 more realistic because it reflects the opportunity cost of the capital invested in the project. This assumption is more reasonable than the IRR's assumption that cash flows are reinvested at the IRR, which may not be feasible or achievable in practice. Therefore, the NPV method is generally preferred over the IRR method.

Question 8

If a project's NPV exceeds its IRR, then the project should be accepted.

Accepted Answer

The decision to accept a project is based on whether the NPV is positive and the IRR exceeds the cost of capital, not on comparing NPV to IRR directly.

Question 9

When considering two mutually exclusive projects, the firm should always select that project whose IRR 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 decision to select a project based solely on the highest IRR can be misleading, especially when comparing mutually exclusive projects. The Net Present Value (NPV) method is generally considered more reliable because it measures the absolute value added to the firm, taking into account the scale of the investment, the cost of capital, and cash flow timing, which IRR does not adequately address.

Question 10

The NPV and IRR methods, when used to evaluate independent and equally risky projects, will lead to different accept/reject decisions if their IRRs are greater than the cost of capital.

Accepted Answer

Both NPV (Net Present Value) and IRR (Internal Rate of Return) methods will generally lead to the same accept/reject decisions for independent projects as long as the projects' cash flows are conventional (i.e., an initial outlay followed by a series of positive cash inflows) and the cost of capital is not changing. The difference in accept/reject decisions typically arises in projects with non-conventional cash flows or in the comparison of mutually exclusive projects.

Question 11

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

This is known as the multiple internal rates of return problem and occurs when there is a change in the sign of cash flows during the life of the project.

Question 12

In theory, any capital budgeting investment rule should depend solely on forecasted cash flows and the opportunity cost of capital. The rule itself should not be affected by managers' tastes, the choice of accounting method, or the profitability of other independent projects.

Accepted Answer

The capital budgeting investment rule should be based only on objective criteria such as forecasted cash flows and opportunity cost of capital, and should not be influenced by subjective factors such as managers' tastes or profitability of other projects.

Question 13

If the IRR of normal Project X is greater than the IRR of mutually exclusive Project Y (also normal), we can conclude that the firm should select X rather than Y if X has NPV > 0.

Accepted Answer

The decision to select Project X over Project Y based solely on a higher IRR can be misleading if not considering the scale of investment, timing of cash flows, and cost of capital. NPV should be the primary criterion for project selection, especially for mutually exclusive projects, as it directly measures the value added to the firm. A project with a higher NPV is generally preferred, regardless of its IRR compared to another project.

Question 14

The MIRR method has wide appeal for professors, but most business executives prefer the NPV method to either the regular IRR or MIRR.

Accepted Answer

The answer of The MIRR method has wide appeal for...

Question 15

When evaluating mutually exclusive projects, the 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

The MIRR (Modified Internal Rate of Return) and NPV (Net Present Value) methods can lead to different capital budgeting decisions, especially when evaluating mutually exclusive projects with different sizes or lifespans. This is because MIRR assumes reinvestment at the project's own rate, while NPV assumes reinvestment at the firm's cost of capital, potentially leading to different preferences between projects.

Question 16

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

Accepted Answer

A series of present values can be summed to determine the total present value of a capital budgeting project. This approach is commonly used in capital budgeting analysis to calculate net present value (NPV), which is the sum of the present values of all cash inflows and outflows associated with a project.

Question 17

The level of detail needed to determine capital budget expenditures related to compliance with safety and/or environmental issues varies depending on the size and scope of the project(s).

Accepted Answer

The level of detail needed for capital budget expenditures related to safety and/or environmental issues depends on the project's size and scope. Therefore, the statement is true.

Question 18

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

Accepted Answer

The payback method calculates the time it takes for an investment to pay for itself, which gives an indication of liquidity and risk as it shows how quickly the investment can generate returns and the likelihood of recovering the initial investment.

Question 19

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.

Accepted Answer

The primary reason is that NPV directly measures the increase in value to the firm, taking into account the scale of the investment and the time value of money, whereas IRR does not always provide a clear measure of value addition, especially in cases of non-conventional cash flows or mutually exclusive projects with different scales and timing of cash flows.

Question 20

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

The NPV of a project whose cash flows come in later in its life is more sensitive to changes in the discount rate because the present value of future cash flows is more heavily impacted by the rate at which those cash flows are discounted back to the present.

Quiz 10: The Basics of Capital Budgeting: Evaluating Cash Flows