Question 1

Small businesses make less use of DCF capital budgeting techniques than large businesses. This may reflect a lack of knowledge on the part of small firms' managers, but it may also reflect a rational conclusion that the costs of using DCF analysis outweigh the benefits of these methods for very small firms.

Accepted Answer

Small businesses may not have the resources or knowledge to use DCF capital budgeting techniques, and may have found other methods of evaluating investments to be more effective for their needs.

Question 2

Assume a project has normal cash flows. All else being equal, which of the following statements is correct?
A) The project's IRR increases as the WACC declines.
B) The project's NPV increases as the WACC declines.
C) The project's MIRR is unaffected by changes in the WACC.
D) The project's regular payback increases as the WACC declines.

Accepted Answer

When the WACC (weighted average cost of capital) declines, the cost of capital decreases which leads to lower discount rate. This results in a higher NPV (net present value) of the project. The IRR (internal rate of return) and MIRR (modified internal rate of return) are affected by changes in the discount rate and therefore are not unaffected by changes in the WACC. Additionally, regular payback period does not consider the time value of money, so it is not affected by changes in the WACC.

Question 3

Which statement regarding normal cash flows is correct?
A) Projects with "normal" cash flows can have only one real IRR.
B) Projects with "normal" cash flows can have two or more real IRRs.
C) The "multiple IRR problem" can arise if a project's cash flows are "normal."
D) Projects with "non-normal" cash flows are almost never encountered in the real world.

Accepted Answer

Normal cash flows involve an initial outlay followed by a series of positive cash inflows, which means there can only be one sign change in the cash flow stream. This characteristic ensures that there can only be one real Internal Rate of Return (IRR), as the IRR is found by solving the equation where the net present value equals zero, and the existence of a single sign change guarantees only one real root to this equation.

Question 4

Theoretically speaking, hard capital rationing does not exist.

Accepted Answer

Hard capital rationing is a situation where a company does not have enough funds or financial resources to undertake all the profitable projects. However, in theory, companies can always raise capital through various means such as issuing equity, debt, or even selling assets. Therefore, theoretically speaking, hard capital rationing does not exist as long as there are ways for companies to raise capital.

Question 5

Which statement regarding normal cash flows is correct?
A) If a project has "normal" cash flows, then its IRR must be positive.
B) If a project has "normal" cash flows, then its MIRR must be positive.
C) If a project has "normal" cash flows, then it will have exactly two real IRRs.
D) If a project has "normal" cash flows, then it can have only one real IRR, whereas a project with "non-normal" cash flows might have more than one real IRR.

Accepted Answer

Normal cash flows involve an initial outlay followed by a series of positive cash inflows, which means the project can have only one real IRR. Non-normal cash flows, which involve sign changes in the cash flow stream more than once, can result in multiple IRRs.

Question 6

Which of the following statements is correct? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
A) A project's regular IRR is found by compounding the initial cost at the WACC to find the terminal value (TV), then discounting the TV at the WACC.
B) A project's regular IRR is found by compounding the cash inflows at the WACC to find the present value (PV), then discounting to find the IRR.
C) If a project's IRR is smaller than the WACC, then its NPV will be positive.
D) A project's IRR is the discount rate that causes the PV of the inflows to equal the project's cost.

Accepted Answer

The internal rate of return (IRR) is the discount rate at which the net present value (NPV) of a project equals zero. Therefore, statement D is correct as it accurately describes how the IRR is calculated. Statement A is incorrect as it describes the terminal value method, which is not relevant to calculating the regular IRR. Statement B is also incorrect as it describes the discounted cash flow (DCF) method for finding the NPV, not the IRR. Statement C is incorrect as a project's NPV will be positive if its IRR is greater than the WACC, not smaller.

Question 7

Which of the following statements is correct? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
A) A project's regular IRR is found by discounting the cash inflows at the WACC to find the present value (PV), then compounding this PV to find the IRR.
B) If a project's IRR is greater than the WACC, then its NPV must be negative.
C) To find a project's IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project's costs.
D) To find a project's IRR, we must find a discount rate that is equal to the WACC.

Accepted Answer

The internal rate of return (IRR) is the discount rate that makes the present value of the cash inflows equal to the present value of the initial investment or costs. Therefore, to find a project's IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project's costs. Option A is incorrect because it describes the process of finding the regular or simple payback period, not the IRR. Option B is incorrect because if a project's IRR is greater than the WACC, then its NPV must be positive, not negative. Option D is incorrect because the IRR may or may not be equal to the WACC; it depends on the specific characteristics of the project and the company's capital structure.

Question 8

Which statement regarding the IRR method is correct?
A) One defect of the IRR method is that it does not take account of cash flows over a project's full life.
B) One defect of the IRR method is that it does not take account of the time value of money.
C) One defect of the IRR method is that it does not take account of the cost of capital.
D) One defect of the IRR method is that it does not assume that the cash flows to be received from a project can be reinvested at a rate other than the IRR itself.

Accepted Answer

The IRR method assumes that all cash flows generated by the project can be reinvested at the internal rate of return itself, which may not always be realistic or achievable in practice. This is a known limitation of the IRR method.

Question 9

Selecting the project that has the highest equivalent annual annuity seems to be the rule for comparing projects with different lives. This rule should apply to both independent and mutually exclusive projects.

Accepted Answer

The equivalent annual annuity (EAA) method is primarily used for comparing projects with different lifespans to determine which has the higher annual return over its life. However, while it's suitable for comparing mutually exclusive projects (where choosing one project precludes the selection of another), it's not necessarily the rule for independent projects. Independent projects do not compete with each other, and the decision to invest in one can be made without affecting the decision on the other, often based on whether they meet a minimum investment criterion, such as a target rate of return, rather than their EAA values.

Question 10

Which of the following statements is correct? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
A) The longer a project's payback period, the more desirable the project is normally considered to be by this criterion.
B) One drawback of the payback criterion for evaluating projects is that this method does not properly account for the time value of money.
C) If a project's payback is positive, then the project should be rejected because it must have a negative NPV.
D) The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem.

Accepted Answer

One drawback of the payback criterion for evaluating projects is that it does not consider the time value of money. It does not account for the present value of future cash flows, which can lead to incorrect decisions when comparing projects with different cash flows over time. The other options are incorrect. Option A is incorrect because the shorter the payback period, the more desirable the project is because it indicates earlier recovery of the initial investment. Option C is incorrect because a positive payback period only means that the initial investment will be recovered after a certain period, but it does not determine the project's overall profitability. Option D is incorrect because the discounted payback method considers cash flows beyond the payback period, but it still does not account for the time value of money.

Question 11

Project S has a pattern of high cash flows in its early life, while Project L has a longer life, with large cash flows late in its life. Neither has negative cash flows after Year 0, and at the current cost of capital, the two projects have identical NPVs. Now, suppose interest rates and money costs decline. Other things held constant, this change will cause L to become preferred to S.

Accepted Answer

When the cost of capital decreases, the present value of future cash flows increases, which benefits Project L with its larger cash flows later in its life. Therefore, L becomes preferred to S.

Question 12

Which of the following statements is correct? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
A) The lower the WACC used to calculate it, the lower the calculated NPV will be.
B) If a project's NPV is less than zero, then its IRR must be less than the WACC.
C) If a project's NPV is greater than zero, then its IRR must be less than zero.
D) The NPV of a relatively low risk project should be found using a relatively high WACC.

Accepted Answer

The IRR is the discount rate that causes the NPV to equal zero. If the project's NPV is less than zero, then the cash outflows are greater than the discounted cash inflows, which means the IRR must be less than the WACC.

Question 13

Normal Projects Q and R have the same NPV when the discount rate is zero. However, Project Q's cash flows come in faster than those of R. Therefore, we know that at any discount rate greater than zero, R will have a higher NPV than Q.

Accepted Answer

The statement is incorrect. If Q's cash flows are coming in faster, it means that Q has a shorter payback period and a higher internal rate of return (IRR) than R. Therefore, at discount rates lower than IRR, Q will have a higher NPV than R. However, at discount rates higher than IRR, R will have a higher NPV than Q. It cannot be concluded that R will always have a higher NPV than Q at any discount rate greater than zero without additional information about their respective IRRs.

Question 14

Financing pressure or liquidity can explain the popular use of payback period in project appraisals for small firms.

Accepted Answer

Payback period is often used by small firms as a quick and easy way to assess the financial feasibility of a project. This is because small firms often face financing pressure or liquidity constraints, and need to ensure that their investments can generate quick returns to cover immediate expenses. The payback period provides a simple measure of how long it will take for a project to recoup its initial investment, which helps small firms to make decisions about whether to invest or not.

Question 15

The IRR of normal Project X is greater than the IRR of normal Project Y, and both IRRs are greater than zero. Also, the NPV of X is greater than the NPV of Y at the cost of capital. If the two projects are mutually exclusive, Project X should definitely be selected, and the investment made, provided we have confidence in the data. Put another way, it is impossible to draw NPV profiles that would suggest not accepting Project X.

Accepted Answer

While Project X has a higher IRR and NPV at a specific cost of capital, NPV profiles could intersect, meaning that the relative attractiveness of the projects could change at different discount rates. If the cost of capital changes, it might make Project Y more attractive under certain conditions.

Question 16

A decrease in the firm's discount rate (r, or WACC) will increase projects' NPVs, which could change the accept/reject decision for any potential project. However, such a change would have no impact on the project's IRR; therefore, the accept/reject decision under the IRR method is independent of the cost of capital.

Accepted Answer

A change in the discount rate affects both the NPV and IRR methods. A decrease in the discount rate would increase the NPV and IRR of a project, making it more attractive for investment. Therefore, the accept/reject decision under both methods is dependent on the cost of capital.

Question 17

If you were evaluating two mutually exclusive projects for a firm with a zero cost of capital, the payback method and NPV method would always lead to the same decision on which project to undertake.

Accepted Answer

The payback method focuses on how quickly investment costs can be recovered, not on the total value created, while the NPV method evaluates the total value a project adds over its lifetime, taking into account the time value of money. Even with a zero cost of capital, these methods can lead to different decisions because they measure different aspects of a project's financial attractiveness.

Question 18

If a firm is experiencing no capital rationing, it should accept all investment proposals whose accounting rate of return is equal to or greater than the weighted average cost of capital.

Accepted Answer

The decision to accept investment proposals should be based on whether the proposals have a positive net present value (NPV) or an internal rate of return (IRR) higher than the weighted average cost of capital (WACC), not solely on the accounting rate of return (ARR), which does not consider the time value of money or the project's risk compared to the firm's WACC.

Question 19

Which statement regarding payback is true?
A) The regular payback method recognizes all cash flows over a project's life.
B) The discounted payback method recognizes all cash flows over a project's life, and it also adjusts these cash flows to account for the time value of money.
C) The regular payback method was widely used years ago, but virtually no companies even calculate the payback today.
D) The regular payback is useful as an indicator of a project's liquidity because it gives managers an idea of how long it will take to recover the funds invested in a project.

Accepted Answer

The regular payback method calculates the time it takes for a project to recover its initial investment, making it a useful indicator of a project's liquidity. However, it does not consider the time value of money and only looks at the cash flows within the payback period. While the discounted payback method is a more accurate measure of a project's profitability, the regular payback method is still commonly used, especially for smaller projects where the time value of money is less of a concern.

Question 20

Which statement regarding payback is true?
A) The shorter a project's payback period, the less desirable the project is normally considered to be by this criterion.
B) One drawback of the payback criterion for evaluating projects is that this method does not take account of cash flows beyond the payback period.
C) If a project's payback is positive, then the project should be accepted because it must have a positive NPV.
D) The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem.

Accepted Answer

This is true because the payback method only considers the time it takes for a project to recoup its initial investment, and does not take into account cash flows that occur beyond that time frame. This can lead to a biased evaluation of a project's long-term profitability. A shorter payback period is generally considered more desirable, as it indicates a quicker return on investment, but this does not necessarily mean it is the best choice for the organization in the long run.

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

Assume a project has normal cash flows. All else being equal, which of the following statements is correct?

Which statement regarding normal cash flows is correct?

Theoretically speaking, hard capital rationing does not exist.

Which statement regarding normal cash flows is correct?

Which of the following statements is correct? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.

Which of the following statements is correct? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.

Which statement regarding the IRR method is correct?

Selecting the project that has the highest equivalent annual annuity seems to be the rule for comparing projects with different lives. This rule should apply to both independent and mutually exclusive projects.

Which of the following statements is correct? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.

Which of the following statements is correct? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.

Normal Projects Q and R have the same NPV when the discount rate is zero. However, Project Q's cash flows come in faster than those of R. Therefore, we know that at any discount rate greater than zero, R will have a higher NPV than Q.

Financing pressure or liquidity can explain the popular use of payback period in project appraisals for small firms.

If you were evaluating two mutually exclusive projects for a firm with a zero cost of capital, the payback method and NPV method would always lead to the same decision on which project to undertake.

If a firm is experiencing no capital rationing, it should accept all investment proposals whose accounting rate of return is equal to or greater than the weighted average cost of capital.

Which statement regarding payback is true?

Which statement regarding payback is true?