Exam 12: Capital Budgeting: Decision Rules

Carolina Company is considering Projects S and L,whose cash flows are shown below.These projects are mutually exclusive,equally risky,and are not repeatable.If the decision is made by choosing the project with the higher IRR,how much value will be forgone? Note that under some conditions choosing projects on the basis of the IRR will cause $0.00 value to be lost.

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

Lancaster Corp.is considering two equally risky,mutually exclusive projects,both of which have normal cash flows.Project A has an IRR of 11%,while Project B's IRR is 14%.When the WACC is 8%,the projects have the same NPV.Given this information,which of the following statements is CORRECT?

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.

Shannon Co.is considering a project that has the following cash flow and WACC data.What is the project's discounted payback?

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.

You are on the staff of O'Hara Inc.The CFO believes project acceptance should be based on the NPV,but Andrew O'Hara,the president,insists that no project should be accepted unless its IRR exceeds the project's risk-adjusted WACC.Now you must make a recommendation on a project that has a cost of $15,000 and two cash flows: $110,000 at the end of Year 1 and −$100,000 at the end of Year 2.The president and the CFO both agree that the appropriate WACC for this project is 10%.At 10%,the NPV is $2,355.37,but you find two IRRs,one at 6.33% and one at 527%,and a MIRR of 11.32%.Which of the following statements best describes your optimal recommendation,i.e.,the analysis and recommendation that is best for the company and least likely to get you in trouble with either the CFO or the president?

Which of the following statements is CORRECT?

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

The NPV and IRR methods,when used to evaluate two equally risky but mutually exclusive projects,will lead to different accept/reject decisions and thus capital budgets if the cost of capital at which the projects' NPV profiles cross is less than the projects' cost of capital.

The WACC for two mutually exclusive projects that are being considered is 12%.Project K has an IRR of 20% while Project R's IRR is 15%.The projects have the same NPV at the 12% current WACC.Interest rates are currently high.However,you believe that money costs and thus your WACC will soon decline.You also think that the projects will not be funded until the WACC has decreased,and their cash flows will not be affected by the change in economic conditions.Under these conditions,which of the following statements is CORRECT?

Modern Refurbishing Inc.is considering a project that has the following cash flow data.What is the project's IRR? Note that a project's IRR can be less than the WACC (and even negative),in which case it will be rejected.

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

Which of the following statements is CORRECT?

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.

Westwood Painting Co.is considering a project that has the following cash flow and WACC data.What is the project's MIRR? Note that a project's MIRR can be less than the WACC (and even negative),in which case it will be rejected.

Scott Enterprises is considering a project that has the following cash flow and WACC data.What is the project's NPV? Note that if a project's expected NPV is negative,it should be rejected.

Worthington Inc.is considering a project that has the following cash flow data.What is the project's payback?

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.

Dickson Co.is considering a project that has the following cash flow and WACC data.What is the project's NPV? Note that a project's expected NPV can be negative,in which case it will be rejected.