Exam 12: Capital Budgeting: Decision Criteria

Dickson Co. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that a project's expected NPV can be negative, in which case it will be rejected. r 12.00\% Year 0 1 2 3 4 5 Cash flows -\ 1,100 \ 400 \ 390 \ 380 \ 370 \ 360

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.

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 cost of capital 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.

When considering two mutually exclusive projects, the firm should always select the project whose internal rate of return is the highest, . This statement is true regardless of whether the projects can be repeated or not.

Patterson Co. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that a project's expected NPV can be negative, in which case it will be rejected. r 10.00\% Year 0 1 2 3 Cash flows -\ 950 \ 500 \ 400 \ 300

Martin Manufacturing is considering two normal, equally risky, mutually exclusive, but not repeatable projects. Martin's cost of capital is 10%. The two projects have the same investment costs, but Project A has an IRR of 15%, while Project B has an IRR of 20%. Assuming the projects' NPV profiles cross in the upper right quadrant, which of the following statements is CORRECT?

Worthington Inc. is considering a project that has the following cash flow data. What is the project's payback? Year 0 1 2 3 Cash flows -\ 500 \ 150 200 \ 300

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.

Which of the following statements is CORRECT?

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

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.

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 cost of capital (and even negative), in which case it will be rejected. Year 0 1 2 3 4 Cash flows -\ 850 300 290 280 270

Which of the following statements is CORRECT?

You are considering two mutually exclusive, equally risky, projects. Both have IRRs that exceed the cost of capital. Which of the following statements is CORRECT? Assume that the projects have normal cash flows, with one outflow followed by a series of inflows.

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

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 cost of capital. 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 σ$100,000 at the end of Year 2. The president and the CFO both agree that the appropriate cost of capital 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?

Clifford Company is choosing between two projects. The larger project has an initial cost of $100,000, annual cash flows of $30,000 for 5 years, and an IRR of 15.24%. The smaller project has an initial cost of $50,000, annual cash flows of $16,000 for 5 years, and an IRR of 16.63%. The projects are equally risky. Which of the following statements is CORRECT?

Silverman Co. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the higher MIRR rather than the one with the higher NPV, how much value will be forgone? Note that under some conditions choosing projects on the basis of the MIRR will cause $0.00 value to be lost. r :8.75\% Year 0 1 2 3 4 -\ 1,100 \ 375 \ 375 \ 375 \ 375 -\ 2,200 \ 725 \ 725 \ 725 \ 725

Nichols 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 cost of capital or negative, in both cases it will be rejected. Year 0 1 2 3 4 5 Cash flows -\ 1250 \ 325 \ 325 \ 325 \ 325 \ 325