Question 1

Projects A and B are mutually exclusive and have normal cash flows.Project A has an IRR of 15% and B's IRR is 20%.The company's WACC is 12%,and at that rate Project A has the higher NPV.Which of the following statements is CORRECT?

Accepted Answer

A)   The crossover rate for the two projects must be less than 12%.
B)   Assuming the timing pattern of the two projects' cash flows is the same,Project B probably has a higher cost (and larger scale) .
C)   Assuming the two projects have the same scale,Project B probably has a faster payback than Project A.
D)   The crossover rate for the two projects must be 12%.
E)   Since B has the higher IRR,then it must also have the higher NPV if the crossover rate is less than the WACC of 12%. C

Question 2

A basic rule in capital budgeting is that if a project's NPV exceeds its IRR,then the project should be accepted.

Accepted Answer

A) True 
 B)False  False

Question 3

An increase in the firm's WACC will decrease projects' NPVs,which could change the accept/reject decision for any potential project.However,such a change would have no impact on projects' IRRs.Therefore,the accept/reject decision under the IRR method is independent of the cost of capital.

Accepted Answer

A) True 
 B)False  False

Question 4

Sexton Inc.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 IRR,how much value will be forgone? Note that under certain conditions choosing projects on the basis of the IRR will not cause any value to be lost because the one with the higher IRR will also have the higher NPV,so no value will be lost if the IRR method is used. $\text { WACC: } \quad 9.50 \%$
$\begin{array}{llrrrr}&0&1&2&3&4\\hline
\mathrm{CF}_{\mathrm{S}} & -\$ 2,050 & \$ 750 & \$ 760 & \$ 770 & \$ 780 \
\mathrm{CF}_{\mathrm{L}} & -\$ 4,300 & \$ 1,500 & \$ 1,518 & \$ 1,536 & \$ 1,554
\end{array}$

Accepted Answer

A)   $188.91
B)   $145.46
C)   $228.58
D)   $226.70
E)   $230.47

Question 5

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

A) True 
 B)False

Question 6

Assume that the economy is enjoying a strong boom,and as a result interest rates and money costs generally are relatively high.The WACC for two mutually exclusive projects that are being considered is 12%.Project S has an IRR of 20% while Project L's IRR is 15%.The projects have the same NPV at the 12% current WACC.However,you believe that the economy will soon fall into a mild recession,and 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?

Accepted Answer

A)   You should reject both projects because they will both have negative NPVs under the new conditions.
B)   You should delay a decision until you have more information on the projects,even if this means that a competitor might come in and capture this market.
C)   You should recommend Project L,because at the new WACC it will have the higher NPV.
D)   You should recommend Project S,because at the new WACC it will have the higher NPV.
E)   You should recommend Project L because it will have both a higher IRR and a higher NPV under the new conditions.

Question 7

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 greater than the crossover rate.

Accepted Answer

A) True 
 B)False

Question 8

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

A) True 
 B)False

Question 9

Conflicts between two mutually exclusive projects occasionally occur,where the NPV method ranks one project higher but the IRR method puts the other one first.In theory,such conflicts should be resolved in favor of the project with the higher NPV.

Accepted Answer

A) True 
 B)False

Question 10

Noe Drilling Inc.is considering Projects S and L,whose cash flows are shown below.These projects are mutually exclusive,equally risky,and not repeatable.The CEO believes the IRR is the best selection criterion,while the CFO advocates the MIRR.If the decision is made by choosing the project with the higher IRR rather than the one with the higher MIRR,how much,if any,value will be forgone,i.e. ,what's the NPV of the chosen project versus the maximum possible NPV? Note that (1)"true value" is measured by NPV,and (2)under some conditions the choice of IRR vs.MIRR will have no effect on the value lost. $$\begin{array} { l c c c c c } 
 \text { WACC: } & 9.00 \% & & & \
&  { 0 } & 1 & 2 & 3 & 4 \
\hline \mathrm { CF } _ { \mathrm { S } } & - \$ 1,100 & \$ 550 & \$ 600 & \$ 100 & \$ 100 \
\mathrm { CF } _ { \mathrm { L } } & - \$ 2,750 & \$ 725 & \$ 725 & \$ 800 & \$ 1,400
\end{array}$$

Accepted Answer

A)   $73.38
B)   $79.56
C)   $0.00
D)   $96.55
E)   $78.01

Question 11

Moerdyk & 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 IRR,how much value will be forgone? Note that under certain conditions choosing projects on the basis of the IRR will not cause any value to be lost because the one with the higher IRR will also have the higher NPV,i.e. ,no conflict will exist. $\text { WACC: } \quad 6.75 \%$
$\begin{array}{lllllr}&0&1&2&3&4\\hline
\mathrm{CF}_{\mathrm{S}} & -\$ 1,025 & \$ 650 & \$ 450 & \$ 250 & \$ 50 \
\mathrm{CF}_{\mathrm{L}} & -\$ 1,025 & \$ 100 & \$ 300 & \$ 500 & \$ 700
\end{array}$

Accepted Answer

A)   $62.75
B)   $59.20
C)   $53.28
D)   $51.51
E)   $65.71

Question 12

Which of the following statements is CORRECT?

Accepted Answer

A)   An NPV profile graph shows how a project's payback varies as the cost of capital changes.
B)   The NPV profile graph for a normal project will generally have a positive (upward) slope as the life of the project increases.
C)   An NPV profile graph is designed to give decision makers an idea about how a project's risk varies with its life.
D)   An NPV profile graph is designed to give decision makers an idea about how a project's contribution to the firm's value varies with the cost of capital.
E)   We cannot draw a project's NPV profile unless we know the appropriate WACC for use in evaluating the project's NPV.

Question 13

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

Accepted Answer

A)   If the two projects' NPV profiles do not cross,then there will be a sharp conflict as to which one should be selected.
B)   If the cost of capital is greater than the crossover rate,then the IRR and the NPV criteria will not result in a conflict between the projects.One project will rank higher by both criteria.
C)   If the cost of capital is less than the crossover rate,then the IRR and the NPV criteria will not result in a conflict between the projects.One project will rank higher by both criteria.
D)   For a conflict to exist between NPV and IRR,the initial investment cost of one project must exceed the cost of the other.
E)   For a conflict to exist between NPV and IRR,one project must have an increasing stream of cash flows over time while the other has a decreasing stream.If both sets of cash flows are increasing or decreasing,then it would be impossible for a conflict to exist,even if one project is larger than the other.

Question 14

A conflict will exist between the NPV and IRR methods,when used to evaluate two equally risky but mutually exclusive projects,if the projects' cost of capital is less than the rate at which the projects' NPV profiles cross.

Accepted Answer

A) True 
 B)False

Question 15

When considering two mutually exclusive projects,the firm should always select the project whose internal rate of return 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

A) True 
 B)False

Question 16

Harry's Inc.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 projected NPV is negative,it should be rejected. $$\begin{array} { l c c c c c c } 
\text { WACC: } & 9.50 \% & & & & \
\text { Year } & 0 & 1 & 2 & 3 & 4 & 5 \
\hline  \text { Cash flows } & - \$ 1,000 & \$ 300 & \$ 300 & \$ 300 & \$ 300 & \$ 300
\end{array}$$

Accepted Answer

A)   0120.01
B)   0135.20
C)   0151.91
D)   0179.26
E)   0133.68

Question 17

Cornell Enterprises is considering a project that has the following cash flow and WACC data.What is the project's NPV? Note that a project's projected NPV can be negative,in which case it will be rejected. $$\begin{array} { l c c c c } 
\text { WACC: } & 10.00 \% \
\text { Year } & 0 & 1 & 2 & 3 \
\hline \text { Cash flows } & - \$ 1,275 & \$ 450 & \$ 460 & \$ 470
\end{array}$$

Accepted Answer

A)   -$106.10
B)   -$132.63
C)   -$139.26
D)   -$125.99
E)   -$165.78

Question 18

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

A) True 
 B)False

Question 19

Barry Company is considering a project that has the following cash flow and WACC data.What is the project's NPV? Note that a project's projected NPV can be negative,in which case it will be rejected. $$\begin{array} { l c c c c c c } 
\text { WACC: } & 11.75 \% & & & & \
\text { Year } & 0 & 1 & 2 & 3 & 4 & 5 \
\hline  \text { Cash flows } & - \$ 1,100 & \$ 400 & \$ 390 & \$ 380 & \$ 370 & \$ 360
\end{array}$$

Accepted Answer

A)   0$286.36
B)   0$294.95
C)   0$349.36
D)   0$309.27
E)   0$355.08

Question 20

Maxwell Feed & Seed is considering a project that has the following cash flow data.What is the project's IRR? Note that a project's projected IRR can be less than the WACC (and even negative),in which case it will be rejected. $$\begin{array} { l c c c c c c } 
\text { Year } & 0 & 1 & 2 & 3 & 4 & 5 \
\hline \text { Cash flows } & - \$ 6,750 & \$ 2,000 & \$ 2,025 & \$ 2,050 & \$ 2,075 & \$ 2,100
\end{array}$$

Accepted Answer

A)   15.45%
B)   17.17%
C)   13.74%
D)   15.61%
E)   12.96%

Exam 11: The Basics of Capital Budgeting

Projects A and B are mutually exclusive and have normal cash flows.Project A has an IRR of 15% and B's IRR is 20%.The company's WACC is 12%,and at that rate Project A has the higher NPV.Which of the following statements is CORRECT?

A basic rule in capital budgeting is that if a project's NPV exceeds its IRR,then the project should be accepted.

An increase in the firm's WACC will decrease projects' NPVs,which could change the accept/reject decision for any potential project.However,such a change would have no impact on projects' IRRs.Therefore,the accept/reject decision under the IRR method is independent of the cost of capital.

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.

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 greater than the crossover rate.

Conflicts between two mutually exclusive projects occasionally occur,where the NPV method ranks one project higher but the IRR method puts the other one first.In theory,such conflicts should be resolved in favor of the project with the higher NPV.

Which of the following statements is CORRECT?

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

A conflict will exist between the NPV and IRR methods,when used to evaluate two equally risky but mutually exclusive projects,if the projects' cost of capital is less than the rate at which the projects' NPV profiles cross.

When considering two mutually exclusive projects,the firm should always select the project whose internal rate of return 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.