Question 1

The cost of capital for two mutually exclusive projects that are being considered is 8%. Project K has an IRR of 20% while Project R's IRR is 15%. The projects have the same NPV at the 8% current cost of capital. However, you believe that money costs and thus your cost of capital will also increase. You also think that the projects will not be funded until the cost of capital has increased, 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 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. 
B)  you should recommend project r, because at the new cost of capital it will have the higher npv. 
C)  you should recommend project k, because at the new cost of capital it will have the higher npv. 
D)  you should recommend project k because it has the higher irr and will continue to have the higher irr even at the new cost of capital. 
E)  you should reject both projects because they will both have negative npvs under the new conditions.

Question 2

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

Accepted Answer

A) True 
 B)False

Question 3

Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a 4-year payback regardless of economic conditions. Other things held constant, which of the following statements is most likely to be true?

Accepted Answer

A)  it will accept too many long-term projects and reject too many short-term projects (as judged by the npv). 
B)  the firm will accept too many projects in all economic states because a 4-year payback is too low. 
C)  the firm will accept too few projects in all economic states because a 4-year payback is too high. 
D)  if the 4-year payback results in accepting just the right set of projects under average economic conditions, then this payback will result in too few long-term projects when the economy is weak. 
E)  it will accept too many short-term projects and reject too many long-term projects (as judged by the npv).

Question 4

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

Accepted Answer

A) True 
 B)False

Question 5

Which of the following statements is CORRECT?

Accepted Answer

A)  the irr method can never be subject to the multiple irr problem, while the mirr method can be. 
B)  one reason some people prefer the mirr to the regular irr is that the mirr is based on a generally more reasonable reinvestment rate assumption. 
C)  the higher the cost of capital, the shorter the discounted payback period. 
D)  the mirr method assumes that cash flows are reinvested at the crossover rate. 
E)  the mirr and npv decision criteria can never conflict.

Question 6

Markman & Sons is considering Projects S and L. These projects are mutually exclusive, equally risky, and not repeatable and their cash flows are shown below. 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 project with the higher IRR will also have the higher NPV, i.e., no conflict will exist. $\begin{array}{cccccc}
{r}{: 10.00 \%} & & & \
\text { Year } & 0 & 1 & 2 & 3 & 4 \
\mathrm{CF}_{\mathrm{S}} & -\$ 1,025 & \$ 650 & \$ 450 & \$ 250 & \$ 50 \
\mathrm{CF}_{\mathrm{L}} & -\$ 1,025 & \$ 100 & \$ 300 & \$ 500 & \$ 700
\end{array}$

Accepted Answer

A)  $5.47 
B)  $6.02 
C)  $6.62 
D)  $7.29 
E)  $7.82

Question 7

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, and when that happens, we don't know which IRR is relevant.

Accepted Answer

A) True 
 B)False

Question 8

The internal rate of return 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

A) True 
 B)False

Question 9

Watts Co. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's MIRR? Note that a project's MIRR can be less than the cost of capital (and even negative), in which case it will be rejected. $\begin{array} { l c c c c c } 
& r = 10.00 \% \
\text { Year } &0& 1 & 2 & 3 & 4 \
\text { Cash flows } & - \$ 850 & 300 & 320 & 340 & 360
\end{array}$

Accepted Answer

A)  14.08% 
B)  15.65% 
C)  17.21% 
D)  18.94% 
E)  20.83%

Question 10

Projects S and L are both normal projects with an initial cost of $10,000, followed by a series of positive cash inflows. Project S's undiscounted net cash flows total $20,000, while L's total undiscounted flows are $30,000. At a cost of capital of 10%, the two projects have identical NPVs. Which project's NPV is more sensitive to changes in the cost of capital?

Accepted Answer

A)  project l. 
B)  both projects are equally sensitive to changes in the cost of capital since their npvs are equal at all costs of capital. 
C)  neither project is sensitive to changes in the discount rate, since both have npv profiles that are horizontal. 
D)  the solution cannot be determined because the problem gives us no information that can be used to determine the projects' relative irrs. 
E)  project s.

Question 11

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

Accepted Answer

A) True 
 B)False

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.

Accepted Answer

A)  a project's regular irr is found by compounding the cash inflows at the cost of capital to find the present value (pv), then discounting the tv to find the irr. 
B)  if a project's irr is smaller than the cost of capital, then its npv will be positive. 
C)  a project's irr is the discount rate that causes the pv of the inflows to equal the project's cost. 
D)  if a project's irr is positive, then its npv must also be positive. 
E)  a project's regular irr is found by compounding the initial cost at the cost of capital to find the terminal value (tv), then discounting the tv at the cost of capital.

Question 13

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.

Accepted Answer

A)  one drawback of the regular payback for evaluating projects is that this method does not properly account for the time value of money. 
B)  if a project's payback is positive, then the project should be rejected because it must have a negative npv. 
C)  the regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem. 
D)  if a company uses the same payback requirement to evaluate all projects, say it requires a payback of 4 years or less, then the company will tend to reject projects with relatively short lives and accept long-lived projects, and this will cause its risk to increase over time. 
E)  the longer a project's payback period, the more desirable the project is normally considered to be by this criterion.

Question 14

The cost of capital 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 cost of capital. Interest rates are currently high. However, you believe that money costs and thus your cost of capital will soon decline. You also think that the projects will not be funded until the cost of capital 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 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. 
B)  you should recommend project r, because at the new cost of capital it will have the higher npv. 
C)  you should recommend project k, because at the new cost of capital it will have the higher npv. 
D)  you should recommend project r because it will have both a higher irr and a higher npv under the new conditions. 
E)  you should reject both projects because they will both have negative npvs under the new conditions.

Question 15

Hart Corp. 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. 
$\begin{array}{l}
\begin{array} { l } 
\text { Year } \
\text { Cash flows }
\end{array}
\begin{array} { c c c c } 
0 & 1 & 2 & 3 \
\hline - \$ 1,000 & \$ 425 & \$ 425 & \$ 425
\end{array}
\end{array}$

Accepted Answer

A)  12.55% 
B)  13.21% 
C)  13.87% 
D)  14.56% 
E)  15.29%

Question 16

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

Accepted Answer

A) True 
 B)False

Question 17

Which of the following statements is CORRECT?

Accepted Answer

A)  the discounted payback method eliminates all of the problems associated with the payback method. 
B)  when evaluating independent projects, the npv and irr methods often yield conflicting results regarding a project's acceptability. 
C)  to find the mirr, we discount the tv at the irr. 
D)  a project's npv profile must intersect the x-axis at the project's cost of capital. 
E)  the irr method appeals to some managers because it gives an estimate of the rate of return on projects rather than a dollar amount, which the npv method provides.

Question 18

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

Accepted Answer

A) True 
 B)False

Question 19

The regular payback method is deficient in that it does not take account of cash flows beyond the payback period. The discounted payback method corrects this fault.

Accepted Answer

A) True 
 B)False

Question 20

Which of the following statements is CORRECT?

Accepted Answer

A)  if project a's irr exceeds project b's, then a must have the higher npv. 
B)  a project's mirr can never exceed its irr. 
C)  if a project with normal cash flows has an irr less than the cost of capital, the project must have a positive npv. 
D)  if the npv is negative, the irr must also be negative. 
E)  if a project with normal cash flows has an irr greater than the cost of capital, the project must also have a positive npv.

Exam 12: Capital Budgeting: Decision Criteria

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

Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a 4-year payback regardless of economic conditions. Other things held constant, which of the following statements is most likely to be true?

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

Which of the following statements is CORRECT?

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, and when that happens, we don't know which IRR is relevant.

The internal rate of return is that discount rate that equates the present value of the cash outflows (or costs) with the present value of the cash inflows.

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?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.

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

Which of the following statements is CORRECT?

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

The regular payback method is deficient in that it does not take account of cash flows beyond the payback period. The discounted payback method corrects this fault.

Which of the following statements is CORRECT?