978-0132757089 Chapter 11 Part 4

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Principles: Principle 1: Money Has a Time Value

38) What is the payback period for a $20,000 project that is expected to return $6,000 for the

first two years and $3,000 for Years 3 through 5?

A) 3 1/2

B) 4 1/2

C) 4 2/3

D) 5

Topic: 11.3 Other Investment Criteria

Keywords: payback period

Principles: Principle 1: Money Has a Time Value

39) One drawback of the payback method is that it focuses primarily on the length of time in

which the cost of the investment is recovered in nominal terms versus measuring total value the

project will add to the firm.

Topic: 11.3 Other Investment Criteria

Keywords: payback period

Principles: Principle 1: Money Has a Time Value

40) One of the disadvantages of the payback method is that it ignores cash flows beyond the

payback period.

Topic: 11.3 Other Investment Criteria

Keywords: payback period

Principles: Principle 1: Money Has a Time Value

41) When several sign reversals in the cash flow stream occur, the IRR equation can have more

than one positive IRR.

Topic: 11.3 Other Investment Criteria

Keywords: internal rate of return

Principles: Principle 1: Money Has a Time Value

42) If the project’s payback period is greater than or equal to zero, the project should always be

accepted.

Topic: 11.3 Other Investment Criteria

Keywords: payback period

Principles: Principle 1: Money Has a Time Value

43) The profitability index provides the same decision result as the net present value (NPV)

method.

Topic: 11.3 Other Investment Criteria

Keywords: profitability index

Principles: Principle 1: Money Has a Time Value

44) The internal rate of return (IRR) will increase as the required rate of return of a project is

increased.

Topic: 11.3 Other Investment Criteria

Keywords: internal rate of return

Principles: Principle 1: Money Has a Time Value

45) The IRR assumes that cash flows are reinvested at the cost of capital.

Topic: 11.3 Other Investment Criteria

Keywords: internal rate of return

Principles: Principle 1: Money Has a Time Value

46) If the NPV of a project is zero, then the profitability index should equal one.

Topic: 11.3 Other Investment Criteria

Keywords: profitability index

Principles: Principle 1: Money Has a Time Value

47) It is possible for a project to have more than one IRR if there is more than one sign change in

the after-tax cash flows due to the project.

Topic: 11.3 Other Investment Criteria

Keywords: internal rate of return

Principles: Principle 1: Money Has a Time Value

48) According to the modified internal rate of return (MIRR) technique, when a project’s MIRR

is greater than its cost of capital, the project should be accepted.

Topic: 11.3 Other Investment Criteria

Keywords: modified internal rate of return

Principles: Principle 1: Money Has a Time Value

49) The IRR is the discount rate that equates the present value of the project’s future net cash

flows with the project’s initial outlay.

Topic: 11.3 Other Investment Criteria

Keywords: internal rate of return

Principles: Principle 1: Money Has a Time Value

50) Determine the IRR on the following projects:

a. Initial outlay of $35,000 with an after-tax cash flow at the end of the year of $5,836 for seven

years

b. Initial outlay of $350,000 with an after-tax cash flow at the end of the year of $70,000 for

seven years

c. Initial outlay of $3,500 with an after-tax cash flow at the end of the year of $1,500 for three

years

Topic: 11.3 Other Investment Criteria

Keywords: internal rate of return

Principles: Principle 1: Money Has a Time Value

51) Discuss the merits and shortcomings of using the payback period for capital budgeting

decisions.

Topic: 11.3 Other Investment Criteria

Keywords: payback period

Principles: Principle 1: Money Has a Time Value

52) Project November requires an initial investment of $500,000. The present value of operating

cash flows is $550,000. Project December requires an initial investment of $750,000. The present

value of operating cash flows is $810,000.

a. Compute the profitability index for each project.

b. If the the projects are mutually exclusive, does the profitability index rank them correctly?

1.08.

b. The PI criterion would select project November because it has the higher PI. December,

however, has the higher NPV ($60,000 v. $50,000) and should be selected, so the method does

not rank the projects correctly.

Topic: 11.3 Other Investment Criteria

Keywords: profitability index

3 ($100,0000)

a. What is the payback period for this project?

b. What is the obvious problem with using the payback method in this case?

Topic: 11.3 Other Investment Criteria

Keywords: payback period

Principles: Principle 1: Money Has a Time Value

54) Tinker Tools, Inc. is considering a project with the following cash flows. Calculate the MIRR

of the project assuming a reinvestment rate of 8%.

4 $100,000

Topic: 11.3 Other Investment Criteria

Keywords: modified internal rate of return

Principles: Principle 1: Money Has a Time Value

1) Recent surveys of the CFOs of large U.S. companies rank the popularity of major capital

budgeting methods in which order?

A) IRR, NPV, Payback, Discounted Payback, Profitability Index

B) Payback, Discounted Payback, Profitability Index,IRR, NPV

C) NPV, IRR, Profitability Index, Discounted Payback, Payback

D) NPV, IRR, Payback, Discounted Payback, Profitability Index

Topic: 11.4 A Glance at Actual Capital-Budgeting Practices

Keywords: current practice

Principles: Principle 3: Cash Flows Are the Source of Value

2) Which of the following best explains the continuing popularity of the payback method?

A) Mathematical simplicity and some insight into the riskiness of cash flows.

B) Uses all cash flows and takes into account the time value of money.

C) Reliably selects the projects that add most value to the firm.

D) It provides objective selection criteria and is taught as the primary method in most business

schools.

Topic: 11.4 A Glance at Actual Capital-Budgeting Practices

Keywords: current practice

Principles: Principle 3: Cash Flows Are the Source of Value

3) With respect to the capital budgeting practices of large U. S. corporations:

A) the profitability index has been gaining in popularity.

B) IRR and NPV have been gaining in popularity.

C) payback and discounted payback have been gaining in popularity.

D) IRR and NPV have declined in popularity.

Topic: 11.4 A Glance at Actual Capital-Budgeting Practices

Keywords: current practice

Principles: Principle 3: Cash Flows Are the Source of Value

4) Many firms today continue to use the payback method but employ the NPV or IRR methods

as secondary decision methods of control for risk.

Topic: 11.4 A Glance at Actual Capital-Budgeting Practices

Keywords: current practice

Principles: Principle 3: Cash Flows Are the Source of Value

5) Currently, most firms use NPV and IRR as their primary capital-budgeting technique.

Topic: 11.4 A Glance at Actual Capital-Budgeting Practices

Keywords: current practice

Principles: Principle 3: Cash Flows Are the Source of Value

6) Most firms use the payback period as a secondary capital-budgeting technique, which in a

sense allows them to control for risk.

Topic: 11.4 A Glance at Actual Capital-Budgeting Practices

Keywords: current practice

Principles: Principle 3: Cash Flows Are the Source of Value

7) Although discounted cash flow decision techniques have become widely accepted, their use

depends to some degree on the size of the project and where within the firm the decision is being

made.

Topic: 11.4 A Glance at Actual Capital-Budgeting Practices

Keywords: current practice

Principles: Principle 3: Cash Flows Are the Source of Value

8) Briefly describe the actual capital budgeting methods of large U.S. corporations.

Topic: 11.4 A Glance at Actual Capital-Budgeting Practices

Keywords: current practice

Principles: Principle 3: Cash Flows Are the Source of Value