978-0133507676 chapter 8 Part 1

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Fundamentals of Corporate Finance, 3e (Berk/DeMarzo/Harford)

Chapter 8 Investment Decision Rules

8.1 The NPV Decision Rule

1) Preference for cash today versus cash in the future in part determines net present value

(NPV).

AACSB Objective: Analytic Skills

Author: DS

Question Status: Previous Edition

2) Net present value (NPV) is the diference between the present value (PV) of the beneits

and the present value (PV) of the costs of a project or investment.

AACSB Objective: Analytic Skills

Author: DS

Question Status: Previous Edition

3) Most corporations measure the value of a project in terms of which of the following?

A) discount value

B) discount factor

C) future value (FV)

D) present value (PV)

AACSB Objective: Analytic Skills

Author: DS

Question Status: Previous Edition

4) The present value (PV) of an investment is ________.

A) the amount that an investment would yield if the beneit were realized today

B) the diference between the cost of the investment and the beneit of the investment in

dollars today

C) the amount you need to invest at the current interest rate to re-create the cash low

from the investment

D) the amount by which the cash low of an investment exceeds or falls short of the cash

low generated by the same amount of money invested at market rate

AACSB Objective: Relective Thinking Skills

Author: DS

Question Status: Revised

5) Tanner is choosing between two investment options. He can invest $500 now and get

(guaranteed) $550 in one year, or invest $500 now and get (guaranteed) $531.40 back later

today. The risk-free rate is 3.5%. Which investment should Tanner prefer?

A) $531.40 later today, since $1 today is worth more than $1 in one year.

B) $550 in one year, since it is $50 more than he invested rather than $31.40 more than he

invested.

C) Neither – both investments have a negative NPV.

D) Tanner should be indiferent between the two investments, since both are equivalent to

the same amount of cash today.

AACSB Objective: Analytic Skills

Author: JP

Question Status: Revised

6) A irm has an opportunity to invest $95,000 today that will yield $109,250 in one year. If

interest rates are 4%, what is the net present value (NPV) of this investment?

A) $10,048

B) $11,053

C) $16,077

D) $14,250

AACSB Objective: Analytic Skills

Author: DS

Question Status: Revised

7) A car dealership ofers a car for $14,000, with up to one year to pay for the car. If the

interest rate is 5%, what is the net present value (NPV) of this ofer to buyers who elect not

to pay for the car for one year?

A) $667

B) $1333

C) $13,333

D) $14,000

AACSB Objective: Analytic Skills

Author: DS

Question Status: Revised

8) Martin is ofered an investment where for $6000 today, he will receive $6180 in one

year. He decides to borrow $6000 from the bank to make this investment. What is the

maximum interest rate the bank needs to ofer on the loan if Martin is at least to break

even on this investment?

A) 1%

B) 2%

C) 3%

D) 4%

AACSB Objective: Analytic Skills

Author: DS

Question Status: Revised

9) A security irm is ofered $80,000 in one year for providing CCTV coverage of a property.

The cost of providing this coverage to the security irm is $74,000, payable now, and the

interest rate is 8.5%. Should the irm take the contract?

A) Yes, since net present value (NPV) is positive.

B) It does not matter whether the contract is taken or not, since NPV = 0.

C) Yes, since net present value (NPV) is negative.

D) No, since net present value (NPV) is negative.

AACSB Objective: Analytic Skills

Author: DS

Question Status: Revised

10) A farmer sows a certain crop. It costs $240,000 to buy the seed, prepare the ground,

and sow the crop. In one year’s time it will cost $93,200 to harvest the crop. If the crop will

be worth $350,000, and the interest rate is 7%, what is the net present value (NPV) of this

investment?

A) $240,000

B) $87,103

C) $0

D) $567,103

AACSB Objective: Analytic Skills

Author: DS

Question Status: Revised

11) A delivery service is buying 600 tires for its leet of vehicles. One supplier ofers to

supply the tires for $80 per tire, payable in one year. Another supplier will supply the tires

for $20,000 down today, then $45 per tire, payable in one year. What is the diference in PV

between the irst and the second ofer, assuming interest rates are 8.1%?

A) -$860

B) -$229

C) -$574

D) $860

AACSB Objective: Analytic Skills

Author: DS

Question Status: Previous Edition

12) Peter has a business opportunity that requires him to invest $10,000 today, and receive

$12,000 in one year. He can either use $10,000 that he already has for this investment or

borrow the money from his bank at an interest rate of 10%. However, the $10,000 he has

right now is needed for urgent repairs to his home, repairs that will cost at least $15,000 if

he delays them for a year. What is the best alternative for Peter out of the following

choices?

A) No, since the net present value (NPV) of the investment, should he take it, is less than

the net present value (NPV) of the home repairs if he delays them for one year.

B) Yes, since he can borrow the $10,000 from a bank, repair his home, invest $10,000 in

the business opportunity, which, since it has a NPV > 0 will mean he will still come out

ahead after repaying the loan.

C) Yes, since the net present value (NPV) of the investment is greater than zero he can

invest the $10,000 in the business opportunity, and then next year use this money plus the

beneit from this money to make the necessary home repairs.

D) Yes, since the net present value (NPV) of the investment, should he take it, is greater

than the net present value (NPV) of the home repairs if he delays them for one year.

AACSB Objective: Relective Thinking Skills

Author: DS

Question Status: Revised

13) What is the Net Present Value rule?

AACSB Objective: Analytic Skills

Author: SS

Question Status: Revised

14) Should personal preferences for cash today versus cash tomorrow play a role in the net

present value (NPV) decision-making process?

AACSB Objective: Relective Thinking Skills

Author: SS

Question Status: Revised

8.2 Using the NPV Rule

1) The Net Present Value rule implies that we should compare a project’s net present value

(NPV) to zero.

AACSB Objective: Analytic Skills

Author: DS

Question Status: Revised

2) An auto-parts company is deciding whether to sponsor a racing team for a cost of $1

million. The sponsorship would last for three years and is expected to increase cash lows

by $570,000 per year. If the discount rate is 6.9%, what will be the change in the value of

the company if it chooses to go ahead with the sponsorship?

A) $498,597

B) $747,896

C) $797,756

D) $847,615

AACSB Objective: Analytic Skills

Author: DS

Question Status: Revised

3) An orcharder spends $110,000 to plant pomegranate bushes. It will take four years for

the bushes to provide a usable crop. He estimates that every year for 20 years after that he

will receive a crop worth $10,500 per year. If the discount rate is 9%, what is the net

present value (NPV) of this investment?

A) -$42,098

B) -$21,049

C) $8420

D) $12,629

AACSB Objective: Analytic Skills

Author: DS

Question Status: Revised

4) The owners of a chain of fast-food restaurants spend $25 million installing donut makers

in all their restaurants. This is expected to increase cash lows by $11 million per year for

the next ive years. If the discount rate is 5.3%, were the owners correct in making the

decision to install donut makers?

A) No, as it has a net present value (NPV) of -$4.45 million.

B) No, as it has a net present value (NPV) of -$2.22 million.

C) Yes, as it has a net present value (NPV) of $13.34 million.

D) Yes, as it has a net present value (NPV) of $22.23 million.

AACSB Objective: Analytic Skills

Author: DS

Question Status: Revised

Use the information for the question(s) below.

5) The owner of a hair salon spends $1,000,000 to renovate its premises, estimating that

this will increase her cash low by $220,000 per year. She constructs the above graph,

which shows the net present value (NPV) as a function of the discount rate. At what

discount rate does her decision to renovate become untenable?

A) 3.0%

B) 3.3%

C) 4.0%

D) 4.8%

AACSB Objective: Analytic Skills

Author: DS

Question Status: Previous Edition

6) The owner of a hair salon spends $1,000,000 to renovate its premises, estimating that

this will increase her cash low by $220,000 per year. She constructs the above graph,

which shows the net present value (NPV) as a function of the discount rate. If her discount

rate is 6%, should she accept the project?

A) Yes, because the NPV is positive at that rate.

B) No, because the NPV is negative at that rate.

C) No, because the NPV is positive at that rate.

D) Cannot be determined from the information given.

AACSB Objective: Analytic Skills

Author: JP

Question Status: Revised

7) The owner of a hair salon spends $1,000,000 to renovate its premises, estimating that

this will increase her cash low by $220,000 per year. She constructs the above graph,

which shows the net present value (NPV) as a function of the discount rate. At what dollar

value should the NPV proile cross the vertical axis?

A) $780,000

B) $1,000,000

C) Cannot be determined because inadequate information is given.

D) The vertical axis crossing point cannot be calculated since the cash inlows are in

perpetuity.

AACSB Objective: Analytic Skills

Author: JP

Question Status: Revised

8) A bakery is deciding whether to buy an extra van to help deliver its products. The van

will cost $28,000, but is expected to increase proits by $6,500 per year over the ive years

of its working life. Which of the following is the correct net present value (NPV) proile for

this purchase?

AACSB Objective: Analytic Skills

Author: DS

Question Status: Revised

9) A manufacturer of video games develops a new game over two years. This costs

$830,000 per year with one payment made immediately and the other at the end of two

years. When the game is released, it is expected to make $1.20 million per year for three

years after that. What is the net present value (NPV) of this decision if the cost of capital is

10%?

A) $950,349

B) $1,045,384

C) $1,520,559

D) $1,805,663

AACSB Objective: Analytic Skills

Author: DS

Question Status: Revised