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18) Suppose you have an investment that costs $80,000 at the beginning of the project, and it
generates $30,000 a year for four years in positive cash flows. The cost of capital is 12%. The
IRR of the project is 18.45% and the NPV is about $11,120. The IRR model assumes that at the
end of the first year you can invest the $30,000 at ________.
A) 18.45%
B) 12.00%
C) a rate less than the cost of capital
D) a rate greater than the IRR
19) Find the Modified Internal Rate of Return (MIRR) for the following series of future cash
flows, given a discount rate of 9%: Year 0: -$18,000; Year 1: $4,000; Year 2: $5,500; Year 3:
$3,000; Year 4: $9,500; and, Year 5: $2,000.
A) About 9.77%
B) About 10.88%
C) About 12.04%
D) About 13.12%
20) Find the Modified Internal Rate of Return (MIRR) for the following annual series of cash
flows, given a discount rate of 14.00%: Year 0: -$65,000; Year 1: $25,000; Year 2: $12,000;
Year 3: $12,000; Year 4: $12,000; and, Year 5: $12,000.
A) About 6.35%
B) About 7.88%
C) About 8.35%
D) About 9.27%
21) J&E Inc., use the Modified Internal Rate of Return (MIRR) when evaluating projects. J&E's
cost of capital is 8.5%. What is the MIRR of a project if the initial costs are $4,300,000 and the
project lasts five years, with each year producing the same after-tax cash inflows of $1,100,000?
A) About 8.81%
B) About 8.67%
C) About 8.50%
D) About 8.24%
22) The IRR decision criterion is to accept a project if the IRR exceeds the desired or required
return rate and to reject the project if the IRR is less than the desired or required rate of return.
23) The IRR is an unpopular capital budgeting decision model because even with the advent of
calculators and spreadsheets, the cumbersome calculation remains.
24) One problem with the decision criterion of IRR is that if cash flow is not standard, there is a
possibility of multiple IRRs for a single project.
25) One of the underlying assumptions of the IRR model is that all cash inflow can be reinvested
at the individual project's internal rate of return (IRR) over the remaining life of the project.
26) Pandora, Inc. is considering a five-year project that has an initial outlay or cost of $70,000.
The cash inflows from its project for years 1, 2, 3, 4 and 5 are all the same at $14,000. The
borrowing costs are 10%. What is the IRR? Should Pandora use the IRR method to evaluate this
project? Explain.
27) Spotify, Inc. is considering a five-year project that has an initial outlay or cost of $22,000.
The future cash inflows from its project for years 1, 2, 3, 4 and 5 are $15,000, $15,000, $15,000,
$15,000 and -$41,000, respectively. Compute both IRRs. Given these IRRs, compute the two
NPVs. If Spotify's true cost of borrowing for this project is 10%, would Spotify choose the
project?
28) Wyatt and Zachary Enterprises (WZE) uses the Modified Internal Rate of Return (MIRR)
when evaluating projects. WZE's cost of capital is 9.75%. What is the MIRR of a project if the
initial cost is $1,200,000 and the project will last seven years, with each year producing cash
inflows of $290,000? Should WZE accept this project according to the MIRR method? Explain.
38
Copyright © 2019 Pearson Education, Inc.
9.5 Profitability Index
1) Which method is designed to give the dollar amount of return for every $1.00 invested in the
project in terms of current dollars?
A) Profitability Index Method
B) Internal Rate of Return Method
C) Net Present Value Method
D) Discounted Payback Period Method
2) ________ is a modification of NPV to produce the ratio of the present value of the benefits
(future cash inflow) to the present value of the costs (initial investment).
A) Modified Internal Rate of Return Method
B) Profitability Index (PI)
C) Payback Period Method
D) Discounted Cash Flow Method
3) The ________ method of capital budgeting is a ratio of the present value of cash inflows
divided by the initial investment.
A) payback period
B) net present value
C) internal rate of return
D) profitability index
4) Which of the statements below is FALSE?
A) The profitability index (PI) decision criterion states: if PI > 1.0, accept the project.
B) The profitability index (PI) decision criterion states: if PI < 1.0, reject the project.
C) The profitability index (PI) method multiplies the Present Value of Benefits by Present Value
of Costs.
D) If the PI is greater than one, the benefits exceed the costs.
5) Which of the statements below is TRUE?
A) According to the profitability index (PI) decision criterion when the PI is greater than 1, the
costs exceed the benefits.
B) If we realize that NPV is the present value of the benefits minus the present value of the costs,
then we simply need to subtract the costs from the NPV to get the present value of the benefits.
C) There are two acceptable projects, but we can only take one due to a shortage of funds. The PI
for these two projects are: Project A: 2.25; Project B: 1.89. We would take Project B.
D) A PI of 1.50 can be interpreted as meaning that for every $1.00 invested today the firm gets
back $1.50 in current dollars.
6) Nodak, Inc. is currently considering an eight-year project that has an initial outlay or cost of
$160,000. The cash inflows from its project for years 1 through 5 are the same at $55,000.
Nodak has a discount rate of 11%. Because there is a shortage of funds to finance all good
projects, Nodak wants to compute the profitability index (PI) for each project. That way Nodak
can get an idea as to which project might be a better choice. What is the PI for Nodak's current
project?
A) About 1.27
B) About 1.24
C) About 1.19
D) About 1.09
7) Project A has an NPV of $20,000 and a PI of 1.2. Project B has an NPV of $10,000 and a PI
of 1.3. Both projects have equal lives. Which project should be preferred if we are NOT
concerned with capital rationing (that is, we are NOT concerned with being short of funds)?
A) We should prefer Project B since it has a higher PI.
B) We should compute the EAA before we make any decision.
C) We should prefer Project A since it has a higher NPV.
D) We should prefer Project B if it has a higher IRR.
8) B&H, Inc. is currently considering an five-year project that has an initial outlay or cost of
$220,000. The future cash inflows from its project for years 1 through 5 are the same at $50,000.
B&H has a discount rate of 8%. Because of capital rationing (shortage of funds for financing),
B&H wants to compute the profitability index (PI) for each project. What is the PI for B&H's
current project?
A) About 0.91
B) About 1.00
C) About 1.19
D) About 1.39
9) InnerC, Inc. is currently considering an five-year project that has an initial outlay or cost of
$60,000. The future cash inflows from its project for years 1 through 5 are the same at $20,000.
InnerC has a discount rate of 15%. Because of concerns about funds being short to finance all
good projects, InnerC wants to compute the profitability index (PI) for each project. What is the
PI for InnerC's current project?
A) About 0.82
B) About 0.92
C) About 1.02
D) About 1.12
10) The present value of the benefits and costs needed to calculate Profitability Index (PI) is the
same information one finds when computing the NPV.
11) When the Profitability Index (PI) is greater than 1, the benefits exceed the costs.
12) A firm is considering four projects with the following PIs, NPVs, and Costs. Project A: PI of
1.3, NPV of $3,600, and cost of $12,000; Project B: PI of 1.4, NPV of $5,600, and cost of
$14,000; Project C: PI of 1.5, NPV of $5,000, and cost of $10,000; Project D: PI of 2.1, NPV of
$8,800, and cost of $8,000. Rank the projects from best to worst in terms of their NPVs. Now
rank the projects from best to worst in terms of their PIs.
1) The ________ method is simple and fast but economically unsound as it ignores all cash flow
after the cutoff date and ignores the time-value of money.
A) Payback Period
B) MIRR
C) Net Present Value
D) IRR
2) The ________ model incorporates the time-value of money but still ignores cash flows after
the cutoff date.
A) Payback Period
B) Discounted Payback Period
C) IRR
D) Modified Internal Rate of Return
3) The ________ method is economically sound and properly ranks projects across various sizes,
time horizons, and levels of risk, without exception for all independent projects.
A) NPV
B) Discounted Payback Period
C) Profitability Index
D) Modified IRR
4) The ________ model provides a single measure (return) but must apply risk outside the
model, thus allowing for errors in rankings of projects.
A) Payback Period
B) IRR
C) Net Present Value
D) Profitability Index
5) ________ corrects for most, but not all, of the problems of IRR and gives the solution in terms
of a return.
A) Profitability Index
B) Discounted Payback Period
C) Net Present Value
D) MIRR
6) The discounted payback method, net present value method (NPV), internal rate of return
(IRR), modified internal rate of return (MIRR), and profitability index (PI) are all consistent with
the time value of money.
7) Calculating IRR, NPV, or MIRR is easy and efficient using a spreadsheet once you know the
relevant cash flow, the timing of the cash flow, the cost of capital, and the reinvestment rate.
8) According to an academic survey of large and small U.S. businesses, the IRR method of
capital budgeting is slightly preferred over NPV by the survey respondents.
9) Describe three of the six decision models used in capital budgeting decision-making and
briefly evaluate their effectiveness.
