Principles of Finance, 6e
Besley/Brigham
Chapter 13
Cengage Learning Testing, Powered by Cognero
Page 61
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password-protected website for classroom use.
cash flows shown below. Your required rate of return is 10 percent. How much value will your firm sacrifice if it selects
the project with the higher IRR?
Project S:
Project L:
a.
$243.43
b.
$291.70
c.
$332.50
d.
$481.15
e.
$535.13
ANSWER:
b
RATIONALE:
NPVS = $243.43; IRRS = 23.38%. NPVL = $535.13; IRRL = 20.00%. Value sacrificed:
$535.13 − $243.43 = $291.70.
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
NPV and IRR
97. Foster Industries has a project which has the following cash flows:
Year
0
1
2
3
4
What cash flow will the project have to generate in the fourth year in order for the project to have an internal rate of return
of 15 percent?
a.
$15.55
b.
$58.95
c.
$100.25
d.
$103.10
e.
$150.75
ANSWER:
d
POINTS:
1
Principles of Finance, 6e
Besley/Brigham
Chapter 13
Cengage Learning Testing, Powered by Cognero
Page 63
100. A company is analyzing two mutually exclusive projects, S and L, whose cash flows are shown below:
The company’s required rate of return is 12 percent. What is the IRR of the better project? (Hint: Note that the better
project may or may not be the one with the higher IRR.)
a.
13.09%
b.
12.00%
c.
17.46%
d.
13.88%
e.
12.53%
ANSWER:
a
RATIONALE:
Financial calculator solution: Calculate the NPV and IRR of each project then select the
IRR of the higher NPV project Project S Inputs: CF0 = −1,100; CF1 = 900; CF2 = 350;
CF3 = 50; CF4 = 10; I = 12. Output: NPVS = 24.53; IRRS = 13.88%. Project L Inputs: CF0
= −1,100; CF1 = 0; CF2 = 300; CF3 = 500; CF4 = 850; I = 12. Output: NPVL = 35.24; IRRL
= 13.09%. Project L has the higher NPV and its IRR = 13.09%.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
NPV and IRR
101. Ryngaert Industries uses the NPV method to establish its capital budget, and it is now considering two mutually
exclusive projects whose after-tax cash flows are shown below:
Year
Project L
0
−$7,000
1
900
2
4,000
3
5,000
If the required rate of return is below some rate, then Project L should be selected, whereas if the required rate of return is
above that rate then Project S should be selected. What is the “crossover” rate at which the NPV profiles of these projects
intersect?
a.
5.21%
b.
7.55%
c.
11.88%
d.
15.66%
e.
18.14%
Principles of Finance, 6e
Besley/Brigham
Chapter 13
POINTS:
1
DIFFICULTY:
Moderate
TOPICS:
Year
100,000
45,000
105,000
65,000
40,000
80,000
10.3%
ANSWER:
c
RATIONALE:
Consistently subtract the periodic cash flow of one project from the other, and use the
difference as the cash flow for that period to determine the IRR. This will be the
“crossover rate” of their NPV profiles.
Year
0
1
2
3
CF0 = 2,000; CF1 = 1,100; CF2 = −1,500; CF3 = −2,500. Solve for IRR = 11.88%.
Alternatively, graph the NPV profiles of each project and “eyeball” the crossover rate. If
we determine the X-axis intercept (IRR) and the Y-axis intercept (NPV when k = 0), then
we can draw each NPV profile.
S
L
NPV at r = 0
$2,000
NPV at r = 0
$2,900
IRRS
= 18.14%
IRRL
= 15.66%
Principles of Finance, 6e
Besley/Brigham
Chapter 13
TOPICS:
NPV Profiles
a.
14−15%
b.
15−16%
c.
16−17%
d.
17−18%
e.
18−19%
ANSWER:
e
b.
13.5%
c.
15.8%
d.
21.7%
e.
34.8%
ANSWER:
d
RATIONALE:
To determine the crossover rate, find the differential cash flows between the 2 projects
and then calculate the IRR of those differential cash flows.
Project D, A − B
0
−50,000
1
55,000
2
40,000
3
−40,000
IRRD = 21.7%. Alternatively, you could draw the NPV profiles of the 2 projects. We can
obtain the Y- and X-axis intercept points to draw the NPV profiles.
A
B
Y-intercept, r = 0
$95,000
$90,000
X-intercept, IRR
33.8%
36.0%
The intersection point or crossover rate
occurs between 20% and 25%, so the correct choice must be d.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Principles of Finance, 6e
Besley/Brigham
Chapter 13
POINTS:
1
DIFFICULTY:
Hard
Blooms Taxonomy-2 – Application
0
−$100
1
10
2
30
3
40
4
60
Is there a crossover point in the relevant part of a NPV profile graph (the northeast, or upper right, quadrant)?
a.
No.
b.
Yes, at r ≈ 7%.
c.
Yes, at r ≈ 9%.
d.
Yes, at r ≈ 11%.
e.
Yes, at r ≈ 13%.
ANSWER:
b
RATIONALE:
Cash flow time line: Financial calculator
solution: Project X Inputs: CF0 = −100; CF1 = 50; CF2 = 40; CF3 = 30; CF4 = 10. Output:
IRR = 14.489% ≈ 14.49%. Project Y Inputs: CF0 = −100; CF1 = 10; CF2 = 30; CF3 = 40;
CF4 = 60. Output: IRR = 11.79%. Calculate the NPVs of the projects at r = 0 discount
rate. NPVX,r = 0% = −100 + 50 + 40 + 30 + 10 = 30. NPVY,r = 0% = −100 + 10 + 30 + 40 +
Principles of Finance, 6e
Besley/Brigham
Chapter 13
Cengage Learning Testing, Powered by Cognero
Page 71
1
0.20
$100,000
$ 20,000
2
0.32
100,000
32,000
3
0.19
100,000
19,000
4
0.12
100,000
12,000
5
0.11
100,000
11,000
6
0.06
100,000
6,000
$100,000
Project analysis worksheet:
I
Initial investment outlay
1)
Machine cost
($100,000)
2)
Decrease in NWC
—
3)
Total net inv.
($100,000)
II
Supplemental operating cash flows
Year: 0
1
2
3
4
5
6
4)
Inc. in before
tax &
depr.
earnings
$15,500
$15,500
$15,500
$15,500
$15,500
$15,500
5)
After-tax inc.
in
revenues
9,300
9,300
9,300
9,300
9,300
9,300
6)
Depr. (table)
20,000
32,000
19,000
12,000
11,000
6,000
7)
Tax savings
deprec.
(line 6 × 0.4)
8,000
12,800
7,600
4,800
4,400
2,400
8)
Net operating
CFs
(line 5 + 7)
$17,300
$22,100
$16,900
$14,100
$13,700
$11,700
III
Terminal CF
9)
Estimated salvage
value
0
10)
Tax on salvage value
0
11)
Return of NWC
0
12)
Net CF
0
IV
Net CFs
13)
Total Net CFs
($100,000)
$17,300
$22,100
$16,900
$14,100
$13,700
$11,700
Financial calculator solution: Inputs: CF0 = −100,000; CF1 = 17,300; CF2 = 22,100; CF3 =
16,900; CF4 = 14,100; CF5 = 13,700; CF6 = 11,700; I = 12. Output: IRR = −1.32%.
POINTS:
1
DIFFICULTY:
Hard
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
Principles of Finance, 6e
Besley/Brigham
Chapter 13
Cengage Learning Testing, Powered by Cognero
Page 77
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
throughout the entire life of a project.
a.
True
b.
False
ANSWER:
False
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Payback Period
127. Assuming that the total cash flows are equal, the NPV of a project whose cash flows accrue relatively rapidly is more
sensitive to changes in the discount rate than is the NPV of a project whose cash flows come in more slowly.
a.
True
b.
False
ANSWER:
False
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
NPV
128. The internal rate of return is that discount rate which equates the present value of the cash outflows (or costs) with
the present value of the cash inflows.
a.
True
b.
False
ANSWER:
True
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
IRR
129. The internal rate of return (IRR) method of evaluating investment projects equates the present value of cash inflows
with the present value of cash outflows by discounting all of the cash flows at the firm’s required rate of return.
a.
True
b.
False
ANSWER:
False
POINTS:
1
Cengage Learning Testing, Powered by Cognero
Page 79
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
133. The phenomenon called “multiple internal rates of return” arises when two or more mutually exclusive projects
which have different lives are being compared.
a.
True
b.
False
ANSWER:
False
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
IRR
134. If a project’s NPV exceeds the project’s IRR, then the project should be accepted.
a.
True
b.
False
ANSWER:
False
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
NPV and IRR
135. Conflicts between two mutually exclusive projects, where the NPV method chooses one project but the IRR method
chooses the other, should generally be resolved in favor of the project with the higher NPV.
a.
True
b.
False
ANSWER:
True
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Mutually Exclusive Projects
136. Since the focus of capital budgeting is on cash flows rather than on net income, changes in noncash balance sheet
accounts such as inventory are not relevant in the analysis.
a.
True
b.
False
ANSWER:
False