Corporate Finance, 3e (Berk/DeMarzo)
Chapter 7 Investment Decision Rules
7.1 NPV and Stand-Alone Projects
1) Which of the following statements is FALSE?
A) About 75% of firms surveyed used the NPV rule for making investment decisions.
B) If you are unsure of your cost of capital estimate, it is important to determine how sensitive
your analysis is to errors in this estimate.
C) To decide whether to invest using the NPV rule, we need to know the cost of capital.
D) NPV is positive only for discount rates greater than the internal rate of return.
Use the following information to answer the question(s) below.
Sarah Palin reportedly was paid a $11 million advance to write her book Going Rogue. The book
took one year to write. In the time she spent writing, Palin could have been paid to give speeches
and appear on TV news as a political commentator. Given her popularity, assume that she could
have earned $8 million over the year (paid at the end of the year) she spent writing the book.
2) Assume that once her book is finished, it is expected to generate royalties of $5 million in the
first year (paid at the end of the year) and these royalties are expected to decrease by 40% per
year in perpetuity. Assuming that Palin’s cost of capital is 10% and given these royalties
payments, the NPV of Palin’s book deal is closest to:
A) $3.75 million
B) $12.20 million
C) $13.00 million
D) $13.75 million
3) Which of the following statements is FALSE?
A) In general, the difference between the cost of capital and the IRR is the maximum amount of
estimation error in the cost of capital estimate that can exist without altering the original
decision.
B) The IRR can provide information on how sensitive your analysis is to errors in the estimate of
your cost of capital.
C) If you are unsure of your cost of capital estimate, it is important to determine how sensitive
your analysis is to errors in this estimate.
D) If the cost of capital estimate is more than the IRR, the NPV will be positive.
Use the following information to answer the question(s) below.
You are considering investing in a start up project at a cost of $100,000. You expect the project
to return $500,000 to you in seven years. Given the risk of this project, your cost of capital is
20%.
4) The NPV for this project is closest to:
A) $29,200
B) $39,500
C) $129,200
D) $139,500
5) The IRR for this project is closest to:
A) 15.60%
B) 18.95%
C) 20.00%
D) 25.85%
6) The decision you should take regarding this project is
A) reject the project since the NPV is negative.
B) reject the project since the NPV is positive.
C) accept the project since the IRR < 20%.
D) accept the project since the IRR > 20%.
Use the following information to answer the question(s) below.
Sarah Palin reportedly was paid a $11 million advance to write her book Going Rogue. The book
took one year to write. In the time she spent writing, Palin could have been paid to give speeches
and appear on TV news as a political commentator. Given her popularity, assume that she could
have earned $8 million over the year (paid at the end of the year) she spent writing the book.
Assume that she was unable to fulfill her media commitments of appearing on TV news as a
political commentator or give speeches.while she was writing the book.
7) Assuming that Palin’s cost of capital is 10%, then the NPV of her book deal is closest to:
A) $2.00 million
B) $2.20 million
C) $3.00 million
D) $3.75 million
8) The IRR of Palin’s book deal is closest to:
A) -27.25%
B) -37.50%
C) 27.25%
D) 37.50%
Use the table for the question(s) below.
Consider a project with the following cash flows:
Year Cash Flow
0 -10,000
1 4,000
2 4,000
3 4,000
4 4,000
9) If the appropriate discount rate for this project is 15%, then the NPV is closest to:
A) $6,000
B) -$867
C) $1,420
D) $867
Use the table for the question(s) below.
Consider the following two projects:
Project Year 0
Cash Flow Year 1
Cash Flow Year 2
Cash Flow Year 3
Cash Flow Year 4
Cash Flow Discount Rate
A -100 40 50 60 N/A .15
B -73 30 30 30 30 .15
10) The NPV of project A is closest to:
A) 12.0
B) 12.6
C) 15.0
D) 42.9
11) The NPV of project B is closest to:
A) 12.6
B) 23.3
C) 12.0
D) 15.0
Use the information for the question(s) below.
The Sisyphean Company is planning on investing in a new project. This will involve the
purchase of some new machinery costing $450,000. The Sisyphean Company expects cash
inflows from this project as detailed below:
Year One Year Two Year Three Year Four
$200,000 $225,000 $275,000 $200,000
The appropriate discount rate for this project is 16%.
12) The NPV for this project is closest to:
A) $176,270
B) $123,420
C) $450,000
D) $179,590
Use the table for the question(s) below.
Consider the following two projects:
Project Year 0
C/F Year 1
C/F Year 2
C/F Year 3
C/F Year 4
C/F Year 5
C/F Year 6
C/F Year 7
C/F Discount
Rate
Alpha -79 20 25 30 35 40 N/A N/A 15%
Beta -80 25 25 25 25 25 25 25 16%
13) The NPV for project alpha is closest to:
A) $20.96
B) $16.92
C) $24.01
D) $14.41
14) The NPV for project beta is closest to:
A) $24.01
B) $16.92
C) $20.96
D) $14.41
Use the information for the question(s) below.
Larry the Cucumber has been offered $14 million to star in the lead role of the next three Larry
Boy adventure movies. If Larry takes this offer, he will have to forgo acting in other Veggie
movies that would pay him $5 million at the end of each of the next three years. Assume Larry’s
personal cost of capital is 10% per year.
15) The NPV of Larry’s three movie Larry Boy offer is closest to:
A) 3.5 million
B) -1.6 million
C) 1.6 million
D) -1.0 million
Use the information for the question(s) below.
Boulderado has come up with a new composite snowboard. Development will take Boulderado
four years and cost $250,000 per year, with the first of the four equal investments payable today
upon acceptance of the project. Once in production the snowboard is expected to produce annual
cash flows of $200,000 each year for 10 years. Boulderado’s discount rate is 10%.
16) The NPV for Boulderado’s snowboard project is closest to:
A) $228,900
B) $46,900
C) $51,600
D) $23,800
17) The NPV profile graphs:
A) the project’s NPV over a range of discount rates.
B) the project’s IRR over a range of discount rates.
C) the project’s cash flows over a range of NPVs.
D) the project’s IRR over a range of NPVs.
18) The NPV profile
A) shows the payback period – the point at which NPV is positive.
B) shows the internal rate of return – the point at which NPV is zero.
C) shows the NPV over a range of discount rates.
D) B and C are correct.
7.2 The Internal Rate of Return Rule
Use the following information to answer the question(s) below.
Frank Dewey Esquire from the firm of Dewey, Cheatum, and Howe, has been offered an upfront
retainer of $30,000 to provide legal services over the next 12 months to Taggart
Transcontinental. In return for this upfront payment, Taggart Transcontinental would have access
to 8 hours of legal services from Frank for each of the next 12 months. Frank’s normal billable
rate is $250 per hour for legal services.
1) Assuming that Dewey’s cost of capital is 12% EAR, then the NPV of his retainer offer is
closest to:
A) -$7,500
B) -$7,400
C) $6,000
D) $7,400
2) Assuming that Dewey’s cost of capital is 12% EAR, then the IRR of his retainer offer is
closest to:
A) -39.3%
B) -3.3%
C) 20.0%
D) 39.3%
3) Assuming that Dewey’s cost of capital is 12% EAR, then the number of potential IRRs that
exist for this problem is equal to:
A) 0
B) 1
C) 2
D) 12
Use the following information to answer the question(s) below.
Rearden Metals is considering opening a strip mining operation to provide some of the raw
materials needed in producing Rearden metal. The initial purchase of the land and the associated
costs of opening up mining operations will cost $100 million today. The mine is expected to
generate $16 million worth of ore per year for the next 12 years. At the end of the 12th year
Rearden will need to spend $20 million to restore the land to its original pristine nature
appearance.
4) The number of potential IRRs that exist for Rearden’s mining operation is equal to:
A) 0
B) 1
C) 2
D) 12
5) One of the IRR for Rearden’s mining operation is closest to:
A) 0%
B) 10.6%
C) 12.4%
D) 72.0%
6) Which of the following statements is FALSE?
A) The IRR investment rule will identify the correct decision in many, but not all, situations.
B) By setting the NPV equal to zero and solving for r, we find the IRR.
C) If you are unsure of your cost of capital estimate, it is important to determine how sensitive
your analysis is to errors in this estimate.
D) The simplest investment rule is the NPV investment rule.
7) Which of the following statements is FALSE?
A) The IRR investment rule states you should turn down any investment opportunity where the
IRR is less than the opportunity cost of capital.
B) The IRR investment rule states that you should take any investment opportunity where the
IRR exceeds the opportunity cost of capital.
C) Since the IRR rule is based upon the rate at which the NPV equals zero, like the NPV
decision rule, the IRR decision rule will always identify the correct investment decisions.
D) There are situations in which multiple IRRs exist.
Use the table for the question(s) below.
Consider a project with the following cash flows:
Year Cash Flow
0 -10,000
1 4,000
2 4,000
3 4,000
4 4,000
8) Assume the appropriate discount rate for this project is 15%. The IRR for this project is
closest to:
A) 21%
B) 22%
C) 15%
D) 60%
Use the table for the question(s) below.
Consider the following two projects:
Project Year 0
Cash Flow Year 1
Cash Flow Year 2
Cash Flow Year 3
Cash Flow Year 4
Cash Flow Discount Rate
A -100 40 50 60 N/A .15
B -73 30 30 30 30 .15
9) The internal rate of return (IRR) for project A is closest to:
A) 7.7%
B) 21.6%
C) 23.3%
D) 42.9%
10) The internal rate of return (IRR) for project B is closest to:
A) 21.6%
B) 23.3%
C) 42.9%
D) 7.7%
11) Which of the following statements is correct?
A) You should accept project A since its IRR > 15%.
B) You should reject project B since its NPV > 0.
C) Your should accept project A since its NPV < 0.
D) You should accept project B since its IRR < 15%.
12) The maximum number of IRRs that could exist for project B is:
A) 3
B) 1
C) 2
D) 0
Use the table for the question(s) below.
Consider the following two projects:
Project Year 0
C/F Year 1
C/F Year 2
C/F Year 3
C/F Year 4
C/F Year 5
C/F Year 6
C/F Year 7
C/F Discount
Rate
Alpha -79 20 25 30 35 40 N/A N/A 15%
Beta -80 25 25 25 25 25 25 25 16%
13) The internal rate of return (IRR) for project Alpha is closest to:
A) 25.0%
B) 22.2%
C) 24.5%
D) 22.7%
14) The internal rate of return (IRR) for project Beta is closest to:
A) 25.0%
B) 22.7%
C) 24.5%
D) 22.2%
15) Which of the following statements is correct?
A) You should invest in project Beta since NPVBeta > 0.
B) You should invest in project Alpha since IRRAlpha > IRRBeta.
C) Your should invest in project Alpha since NPVAlpha < 0.
D) You should invest in project Beta since IRRBeta > 0.
Use the information for the question(s) below.
The Sisyphean Company is planning on investing in a new project. This will involve the
purchase of some new machinery costing $450,000. The Sisyphean Company expects cash
inflows from this project as detailed below:
Year One Year Two Year Three Year Four
$200,000 $225,000 $275,000 $200,000
The appropriate discount rate for this project is 16%.
16) The IRR for this project is closest to:
A) 18.9%
B) 22.7%
C) 34.1%
D) 39.1%
Use the information for the question(s) below.
Larry the Cucumber has been offered $14 million to star in the lead role of the next three Larry
Boy adventure movies. If Larry takes this offer, he will have to forgo acting in other Veggie
movies that would pay him $5 million at the end of each of the next three years. Assume Larry’s
personal cost of capital is 10% per year.
17) The IRR for Larry’s three movie deal offer is closest to:
A) 3.5%
B) 1.6%
C) -3.5%
D) -1.6%
18) Larry should:
A) reject the offer because the NPV < 0.
B) accept the offer even though the IRR < 10%, because the NPV > 0.
C) reject the offer because the IRR < 10%.
D) accept the offer because the IRR > 0%.
Use the information for the question(s) below.
Boulderado has come up with a new composite snowboard. Development will take Boulderado
four years and cost $250,000 per year, with the first of the four equal investments payable today
upon acceptance of the project. Once in production the snowboard is expected to produce annual
cash flows of $200,000 each year for 10 years. Boulderado’s discount rate is 10%.
19) The IRR for Boulderado’s snowboard project is closest to:
A) 10.4%
B) 10.0%
C) 11.0%
D) 15.1%
20) Calculate the IRR for the snow board project and use it to determine he maximum deviation
allowable in the cost of capital estimate that leaves the investment decision unchanged. The
maximum deviation allowable is closest to:
A) 11.0%
B) 0.0%
C) 2.5%
D) 1.0%
21) When using the internal rate of return (IRR) investment rule, we compare:
A) the average return on the investment opportunity to returns on all other investment
opportunities in the market.
B) the average return on the investment opportunity to returns on other alternatives in the market
with equivalent risk and maturity.
C) the NPV of the investment opportunity to the average return on the investment opportunity.
D) the average return on the investment opportunity to the risk-free rate of return.