Chapter 7—Capital Budgeting Process and Techniques
MULTIPLE CHOICE
1. When using IRR, NPV, or PI in capital budgeting:
a.
mutually exclusive projects are always ranked the same
b.
direct estimates of the increase or decrease in shareholder value can be obtained
c.
the time value of money is taken into account
d.
accounting measures of profit are considered
e.
the method is simple and decisions are intuitive
2. Which of the following capital budgeting techniques considers the influence of reported earnings,
reflects the inherent risk of a project, and provides a direct estimate of change in shareholder value
resulting from a given investment?
a.
discounted payback
b.
accounting rate of return
c.
IRR
d.
NPV
e.
none of the above
3. Marcus argues for the use of payback decision rule when assessing capital budgeting decisions. Lisa
insists that the discounted payback rule is better and is justified because it:
a.
will not lead to underinvestment in projects offering higher returns in the long run
b.
does a better job of focusing on the market value of assets rather than book value
c.
determines each project’s contribution to net income
d.
does a better job of accounting for the time value of cash flows
e.
takes into account cash flows that occur beyond the cutoff point
4. The accounting rate of return is preferred for capital budgeting decisions at Accounts-R-Awesome.
Which of the following is not a flaw of accounting-based techniques?
a.
fail to properly account for the time value of money
b.
consistent with the focus of Wall Street securities analysts on earnings
c.
do not factor all cash flows of a project into the process
d.
make no adjustment for project risk
e.
calculations are seriously affected by the choice of depreciation method
5. Your firm uses straight-line depreciation and calculates the accounting rate of return by dividing a
project’s average contribution to net income by its average book value. The average net income of a
potential project is $ani million. The beginning book value of the project is $bv million, and after t
years is $0. Among the hurdle rates below, which is the highest that would still result in the project
being accepted?
a.
ans%
b.
w1%
c.
w2%
d.
w3%
e.
none of the above
6. Jonathan is offered two mutually exclusive choices. #1) invest $1 at 9 a.m. and receive $2 at 10 a.m.
#2) invest $10 at 9 a.m. and receive $13 at 10 a.m. Jonathan believes these are both great deals,
offering positive NPVs and one-hour returns of 100% and 30%, respectively. Which investment
should Jonathan make?
a.
neither investment involves enough monetary value to bother with
b.
both investments will be undertaken
c.
#1, because the annualized rate of return given a 100% increase in value over 1 hour
would be incredible
d.
#1, because the percentage return is greater for a smaller amount invested
e.
#2, because it maximizes wealth
7. Two firms are faced with the same potential investment. The project costs $c million and will result in
cash flows of $cf million per year for each of the next 3 years. Firm A has a discount rate of d1%,
while Firm B’s cost of capital is d2%. Based on NPV analysis, which of the following statements is
true?
a.
Neither firm should invest in the project.
b.
Both firms should invest in the project.
c.
Only firm A should invest in the project.
d.
Only firm B should invest in the project.
e.
Firms with different costs of capital will always reject identical projects.
8. When a firm regularly undertakes projects with positive NPVs, its stock price will rise because:
a.
the projects provide returns which exceed shareholder expectations
b.
investors lower their forecast of future dividends
c.
stock price will reflect the reduced value of all future cash distributions expected by
investors
d.
all of the above
e.
only a and c
9. The internal rate of return (IRR) on a project:
a.
is the compound annual return on the project, given its up-front costs and subsequent cash
flows
b.
is the discount rate that causes the NPV of the project to equal zero
c.
is analogous to a bond’s yield to maturity (YTM)
d.
all of the above
e.
only a and b
10. Which of the following is not an advantage of both NPV and IRR?
a.
will lead to the correct decision when a project’s cash flows alternate between negative and
positive values
b.
incorporates all cash flows that a project generates over its life
c.
makes an appropriate adjustment for the time value of money
d.
makes adjustments for differences in risk across projects
e.
focuses on cash flows
11. Britney is evaluating capital investments for three firms. The first firm has an unlimited capital budget
and is looking at four independent projects. The second firm has several perfectly divisible potential
projects, but faces capital rationing. The third firm is trying to decide between mutually exclusive
projects. The best capital budgeting techniques for these situations would be __________,
__________, and __________, respectively.
a.
IRR; NPV; PI
b.
NPV; PI; NPV
c.
NPV; IRR; NPV
d.
PI; PI; NPV
e.
NPV; NPV; IRR
12. Decisions-Decisions, Inc. is evaluating three potential projects. Given the information in the table
below, the fact that the firm can invest no more than $30 million, and the hurdle rate is i%, the firm
should invest in:
Year
Projects ($ in millions)
1
2
0
c1
c2
1
cf1
cf3
2
cf2
cf4
NPV
npv1
npv2
a.
only project 1
b.
projects 1 and 2
c.
projects 1 and 3
d.
only project 2
e.
only project 3
13. The __________ provides a direct estimate of the increase or decrease in shareholder value resulting
from a particular investment.
a.
IRR
b.
NPV
c.
PI
d.
Payback method
e.
Discounted payback method
14. The output of __________ analysis is a single, intuitively appealing number representing the
compound annual return that an investment earns over its life.
a.
IRR
b.
NPV
c.
PI
d.
Payback method
e.
Discounted payback method
15. How many IRRs may result from three sign changes in the cash flow stream?
a.
1
b.
2
c.
3
d.
4
e.
an imaginary number of IRRs
16. Identify the problem that the internal rate of return (IRR) and profitability index (PI) share as an
important flaw.
a.
lending versus borrowing problem
b.
timing problem
c.
scale problem
d.
multiple solution problem
e.
none of the above
17. All of the following are commonly cited problems with the internal rate of return (IRR) technique
EXCEPT:
a.
the possibility of multiple solutions
b.
the scale problem with mutually exclusive investments
c.
the lending versus borrowing problem
d.
the timing problem with mutually exclusive investments
e.
none of the above
18. Recent surveys of companies using capital budgeting methods identified which two techniques as
being used most often?
a.
IRR and PI
b.
PI and NPV
c.
PI and Payback method
d.
accounting rate of return and PI
e.
NPV and IRR
19. Conflicts between two mutually exclusive projects with greatly differing cash flow timing where the
NPV method chooses one project but the IRR method chooses the other:
a.
Should generally be resolved in favor of the project with the higher NPV or by applying
incremental analysis when using the IRR.
b.
Instead requires the use of the payback period, profitability index, or accounting rate of
return technique to make a final decision.
c.
Results in both projects being rejected since no clear preference occurs.
d.
Should not happen if calculations are done accurately.
e.
Results in the need to rework the cash flows to eliminate the different timing patterns.
20. Which of the following decision methods is designed to incorporate the value of managerial flexibility
and of options to increase returns on investments?
a.
Accounting rate of return
b.
Profitability index
c.
NPV
d.
IRR
e.
None of the above
21. Managers who have MBAs and work for large, publicly traded firms are most likely to use which
capital budgeting technique the most?
a.
NPV
b.
Profitability Index
c.
Average Accounting Return
d.
Payback
22. Two mutually exclusive projects offer the following cash flows at years 0, and 1:
Project
0
1
X
cf1
cf2
Y
cf3
cf4
Calculate an incremental IRR of doing project Y and on that basis decide which project is preferable if
the appropriate hurdle rate for each project is i%.
a.
incremental IRR = irr% so that project X should be done
b.
incremental IRR = irr% so that project Y should be done
c.
incremental IRR = w1% so that project X should be done
d.
incremental IRR = w2% so that project Y should be done
e.
incremental IRR = w2% so that project X should be done
23. A project has cash flows across time as follows:
Year
0
1
2
3
4
5
6
7
Cash Flow
cf1
cf2
cf3
cf4
cf5
cf6
cf7
cf8
The project’s payback is
a.
3 years
b.
4 years
c.
w3 years
d.
ans years
e.
w4 years
24. A project requires an initial investment of $c million. It generates cash flows of $cf1 million in one
year and $cf2 million in two years. The project’s required return is i%. What is the project’s
profitability index?
a.
w1
b.
ans
c.
w2
d.
w3
e.
none of the above
25. Managers concerned about a firm’s and/or liquidity might be drawn towards
a.
Using the NPV rule
b.
Using the IRR rule
c.
Using the MIRR rule
d.
Using Payback rule
26. An advantage of the NPV rule over the IRR is:
a.
The NPV has a clear cutoff point
b.
The NPV is always correct
c.
The IRR is less easily understood
d.
The NPV is a direct measure of changes in wealth
27. A weakness of the NPV rule is
a.
The NPV contradicts the IRR at times
b.
The NPV does not include managerial flexibility
c.
The NPV and IRR consistently rank mutually exclusive projects
d.
The NPV has no weaknesses
28. What should you do when calculating the IRR of and investment and generate multiple IRRs?
a.
You should rely on the lowest IRR generated
b.
You should rely on the highest IRR generated
c.
The IRR that is closest to the hurdle rate is the appropriate IRR to use
d.
You should not use the IRR rule if it generates multiple IRRs
29. What would shareholders prefer?
a.
Managers accepting projects with low payback periods
b.
Managers accepting projects with high Profitability Indices
c.
Managers accepting projects with high returns
d.
Managers accepting projects with high NPVs
30. The Profitability Index rule is most useful
a.
When the IRR and the NPV give contradicting investment decisions
b.
When managers desire to solve the scale problem
c.
When managers face capital rationing
d.
To determine optimal payback periods
31. In practice, firms and capital budgeting rules,
a.
Larger firms and Education are positively associated with using NPV and IRR; small
firms are associated with using payback
b.
All firms tend to use NPV and IRR
c.
Firms tend to blend different rules to their needs, with no rule dominating the other
d.
Age and education do not influence the use of capital budgeting rules
MATCHING
Match the following terms to their definitions:
a.
discounted payback
b.
payback period
c.
accounting rate of return
d.
net present value (NPV)
e.
internal rate of return (IRR)
1. the amount of time it takes for a given project’s cumulative net cash outflows to recoup the initial
investment
2. the amount of time it takes for a given project’s discounted cash flows to recoup the initial investment
3. the rate that causes the present value of a project’s flows to just equal zero
4. dividing net income by the book value of assets
5. the sum of discounted cash flows of a project at an interest rate reflecting its risk
Match the following capital budgeting tools with their disadvantages:
a.
payback method
b.
accounting rate of return
c.
discounted payback
d.
NPV
e.
IRR
f.
PI
6. the depreciation method selected has a large impact on the formula
7. recognizes the time value of money but causes underinvestment in projects with long-run payoffs
8. may be more than one solution with two or more sign changes of the cash flows
9. the present value of a project’s cash flows, excluding the initial cash outflow, divided by its initial cash
outflow
10. although very popular, this technique seems less intuitive to many users
11. ignores projected cash flows during some years of the project’s life
SHORT ANSWER
1. You are considering an investment in a project with a life of eight years, an initial outlay of $c, and
annual after-tax cash flows of $cf. The project also requires an increase in inventories of $in. This $in
investment in inventory is required at the outset of the project and will be released when the project is
completed. The appropriate discount rate for this project is i percent.
a.
Calculate the payback period for this project.
b.
Calculate the discounted payback period for this project.
c.
The firm has a required payback period of three years for both payback and discounted
payback. What do your calculations in a. and b. suggest regarding the project’s acceptability?
Fully explain your answer.
d.
Calculate the NPV for this project.
e.
Should the project be accepted? Fully explain your answer.
2. Consider the following cash flows associated with a project your firm is considering.
End of Year
Cash Flow ($)
0
$cf0
1
cf1
2
cf1
3
cf1
4
cf4
5
cf4
6
cf4
7
cf7
8
cf7
The appropriate discount rate for this project is i percent.
a.
Calculate the project’s IRR.
b.
Calculate the project’s NPV.
3. You have been asked to assess a difficult situation for your superior. She has just finished examining a
project and has learned that it has cash flows over the next ten years as shown in the table below:
End of Year
Cash Flow ($)
0
$cf0
1
cf1
2
cf1
3
cf1
4
cf1
5
cf1
6
cf6
7
cf6
8
cf6
9
cf6
10
cf10
Your boss typically uses IRR for most decisions, but she is having difficulty even calculating the IRR
for this project.
a.
Calculate the NPV of this project assuming a discount rate of 0 percent.
b.
Calculate the NPV of this project assuming a discount rate of irr percent.
c.
If this project’s risk adjusted discount rate is i percent should the project be accepted?
0
0
1
2
3
4
5
6
7
8
4. Consider the projects described in the table below:
End of Year
Project A Cash Flow ($)
Project B Cash Flow ($)
0
$acf0
$bcf0
1
acf1
0
2
acf1
0
3
acf1
0
4
acf1
0
5
acf1
0
6
acf1
bcf1
7
acf1
bcf1
8
acf1
bcf1
9
acf1
bcf1
10
acf1
bcf2
Both projects have an appropriate risk adjusted discount rate of i percent.
a.
Calculate the NPV and IRR for both projects
b.
If projects A and B are independent, which will you undertake?
c.
If projects A and B are mutually exclusive, which will you undertake?
b.
If the projects are independent, both should be undertaken as they both increase firm value as
measured by their positive NPVs.
If the projects are mutually exclusive, only project B should be undertaken as it produces the
largest NPV at the discount rate of 6 percent.
5. You are considering a massive expansion of your manufacturing facility in Newpisqipo. Two
proposals are being considered. The first facility, code named Quick and Dirty, will cost $c1
immediately and will produce $cf1 per year in cash flows for the next ten years. The second
alternative, code named Slow but Sure, will require an outlay of $c2 and will produce cash flows of
$cf2 per year for the next ten years. The required rate of return on both of these projects is i percent.
a.
Calculate the net present value and profitability index for both projects.
b.
If you can undertake only one of these two projects, which will you choose?
c.
If you learn that your firm is only able to invest $c2 in funds for the next year, will this
influence your decision? If so, what else would you wish to know before proceeding with a
decision?
a.