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Chapter 11: The Basics of Capital Budgeting
1. A firm should never accept a project if its acceptance would lead to an increase in the firm's cost of capital (its WACC).
a.
True
b.
False
2. Because "present value" refers to the value of cash flows that occur at different points in time, a series of present values
of cash flows should not be summed to determine the value of a capital budgeting project.
a.
True
b.
False
3. Assuming that their NPVs based on the firm's cost of capital are equal, the NPV of a project whose cash flows accrue
relatively rapidly will be more sensitive to changes in the discount rate than the NPV of a project whose cash flows come
in later in its life.
a.
True
b.
False
Chapter 11: The Basics of Capital Budgeting
4. A basic rule in capital budgeting is that if a project's NPV exceeds its IRR, then the project should be accepted.
a.
True
b.
False
5. Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher
but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the
higher NPV.
a.
True
b.
False
6. Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher
but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the
higher IRR.
a.
True
b.
False
Chapter 11: The Basics of Capital Budgeting
7. The internal rate of return is that discount rate that equates the present value of the cash outflows (or costs) with the
present value of the cash inflows.
a.
True
b.
False
8. Other things held constant, an increase in the cost of capital will result in a decrease in a project's IRR.
a.
True
b.
False
9. Under certain conditions, a project may have more than one IRR. One such condition is when, in addition to the initial
investment at time = 0, a negative cash flow (or cost) occurs at the end of the project's life.
a.
True
b.
False
Chapter 11: The Basics of Capital Budgeting
10. The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects that
have different lives are being compared.
a.
True
b.
False
11. The NPV method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost
of capital.
a.
True
b.
False
12. The IRR method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost
of capital.
Chapter 11: The Basics of Capital Budgeting
a.
True
b.
False
13. The NPV method's assumption that cash inflows are reinvested at the cost of capital is generally more reasonable than
the IRR's assumption that cash flows are reinvested at the IRR. This is an important reason why the NPV method is
generally preferred over the IRR method.
a.
True
b.
False
14. For a project with one initial cash outflow followed by a series of positive cash inflows, the modified IRR (MIRR)
method involves compounding the cash inflows out to the end of the project's life, summing those compounded cash flows
to form a terminal value (TV), and then finding the discount rate that causes the PV of the TV to equal the project's cost.
a.
True
b.
False
Chapter 11: The Basics of Capital Budgeting
15. Both the regular and the modified IRR (MIRR) methods have wide appeal to professors, but most business executives
prefer the NPV method to either of the IRR methods.
a.
True
b.
False
16. When evaluating mutually exclusive projects, the modified IRR (MIRR) always leads to the same capital budgeting
decisions as the NPV method, regardless of the relative lives or sizes of the projects being evaluated.
a.
True
b.
False
17. One advantage of the payback method for evaluating potential investments is that it provides information about a
project's liquidity and risk.
a.
True
b.
False
Chapter 11: The Basics of Capital Budgeting
18. When considering two mutually exclusive projects, the firm should always select the project whose internal rate of
return is the highest, provided the projects have the same initial cost. This statement is true regardless of whether the
projects can be repeated or not.
a.
True
b.
False
19. The primary reason that the NPV method is conceptually superior to the IRR method for evaluating mutually
exclusive investments is that multiple IRRs may exist, and when that happens, we don't know which IRR is relevant.
a.
True
b.
False
Chapter 11: The Basics of Capital Budgeting
20. The NPV and IRR methods, when used to evaluate two independent and equally risky projects, will lead to different
accept/reject decisions and thus capital budgets if the projects' IRRs are greater than their costs of capital.
a.
True
b.
False
21. The NPV and IRR methods, when used to evaluate two equally risky but mutually exclusive projects, will lead to
different accept/reject decisions and thus capital budgets if the cost of capital at which the projects' NPV profiles cross is
greater than the crossover rate.
a.
True
b.
False
22. A conflict will exist between the NPV and IRR methods, when used to evaluate two equally risky but mutually
exclusive projects, if the projects' cost of capital is less than the rate at which the projects' NPV profiles cross.
a.
True
b.
False
Chapter 11: The Basics of Capital Budgeting
23. Project S has a pattern of high cash flows in its early life, while Project L has a longer life, with large cash flows late
in its life. Neither has negative cash flows after Year 0, and at the current cost of capital, the two projects have identical
NPVs. Now suppose interest rates and money costs decline. Other things held constant, this change will cause L to
become preferred to S.
a.
True
b.
False
24. The regular payback method is deficient in that it does not take account of cash flows beyond the payback period. The
discounted payback method corrects this fault.
a.
True
b.
False
Chapter 11: The Basics of Capital Budgeting
25. In theory, capital budgeting decisions should depend solely on forecasted cash flows and the opportunity cost of
capital. The decision criterion should not be affected by managers' tastes, choice of accounting method, or the profitability
of other independent projects.
a.
True
b.
False
26. If you were evaluating two mutually exclusive projects for a firm with a zero cost of capital, the payback method and
NPV method would always lead to the same decision on which project to undertake.
a.
True
b.
False
27. Small businesses make less use of DCF capital budgeting techniques than large businesses. This may reflect a lack of
knowledge on the part of small firms' managers, but it may also reflect a rational conclusion that the costs of using DCF
analysis outweigh the benefits of these methods for very small firms.
a.
True
b.
False
Chapter 11: The Basics of Capital Budgeting
28. An increase in the firm's WACC will decrease projects' NPVs, which could change the accept/reject decision for any
potential project. However, such a change would have no impact on projects' IRRs. Therefore, the accept/reject decision
under the IRR method is independent of the cost of capital.
a.
True
b.
False
29. The IRR of normal Project X is greater than the IRR of normal Project Y, and both IRRs are greater than zero. Also,
the NPV of X is greater than the NPV of Y at the cost of capital. If the two projects are mutually exclusive, Project X
should definitely be selected, and the investment made, provided we have confidence in the data. Put another way, it is
impossible to draw NPV profiles that would suggest not accepting Project X.
a.
True
b.
False
Chapter 11: The Basics of Capital Budgeting
30. Normal Projects S and L have the same NPV when the discount rate is zero. However, Project S's cash flows come in
faster than those of L. Therefore, we know that at any discount rate greater than zero, L will have the higher NPV.
a.
True
b.
False
31. If the IRR of normal Project X is greater than the IRR of mutually exclusive (and also normal) Project Y, we can
conclude that the firm should always select X rather than Y if X has NPV > 0.
a.
True
b.
False
Chapter 11: The Basics of Capital Budgeting
32. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows,
with one outflow followed by a series of inflows.
a.
A project’s NPV is found by compounding the cash inflows at the IRR to find the terminal value (TV), then
discounting the TV at the WACC.
b.
The lower the WACC used to calculate it, the lower the calculated NPV will be.
c.
If a project’s NPV is less than zero, then its IRR must be less than the WACC.
d.
If a project’s NPV is greater than zero, then its IRR must be less than zero.
e.
The NPV of a relatively low-risk project should be found using a relatively high WACC.
33. Which of the following statements is CORRECT?
a.
One defect of the IRR method is that it does not take account of cash flows over a project’s full life.
b.
One defect of the IRR method is that it does not take account of the time value of money.
c.
One defect of the IRR method is that it does not take account of the cost of capital.
d.
One defect of the IRR method is that it values a dollar received today the same as a dollar that will not be
received until sometime in the future.
e.
One defect of the IRR method is that it assumes that the cash flows to be received from a project can be
reinvested at the IRR itself, and that assumption is often not valid.
Chapter 11: The Basics of Capital Budgeting
34. Which of the following statements is CORRECT?
a.
One defect of the IRR method versus the NPV is that the IRR does not take account of cash flows over a
project’s full life.
b.
One defect of the IRR method versus the NPV is that the IRR does not take account of the time value of
money.
c.
One defect of the IRR method versus the NPV is that the IRR does not take account of the cost of capital.
d.
One defect of the IRR method versus the NPV is that the IRR values a dollar received today the same as a
dollar that will not be received until sometime in the future.
e.
One defect of the IRR method versus the NPV is that the IRR does not take proper account of differences in
the sizes of projects.
35. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows,
with one outflow followed by a series of inflows.
a.
A project’s regular IRR is found by compounding the cash inflows at the WACC to find the terminal value
(TV), then discounting this TV at the WACC.
b.
A project’s regular IRR is found by discounting the cash inflows at the WACC to find the present value (PV),
then compounding this PV to find the IRR.
c.
If a project’s IRR is greater than the WACC, then its NPV must be negative.
d.
To find a project’s IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV
of the project’s costs.
e.
To find a project’s IRR, we must find a discount rate that is equal to the WACC.
Chapter 11: The Basics of Capital Budgeting
36. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows,
with one outflow followed by a series of inflows.
a.
A project’s regular IRR is found by compounding the initial cost at the WACC to find the terminal value (TV),
then discounting the TV at the WACC.
b.
A project’s regular IRR is found by compounding the cash inflows at the WACC to find the present value
(PV), then discounting the TV to find the IRR.
c.
If a project’s IRR is smaller than the WACC, then its NPV will be positive.
d.
A project’s IRR is the discount rate that causes the PV of the inflows to equal the project’s cost.
e.
If a project’s IRR is positive, then its NPV must also be positive.
37. Which of the following statements is CORRECT?
a.
If a project has “normal” cash flows, then its IRR must be positive.
b.
If a project has “normal” cash flows, then its MIRR must be positive.
c.
If a project has “normal” cash flows, then it will have exactly two real IRRs.
d.
The definition of “normal” cash flows is that the cash flow stream has one or more negative cash flows
followed by a stream of positive cash flows and then one negative cash flow at the end of the project’s life.
e.
If a project has “normal” cash flows, then it can have only one real IRR, whereas a project with "nonnormal"
cash flows might have more than one real IRR.
Chapter 11: The Basics of Capital Budgeting
38. Which of the following statements is CORRECT?
a.
Projects with “normal” cash flows can have only one real IRR.
b.
Projects with “normal” cash flows can have two or more real IRRs.
c.
Projects with “normal” cash flows must have two changes in the sign of the cash flows, e.g., from negative to
positive to negative. If there are more than two sign changes, then the cash flow stream is “nonnormal.”
d.
The “multiple IRR problem” can arise if a project’s cash flows are “normal.”
e.
Projects with “nonnormal” cash flows are almost never encountered in the real world.
39. Which of the following statements is CORRECT?
a.
The regular payback method recognizes all cash flows over a project’s life.
b.
The discounted payback method recognizes all cash flows over a project’s life, and it also adjusts these cash
flows to account for the time value of money.
c.
The regular payback method was, years ago, widely used, but virtually no companies even calculate the
payback today.
d.
The regular payback is useful as an indicator of a project’s liquidity because it gives managers an idea of how
long it will take to recover the funds invested in a project.
e.
The regular payback does not consider cash flows beyond the payback year, but the discounted payback
overcomes this defect.
Chapter 11: The Basics of Capital Budgeting
40. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows,
with one outflow followed by a series of inflows.
a.
The longer a project’s payback period, the more desirable the project is normally considered to be by this
criterion.
b.
One drawback of the payback criterion for evaluating projects is that this method does not properly account
for the time value of money.
c.
If a project’s payback is positive, then the project should be rejected because it must have a negative NPV.
d.
The regular payback ignores cash flows beyond the payback period, but the discounted payback method
overcomes this problem.
e.
If a company uses the same payback requirement to evaluate all projects, say it requires a payback of 4 years
or less, then the company will tend to reject projects with relatively short lives and accept long-lived projects,
and this will cause its risk to increase over time.
41. Which of the following statements is CORRECT?
a.
The shorter a project’s payback period, the less desirable the project is normally considered to be by this
criterion.
b.
One drawback of the payback criterion is that this method does not take account of cash flows beyond the
payback period.
c.
If a project’s payback is positive, then the project should be accepted because it must have a positive NPV.
d.
The regular payback ignores cash flows beyond the payback period, but the discounted payback method
overcomes this problem.
e.
One drawback of the discounted payback is that this method does not consider the time value of money, while
the regular payback overcomes this drawback.
Chapter 11: The Basics of Capital Budgeting
42. Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT?
a.
A project’s IRR increases as the WACC declines.
b.
A project’s NPV increases as the WACC declines.
c.
A project’s MIRR is unaffected by changes in the WACC.
d.
A project’s regular payback increases as the WACC declines.
e.
A project’s discounted payback increases as the WACC declines.
43. Which of the following statements is CORRECT?
a.
The internal rate of return method (IRR) is generally regarded by academics as being the best single method
for evaluating capital budgeting projects.
b.
The payback method is generally regarded by academics as being the best single method for evaluating capital
budgeting projects.
c.
The discounted payback method is generally regarded by academics as being the best single method for
evaluating capital budgeting projects.
d.
The net present value method (NPV) is generally regarded by academics as being the best single method for
evaluating capital budgeting projects.
e.
The modified internal rate of return method (MIRR) is generally regarded by academics as being the best
single method for evaluating capital budgeting projects.
Chapter 11: The Basics of Capital Budgeting
44. Which of the following statements is CORRECT?
a.
An NPV profile graph shows how a project’s payback varies as the cost of capital changes.
b.
The NPV profile graph for a normal project will generally have a positive (upward) slope as the life of the
project increases.
c.
An NPV profile graph is designed to give decision makers an idea about how a project’s risk varies with its
life.
d.
An NPV profile graph is designed to give decision makers an idea about how a project’s contribution to the
firm’s value varies with the cost of capital.
e.
We cannot draw a project’s NPV profile unless we know the appropriate WACC for use in evaluating the
project’s NPV.
45. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows,
with one outflow followed by a series of inflows.
a.
A project’s NPV is generally found by compounding the cash inflows at the WACC to find the terminal value
(TV), then discounting the TV at the IRR to find its PV.
b.
The higher the WACC used to calculate the NPV, the lower the calculated NPV will be.
c.
If a project’s NPV is greater than zero, then its IRR must be less than the WACC.
d.
If a project’s NPV is greater than zero, then its IRR must be less than zero.
e.
The NPVs of relatively risky projects should be found using relatively low WACCs.
Chapter 11: The Basics of Capital Budgeting
46. Which of the following statements is CORRECT?
a.
For a project to have more than one IRR, then both IRRs must be greater than the WACC.
b.
If two projects are mutually exclusive, then they are likely to have multiple IRRs.
c.
If a project is independent, then it cannot have multiple IRRs.
d.
Multiple IRRs can occur only if the signs of the cash flows change more than once.
e.
If a project has two IRRs, then the smaller one is the one that is most relevant, and it should be accepted and
relied upon.
47. Which of the following statements is CORRECT?
a.
The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes
reinvestment at the IRR.
b.
The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method
assumes reinvestment at the IRR.
c.
The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes
reinvestment at the risk-free rate.
d.
The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
e.
The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
