Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows
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 10: The Basics of Capital Budgeting: Evaluating Cash Flows
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 ranks the other one first. In theory, such conflicts should be resolved in favor of the project with the
higher positive 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 ranks the other one first. In theory, such conflicts should be resolved in favor of the project with the
higher positive IRR.
a. True
b. False
Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows
7. 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
8. 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 lower the cost of capital used to calculate a project’s NPV, the lower the calculated NPV will be.
b. If a project’s NPV is less than zero, then its IRR must be less than the cost of capital.
c. If a project’s NPV is greater than zero, then its IRR must be less than zero.
d. The NPV of a relatively low-risk project should be found using a relatively high cost of capital.
e. 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 cost of capital.
Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows
9. 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 higher the cost of capital used to calculate the NPV, the lower the calculated NPV will be.
b. If a project’s NPV is greater than zero, then its IRR must be less than the cost of capital.
c. If a project’s NPV is greater than zero, then its IRR must be less than zero.
d. The NPVs of relatively risky projects should be found using relatively low costs of capital.
e. A project’s NPV is generally found by compounding the cash inflows at the cost of capital to find the terminal
value (TV), then discounting the TV at the IRR to find its PV.
10. Ellmann Systems is considering a project that has the following cash flow and cost of capital (r) data. What is the
project’s NPV? Note that if a project’s expected NPV is negative, it should be rejected.
r: 9.00%
Year 0 1 2 3
Cash flows −$1,000 $500 $500 $500
a. $265.65
b. $278.93
c. $292.88
d. $307.52
e. $322.90
Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows
11. Scott Enterprises is considering a project that has the following cash flow and cost of capital (r) data. What is the
project’s NPV? Note that if a project’s expected NPV is negative, it should be rejected.
r: 11.00%
Year 0 1 2 3 4
Cash flows −$1,000 $350 $350 $350 $350
a. $77.49
b. $81.56
c. $85.86
d. $90.15
e. $94.66
12. Robbins Inc. is considering a project that has the following cash flow and cost of capital (r) data. What is the project’s
NPV? Note that if a project’s expected NPV is negative, it should be rejected.
r: 10.25%
Year 0 1 2 3 4 5
Cash flows −$1,000 $300 $300 $300 $300 $300
Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows
a. $105.89
b. $111.47
c. $117.33
d. $123.51
e. $130.01
13. Reed Enterprises is considering a project that has the following cash flow and cost of capital (r) data. What is the
project’s NPV? Note that a project’s expected NPV can be negative, in which case it will be rejected.
r: 10.00%
Year 0 1 2 3
Cash flows −$1,050 $450 $460 $470
a. $92.37
b. $96.99
c. $101.84
d. $106.93
e. $112.28
Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows
14. Patterson Co. is considering a project that has the following cash flow and cost of capital (r) data. What is the project’s
NPV? Note that a project’s expected NPV can be negative, in which case it will be rejected.
r: 10.00%
Year 0 1 2 3
Cash flows −$950 $500 $400 $300
a. $54.62
b. $57.49
c. $60.52
d. $63.54
e. $66.72
15. Yoga Center Inc. is considering a project that has the following cash flow and cost of capital (r) data. What is the
project’s NPV? Note that a project’s expected NPV can be negative, in which case it will be rejected.
r: 14.00%
Year 0 1 2 3 4
Cash flows −$1,200 $400 $425 $450 $475
a. $41.25
b. $45.84
c. $50.93
d. $56.59
e. $62.88
Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows
16. Dickson Co. is considering a project that has the following cash flow and cost of capital (r) data. What is the project’s
NPV? Note that a project’s expected NPV can be negative, in which case it will be rejected.
r: 12.00%
Year 0 1 2 3 4 5
Cash flows −$1,100 $400 $390 $380 $370 $360
a. $250.15
b. $277.94
c. $305.73
d. $336.31
e. $369.94
17. Last month, Standard Systems analyzed the project whose cash flows are shown below. However, before the decision
to accept or reject the project took place, the Federal Reserve changed interest rates and therefore the firm’s cost of capital
(r). The Fed’s action did not affect the forecasted cash flows. By how much did the change in the r affect the project’s
forecasted NPV? Note that a project’s expected NPV can be negative, in which case it should be rejected.
Old r: 10.00% New r: 11.25%
Year 0 1 2 3
Cash flows −$1,000 $410 $410 $410
Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows
a. −$18.89
b. −$19.88
c. −$20.93
d. −$22.03
e. −$23.13
18. Corner Jewelers, Inc. recently analyzed the project whose cash flows are shown below. However, before the company
decided to accept or reject the project, the Federal Reserve changed interest rates and therefore the firm’s cost of capital
(r). The Fed’s action did not affect the forecasted cash flows. By how much did the change in the r affect the project’s
forecasted NPV? Note that a project’s expected NPV can be negative, in which case it should be rejected.
Old r: 8.00% New r: 11.25%
Year 0 1 2 3
Cash flows −$1,000 $410 $410 $410
a. −$59.03
b. −$56.08
c. −$53.27
d. −$50.61
e. −$48.08
Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows
19. 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
20. 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
21. A project’s IRR is independent of the firm’s cost of capital. In other words, a project’s IRR doesn’t change with a
change in the firm’s cost of capital.
a. True
b. False
Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows
22. 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
23. The phenomenon called “multiple internal rates of return” arises when two or more mutually exclusive projects that
have different lives are compared to one another.
a. True
b. False
24. 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
Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows
b. False
25. The IRR 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
26. 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
Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows
27. 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
28. An increase in the firm’s cost of capital 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 10: The Basics of Capital Budgeting: Evaluating Cash Flows
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
Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows
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
32. 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 the time value of money.
b. One defect of the IRR method versus the NPV is that the IRR does not take account of the cost of capital.
c. 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.
d. 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.
e. 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.
Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows
33. 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 discounting the cash inflows at the cost of capital to find the present value
(PV), then compounding this PV to find the IRR.
b. If a project’s IRR is greater than the WACC, then its NPV must be negative.
c. 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.
d. To find a project’s IRR, we must find a discount rate that is equal to the cost of capital.
e. A project’s regular IRR is found by compounding the cash inflows at the cost of capital to find the terminal value
(TV), then discounting this TV at the cost of capital.
34. 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 cost of capital to find the present value
(PV), then discounting the TV to find the IRR.
b. If a project’s IRR is smaller than the cost of capital, then its NPV will be positive.
c. A project’s IRR is the discount rate that causes the PV of the inflows to equal the project’s cost.
d. If a project’s IRR is positive, then its NPV must also be positive.
e. A project’s regular IRR is found by compounding the initial cost at the cost of capital to find the terminal value
(TV), then discounting the TV at the cost of capital.
35. Which of the following statements is CORRECT?
Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows
a. If a project has “normal” cash flows, then its MIRR must be positive.
b. If a project has “normal” cash flows, then it will have exactly two real IRRs.
c. 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.
d. 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.
e. If a project has “normal” cash flows, then its IRR must be positive.
36. Which of the following statements is CORRECT?
a. Projects with “normal” cash flows can have two or more real IRRs.
b. 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.”
c. The “multiple IRR problem” can arise if a project’s cash flows are “normal.”
d. Projects with “nonnormal” cash flows are almost never encountered in the real world.
e. Projects with “normal” cash flows can have only one real IRR.
37. Which of the following statements is CORRECT?
a. One defect of the IRR method is that it does not take account of the time value of money.
b. One defect of the IRR method is that it does not take account of the cost of capital.
c. 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.
Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows
d. 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.
e. One defect of the IRR method is that it does not take account of cash flows over a project’s full life.
38. Which of the following statements is CORRECT?
a. The NPV profile graph for a normal project will generally have a positive (upward) slope as the life of the project
increases.
b. An NPV profile graph is designed to give decision makers an idea about how a project’s risk varies with its life.
c. 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.
d. We cannot draw a project’s NPV profile unless we know the appropriate cost of capital for use in evaluating the
project’s NPV.
e. An NPV profile graph shows how a project’s payback varies as the cost of capital changes.
39. Which of the following statements is CORRECT?
a. If the cost of capital declines, this lowers a project’s NPV.
b. The NPV method is regarded by most academics as being the best indicator of a project’s profitability; hence,
most academics recommend that firms use only this one method.
c. A project’s NPV depends on the total amount of cash flows the project produces, but because the cash flows are
discounted at the cost of capital, it does not matter if the cash flows occur early or late in the project’s life.
Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows
d. The NPV and IRR methods may give different recommendations regarding which of two mutually exclusive
projects should be accepted, but they always give the same recommendation regarding the acceptability of a normal,
independent project.
e. The NPV method was once the favorite of academics and business executives, but today most authorities regard
the MIRR as being the best indicator of a project’s profitability.
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. If Project A has a higher IRR than Project B, then Project A must also have a higher NPV.
b. The IRR calculation implicitly assumes that all cash flows are reinvested at the cost of capital.
c. The IRR calculation implicitly assumes that cash flows are withdrawn from the business rather than being
reinvested in the business.
d. If a project has normal cash flows and its IRR exceeds its cost of capital, then the project’s NPV must be positive.
e. If Project A has a higher IRR than Project B, then Project A must have the lower NPV.
41. Which of the following statements is CORRECT?
a. If two projects are mutually exclusive, then they are likely to have multiple IRRs.
b. If a project is independent, then it cannot have multiple IRRs.
c. Multiple IRRs can occur only if the signs of the cash flows change more than once.
Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows
d. 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.
e. For a project to have more than one IRR, then both IRRs must be greater than the cost of capital.
42. Which of the following statements is CORRECT?
a. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes
reinvestment at the IRR.
b. The NPV method assumes that cash flows will be reinvested at the cost of capital, while the IRR method assumes
reinvestment at the risk-free rate.
c. The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
d. The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
e. The NPV method assumes that cash flows will be reinvested at the cost of capital, while the IRR method assumes
reinvestment at the IRR.
43. Projects A and B have identical expected lives and identical initial cash outflows (costs). However, most of one
project’s cash flows come in the early years, while most of the other project’s cash flows occur in the later years. The two
NPV profiles are given below: