91) Compute the discounted payback period for a project with the following cash flows received
uniformly within each year and with a required return of 8%:
Initial Outlay = $100
Cash Flows: Year 1 = $40
Year 2 = $50
Year 3 = $60
A) 2.10 years
B) 2.21 years
C) 2.33 years
D) 3.00 years
92) Consider a project with the following information:
After-tax After-tax
Accounting Cash Flow
Year Profits from Operations
1 $799 $750
2 150 1,000
3 200 1,200
Initial outlay = $1,500
Compute the profitability index if the company’s discount rate is 10%.
A) 15.8
B) 1.61
C) 1.81
D) 0.62
93) If the NPV (Net Present Value) of a project with one sign reversal is positive, then the
project’s IRR (Internal Rate of Return) ________ the required rate of return.
A) must be less than
B) must be greater than
C) could be greater or less than
D) Cannot be determined without actual cash flows
94) You are considering investing in a project with the following year-end after-tax cash flows:
Year 1: $57,000
Year 2: $72,000
Year 3: $78,000
If the initial outlay for the project is $185,000, compute the project’s internal rate of return.
A) 3.98%
B) 5.54%
C) 11.89%
D) 14.74%
95) Different discounted cash flow evaluation methods may provide conflicting rankings of
investment projects when
A) the size of investment outlays differ.
B) the projects are mutually exclusive.
C) the accounting policies differ.
D) the internal rate of return equals the cost of capital.
96) The Net Present Value (or NPV) criteria for capital budgeting decisions assumes that
expected future cash flows are reinvested at ________, and the Internal Rate of Return (or IRR)
criteria assumes that expected future cash flows are reinvested at ________.
A) the firm’s discount rate, the internal rate of return
B) the internal rate of return, the internal rate of return
C) the internal rate of return, the firm’s discount rate
D) neither criteria assumes reinvestment of future cash flows
97) A significant advantage of the payback period is that it
A) places emphasis on time value of money.
B) allows for the proper ranking of projects.
C) tends to reduce firm risk because it favors projects that generate early, less uncertain returns.
D) gives proper weighting to all cash flows.
98) A significant disadvantage of the payback period is that it
A) is complicated to explain.
B) increases firm risk.
C) does not properly consider the time value of money.
D) provides a measure of liquidity
99) Your firm is considering an investment that will cost $750,000 today. The investment will
produce cash flows of $250,000 in year 1, $300,000 in years 2 through 4, and $100,000 in year 5.
What is the investment’s discounted payback period if the required rate of return is 10%?
A) 3.33 years
B) 3.16 years
C) 2.67 years
D) 2.33 years
100) A significant advantage of the internal rate of return is that it
A) provides a means to choose between mutually exclusive projects.
B) provides the most realistic reinvestment assumption.
C) avoids the size disparity problem.
D) considers all of a project’s cash flows and their timing.
101) An independent project should be accepted if it
A) produces a net present value that is greater than or equal to zero.
B) produces a net present value that is greater than the equivalent IRR.
C) has only one sign reversal.
D) produces a profitability index greater than or equal to zero.
102) What is the net present value’s assumption about how cash flows are reinvested?
A) They are reinvested at the IRR.
B) They are reinvested at the APR.
C) They are reinvested at the firm’s discount rate.
D) They are reinvested only at the end of the project.
103) Your firm is considering an investment that will cost $920000 today. The investment will
produce cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in year 5.
The discount rate that your firm uses for projects of this type is 11.25%. What is the investment’s
net present value?
A) $540,000
B) $378,458
C) $192,369
D) $112,583
104) Your firm is considering an investment that will cost $920,000 today. The investment will
produce cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in year 5.
The discount rate that your firm uses for projects of this type is 11.25%. What is the investment’s
profitability index?
A) 1.21
B) 1.26
C) 1.43
D) 1.69
105) Your firm is considering an investment that will cost $920,000 today. The investment will
produce cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in year 5.
The discount rate that your firm uses for projects of this type is 11.25%. What is the investment’s
internal rate of return?
A) 27.28%
B) 21.26%
C) 20.53%
D) 15.98%
106) Which of the following statements about the internal rate of return (IRR) is true?
A) It has the most conservative and realistic reinvestment assumption.
B) It never gives conflicting answers.
C) It fully considers the time value of money.
D) It is greater than the modified internal rate of return if the discount rate is higher than the IRR.
107) A significant disadvantage of the internal rate of return is that it
A) does not fully consider the time value of money.
B) it does not give proper weight to all cash flows.
C) can result in multiple rates of return (more than one IRR).
D) it is expressed as a percentage.
108) A significant disadvantage of the internal rate of return is that it
A) does not fully consider the time value of money.
B) does not give proper weight to all cash flows.
C) may have an unrealistic reinvestment assumption.
D) It is expressed as a percentage.
109) A one-sign-reversal project should be accepted if it
A) generates an internal rate of return that is higher than the profitability index.
B) produces an internal rate of return that is greater than the firm’s discount rate.
C) results in an internal rate of return that is above a project’s equivalent annual annuity.
D) results in a modified internal rate of return that is higher than the internal rate of return.
110) What is the internal rate of return’s assumption about how cash flows are reinvested?
A) They are reinvested at the firm’s discount rate.
B) They are reinvested at the required rate of return.
C) They are reinvested at the project’s internal rate of return.
D) They are only reinvested at the end of the project.
111) If the NPV (Net Present Value) of a project with multiple sign reversals is positive, then the
project’s required rate of return ________ its calculated IRR (Internal Rate of Return).
A) must be less than
B) must be greater than
C) could be greater or less than
D) Cannot be determined without actual cash flows.
112) Kingston Corp. is considering a new machine that requires an initial investment of
$480,000 installed, and has a useful life of 8 years. The expected annual after-tax cash flows for
the machine are $89,000 for each of the 8 years and nothing thereafter.
a. Calculate the net present value of the machine if the required rate of return is 11 percent.
b. Calculate the IRR of this project.
c. Should Kingston accept the project (assume that it is independent and not subject to any
capital rationing constraint)? Explain your answer.
113) D&B Contracting plans to purchase a new backhoe. The one under consideration costs
$233,000, and has a useful life of 8 years. After-tax cash flows are expected to be $31,384 in
each of the 8 years and nothing thereafter. Calculate the internal rate of return for the grader.
114) Consider two mutually exclusive projects X and Y with identical initial outlays of $600,000
and useful lives of 5 years. Project X is expected to produce an after-tax cash flow of $180,000
each year. Project Y is expected to generate a single after-tax net cash flow of $1,015,000 in year
5. The discount rate is 14 percent.
a. Calculate the net present value for each project.
b. Calculate the IRR for each project.
c. What decision should you make regarding these projects?
115) A project that requires an initial investment of $340,000 is expected to have an after-tax
cash flow of $70,000 per year for the first two years, $90,000 per year for the next two years, and
$150,000 for the fifth year? Assume the required return for this project is 10%.
a. What is the NPV of the project%?
b. What is the IRR of the project?
c. What is the MIRR of the project?
d. What is the PI of the project?
e. What decision would you make regarding this project if the required rate of return is 10%?
f. What is the equivalent annual annuity using a 10% required rate of return?
116) The Bolster Company is considering two mutually exclusive projects:
Year
Initial Outlay
NPV
0
-$100,000
-$100,000
1
31,250
0
2
31,250
0
3
31,250
0
4
31,250
0
5
31,250
200,000
The required rate of return on these projects is 12 percent.
a. What is each project’s payback period?
b. What is each project’s discounted payback period?
c. What is each project’s net present value?
d. What is each project’s internal rate of return?
e. Fully explain the results of your analysis. Which project do you prefer, and why?
10.3 Learning Objective 3
1) The payback period may be more appropriate to use for companies experiencing capital
rationing.
2) The profitability index can be helpful when a financial manager encounters a situation where
capital rationing is required.
3) Positive NPV projects may be rejected when capital must be rationed.
4) Capital rationing generally leads to higher stock prices as management is doing the best job it
can in selecting only the best capital budgeting projects.
5) When capital rationing exists, the divisibility of projects is ignored and projects are funded in
order of their PI’s or IRR’s.
6) The net present value always provides the correct decision provided that
A) cash flows are constant over the asset’s life.
B) the required rate of return is greater than the internal rate of return.
C) capital rationing is not imposed.
D) the internal rate of return is positive.
7) Capital rationing may be imposed because of all of the following except:
A) capital market conditions are poor.
B) management has a fear of debt.
C) stockholder control problems prevent issuance of additional stock.
D) the company’s stock price is at an historically high level.
27
8) You are in charge of one division of Bigfella Conglomerate Inc. Your division is subject to
capital rationing. Your division has 4 indivisible projects available, detailed as follows:
Project Initial Outlay IRR NPV
1 2 million 18% 2,500,000
2 1 million 15% 950,000
3 1 million 10% 600,000
4 3 million 9% 2,000,000
If you must select projects subject to a budget constraint of 5 million dollars, which set of
projects should be accepted so as to maximize firm value?
A) Projects 1, 2 and 3
B) Project 1 only
C) Projects 1 and 4
D) Projects 2, 3 and 4
9) Under what condition would you not accept a project that has a positive net present value?
A) If the project has a profitability index less than zero.
B) If two or more projects are mutually inclusive.
C) If the firm is limited in the capital it has available (capital rationing).
D) If a project has more than one sign reversal.
10) Patrick Motors has several investment projects under consideration, all with positive net
present values. However, due to a shortage of trained personnel, a limit of $1,250,000 has been
placed on the capital budget for this year. Which of the projects listed below should be included
in this year’s capital budget? Explain your answer.
Project
Initial Outlay
NPV
A
$250,000
$325,000
B
250,000
350,000
C
100,000
700,000
D
375,000
112,500
E
375,000
75,000
10.4 Learning Objective 4
1) If two projects are mutually exclusive then the IRR is more important than the NPV in
deciding the project that should be chosen.
2) IRR should not be used to choose between mutually exclusive projects.
3) The mutually exclusive project with the highest positive NPV will also have the highest IRR.
4) The size disparity problem occurs when mutually exclusive projects of unequal size are being
examined.
5) A project’s equivalent annual annuity (EAA) is the annuity cash flow that yields the same
present value as the project’s NPV.
6) An infinite-life replacement chain allows projects of different lengths to be compared.
7) Two projects are mutually exclusive if the accept/reject decision for one project has no impact
on the accept/reject decision for the other project.
8) Finance theory suggests that the IRR criterion is the most favorable capital budgeting decision
tool.
9) If a project is acceptable using the NPV criterion, then it will also be acceptable using the
discounted payback period since both methods use discounted cash flows to make the
accept/reject decision.
10) Both the profitability index (PI) and net present value (NPV) are based on the present value
of all future free cash flows, but the PI is a relative measure while the NPV is an absolute
measure of a project’s desirability.
11) If a project’s IRR is equal to its required return, then the project’s NPV is equal to zero and its
PI is equal to one.
12) If a project is acceptable using the IRR criterion, it will also be acceptable using the MIRR
criterion.
13) Zellars, Inc. is considering two mutually exclusive projects, A and B. Project A costs
$95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs
$120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year
three, and $45,000 in year four. Zellars, Inc.’s required rate of return for these projects is 10%.
The equivalent annual annuity amount for project A is
A) $12,989.
B) $13,357.
C) $15,024.
D) $18,532
14) The Kitchen Inc. is considering the following 3 mutually exclusive projects. Projected cash
flows for these ventures are as follows:
Plan A Plan B Plan C
Initial Initial Initial
Outlay=$3,600,000 Outlay=$6,000,000 Outlay=$3,500,000
Cash Flow: Cash Flow: Cash Flow:
Yr 1=$ -0- Yr 1=$4,000,000 Yr 1=$2,000,000
Yr 2= -0- Yr 2= 3,000,000 Yr 2= -0-
Yr 3= -0- Yr 3= 2,000,000 Yr 3=2,000,000
Yr 4= -0- Yr 4= -0- Yr 4=2,000,000
Yr 5=$7,000,000 Yr 5= -0- Yr 5=2,000,000
If the Kitchen has a 12% cost of capital, what decision should be made regarding the projects
above?
A) Accept plan A
B) Accept plan B
C) Accept plan C
D) Accept Plans A, B and C
15) Your company is considering an investment in one of two mutually exclusive projects.
Project one involves a labor intensive production process. Initial outlay for Project 1 is $1,495
with expected after tax cash flows of $500 per year in years 1-5. Project two involves a capital
intensive process, requiring an initial outlay of $6,704. After tax cash flows for Project 2 are
expected to be $2,000 per year for years 1-5. Your firm’s discount rate is 10%. If your company
is not subject to capital rationing, which project(s) should you take on?
A) Project 1
B) Project 2
C) Projects 1 and 2
D) Neither project is acceptable.
16) Your firm is considering investing in one of two mutually exclusive projects. Project A
requires an initial outlay of $3,500 with expected future cash flows of $2,000 per year for the
next three years. Project B requires an initial outlay of $2,500 with expected future cash flows of
$1,500 per year for the next two years. The appropriate discount rate for your firm is 12% and it
is not subject to capital rationing. Assuming both projects can be replaced with a similar
investment at the end of their respective lives, compute the NPV of the two chain cycle for
Project A and three chain cycle for Project B.
A) $2,232 and $85
B) $5,000 and $1,500
C) $2,865 and $94
D) $3,528 and $136
17) Determine the five-year equivalent annual annuity of the following project if the appropriate
discount rate is 16%:
Initial Outflow = $150,000
Cash Flow Year 1 = $40,000
Cash Flow Year 2 = $90,000
Cash Flow Year 3 = $60,000
Cash Flow Year 4 = $0
Cash Flow Year 5 = $80,000
A) $7,058
B) $8,520
C) $9,454
D) $9,872
18) Which of the following statements about the net present value is true?
A) It produces a percentage result that is easy to describe.
B) It has an inadequate reinvestment assumption.
C) It is likely that there will be more than one NPV for a project.
D) It may be used to select among projects of different sizes.
19) A project would be acceptable if
A) the payback is greater than the discounted equivalent annual annuity.
B) the equivalent annual annuity is greater than or equal to the firm’s discount rate.
C) the profitability index is greater than the net present value.
D) the net present value is positive.
20) Mutually exclusive projects occur when
A) projects have uneven cash flows.
B) more than one firm can use the projects.
C) a set of investment proposals perform essentially the same task.
D) projects are independent.
21) Which of the following methods of evaluating investment projects can properly evaluate
projects of unequal lives?
A) The net present value.
B) The payback.
C) The internal rate of return.
D) The equivalent annual annuity.
22) Your firm is considering an investment that will cost $920,000 today. The investment will
produce cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in year 5.
The discount rate that your firm uses for projects of this type is 11.25%. What is the investment’s
equivalent annual annuity?
A) $52,377
B) $42,923
C) $41,387
D) $40,399
23) Consider the following two projects:
Initial Outlay
Net Cash Flow Each Period
1
2
3
4
Project A $4,000,000
$2,003,000
$2,003,000
$2,003,000
$2,003,000
Project B $4, 000,000
0
0
0
$11,000,000
a. Calculate the net present value of each of the above projects, assuming a 14 percent discount
rate.
b. What is the internal rate of return for each of the above projects?
c. Compare and explain the conflicting rankings of the NPVs and IRRs obtained in parts a and b
above.
d. If 14 percent is the required rate of return, and these projects are independent, what decision
should be made?
e. If 14 percent is the required rate of return, and the projects are mutually exclusive, what
decision should be made?
24) The Meacham Tire Company is considering two mutually exclusive projects with useful
lives of 3 and 6 years. The after-tax cash flows for projects S and L are listed below.
Year
Cash Flow S
Cash Flow L
0
-$60,000
-$115,000
1
38,000
28,500
2
25,000
49,500
3
35,000
26,850
4
22,600
5
18,750
6
23,500
The required rate of return on these projects is 14 percent. What decision should be made? As
part of your answer, calculate the NPV assuming a replacement chain for Project S, and also
calculate the equivalent annual annuity for each project.
25) The Dickerson PR Firm is considering two mutually exclusive projects with useful lives of 3
and 6 years. The after-tax cash flows for projects S and L are listed below.
Year
Cash Flow S
Cash Flow L
0
-$60,000
-$51,500
1
40,000
13,000
2
20,000
19,000
3
17,000
11,000
4
20,000
5
10,000
6
8,000
Calculate the equivalent annual annuity for each project assuming a required return of 15%.
What decision should be made?
35
26) Company K is considering two mutually exclusive projects. The cash flows of the projects
are as follows:
Year
Project A
Project B
0
-$2,000,000
-$2,000,000
1
500,000
2
500,000
3
500,000
4
500,000
5
500,000
6
500,000
7
500,000
5,650,000
a. Compute the NPV and IRR for the above two projects, assuming a 13% required rate of
return.
b. Discuss the ranking conflict.
c. What decision should be made regarding these two projects?
10.5 Learning Objective 5 (No Questions)
10.6 Learning Objective 6
1) Two potential approaches to capital budgeting decision problems are a deterministic approach
and a probabilistic approach.
2) Given the complications of capital budgeting, it is much easier to identify profitable projects
than it is to analyze or evaluate them using NPV and IRR.
10.7 Learning Objective 7 (No Questions)