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Chapter 12: Capital Budgeting: Decision Criteria
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
ANSWER:
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
ANSWER:
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
ANSWER:
False
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
ANSWER:
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
ANSWER:
True
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
ANSWER:
False
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
ANSWER:
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.
ANSWER:
b
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.
ANSWER:
a
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10. Ellmann Systems is considering a project that has the following cash flow and cost of capital (r) data. What is the
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
ANSWER:
a
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
ANSWER:
c
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
a.
$105.89
b.
$111.47
c.
$117.33
d.
$123.51
e.
$130.01
ANSWER:
e
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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
ANSWER:
a
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
ANSWER:
c
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
ANSWER:
e
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
ANSWER:
b
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
a.
−$18.89
b.
−$19.88
c.
−$20.93
d.
−$22.03
e.
−$23.13
ANSWER:
d
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
ANSWER:
a
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
ANSWER:
True
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
ANSWER:
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
ANSWER:
True
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
ANSWER:
True
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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
ANSWER:
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
b.
False
ANSWER:
True
25. The IRR method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost
of capital.
Chapter 12: Capital Budgeting: Decision Criteria
a.
True
b.
False
ANSWER:
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
ANSWER:
True
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
ANSWER:
True
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
ANSWER:
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
ANSWER:
False
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
ANSWER:
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
ANSWER:
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.
ANSWER:
d
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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.
ANSWER:
c
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
Chapter 12: Capital Budgeting: Decision Criteria
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Page 19
(TV), then discounting the TV at the cost of capital.
ANSWER:
c
35. Which of the following statements is CORRECT?
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.
ANSWER:
d
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
Chapter 12: Capital Budgeting: Decision Criteria
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Page 20
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.
ANSWER:
e
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.
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.
ANSWER:
d
