Corporate Finance, 4e (Berk / DeMarzo)
Chapter 7 Investment Decision Rules
7.1 NPV and Stand-Alone Projects
1) Which of the following statements is FALSE?
A) About 75% of firms surveyed used the NPV rule for making investment decisions.
B) If you are unsure of your cost of capital estimate, it is important to determine how sensitive your
analysis is to errors in this estimate.
C) To decide whether to invest using the NPV rule, we need to know the cost of capital.
D) NPV is positive only for discount rates greater than the internal rate of return.
Use the following information to answer the question(s) below.
Sarah Palin reportedly was paid a $11 million advance to write her book Going Rogue. The book took
one year to write. In the time she spent writing, Palin could have been paid to give speeches and appear
on TV news as a political commentator. Given her popularity, assume that she could have earned $8
million over the year (paid at the end of the year) she spent writing the book.
2) Assume that once her book is finished, it is expected to generate royalties of $5 million in the first
year (paid at the end of the year) and these royalties are expected to decrease by 40% per year in
perpetuity. Assuming that Palin’s cost of capital is 10% and given these royalties payments, the NPV of
Palin’s book deal is closest to:
A) $3.75 million
B) $12.20 million
C) $13.00 million
D) $13.75 million
3) Which of the following statements is FALSE?
A) In general, the difference between the cost of capital and the IRR is the maximum amount of
estimation error in the cost of capital estimate that can exist without altering the original decision.
B) The IRR can provide information on how sensitive your analysis is to errors in the estimate of your
cost of capital.
C) If you are unsure of your cost of capital estimate, it is important to determine how sensitive your
analysis is to errors in this estimate.
D) If the cost of capital estimate is more than the IRR, the NPV will be positive.
Use the following information to answer the question(s) below.
You are considering investing in a start up project at a cost of $100,000. You expect the project to return
$500,000 to you in seven years. Given the risk of this project, your cost of capital is 20%.
4) The NPV for this project is closest to:
A) $29,200
B) $39,500
C) $129,200
D) $139,500
5) The IRR for this project is closest to:
A) 15.60%
B) 18.95%
C) 20.00%
D) 25.85%
6) The decision you should take regarding this project is
A) reject the project since the NPV is negative.
B) reject the project since the NPV is positive.
C) accept the project since the IRR < 20%.
D) accept the project since the IRR > 20%.
Use the following information to answer the question(s) below.
Sarah Palin reportedly was paid a $11 million advance to write her book Going Rogue. The book took
one year to write. In the time she spent writing, Palin could have been paid to give speeches and appear
on TV news as a political commentator. Given her popularity, assume that she could have earned $8
million over the year (paid at the end of the year) she spent writing the book.
7) Assuming that Palin’s cost of capital is 10%, then the NPV of her book deal is closest to:
A) $2.00 million
B) $2.20 million
C) $3.00 million
D) $3.75 million
8) The IRR of Palin’s book deal is closest to:
A) -27.25%
B) -37.50%
C) 27.25%
D) 37.50%
Use the table for the question(s) below.
Consider a project with the following cash flows:
Year
Cash Flow
0
-10,000
1
4000
2
4000
3
4000
4
4000
9) If the appropriate discount rate for this project is 15%, then the NPV is closest to:
A) $6000
B) -$867
C) $1420
D) $867
Use the table for the question(s) below.
Consider the following two projects:
Project
Year 0
Cash
Flow
Year 1
Cash
Flow
Year 2
Cash
Flow
Year 3
Cash
Flow
Year 4
Cash
Flow
Discount
Rate
A
–100
40
50
60
N/A
.15
B
–73
30
30
30
30
.15
10) The NPV of project A is closest to:
A) 12.0
B) 12.6
C) 15.0
D) 42.9
11) The NPV of project B is closest to:
A) 12.6
B) 23.3
C) 12.0
D) 15.0
Use the information for the question(s) below.
The Sisyphean Company is planning on investing in a new project. This will involve the purchase of
some new machinery costing $450,000. The Sisyphean Company expects cash inflows from this project
as detailed below:
Year One
Year Two
Year
Three
Year Four
$200,000
$225,000
$275,000
$200,000
The appropriate discount rate for this project is 16%.
12) The NPV for this project is closest to:
A) $176,270
B) $123,420
C) $450,000
D) $179,590
Use the table for the question(s) below.
Consider the following two projects:
Project
Year 0
C/F
Year 1
C/F
Year 2
C/F
Year 3
C/F
Year 4
C/F
Year 5
C/F
Year 6
C/F
Year 7
C/F
Discount
Rate
Alpha
–79
20
25
30
35
40
N/A
N/A
15%
Beta
–80
25
25
25
25
25
25
25
16%
13) The NPV for project Alpha is closest to:
A) $20.96
B) $16.92
C) $24.01
D) $14.41
14) The NPV for project Beta is closest to:
A) $24.01
B) $16.92
C) $20.96
D) $14.41
Use the information for the question(s) below.
Larry the Cucumber has been offered $14 million to star in the lead role of the next three Larry Boy
adventure movies. If Larry takes this offer, he will have to forgo acting in other Veggie movies that
would pay him $5 million at the end of each of the next three years. Assume Larry’s personal cost of
capital is 10% per year.
15) The NPV of Larry’s three movie Larry Boy offer is closest to:
A) 3.5 million
B) -1.6 million
C) 1.6 million
D) -1.0 million
Use the information for the question(s) below.
Boulderado has come up with a new composite snowboard. Development will take Boulderado four
years and cost $250,000 per year, with the first of the four equal investments payable today upon
acceptance of the project. Once in production the snowboard is expected to produce annual cash flows
of $200,000 each year for 10 years. Boulderado’s discount rate is 10%.
16) The NPV for Boulderado’s snowboard project is closest to:
A) $228,900
B) $46,900
C) $51,600
D) $23,800
17) The NPV profile graphs:
A) the project’s NPV over a range of discount rates.
B) the project’s IRR over a range of discount rates.
C) the project’s cash flows over a range of NPVs.
D) the project’s IRR over a range of NPVs.
18) The NPV profile:
A) shows the payback period—the point at which NPV is positive.
B) shows the internal rate of return—the point at which NPV is zero.
C) shows the NPV over a range of discount rates.
D) B and C are correct.
7.2 The Internal Rate of Return Rule
Use the following information to answer the question(s) below.
Frank Dewey Esquire from the firm of Dewey, Cheatum, and Howe, has been offered an upfront
retainer of $30,000 to provide legal services over the next 12 months to Taggart Transcontinental. In
return for this upfront payment, Taggart Transcontinental would have access to 8 hours of legal services
from Frank for each of the next 12 months. Frank’s normal billable rate is $250 per hour for legal
services.
1) Assuming that Dewey’s cost of capital is 12% EAR, then the NPV of his retainer offer is closest to:
A) -$7500
B) -$7400
C) $6000
D) $7400
2) Assuming that Dewey’s cost of capital is 12% EAR, then the IRR of his retainer offer is closest to:
A) -39.3%
B) -3.3%
C) 20.0%
D) 39.3%
3) Assuming that Dewey’s cost of capital is 12% EAR, then the number of potential IRRs that exist for
this problem is equal to:
A) 0
B) 1
C) 2
D) 12
Use the following information to answer the question(s) below.
Rearden Metals is considering opening a strip mining operation to provide some of the raw materials
needed in producing Rearden metal. The initial purchase of the land and the associated costs of opening
up mining operations will cost $100 million today. The mine is expected to generate $16 million worth
of ore per year for the next 12 years. At the end of the 12th year Rearden will need to spend $20 million
to restore the land to its original pristine nature appearance.
4) The number of potential IRRs that exist for Rearden’s mining operation is equal to:
A) 0
B) 1
C) 2
D) 12
5) One of the IRRs for Rearden’s mining operation is closest to:
A) 0%
B) 10.6%
C) 12.4%
D) 72.0%
6) Which of the following statements is FALSE?
A) The IRR investment rule will identify the correct decision in many, but not all, situations.
B) By setting the NPV equal to zero and solving for r, we find the IRR.
C) If you are unsure of your cost of capital estimate, it is important to determine how sensitive your
analysis is to errors in this estimate.
D) The simplest investment rule is the NPV investment rule.
7) Which of the following statements is FALSE?
A) The IRR investment rule states you should turn down any investment opportunity where the IRR is
less than the opportunity cost of capital.
B) The IRR investment rule states that you should take any investment opportunity where the IRR
exceeds the opportunity cost of capital.
C) Since the IRR rule is based upon the rate at which the NPV equals zero, like the NPV decision rule,
the IRR decision rule will always identify the correct investment decisions.
D) There are situations in which multiple IRRs exist.
Use the table for the question(s) below.
Consider a project with the following cash flows:
Year
Cash Flow
0
-10,000
1
4000
2
4000
3
4000
4
4000
8) Assume the appropriate discount rate for this project is 15%. The IRR for this project is closest to:
A) 21%
B) 22%
C) 15%
D) 60%
Use the table for the question(s) below.
Consider the following two projects:
Project
Year 0
Cash
Flow
Year 1
Cash
Flow
Year 2
Cash
Flow
Year 3
Cash
Flow
Year 4
Cash
Flow
Discount
Rate
A
–100
40
50
60
N/A
.15
B
–73
30
30
30
30
.15
9) The internal rate of return (IRR) for project A is closest to:
A) 7.7%
B) 21.6%
C) 23.3%
D) 42.9%
10) The internal rate of return (IRR) for project B is closest to:
A) 21.6%
B) 23.3%
C) 42.9%
D) 7.7%
11) Which of the following statements is correct?
A) You should accept project A since its IRR > 15%.
B) You should reject project B since its NPV > 0.
C) Your should accept project A since its NPV < 0.
D) You should accept project B since its IRR < 15%.
12) The maximum number of IRRs that could exist for project B is:
A) 3
B) 1
C) 2
D) 0
Use the table for the question(s) below.
Consider the following two projects:
Project
Year 0
C/F
Year 1
C/F
Year 2
C/F
Year 3
C/F
Year 4
C/F
Year 5
C/F
Year 6
C/F
Year 7
C/F
Discount
Rate
Alpha
–79
20
25
30
35
40
N/A
N/A
15%
Beta
–80
25
25
25
25
25
25
25
16%
13) The internal rate of return (IRR) for project Alpha is closest to:
A) 25.0%
B) 22.2%
C) 24.5%
D) 22.7%
14) The internal rate of return (IRR) for project Beta is closest to:
A) 25.0%
B) 22.7%
C) 24.5%
D) 22.2%
15) Which of the following statements is correct?
A) You should invest in project Beta since NPVBeta > 0.
B) You should invest in project Alpha since IRRAlpha > IRRBeta.
C) Your should invest in project Alpha since NPVAlpha < 0.
D) You should invest in project Beta since IRRBeta > 0.
Use the information for the question(s) below.
The Sisyphean Company is planning on investing in a new project. This will involve the purchase of
some new machinery costing $450,000. The Sisyphean Company expects cash inflows from this project
as detailed below:
Year One
Year Two
Year
Three
Year Four
$200,000
$225,000
$275,000
$200,000
The appropriate discount rate for this project is 16%.
16) The IRR for this project is closest to:
A) 18.9%
B) 22.7%
C) 34.1%
D) 39.1%
Use the information for the question(s) below.
Larry the Cucumber has been offered $14 million to star in the lead role of the next three Larry Boy
adventure movies. If Larry takes this offer, he will have to forgo acting in other Veggie movies that
would pay him $5 million at the end of each of the next three years. Assume Larry’s personal cost of
capital is 10% per year.
17) The IRR for Larry’s three movie deal offer is closest to:
A) 3.5%
B) 1.6%
C) –3.5%
D) -1.6%
18) Larry should:
A) reject the offer because the NPV < 0.
B) accept the offer even though the IRR < 10%, because the NPV > 0.
C) reject the offer because the IRR < 10%.
D) accept the offer because the IRR > 0%.
Use the information for the question(s) below.
Boulderado has come up with a new composite snowboard. Development will take Boulderado four
years and cost $250,000 per year, with the first of the four equal investments payable today upon
acceptance of the project. Once in production the snowboard is expected to produce annual cash flows
of $200,000 each year for 10 years. Boulderado’s discount rate is 10%.
19) The IRR for Boulderado’s snowboard project is closest to:
A) 10.4%
B) 10.0%
C) 11.0%
D) 15.1%
20) Calculate the IRR for the snow board project and use it to determine the maximum deviation
allowable in the cost of capital estimate that leaves the investment decision unchanged. The maximum
deviation allowable is closest to:
A) 11.0%
B) 0.0%
C) 2.5%
D) 1.0%
21) When using the internal rate of return (IRR) investment rule, we compare:
A) the average return on the investment opportunity to returns on all other investment opportunities in
the market.
B) the average return on the investment opportunity to returns on other alternatives in the market with
equivalent risk and maturity.
C) the NPV of the investment opportunity to the average return on the investment opportunity.
D) the average return on the investment opportunity to the risk-free rate of return.