Corporate Finance: Core Principles & Apps, 5e (Ross)
Chapter 7 Net Present Value and Other Investment Rules
1) What is the key reason why a positive NPV project should be accepted?
A) The project is expected to increase shareholder value.
B) The present value of the expected cash flows equals the project’s cost.
C) The project will produce positive cash flows in the future.
D) The project’s payback will be positive during its life.
E) The project’s PI will be less than 1, which indicates acceptance.
2) The net present value of a project is projected at $210. How should this amount be interpreted?
A) The project’s cash inflows exceed its outflows by $210.
B) The project will return an accounting profit of $210.
C) The project’s discounted cash flows are $210 less than its undiscounted cash flows.
D) The project will increase the firm’s cash account by $210 when the project is started.
E) The project is earning $210 in addition to the project’s required rate of return.
3) The value of a firm
A) increases when a new project with a negative net present value is accepted.
B) equals the sum of the individual values of the firm’s projects and divisions.
C) is unaffected by the value of any one individual project.
D) increases anytime a project with a zero net present value is accepted.
E) is equal to the sum of all of the future cash flows derived from the firm’s projects.
4) Assume a project has normal cash flows. Given this, you should accept the project
A) if, and only if, the NPV is exactly equal to zero.
B) only if the NPV is equal to the initial cash flow.
C) if the NPV is positive and reject it if the NPV is negative.
D) if the total cash inflows exceed the initial cash outflow.
E) because it has positive cash flows for every time period after the initial investment.
5) All else constant, the net present value of a typical investment project increases when
A) the discount rate increases.
B) each cash inflow is delayed by one year.
C) the initial cost of a project increases.
D) the rate of return decreases.
E) all cash inflows are moved to the last year of the project.
6) A project has a net present value of $1,200 and a project life of 4 years. Which one of these
statements must be true?
A) The project’s total cash inflows minus its cash outflows equals $1,200.
B) The project is expected to return $1,200 in Time 0 dollars over and above the discount rate.
C) The project would also have a positive net present value if Year 4 was omitted.
D) The project’s cash inflows exceed its outflows by $1,200 over the 4 years.
E) The project is expected to return $1,200 in Year 4 dollars over and above the initial investment.
7) A firm should accept projects with positive net present values primarily because those projects
will
A) produce cash inflows that exceed the cash outflows.
B) return the firm’s initial cash outlay within 1 year.
C) create value for the firm’s current stockholders.
D) produce only positive cash flows after the initial investment period.
E) increase the current liquidity of the firm.
8) Net present value
A) considers only cash flows occurring during the first 5 years of a project.
B) is based on projected annual net income for each year of a project’s life.
C) calculations consider the risk of each project.
D) ignores the time value of money.
E) assumes all projects are risk-free.
9) One advantage of the payback method of project analysis is the method’s
A) application of a discount rate to each separate cash flow.
B) simplicity.
C) difficulty of use.
D) arbitrary cutoff point.
E) consideration of all relevant cash flows.
10) The payback method is a convenient and useful tool because
A) it provides a quick estimate of how rapidly an initial investment will be recouped.
B) it considers all of a project’s relevant cash flows.
C) it considers the time value of money.
D) the required payback period for all of a firm’s projects must be identical.
E) it only considers the cash flows within the current period of 12 months.
11) All else equal, the payback period for a project will decrease whenever the
A) duration of a project is lengthened.
B) cash inflows are moved earlier in time.
C) assigned discount rate decreases.
D) required return for a project increases.
E) initial cost increases.
12) The payback method
A) discounts all cash flows properly.
B) requires each firm to set a firmwide cash flow cutoff period.
C) considers all relevant cash flows.
D) superior to the net present value method.
E) ignores the time value of money.
13) An investment
A) is acceptable if its calculated payback period is less than some prespecified period of time.
B) should be accepted if the payback is positive and rejected if it is negative.
C) should be rejected if the payback is positive and accepted if it is negative.
D) is acceptable if its calculated payback period is greater than some prespecified period of time.
E) should be accepted any time the payback period is less than the discounted payback period,
given a positive discount rate.
14) The length of time required for an investment to generate cash flows sufficient to recover the
initial cost of the investment is called the
A) net present value.
B) payback period.
C) internal rate of return.
D) profitability index.
E) discounted cash period.
15) If the discounted payback method is preferable to the payback method, then why is the
payback method ever used?
A) The discounted payback requires an arbitrary cutoff point while payback does not.
B) Payback is easier to compute than discounted payback.
C) Payback considers all of a project’s cash flows but discounted payback does not.
D) Payback requires the initial investment be recovered during a project’s life while the required
discounted payback period may be shorter.
E) Payback can be used with mutually exclusive projects but discounted payback cannot.
16) Which methods of project analysis are most biased towards short-term projects?
A) Net present value and internal rate of return
B) Payback and discounted payback
C) Accounting rate of return and internal rate of return
D) Payback and accounting rate of return
E) Internal rate of return and discounted payback
17) The discounted payback period of a project will decrease whenever the
A) initial cash outlay for the project is increased.
B) amount of each projected cash inflow is decreased.
C) discount rate applied to the project is decreased.
D) time period of the project is increased.
E) costs of the fixed assets utilized in the project increase.
18) The discounted payback method
A) discounts a project’s initial cost.
B) is simpler and more reliable than the payback period.
C) is as reliable as NPV because both methods use discounted cash flo.
D) uses an arbitrary cutoff period.
E) ignores a project’s initial costs.
19) What is the primary shortcoming of the average accounting rate of return from a financial
perspective?
A) The lack of use in the business world
B) The lack of a clear-cut decision rule
C) The degree of the calculation difficulty
D) The degree of estimation involved with the initial cost
E) The use of net income rather than cash flows
20) An investment is acceptable if its average accounting return (AAR)
A) exceeds the target AAR.
B) is less than the target AAR.
C) exceeds the firm’s return on equity (ROE).
D) is less than the firm’s return on assets (ROA).
E) is equal to zero.
21) Assume a project has an initial cost of $48,000 and will produce net income for 5 years. The
project will use straight-line depreciation over the life of the project. The AAR of this project can
be computed as
A) (Sum of all net income / 5) / ($48,000 / 2)
B) (Sum of all net income / 2) / ($48,000 / 2)
C) ($48,000 / 5) / (Sum of all net income / 5)
D) ($48,000 / 2) / (Sum of all net income / 2)
E) (Sum of all net income / 5) / $48,000
22) The average accounting return method
A) ignores some project years.
B) ignores the timing of net income.
C) properly discounts all values.
D) is preferred by financial analysts over the alternative methods.
E) is never used in practice.
23) Assume a project has normal cash flows. According to the accept/reject rules, the project
should be accepted if the
A) PI is less than 1.
B) AAR is less than the required AAR.
C) IRR exceeds the required return.
D) payback period is less than the life of the project.
E) discounted payback period is less than the life of the project.
24) Assume a project has normal cash flows and a positive (non-zero) net present value. The
project’s
A) profitability index will be less than 1.
B) internal rate of return will exceed its required rate of return.
C) costs exceed its benefits.
D) discounted payback period will exceed the life of the project.
E) payback period must equal the life of the project.
25) The discount rate that makes the net present value of an investment exactly equal to zero is
called the
A) profitable rate of return.
B) internal rate of return.
C) average accounting return.
D) profitability index.
E) risk-free rate.
26) You are considering a project with conventional cash flows. The IRR is 12.6 percent, NPV is –
$198, and the payback period is 2.87 years. Which one of the following statements is correct given
this information?
A) The discount rate used in computing the net present value was less than 12.6 percent.
B) The discounted payback period will have to be less than 2.87 years.
C) The project life must be 2.87 years.
D) This project should be accepted based on the internal rate of return.
E) The required rate of return must be greater than 12.6 percent.
27) Two key weaknesses of the internal rate of return rule are the
A) arbitrary determination of a discount rate and failure to consider initial expenditures.
B) failure to correctly analyze mutually exclusive projects and the multiple rate of return problem.
C) failure to consider all cash flows and the multiple rate of return problem.
D) failure to consider initial expenditures and failure to correctly analyze mutually exclusive
projects.
E) failure to correctly analyze mutually exclusive projects and the lack of a clear-cut decision rule.
28) The internal rate of return
A) is more reliable as a decision making tool than net present value when considering mutually
exclusive projects.
B) is the discount rate that makes the net present value of a project equal to one.
C) is easier to apply than net present value when cash flows are unconventional.
D) will provide the same accept/reject decision as NPV when cash flows are conventional and
projects are independent.
E) is influenced by daily changes in the market rate of interest.
29) The modified internal rate of return is designed primarily to analyze projects that
A) are financing rather than investing projects.
B) are mutually exclusive.
C) have positive and then negative cash flows following the initial cash flow.
D) have significantly different sizes.
E) are both mutually exclusive and have significantly different lives.
30) An independent, financing type project has an IRR of 11.4 percent and a required rate of return
of 10.6 percent. Given this, you know the
A) initial cash flow is negative.
B) net present value is positive.
C) cash flows are conventional.
D) accept/reject decision cannot be based on the IRR.
E) project should be rejected.
31) Projects A and B require an initial investment of $48,000 and $98,000, respectively. The
projects are mutually exclusive, and you know the smaller project has a positive NPV. Which one
of these methods is probably the best method to use to determine which project to accept?
A) Discounted payback
B) Modified internal rate of return
C) Average accounting rate of return
D) Incremental internal rate of return
E) Internal rate of return
32) A project has an initial cost of $12,100 and cash flows of –$2,100, $5,800, $16,600, and –$800
for Years 1 to 4, respectively. How many IRRs will this project have?
A) 0
B) 1
C) 2
D) 3
E) 4
33) Two mutually exclusive projects produce the same positive NPV at a discount rate of 11.34
percent. Both projects have 4-year lives. Project A has larger cash flows than Project B in the first
2 years. Given this information, you know that
A) it makes no difference which project you accept as long as the discount rate does not exceed
11.34 percent.
B) Project A should always be preferred.
C) one project will be preferred at rates less than 11.34 percent and the other will be preferred at
higher rates.
D) Project B must require a smaller investment than Project A at Time 0.
E) Project B should only be accepted if the discount rate is 11.34 percent.
34) Uptown Developers is considering two projects. Project A consists of building a wholesale
book outlet on the firm’s downtown lot. Project B consists of building a sit-down restaurant on that
same lot. The lot can only accommodate one of the projects. When trying to decide whether to
build the book outlet or the restaurant, management should rely most heavily on the analysis
results from which one of these methods?
A) Profitability index
B) Internal rate of return
C) Payback
D) Net present value
E) Accounting rate of return
35) When two projects can share the same economic resource, the projects are generally
considered to be
A) mutually exclusive.
B) independent.
C) underfunded.
D) inferior.
E) financially equivalent.
36) Assume you are looking at a graph that relates the net present value of two mutually exclusive
investment projects to various discount rates. Assume the projects have differing cash flows and
finite lives. Which one of these statements accurately reflects this graph?
A) The lines representing the projects will be upward sloping.
B) If one project has equal cash flows for each year of its life, the line representing that project will
be horizontal.
C) The lines representing the projects will be parallel over multiple discount rates.
D) The lines representing the projects must cross at a point where the NPV of each project is
positive.
E) The project lines will reflect lower NPV values at higher discount rates.
37) You know that two mutually exclusive projects are of different sizes. The smaller project is
known to have a positive NPV. Which one of these accurately describes a method of properly
determining which one, if either, project should be accepted?
A) Select the project with the higher internal rate of return
B) Accept the project with the shorter payback period
C) Accept the larger project if the incremental IRR exceeds the discount rate
D) Select the project with the higher profitability index
E) Accept the smaller project without any further analysis
38) Analysis using the profitability index
A) frequently conflicts with the accept and reject decisions generated by the application of the net
present value rule.
B) is useful as a decision tool when investment funds are limited.
C) offers no real value when making capital structure decisions.
D) utilizes the same basic variables as those used in the average accounting return.
E) produces results that typically are difficult to comprehend or apply.
39) An investment is acceptable if the profitability index (PI) of the investment is
A) greater than one.
B) less than one.
C) greater than the internal rate of return (IRR).
D) less than the net present value (NPV).
E) greater than a prespecified rate of return.
40) The two most commonly used methods of capital budgeting analysis are the
A) internal rate of return and net present value methods.
B) net present value and payback methods.
C) profitability index and the internal rate of return methods.
D) net present value and discounted payback methods.
E) average accounting return and discounted payback methods.
41) A project requires an initial investment of $59,600 and will produce cash inflows of $21,200,
$44,500, and $11,700 over the next 3 years, respectively. What is the project’s NPV at a required
return of 16 percent?
A) –$687.22
B) –$757.69
C) –$204.15
D) –$878.92
E) –$696.94
42) A project has an initial cash outflow of $22,400 and cash inflows of $13,400 a year for Years 1
and 2 and a final cash inflow in Year 6 of $7,500. The required return is 15.5 percent. What is the
net present value?
A) $2,405.66
B) $1,608.14
C) $1,919.08
D) $2,134.85
E) $2,671.02
43) A project initially costs $40,500 and will not produce any cash flows for the first 2 years.
Starting in Year 3, it will produce cash flows of $34,500 a year for 2 years. In Year 6, the project
will end and should produce a final cash inflow of $12,000. What is the net present value of this
project if the required rate of return is 18.5 percent?
A) $2,474.76
B) $2,063.19
C) $1,935.56
D) $1,865.95
E) $2,647.76
44) You are considering two independent projects. The required rate of return is 13.75 percent for
Project A and 14.25 percent for Project B. Project A has an initial cost of $51,400 and cash inflows
of $21,400, $24,900, and $22,200 for Years 1 to 3, respectively. Project B has an initial cost of
$38,300 and cash inflows of $23,000 a year for 2 years. Which project(s), if either, should you
accept?
A) Accept both A and B
B) Reject both A and B
C) Accept A and reject B
D) Accept B and reject A
E) Accept either A or B but not both A and B
45) A new project has an initial cost of $125,000 and cash flows of $33,300, $78,700, and $69,500
for Years 1 to 3, respectively. What is the net present value (NPV) of this project if the discount
rate is 19.3 percent? What is the NPV if the discount rate is 12.7 percent?
A) $1,127.10; $17,209.11
B) –$859.11; $17,209.11
C) –$859.11; $15,062.34
D) $1,127.10; $17,388.09
E) –$604.17; $15,062.34
46) Baxter’s Market is considering opening a new location with an initial cost of $139,200. This
location is expected to generate cash flows of $22,400, $61,500, $37,800, and $21,000 in Years 1
to 4, respectively. What is the payback period?
A) 3.92 years
B) 3.83 years
C) 2.46 years
D) 2.57 years
E) 3.01 years
47) It will cost $28,900 to acquire a small ice cream cart. Cart sales are expected to be $10,500 a
year for 3 years. After the 3 years, the cart is expected to be worthless. What is the payback period?
A) 2.68 years
B) 2.07 years
C) 2.75 years
D) 2.46 years
E) Never
48) You are considering a project with an initial cost of $13,000. What is the payback period for
this project if the annual cash inflows are $3,450, $5,970, $2,100, and $1,400 for Years 1 to 4,
respectively?
A) 4.06 years
B) 3.97 years
C) 3.89 years
D) Never
E) 3.81 years
49) Leo is considering adding a deli to his general store. The remodelling expenses and shelving
costs are estimated at $27,500. Deli sales are expected to produce net cash inflows of $7,300,
$8,600, $9,700, and $9,750 for Years 1 to 4, respectively. Leo has a firm 3-year payback
requirement. Should he add the deli?
A) Yes; because the payback period is 3.19 years
B) Yes; because the payback period is 2.82 years
C) No; because the project never pays back
D) No; because the payback period is 2.82 years
E) No; because the payback period is 3.19 years