Answer Options:
a. One advantage of the NPV over the IRR is that NPV takes account of cash flows over a project’s full life whereas IRR does not.
b. One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at the WACC, whereas IRR assumes that cash flows are reinvested at the IRR. NPV also aims to generally more appropriate.
c. One advantage of the MIRR over the IRR method is that NPV discounts cash flows whereas the MIRR is based on undiscounted cash flows.
d. Since cash flows under the IRR and MIRR are both discounted at the same rate (the WACC), these two methods always rank mutually exclusive projects in the same order.
e. None of the above statements is correct.
Answer: B. One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at the WACC, whereas IRR assumes that cash flows are reinvested at the IRR. NPV also aims to generally more appropriate.
Question: The change in net operating working capital associated with new projects is always positive, because new projects mean that more operating working capital will be required.
Answer Options:
a. True
b. False
Answer: B. False
Question: The two cardinal rules that financial analysts should follow to avoid errors are: (1) in the NPV equation, the numerator should use income calculated in accordance with generally accepted accounting principles, and (2) all incremental cash flows should be considered when making accept/reject decisions for capital budgeting projects.
Answer Options:
a. True
b. False
Answer: B. False
Question: Which of the following statements is INCORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
Answer Options:
a. The longer a project’s payback period, the more desirable the project is normally considered to be by this criterion.
b. One drawback of the payback criterion for evaluating projects is that this method does not properly account for the time value of money.
c. If a project’s payback is positive, then the project should be rejected because it must have a negative NPV.
d. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem.
e. If a company uses the same payback requirement to evaluate all projects, say it requires a payback of 4 years or less, then the company will tend to reject projects with relatively short lives and accept long-lived projects, and this will cause its risk to increase over time.
Answer: A. The longer a project’s payback period, the more desirable the project is normally considered to be by this criterion.
Question: Suppose Tapley Inc. uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Tapley accept, assuming that the company uses the NPV method when choosing projects?
Answer Options:
a. Project A, which has average risk and an IRR = 9%.
b. Project B, which has below-average risk and an IRR = 8.5%.
c. Project C, which has above-average risk and an IRR = 11%.
d. Without information about the projects’ NPVs we cannot determine which one or ones should be accepted.
Answer: D. Without information about the projects’ NPVs we cannot determine which one or ones should be accepted.
Question: If you were evaluating two mutually exclusive projects for a firm with a zero cost of capital, the payback method and NPV method would always lead to the same decision on which project to undertake.
Answer Options:
a. True
b. False
Answer: False
Question: Although it is extremely difficult to make accurate forecasts of the revenues that a project will generate, projects’ initial outlays and subsequent costs can be forecasted with great accuracy. This is especially true for large product development projects.
Answer Options:
a. True
b. False
Answer: B. False
Question: Typically, a project will have a higher NPV if the firm uses accelerated rather than straight-line depreciation. This is because the total cash flows over the project’s life will be higher if accelerated depreciation is used, other things held constant.
Answer Options:
a. True
b. False
Answer: B. False
Question: Extending the lives of projects with different lives out to a common life for comparison purposes, while theoretically appealing, is valid only if there is a reasonably high probability that the projects will actually be repeated beyond their initial lives.
Answer Options:
a. True
b. False
Answer: B. False
Question: Which of the following statements is CORRECT?
Answer Options:
a. The NPV, IRR, MIRR, and discounted payback (using a payback requirement of 3 years or less) methods always lead to the same accept/reject decisions for independent projects.
b. For mutually exclusive projects with normal cash flows, the NPV and MIRR methods can never conflict, but their results could conflict with the discounted payback and the regular IRR methods.
c. Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the regular IRR.
d. If a firm uses the discounted payback method with a required payback of 4 years, then it will accept more projects than if it used a regular payback of 4 years.
e. The percentage difference between the MIRR and the IRR is equal to the project’s WACC.
Answer: C. Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the regular IRR.
Question: When evaluating mutually exclusive projects, the modified IRR (MIRR) always leads to the same capital budgeting decisions as the NPV method, regardless of the relative lives or sizes of the projects being evaluated.
Answer Options:
a. True
b. False
Answer: False
Question: 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.
Answer Options:
a. True
b. False
Answer: True
Question: The two methods discussed in the text for dealing with unequal project lives are (1) the replacement chain approach and (2) the equivalent annual annuity (EAA) approach.
Answer Options:
a. True
b. False
Answer: A. True
Question: Which of the following statements is CORRECT?
Answer Options:
a. The NPV, IRR, MIRR, and discounted payback (using a payback requirement of 3 years or less) methods always lead to the same accept/reject decisions for independent projects.
b. For mutually exclusive projects with normal cash flows, the NPV and MIRR methods can never conflict, but their results could conflict with the discounted payback and the regular IRR methods.
c. Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the regular IRR.
d. If a firm uses the discounted payback method with a required payback of 4 years, then it will accept more projects than if it used a regular payback of 4 years.
e. The percentage difference between the MIRR and the IRR is equal to the project’s WACC.
Answer: C. Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the regular IRR.
Question: Which of the following statements is CORRECT?
Answer Options:
a. An example of a sunk cost is the cost associated with restoring the site of a strip mine once the ore has been depleted.
b. Sunk costs must be considered if the IRR method is used but not if the firm relies on the NPV method.
c. A good example of a sunk cost is a situation where a bank opens a new office, and that new office leads to a decline in deposits of the bank’s other offices.
d. A good example of a sunk cost is money that a banking corporation spent last year to investigate the site for a new office, then expensed that cost for tax purposes, and now is deciding whether to go forward with the project.
e. If sunk costs are considered and reflected in a project’s cash flows, then the project’s calculated NPV will be higher than it otherwise would have been had the sunk costs been ignored.
Answer:
Question: Assume that the economy is in a mild recession, and as a result interest rates and money costs generally are relatively low. The WACC for two mutually exclusive projects that are being considered is 8%. Project S has an IRR of 20% while Project L’s IRR is 15%. The projects have the same NPV at the 8% current WACC. However, you believe that the economy is about to recover, and money costs and thus your WACC will also increase. You also think that the projects will not be funded until the WACC has increased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT?
Answer Options:
a. You should delay a decision until you have more information on the projects, even if this means that a competitor might come in and capture this market.
b. You should recommend Project L, because at the new WACC it will have the higher NPV.
c. You should recommend Project S, because at the new WACC it will have the higher NPV.
d. You should recommend Project L, because at the new WACC it will have the higher IRR.
e. You should recommend Project L because it will have both a higher IRR and a higher NPV under the new conditions.
Answer: D. You should recommend Project L, because at the new WACC it will have the higher IRR.
Question: A conflict will exist between the NPV and IRR methods, when used to evaluate two equally risky but mutually exclusive projects, if the projects’ cost of capital is less than the rate at which the projects’ NPV profiles cross.
Answer Options:
a. True
b. False
Answer: True
Question: Traditionally, an NPV analysis assumes that projects will be accepted or rejected, which implies that they will be undertaken now or never. However, in practice, companies sometimes have a third choice—delay the decision until later, when more information will be available.
Answer Options:
a. True
b. False
Answer: b. False