Answer Options:
a. If a project has “normal” cash flows, then its IRR must be positive.
b. If a project has “normal” cash flows, then its MIRR must be positive.
c. If a project has “normal” cash flows, then it will have exactly two real IRRs.
d. 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.
e. 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.
Answer: E. 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.
Question: The primary reason that the NPV method is conceptually superior to the IRR method for evaluating mutually exclusive investments is that multiple IRRs may exist, and when that happens, we don’t know which IRR is relevant.
Answer Options:
a. True
b. False
Answer: False
Question: The regular payback method is deficient in that it does not take account of cash flows beyond the payback period. The discounted payback method corrects this fault.
Answer Options:
a. True
b. False
Answer: False
Question: Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product?
Answer Options:
a. A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes.
b. A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm’s current products.
c. A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery.
d. A firm has spent $2 million on research and development associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected.
e. A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm’s other products.
Answer: D. A firm has spent $2 million on research and development associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected.
Question: Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a 4-year payback regardless of economic conditions. Other things held constant, which of the following statements is most likely to be true?
Answer Options:
a. It will accept too many short-term projects and reject too many long-term projects (as judged by the NPV).
b. It will accept too many long-term projects and reject too many short-term projects (as judged by the NPV).
c. The firm will accept too many projects in all economic states because a 4-year payback is too low.
d. The firm will accept too few projects in all economic states because a 4-year payback is too high.
e. If the 4-year payback results in accepting just the right set of projects under average economic conditions, then this payback will result in too few long-term projects when the economy is weak.
Answer: D. The firm will accept too few projects in all economic states because a 4-year payback is too high.
Question: Other things held constant, which of the following would increase the NPV of a project being considered?
Answer Options:
a. A shift from straight-line to MACRS depreciation.
b. Making the initial investment in the first year rather than spreading it over the first three years.
c. An increase in the discount rate associated with the project.
d. An increase in required net operating working capital.
e. The project would decrease sales of another product line.
Answer: A. A shift from straight-line to MACRS depreciation.
Question: Rowell Company spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale or for a new product. Rowell owns the building free and clear—there is no mortgage on it. Which of the following statements is CORRECT?
Answer Options:
a. Since the building has been paid for, it can be used by another project with no additional cost. Therefore, it should not be reflected in the cash flows of the capital budgeting analysis for any new project.
b. If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it.
c. This is an example of an externality, because the very existence of the building affects the cash flows for any new project that Rowell might consider.
d. Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new projects.
e. If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project that used the building.
Answer: B. If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it.
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. Because the analysis extends out at least one additional year from the original analysis, it is unlikely that the firm would ever delay a project—particularly given the loss of the “first mover advantage.”
Answer Options:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT?
Answer Options:
a. In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project’s cash flows will lead to an upward bias in the NPV.
b. In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project’s cash flows will lead to a downward bias in the NPV.
c. The existence of any type of “externality” will reduce the calculated NPV versus the NPV that would exist without the externality.
d. If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net proceeds that could be obtained should be charged as a cost to the project under consideration.
e. If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored.
Answer: D. If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net proceeds that could be obtained should be charged as a cost to the project under consideration.
Question: Four of the following statements are truly disadvantages of the regular payback method, but one is not a disadvantage of this method. Which one is NOT a disadvantage of the payback method?
Answer Options:
a. Lacks an objective, market-determined benchmark for making decisions.
b. Ignores cash flows beyond the payback period.
c. Does not directly account for the time value of money.
d. Does not provide any indication regarding a project’s liquidity or risk.
e. Does not take account of differences in size among projects.
Answer: D. Does not provide any indication regarding a project’s liquidity or risk.
Question: 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.
Answer Options:
a. A project’s NPV is generally found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting the TV at the IRR to find its PV.
b. The higher the WACC used to calculate the NPV, the lower the calculated NPV will be.
c. If a project’s NPV is greater than zero, then its IRR must be less than the WACC.
d. If a project’s NPV is greater than zero, then its IRR must be more than zero.
e. The NPVs of relatively risky projects should be found using relatively low WACCs.
Answer: B. The higher the WACC used to calculate the NPV, the lower the calculated NPV will be.
Question: Which of the following statements is CORRECT?
Answer Options:
a. In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project’s cash flows will lead to an upward bias in the NPV.
b. In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project’s cash flows will lead to a downward bias in the NPV.
c. The existence of any type of “externality” will reduce the calculated NPV versus the NPV that would exist without the externality.
d. If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net proceeds that could be obtained should be charged as a cost to the project under consideration.
e. If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored.
Answer: D. If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net proceeds that could be obtained should be charged as a cost to the project under consideration.
Question: Which of the following statements is CORRECT?
Answer Options:
a. If a project with normal cash flows has an IRR greater than the WACC, the project must also have a positive NPV.
b. If Project A’s IRR exceeds Project B’s, then A must have the higher NPV.
c. A project’s MIRR can never exceed its IRR.
d. If a project with normal cash flows has an IRR less than the WACC, the project must have a positive NPV.
e. If the NPV is negative, the IRR must also be negative.
Answer: A. If a project with normal cash flows has an IRR greater than the WACC, the project must also have a positive NPV.
Question: It is extremely difficult to estimate the revenues and costs associated with large, complex projects that take several years to develop. This is why subjective judgment is often used for such projects along with discounted cash flow analysis.
Answer Options:
a. True
b. False
Answer: A. True
Question: Which of the following statements is CORRECT?
Answer Options:
a. Projects with “normal” cash flows can have only one real IRR.
b. Projects with “normal” cash flows can have two or more real IRRs.
c. Projects with “normal” cash flows must have two changes in the sign of the cash flows, e.g., from negative to positive to negative. If there are more than two sign changes, then the cash flow stream is “nonnormal.”
d. The “multiple IRR problem” can arise if a project’s cash flows are “normal.”
e. Projects with “nonnormal” cash flows are almost never encountered in the real world.
Answer: A. Projects with “normal” cash flows can have only one real IRR.
Question: Which of the following statements is CORRECT?
Answer Options:
a. If a project with normal cash flows has an IRR greater than the WACC, the project must also have a positive NPV.
b. If Project A’s IRR exceeds Project B’s, then A must have the higher NPV.
c. A project’s MIRR can never exceed its IRR.
d. If a project with normal cash flows has an IRR less than the WACC, the project must have a positive NPV.
e. If the NPV is negative, the IRR must also be negative.
Answer: A. If a project with normal cash flows has an IRR greater than the WACC, the project must also have a positive NPV.
Question: Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the higher IRR.
Answer Options:
a. True
b. False
Answer: False
Question: Which of the following statements is CORRECT?
Answer Options:
a. The IRR method appeals to some managers because it gives an estimate of the rate of return on projects rather than a dollar amount.
b. The NPV and IRR methods both assume that cash flows can be reinvested at the WACC. However, the MIRR method assumes reinvestment at the MIRR itself.
c. The NPV and IRR methods both assume that cash flows can be reinvested at the WACC. However, the MIRR method projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the higher IRR probably has more of its cash flows coming in the later years.
d. If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the lower IRR probably has more of its cash flows coming in the later years.
e. The IRR method appeals to some managers because it gives an estimate of the rate of return on projects rather than the NPV, which is a dollar amount.
Answer: A. The IRR method appeals to some managers because it gives an estimate of the rate of return on projects rather than a dollar amount.