Question 1

In theory, capital budgeting decisions should depend solely on forecasted cash flows and the opportunity cost of capital. The decision criterion should not be affected by managers' tastes, choice of accounting method, or the profitability of other independent projects.

Accepted Answer

Capital budgeting decisions should be based on objective factors such as cash flows and opportunity cost of capital, and should not be influenced by subjective or irrelevant factors.

Question 2

The NPV and IRR methods, when used to evaluate two independent and equally risky projects, will lead to different accept/reject decisions and thus capital budgets if the projects' IRRs are greater than their cost of capital.

Accepted Answer

Both NPV (Net Present Value) and IRR (Internal Rate of Return) methods will lead to the same accept/reject decision for independent projects if the projects' IRRs are greater than the cost of capital. This is because both methods will indicate that the projects are expected to generate returns above the required threshold, making them acceptable investments.

Question 3

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.

Accepted Answer

The payback method focuses on how quickly investment costs can be recovered, not on the total value created, while the NPV method evaluates the total value a project adds over its lifetime, taking into account the time value of money. Even with a zero cost of capital, these methods can lead to different decisions because they measure different aspects of a project's financial attractiveness.

Question 4

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.

Accepted Answer

The decision to select a project based on IRR when comparing mutually exclusive projects can be misleading. The correct approach is to compare the NPVs of the projects. A project with a higher IRR might have a lower NPV, and since NPV is the direct measure of how much value a project adds to the firm, the project with the higher NPV should be selected, regardless of the IRR comparison.

Question 5

Which of the following statements is CORRECT?
A) The shorter a project's payback period, the less desirable the project is normally considered to be by this criterion.
B) One drawback of the regular payback is that this method does not take account of cash flows beyond the payback period.
C) If a project's payback is positive, then the project should be accepted because it must have a positive NPV.
D) The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem.
E) One drawback of the discounted payback is that this method does not consider the time value of money, while the regular payback overcomes this drawback.

Accepted Answer

The regular payback method only looks at the time it takes to recoup the initial investment and does not consider cash flows beyond that point. This means that potentially profitable projects with longer cash flows may not be selected.

Question 6

No 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 exceeds the rate at which the projects' NPV profiles cross.

Accepted Answer

If the projects' cost of capital exceeds the rate at which the projects' NPV profiles cross, it means that the discount rate used in the NPV calculation is higher than the IRR of the projects. This indicates that the projects' cash flows are discounted at a rate that exceeds the return generated by the project, and therefore the projects are not profitable. In this case, both methods will recommend rejecting the projects, and no conflict will exist.

Question 7

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 WACC to find the terminal value (TV), then discounting this TV at the WACC.
B) A project's regular IRR is found by discounting the cash inflows at the WACC to find the present value (PV), then compounding this PV to find the IRR.
C) If a project's IRR is greater than the WACC, then its NPV must be negative.
D) 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.
E) To find a project's IRR, we must find a discount rate that is equal to the WACC.

Accepted Answer

The Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of a project equal to zero. Therefore, to find a project's IRR, we must solve for the discount rate that causes the present value (PV) of the inflows to equal the PV of the project's costs, which will result in an NPV of zero. Choices A, B, and E are incorrect because they involve compounding or discounting cash flows at the Weighted Average Cost of Capital (WACC), which is only used to calculate NPV, not IRR. Choice C is incorrect because if a project's IRR is greater than the WACC, then its NPV will be positive, not negative.

Question 8

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.

Accepted Answer

Project S, with faster incoming cash flows, will have a higher NPV at any positive discount rate because earlier cash flows are more valuable when discounted back to the present value.

Question 9

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 cash flows over a project's full life.
B) One defect of the IRR method versus the NPV is that the IRR does not take account of the time value of money.
C) One defect of the IRR method versus the NPV is that the IRR does not take account of the cost of capital.
D) 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.
E) 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.

Accepted Answer

The answer of Which of the following statements is CORRECT?
A)...

Question 10

Which of the following statements is CORRECT?
A) One defect of the IRR method is that it does not take account of cash flows over a project's full life.
B) One defect of the IRR method is that it does not take account of the time value of money.
C) One defect of the IRR method is that it does not take account of the cost of capital.
D) 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.
E) 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.

Accepted Answer

The answer of Which of the following statements is CORRECT?
A)...

Question 11

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.

Accepted Answer

As the cost of capital declines, the present value of distant cash flows rises more than the present value of nearby cash flows. Project L's larger cash flows come later than Project S, so the declining cost of capital increases the present value of Project L more than it does for Project S, causing Project L to become preferred. Therefore, the given statement is true.

Question 12

The NPV and IRR methods, when used to evaluate two equally risky but mutually exclusive projects, will lead to different accept/reject decisions and thus capital budgets if the cost of capital at which the projects' NPV profiles cross is less than the projects' cost of capital.

Accepted Answer

The answer of The NPV and IRR methods, when used...

Question 13

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.

Accepted Answer

The discounted payback method still does not consider cash flows beyond the payback period; it merely discounts the cash flows to their present value within the payback period.

Question 14

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 initial cost at the WACC to find the terminal value (TV), then discounting the TV at the WACC.
B) A project's regular IRR is found by compounding the cash inflows at the WACC to find the present value (PV), then discounting the TV to find the IRR.
C) If a project's IRR is smaller than the WACC, then its NPV will be positive.
D) A project's IRR is the discount rate that causes the PV of the inflows to equal the project's cost.
E) If a project's IRR is positive, then its NPV must also be positive.

Accepted Answer

The internal rate of return (IRR) is the discount rate that makes the net present value (NPV) of the project equal to zero. Therefore, choice D is the correct statement. Choices A and B describe incorrect methods for calculating the regular IRR. Choice C is not necessarily true as a project's NPV will only be positive if its IRR is greater than the WACC. Choice E is also not necessarily true as a project's NPV will depend on the size and timing of its cash inflows and outflows.

Question 15

An increase in the firm's WACC 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.

Accepted Answer

The answer of An increase in the firm's WACC will...

Question 16

Which of the following statements is CORRECT?
A) The regular payback method recognizes all cash flows over a project's life.
B) The discounted payback method recognizes all cash flows over a project's life, and it also adjusts these cash flows to account for the time value of money.
C) The regular payback method was, years ago, widely used, but virtually no companies even calculate the payback today.
D) The regular payback is useful as an indicator of a project's liquidity because it gives managers an idea of how long it will take to recover the funds invested in a project.
E) The regular payback does not consider cash flows beyond the payback year, but the discounted payback overcomes this defect.

Accepted Answer

The regular payback method only considers the amount of time it takes to recover the initial investment in a project, and does not account for any cash flows beyond that point. However, it can still be useful as an indicator of a project's liquidity because it gives managers an idea of how quickly they will recoup their initial investment. While the discounted payback method does adjust for the time value of money, it still only considers cash flows up to the point of payback. Choice A is incorrect because the regular payback method only considers cash flows up to the point of payback. Choice B is inaccurate because it states that the regular payback method adjusts for the time value of money when it does not. Choice C is incorrect because while the regular payback method is less commonly used today, some companies still use it. Choice E is incorrect because it states that the discounted payback overcomes a defect of the regular payback method that it actually shares.

Question 17

Which of the following statements is CORRECT?
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.

Accepted Answer

The answer of Which of the following statements is CORRECT?
A)...

Question 18

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.

Accepted Answer

While Project X has a higher IRR and NPV at a specific cost of capital, NPV profiles could intersect, meaning that the relative attractiveness of the projects could change at different discount rates. If the cost of capital changes, it might make Project Y more attractive under certain conditions.

Question 19

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 NPV is found by compounding the cash inflows at the IRR to find the terminal value (TV), then discounting the TV at the WACC.
B) The lower the WACC used to calculate a project's NPV, the lower the calculated NPV will be.
C) If a project's NPV is less 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 less than zero.
E) The NPV of a relatively low-risk project should be found using a relatively high WACC.

Accepted Answer

If a project's NPV is less than zero, it means that the initial cash outflow is greater than the present value of the cash inflows. This is only possible if the project's IRR is less than the WACC. Therefore, statement C is correct. Statement A is incorrect because the correct method is to discount the cash inflows at the WACC to find the present value, then subtract the initial outflow. Statement B is incorrect because a lower WACC will result in a higher calculated NPV. Statement D is incorrect because a positive NPV indicates that the project's IRR is greater than the WACC. Statement E is incorrect because a lower WACC should be used for a relatively low-risk project.

Question 20

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 longer a project's payback period, the more desirable the project is normally considered to be by this criterion.
B) One drawback of the regular payback 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.

Accepted Answer

The regular payback method does not consider the time value of money, which means that it does not account for the fact that money today is worth more than the same amount of money in the future. This can lead to incorrect decisions. The discounted payback method, on the other hand, does account for the time value of money by using discounted cash flows. Therefore, option D is incorrect. Option A is also incorrect because a longer payback period indicates that it takes longer to recover the initial investment, which is not desirable. Option C is incorrect because a positive payback period means that the initial investment is recovered at some point, but it does not indicate whether the project has a positive or negative NPV. Option E is incorrect because it assumes that all long-lived projects are riskier, which is not necessarily true. Companies should consider other factors, such as market conditions and competition, when evaluating the risk of a project.

Quiz 10: The Basics of Capital Budgeting: Evaluating Cash Flows

In theory, capital budgeting decisions should depend solely on forecasted cash flows and the opportunity cost of capital. The decision criterion should not be affected by managers' tastes, choice of accounting method, or the profitability of other independent projects.

The NPV and IRR methods, when used to evaluate two independent and equally risky projects, will lead to different accept/reject decisions and thus capital budgets if the projects' IRRs are greater than their cost of capital.

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.

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.

Which of the following statements is CORRECT?

No 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 exceeds the rate at which the projects' NPV profiles cross.

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.

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.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

The NPV and IRR methods, when used to evaluate two equally risky but mutually exclusive projects, will lead to different accept/reject decisions and thus capital budgets if the cost of capital at which the projects' NPV profiles cross is less than the projects' cost of capital.

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.

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.

An increase in the firm's WACC 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.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

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.

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.