Question 1

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 2

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.

Accepted Answer

The regular payback method is often criticized for not taking into account any cash flows occurring beyond the payback period. This ignores the time value of money, which is why the discounted payback method is often preferred. Option A is incorrect because a shorter payback period is considered more desirable as it helps in recovering the initial investment in a shorter period. Option C is incorrect because the payback period does not take the time value of money into account, so positive payback does not necessarily mean a positive NPV. Option D is incorrect because the statement is only partially correct. The discounted payback method overcomes the problem of ignoring cash flows beyond the payback period, but it still suffers from some limitations.

Question 3

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 IRR method does indeed consider the time value of money, cash flows over the project's full life, and does not value a dollar received today the same as a dollar received in the future. However, it may not properly account for differences in the sizes of projects, which is a limitation compared to the NPV method that can more accurately reflect the scale of an investment's value.

Question 4

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

When the cost of capital is greater than the crossover rate, both the NPV and IRR methods will recommend the same project because the projects' cash flows generate a return exceeding the cost of capital. Therefore, there will be no conflict between the two methods.

Question 5

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 the cost of capital, NPV profiles could intersect, meaning there might be a different cost of capital where Project Y becomes more desirable. The decision depends on the cost of capital and other factors, not just the IRR and NPV at one point.

Question 6

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 calculates the time it takes to recover the initial investment, but it does not consider cash flows beyond the payback year. Therefore, it 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. The other statements are incorrect.

Question 7

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 solely on the time it takes to recover the initial investment, ignoring any cash flows that occur after the payback period and the time value of money. The NPV method considers all cash flows and the time value of money, leading to potentially different decisions.

Question 8

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 IRR is the discount rate that makes the NPV of a project equal to zero. Therefore, 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. Option A is incorrect because compounding the cash flows at the WACC to find the terminal value is used to find the Modified IRR (MIRR), not the regular IRR. Option B is incorrect because discounting the cash inflows at the WACC to find the present value is the first step in calculating a project's NPV, not its IRR. Option C is incorrect because if a project's IRR is greater than the WACC, then its NPV must be positive, not negative. Option E is incorrect because while a project's IRR may be equal to its WACC in some cases, it is not always the case.

Question 9

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.

Accepted Answer

A project's NPV is the present value of its future cash flows, discounted at the appropriate discount rate (usually the WACC). If the NPV is less than zero, it means that the project's cash outflows exceed its discounted cash inflows, i.e. the project is not generating enough return to cover its cost of capital. In this scenario, the IRR would be less than the WACC. Option A is incorrect because it refers to a terminal value, which is not always relevant or applicable to a project's cash flows. Option B is incorrect because a lower WACC would increase the present value of a project's cash inflows, thus increasing its NPV. Option D is incorrect because if a project's NPV is positive, it means that its cash inflows exceed its outflows, and therefore the IRR would be greater than the WACC.

Question 10

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

An increase in the firm's WACC will also increase the cost of capital used in calculating projects' IRRs, which could potentially lower the IRRs to a point where some projects would be rejected. Therefore, the accept/reject decision under the IRR method is not independent of the cost of capital.

Question 11

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 12

Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT?
A) A project's IRR increases as the WACC declines.
B) A project's NPV increases as the WACC declines.
C) A project's MIRR is unaffected by changes in the WACC.
D) A project's regular payback increases as the WACC declines.
E) A project's discounted payback increases as the WACC declines.

Accepted Answer

The NPV of a project is calculated by discounting the cash flows at the WACC. As the WACC declines, the discount rate used to calculate NPV decreases, which increases the present value of the cash flows and thus increases the NPV. The other options are incorrect, as IRR increases as the WACC decreases; MIRR is affected by changes in WACC; regular payback decreases as the WACC decreases; and discounted payback also decreases as the WACC decreases.

Question 13

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

One drawback of the regular payback for evaluating projects is that this method does not properly account for the time value of money. The longer a project's payback period, the less desirable the project is normally considered to be because it takes longer to recover the initial investment. If a project has a positive payback period, it means that the initial investment will not be fully recovered within the project's lifetime. The discounted payback method solves the regular payback's problem of not accounting for the time value of money by discounting each cash flow before summing them. If a company uses the same payback requirement for all projects, it will tend to accept short-lived projects and reject long-lived ones, which increases the company's risk over time.

Question 14

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

According to the principles of capital budgeting, decisions should be based on objective criteria such as forecasted cash flows and opportunity cost of capital, and should not be influenced by subjective factors such as manager's tastes or accounting methods.

Question 15

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

A decline in interest rates and money costs would reduce the present value of future cash flows, which would benefit Project L with its large cash flows later in its life. As a result, Project L would become more preferable than Project S, which has high cash flows early in its life.

Question 16

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 compared to Project L, because earlier cash flows are more valuable when discounted back to the present value.

Question 17

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 Project X over Project Y based solely on a higher IRR can be misleading if not considering the scale of investment, timing of cash flows, and cost of capital. NPV should be the primary criterion for project selection, especially for mutually exclusive projects, as it directly measures the value added to the firm. A project with a higher NPV, even if it has a lower IRR, can be more beneficial to the firm.

Question 18

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 19

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?
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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) 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.

Accepted Answer

The IRR is the discount rate that makes the NPV of the project equal to zero, so statement D is correct. Statement A is incorrect because the terminal value should be discounted back to the present time, not at the WACC. Statement B is incorrect because the cash inflows should be discounted back to the present time to find the PV, not compounded. Statement C is incorrect because if the IRR is smaller than the WACC, then the project's NPV will be negative, not positive.

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

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.

Which of the following statements is CORRECT?

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?

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.

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.

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.

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.

Assume a project has normal cash flows. All else equal, 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.

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.

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.

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.

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.

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.