Question 1

Unlike using IRR, selecting projects according to their NPV will always lead to a correct accept-reject decision.

Accepted Answer

NPV takes into account the time value of money and gives a dollar value to the net benefit of a project, while IRR only considers the project's overall return. Therefore, choosing projects based on their NPV will always lead to a correct decision, while using IRR may lead to incorrect decisions in certain situations, such as when there are multiple IRRs or non-conventional cash flows.

Question 2

The payback rule states that a project is acceptable if you get your money back within a specified period.

Accepted Answer

The payback rule or payback period method specifies a time period within which the cash inflows from a project must equal the initial investment to consider the project acceptable. Therefore, the statement is true.

Question 3

A risky dollar is worth more than a safe one.

Accepted Answer

A risky dollar is generally considered to be worth less than a safe one because individuals and investors require a premium or additional compensation for taking on additional risk.

Question 4

As the opportunity cost of capital decreases, the net present value of a project increases.

Accepted Answer

As the opportunity cost of capital decreases, the discount rate used to calculate the net present value decreases, which increases the net present value of a project.

Question 5

Projects with an NPV of zero decrease shareholders' wealth by the cost of the project.

Accepted Answer

Projects with an NPV of zero do not decrease or increase shareholders' wealth, they simply break even.

Question 6

The IRR is the rate of return on the cash flows of the investment, also known as the opportunity cost of capital.

Accepted Answer

The IRR (Internal Rate of Return) is the discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. It is not the opportunity cost of capital, but rather a measure used to estimate the profitability of potential investments.

Question 7

Because of deficiencies associated with the payback method, it is seldom used in corporate financial analysis today.

Accepted Answer

While the payback method does have its drawbacks, it is still commonly used in corporate financial analysis as one of several methods for evaluating investment projects.

Question 8

Soft rationing should never cost the firm anything.

Accepted Answer

Soft rationing involves measures such as prioritizing projects, improving resource allocation efficiency, and maximizing utilization of existing resources without additional cost to the firm. Therefore, soft rationing should not cost the firm anything.

Question 9

A project's payback period is the length of time necessary to generate an NPV of zero.

Accepted Answer

The payback period is the length of time required to recover the initial investment in a project, not the time it takes to generate a Net Present Value (NPV) of zero. NPV is a separate financial metric that calculates the present value of all cash flows (both incoming and outgoing) associated with a project, discounted back to the present value.

Question 10

For most managers, discounted cash-flow analysis is in fact the dominant tool for project evaluation.

Accepted Answer

Discounted cash-flow analysis is widely used by managers for project evaluation as it helps in determining the present value of future cash flows. It takes into account the time value of money and provides a more accurate assessment of a project's profitability. Other tools like payback period and accounting rate of return may also be used, but discounted cash-flow analysis is considered to be the most comprehensive and reliable method.

Question 11

Both the NPV and the internal rate of return methods recognize that the timing of cash flows affects project value.

Accepted Answer

Both the NPV and IRR methods consider the timing of cash inflows and outflows when calculating project value. The NPV method discounts future cash flows back to their present value and compares them to the initial cost of the project, while the IRR method calculates the rate at which the project's net present value is equal to zero. Both methods take into account the time value of money, which means that cash flows received earlier are worth more than those received later on.

Question 12

When calculating IRR with a trial and error process, discount rates should be raised when NPV is positive.

Accepted Answer

When the NPV (Net Present Value) is positive, it indicates that the present value of future cash flows is greater than the initial investment, suggesting that the discount rate (or interest rate) is too low. Therefore, to find the IRR (Internal Rate of Return), the discount rate should be raised to reach a point where NPV equals zero.

Question 13

For mutually exclusive projects, the project with the higher IRR is the correct selection.

Accepted Answer

For mutually exclusive projects, the project with the higher Net Present Value (NPV) should be selected, not necessarily the one with the higher Internal Rate of Return (IRR), as NPV provides a direct measure of how much value is added by undertaking the project.

Question 14

When we compare assets with different lives, we should select the machine that has the lowest equivalent annual cost.

Accepted Answer

When comparing assets with different lives, it is important to consider the equivalent annual cost, which takes into account the purchase price, salvage value, and operating costs over the asset's useful life. By selecting the machine with the lowest equivalent annual cost, we can make the most cost-effective decision.

Question 15

The payback rule always makes shareholders better off.

Accepted Answer

The payback rule focuses only on the timing of cash flows and ignores the profitability of a project over its entire life. This can lead to accepting projects with short payback periods that may not be profitable in the long run, potentially decreasing shareholder value. Therefore, the payback rule does not always make shareholders better off.

Question 16

If a project has multiple IRRs, the highest one is assumed to be correct.

Accepted Answer

If a project has multiple IRRs, it means that there are multiple discount rates at which the project's net present value is equal to zero. In this scenario, it is not sufficient to rely on the highest IRR alone to make investment decisions. Instead, other measures such as net present value and profitability index should be considered to determine the viability of the project.

Question 17

When using a profitability index to select projects, a value of .63 is preferred over a value of 0.21.

Accepted Answer

A profitability index (PI) is a tool used in capital budgeting to evaluate the profitability of investment opportunities. The PI is calculated as the present value of future cash flows divided by the initial investment. A PI greater than 1 indicates that the project is expected to generate positive net present value and is generally considered acceptable. Therefore, a PI of 0.63 is preferred over a PI of 0.21 since the former indicates a higher expected return on investment.

Question 18

For many firms the limits on capital funds are "soft." By this we mean that the capital rationing is not imposed by investors.

Accepted Answer

Soft capital rationing means that the limits on capital funds are not imposed by external investors, but rather are self-imposed by the firm based on its own internal financial constraints.

Question 19

The payback period considers all project cash flows.

Accepted Answer

The payback period only considers the time it takes to recover the initial investment, not all future cash flows or their time value.

Question 20

When choosing among mutually exclusive projects, the choice is easy using the NPV rule. As long as at least one project has positive NPV, simply choose the project with the highest NPV.

Accepted Answer

The NPV rule states that if at least one project has a positive NPV, it should be chosen over any other mutually exclusive project with lower NPV. Therefore, if one project has a positive NPV and the others have negative NPV, the choice is easy and the project with the highest positive NPV should be chosen. It is important to note that the choice may not be as straightforward if all projects have negative NPV or if there are constraints such as limited resources that need to be taken into account.

Quiz 8: Net Present Value and Other Investment Criteria