Question 1

A company is choosing between two projects. The larger project has an initial cost of $100,000, annual cash flows of $30,000 for 5 years, and an IRR of 15.24%. The smaller project has an initial cost of $50,000, annual cash flows of $16,000 for 5 years, and an IRR of 16.63%. The projects are equally risky. Which of the following statements is correct?
A) Since the smaller project has the higher IRR, the two projects' NPV profiles cannot cross, and the smaller project's NPV will be higher at all positive values of WACC.
B) Since the smaller project has the higher IRR, the two projects' NPV profiles will cross, and the larger project will look better based on the NPV at all positive values of WACC.
C) Since the smaller project has the higher IRR but the larger project has the higher NPV at a zero discount rate, the two projects' NPV profiles will cross, and the larger project will have the higher NPV if the WACC is less than the crossover rate.
D) Since the smaller project has the higher IRR and the larger NPV at a zero discount rate, the two projects' NPV profiles will cross, and the larger smaller project will look better if the WACC is less than the crossover rate.

Accepted Answer

The smaller project has the higher IRR, but the larger project has the higher NPV at a zero discount rate, which means that the larger project has a higher total cash inflow. Therefore, the two projects' NPV profiles will cross at some point. The larger project will have the higher NPV if the WACC is less than the crossover rate because it has a higher total cash inflow. Therefore, option C is correct.

Question 2

Projects A and B are mutually exclusive and have normal cash flows. Project A has an IRR of 15% and Project B's IRR is 20%. The company's WACC is 12%, and at that rate Project A has the higher NPV. Which of the following statements is correct?
A) The crossover rate for the two projects must be less than 12%.
B) Assuming the timing pattern of the two projects' cash flows is the same, Project B probably has a higher cost (and larger scale).
C) Assuming the two projects have the same scale, Project B probably has a faster payback than Project A.
D) Since B has the higher IRR, then it must also have the higher NPV if the crossover rate is less than the WACC of 12%.

Accepted Answer

Since Project A has a lower IRR, it indicates that its project cash flows are spread out over a longer period, and therefore, it may take longer to pay back. Conversely, Project B, with the higher IRR, suggests that its annual cash flows are higher (assuming the same initial investment), meaning it is generating more cash per year, and thus may have a faster payback. Therefore, assuming the two projects have the same scale, Project B probably has a faster payback than Project A. The crossover rate can often be higher than WACC, so A is incorrect. It is not possible to determine the cost or scale of the projects from the information given, so B is incorrect. Similarly, it cannot be assumed that Project B will have a higher NPV than Project A at the crossover rate, so D is also incorrect.

Question 3

Which statement about a project's MIRR 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 MIRR is always greater than its regular IRR.
B) A project's MIRR is always less than its regular IRR.
C) If a project's IRR is greater than its WACC, then the MIRR will be less than the IRR.
D) If a project's IRR is greater than its WACC, then the MIRR will be greater than the IRR.

Accepted Answer

The answer of Which statement about a project's MIRR is...

Question 4

Projects S and L both have normal cash flows, and the projects have the same risk; hence, both are evaluated with the same WACC, 10%. However, S has a higher IRR than L. Which of the following statements is correct?
A) Project S must have a higher NPV than Project L.
B) If Project S has a positive NPV, then Project L must also have a positive NPV.
C) If the WACC falls, then each project's IRR will increase.
D) If Projects S and L have the same NPV at the current WACC, 10%, then Project L, the one with the lower IRR, would have a higher NPV if the WACC used to evaluate the projects declined.

Accepted Answer

Explanation: The statement in D is correct because when evaluating projects with different IRRs, if they have the same NPV at a certain discount rate (in this case, the WACC of 10%), the project with the lower IRR (Project L) will have a higher NPV if the discount rate decreases. This is due to the relationship between NPV and discount rates: as the discount rate decreases, the NPV of projects generally increases, and the project with the lower IRR will see a relatively larger increase in NPV because its cash flows are discounted less steeply.

Question 5

Which statement about a project's MIRR is correct? Assume that the project being considered has normal cash flows, with one cash outflow at t = 0 followed by a series of positive cash flows.
A) A project's MIRR is always greater than its regular IRR.
B) A project's MIRR is always less than its regular IRR.
C) To find a project's MIRR, we compound cash inflows at the regular IRR and then find the discount rate that causes the PV of the terminal value to equal the initial cost.
D) To find a project's MIRR, the textbook procedure compounds cash inflows at the WACC and then finds the discount rate that causes the PV of the terminal value to equal the initial cost.

Accepted Answer

The Modified Internal Rate of Return (MIRR) is calculated by compounding the project's cash inflows at the project's cost of capital (often the Weighted Average Cost of Capital, WACC) to the end of the project and then finding the discount rate that equates this terminal value to the project's initial cost. This method addresses some of the reinvestment rate assumptions inherent in the traditional IRR calculation.

Question 6

Which statement about a project's IRR is correct? Assume that all projects being considered have normal cash flows and are equally risky.
A) If a project's IRR is equal to its WACC, then, under all reasonable conditions, the project's NPV must be negative.
B) If a project's IRR is equal to its WACC, then, under all reasonable conditions, the project's IRR must be negative.
C) If a project's IRR is equal to its WACC, then, under all reasonable conditions, the project's NPV must be zero.
D) There is no necessary relationship between a project's IRR, its WACC, and its NPV.

Accepted Answer

If a project's Internal Rate of Return (IRR) is equal to its Weighted Average Cost of Capital (WACC), the Net Present Value (NPV) of the project is zero. This is because the IRR is the discount rate that makes the NPV of all cash flows from a particular project equal to zero.

Question 7

Project X's IRR is 19% and Project Y's IRR is 17%. The projects have the same risk and the same lives, and each has constant cash flows during each year of their lives. If the WACC is 10%, Project Y has a higher NPV than X. Given this information, which of the following statements is correct?
A) The crossover rate between the two projects must be less than 10%.
B) The crossover rate between the two projects must be greater than 10%.
C) If the WACC is 8%, Project X will have the higher NPV.
D) If the WACC is 18%, Project Y will have the higher NPV.

Accepted Answer

DThe crossover rate is the discount rate at which the NPVs of two projects are equal. Since Project Y has a higher NPV than Project X at a WACC of 10%, and given that Project Y's IRR is lower than Project X's IRR, the crossover rate must be greater than 10%. This is because as the discount rate increases from the crossover point, the project with the lower IRR (Project Y) will have a higher NPV than the project with the higher IRR (Project X) until the discount rate reaches the IRR of the project with the higher IRR. Additionally, if the WACC is 18%, which is closer to Project X's IRR of 19% than to Project Y's IRR of 17%, the NPV of Project Y would be higher than that of Project X because the NPV decreases as the discount rate approaches the IRR from below.

Question 8

McCall Manufacturing has a WACC of 10%. The firm is considering two normal, equally risky, mutually exclusive, but not repeatable projects. The two projects have the same investment costs, but Project A has an IRR of 15%, while Project B has an IRR of 20%. Which of the following statements is correct?
A) Each project must have a negative NPV.
B) Since the projects are mutually exclusive, the firm should always select Project B.
C) If the crossover rate is 8%, Project B will have the higher NPV.
D) If the crossover rate is 8%, Project A will have a higher NPV than Project B.

Accepted Answer

The answer of McCall Manufacturing has a WACC of 10%....

Question 9

You are on the staff of Camden Inc. The CFO believes project acceptance should be based on the NPV, but Steve Camden, the president, insists that no project can be accepted unless its IRR exceeds the project's risk-adjusted WACC. Now you must make a recommendation on a project that has a cost of $15,000 and two cash flows: $110,000 at the end of Year 1 and -$100,000 at the end of Year 2. The president and the CFO both agree that the appropriate WACC for this project is 10%. At 10%, the NPV is $2,355.37, but you find two IRRs, one at 6.33% and one at 5.27%, and a MIRR of 11.32%. Which of the following statements best describes your optimal recommendation, i.e., the analysis and recommendation that is best for the company and least likely to get you in trouble with either the CFO or the president?
A) You should recommend that the project be rejected because its NPV is negative and its IRR is less than the WACC.
B) You should recommend that the project be rejected because, although its NPV is positive, it has an IRR that is less than the WACC.
C) You should recommend that the project be accepted because (1) its NPV is positive and (2) although it has two IRRs, in this case it would be better to focus on the MIRR, which exceeds the WACC. You should explain this to the president and tell him that that the firm's value will increase if the project is accepted.
D) You should recommend that the project be rejected because (1) its NPV is positive and (2) it has two IRRs, one of which is less than the WACC, which indicates that the firm's value will decline if the project is accepted.

Accepted Answer

The project has a positive NPV at the appropriate WACC, indicating that the project will increase the firm's value. Although it has two IRRs, the focus should be on the MIRR which exceeds the WACC. Therefore, the project should be accepted and the recommendation should be explained to the president.

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

Projects A and B are mutually exclusive and have normal cash flows. Project A has an IRR of 15% and Project B's IRR is 20%. The company's WACC is 12%, and at that rate Project A has the higher NPV. Which of the following statements is correct?

Which statement about a project's MIRR is correct? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.

Projects S and L both have normal cash flows, and the projects have the same risk; hence, both are evaluated with the same WACC, 10%. However, S has a higher IRR than L. Which of the following statements is correct?

Which statement about a project's MIRR is correct? Assume that the project being considered has normal cash flows, with one cash outflow at t = 0 followed by a series of positive cash flows.

Which statement about a project's IRR is correct? Assume that all projects being considered have normal cash flows and are equally risky.

Project X's IRR is 19% and Project Y's IRR is 17%. The projects have the same risk and the same lives, and each has constant cash flows during each year of their lives. If the WACC is 10%, Project Y has a higher NPV than X. Given this information, which of the following statements is correct?