Deck 22: Capital Budgeting

Question 1

The internal rate of return method of capital budgeting permits a ranking of investment proposals.​

Answer 1

True

Question 2

An increase in an investment's cash inflows that is not the result of an increase in earnings has no effect on the net present value of an investment.​

Answer 2

False

Question 3

The internal rate of return assumes that cash inflows are reinvested at the firm's cost of capital.​

Answer 3

False

Question 4

If a firm switches from straight-line to accelerated depreciation, an investment's internal rate of return declines.

Question 5

A decrease in the cost of an investment will increase its net present value.​

Question 6

The internal rate of return equates the present value of an investment's cash inflows and its cost (outflows).​

Question 7

A major difference between the net present value and internal rate of return is the interest factor.​

Question 8

A decrease in investors' required rate of return will increase an investment's net present value.​

Question 9

An increase in investors' required return decreases an investment's internal rate of return.​

Question 10

If two investments are mutually exclusive, the firm cannot make both investments.​

Question 11

An increase in the cost of an investment decreases the investment's cash flows.​

Question 12

An increase in interest rates increases the net present value of an investment.​

Question 13

For a given set of cash inflows, the more an investment costs, the smaller will be its NPV​.

Question 14

The internal rate of return equates the net present value and the cost of an investment.​

Question 15

The net present value of an investment cannot be negative.​

Question 16

If an investment requires the firm to carry more current assets, that increases the investment's net present value.​

Question 17

A high cost of capital favors investments with large initial cash inflows.​

Question 18

A decrease in interest rates decreases the net present value of an investment.​

Question 19

If the cost of capital exceeds the internal rate of return, the firm should not make the investment.​

Question 20

The net present value assumes that cash inflows are reinvested at the net present value.​

Question 21

A higher standard deviation for an investment's cash inflows is associated with greater risk.​

Question 22

The net present value of an investment is independent of the firm's cost of capital.​

Question 23

If an investment is riskier, using a higher beta coefficient to analyze the alternative reduces the investment's internal rate of return.​

Question 24

Certainty equivalents adjust an investment's cash outflows in terms of a risk-free return.​

Question 25

If the cost of capital rises, an investment's internal rate of return falls.​

Question 26

Greater risk is associated with larger beta coefficients.​

Question 27

One type of risk adjustment alters the firm's cost of capital for the probability of occurrence.​

Question 28

If two investments are not mutually exclusive, the firm can make only one of them.​

Question 29

Analyzing an investment from a stand-alone perspective avoids considering portfolio effects.​

Question 30

The internal rate of return of an investment is independent of the firm's cost of capital.​

Question 31

Lower beta coefficients imply the investment may be analyzed on a stand-alone basis.​

Question 32

The net present value will be larger if

A) ​the cost of capital is higher
B) ​there is no salvage value
C) ​the cost of the investment is lower
D) ​the firm uses straight-line depreciation

Question 33

​The net present value method considers ​
1) the timing of the cash inflows from an investment
2) the cost of an investment
3) the firm's cost of capital

A)​1 and 2
B)​1 and 3
C)​2 and 3
D)​1, 2, and 3

Question 34

Low correlation among cash inflows is associated with lower net present values.​

Question 35

Risk adjustments favor the use of net present value over the internal rate of return.​

Question 36

If the probability of an investment's cash inflows is decreased, the firm's cost of capital should be increased.​

Question 37

For an investment to diversify a portfolio, its returns must be positively correlated with other returns.​

Question 38

A higher cost of capital reduces an investment's internal rate of return.​

Question 39

The internal rate of return will be higher if​

A) ​the cost of capital is lower
B) ​the cost of capital is higher
C) ​the cost of the investment is lower
D) ​the cost of the investment is higher

Question 40

The coefficient of variation divides an investment's standard deviation by the internal rate of return.​

Question 41

If the net present value is positive,​
1) the internal rate of return exceeds the firm's cost of capital
2) the internal rate of return is less than the firm's cost of capital
3) the present value of cash inflows exceeds the present cost of an investment
4) the present value of cash inflows is less than the present cost of an investment

A)​1 and 3
B)​1 and 4
C)​2 and 3
D)​2 and 4

Question 42

If the risk-adjusted net present value is positive,​
1) the internal rate of return exceeds the firm's cost of capital
2) the internal rate of return is less than the firm's cost of capital
3) the present value of cash inflows exceeds the present cost of an investment
4) the present value of cash inflows is less than the present cost of an investment

A)​1 and 3
B)​1 and 4
C)​2 and 3
D)​2 and 4

Question 43

If the internal rates of return of two mutually exclusive investments exceed the firm's cost of capital, the firm should​

A) ​make both investments
B) ​make neither investment
C) ​make the investment with the lower internal rate of return
D) ​make the investment with the higher internal rate of return

Question 44

A stand-alone perspective for capital budgeting suggests​

A) ​an investment has no risk
B) cash flows are independent of the firm's other investments
C) ​portfolio effects are ignored
D) ​the investment has a low beta

Question 45

NPV may be preferred to IRR because​

A) ​IRR makes the more conservative assumption concerning reinvestment
B) ​NPV makes the more conservative assumption concerning reinvestment
C) ​IRR excludes salvage value
D) ​NPV includes salvage value

Question 46

A firm should not make an investment if the internal rate of return is​

A) ​greater than the cost of capital
B) ​less than the cost of capital
C) ​greater than the interest rate
D) ​less than the interest rate

Question 47

Small standard deviations for cash inflows​

A) ​reduces an investment's net present value
B) ​increases an investment's internal rate of return
C) ​increases the firm's cost of capital
D) ​implies more certainty

Question 48

​If the internal rate of return of two mutually exclusive investments is less than the firm's cost of capital, the firm should make

A) ​both investments
B) ​neither investment
C) ​the investment with the higher internal rate of return
D) ​the investment with the lower net present value

Question 49

A firm should make an investment if the present value of the cash inflows is​

A) ​less than zero
B) ​greater than zero
C) ​less than the cost of the investment
D) ​greater than the cost of the investment

Question 50

​The lack of correlation between an investment's return and the firm's other investments suggests

A) ​the investment has little risk
B) ​portfolio effects may exist
C) ​the investment's beta coefficient is low
D) ​the investment's net present value is negative

Question 51

An increase in the cost of capital will​

A) ​increase an investment's internal rate of return
B) ​decrease an investment's internal rate of return
C) ​increase an investment's net present value
D) decrease an investment's net present value

Question 52

If an investment's net present value is negative,​
1) the firm should not make the investment
2) the costs exceed the present value of the cash inflows
3) the investment will increase the value of the firm

A)​1 and 2
B)​1 and 3
C)​2 and 3
D)​1, 2, and 3

Question 53

The internal rate of return and net present value methods of capital budgeting assume the cash flows are reinvested at​ ​

A) ​the cost of capital
B) ​the internal rate of return
C) ​the cost of capital for IRR and the internal rate of return for NPV
D) the cost of capital for NPV and the internal rate of return for IRR

Question 54

​Risk may be incorporated into capital budgeting by
1) increasing an investment's internal rate of return by risk premium
2) adjusting the cash flows by the probability of occurrence
3) increasing the cost of capital by a risk premium

A)​1 and 2
B)​1 and 3
C)​2 and 3
D)​1, 2, and 3

Question 55

If the net present value of two mutually exclusive investments is positive, the firm should​

A) ​make both investments
B) ​make neither investment
C) ​make the investment with the higher present value
D) ​make the investment with the higher net present value

Question 56

Risk analysis may be introduced by​

A) ​estimating an investment's beta
B) ​using the firm's cost of capital
C) ​reducing an investment's expected life
D) ​using accelerated depreciation

Question 57

According to the risk-adjusted net present value, an investment should be made if ​

A) ​the net present value is positive
B) ​the internal rate of return is positive
C) ​the cost of capital is positive
D) ​the cost of equity is positive

Question 58

The internal rate of return will be higher if​

A) ​the cost of capital is lower
B) ​the cost of the investment is higher
C) ​the cost of the investment is lower
D) ​the cost of capital is higher

Question 59

According to net present value, the reinvestment rate is​

A) ​the net present value
B) ​the internal rate of return
C) ​the cost of capital
D) ​the cost of equity

Question 60

​A firm should not make an investment if
1) its net present value is positive
2) its net present value is negative
3) the internal rate of return exceeds the cost of capital
4) the internal rate of return is less than the cost of capital

A)1 and 3
B)​1 and 4
C)​2 and 3
D)​2 and 4

Question 61

A risky $500,000 investment is expected to generate the following cash flows:​ $$\begin{array} { l c c c } \text { Year } & 1 & 2 & 3 \\& \$ 250,000 & \$ 266,667 & \$ 285,715 .\end{array}$$ ​
The probability of receiving each cash inflow is 80, 75, and 70 percent, respectively. If the firm's cost of capital is 10 percent, should the investment be made?

Question 62

​A firm has the following investment alternatives. Each cost$10,000 and has the following cash inflows.​ $$\begin{array}{l}\text { Cash flow Year }\\\begin{array} { c c c c c } & 1 & 2 & 3 & 4 \\\text { Investment } A & \$ 4,000 & 4,000 & 4,000 & 4,000 \\B & \$ 3,600 & 3,800 & 4,200 & 4,600\end{array}\end{array}$$ Investment A is considered to be typical of the firm's investments, but investment B's cash flows are less certain. The firm's cost of capital is 8 percent, but the financial manager uses a hurdle rate of 6 percent for less risky projects and 10 percent for riskier projects.
a. Based on the cost of capital, which investment(s) should be made?
b. If the financial manager uses the risk-adjusted cost of capital, which investment(s) should be made?
c. Would the answers to (a) and (b) be different if the two investments were not mutually exclusive?

Question 63

An investment costs $10,000 and will generate annual cash inflows of $1,770 for ten years. According to the net present value and internal rate of return methods of capital budgeting, should the firm make this investment if its cost of capital is (a) 10% or (b) 14%?​

Question 64

​The use of certainty equivalents means

A) ​the investment's cash inflows are certain
B) ​an investment's cash inflows are expressed as if they were certain
C) ​the cost of capital is known
D) ​the probability of occurrence is certain

Question 65

A firm has the following investment alternatives:​ $\begin{array}{cccc}&&\text { Cash Inflow }\\\text { Year } &A&B&C\\1 & \$ 400 & \$-- & \$-- \\2 & 400 & 400 & -- \\3 & 400 & 800 & -- \\4 & 400 & 800 & 1,800\end{array}$

Each investment costs $1,400 and the firm's cost of capital is 10 percent.
a. What is each investment's internal rate of return?
b. Should the firm make any of these investments?
c. What is each investment's net present value?
d. Should the firm make any of these investments?

Question 66

Investments A and B are mutually exclusive and cost $2,000 each. The firm's cost of capital is 9%, and the investments' estimated cash inflows are​ $\begin{array} { c c c c } & \text { cash inflow } & A & B \\\text { year } & & & \\1 & \$ 2,320 & \cdots \\2 & \cdots & \cdots \\3 & \cdots & \$ 2,810\end{array}$
a. What investment(s) should the firm make according to net present value?
b. What investment(s) should the firm make according to internal rate of return?
c. If the firm can reinvest funds earned in year 1 at 10%, which investment(s) should the firm make?

Question 67

​A risky $1,000 investment is expected to generate the following cash flows:
​ $\begin{array}{ll}\text {Year }&1&2&3\\&\$600&\$600&\$600\end{array}$

a. If the firm's cost of capital is 10 percent, should the investment be made?
b. An alternative use for the $1,000 is a three-year U.S. Treasury note that pays $50 annually and repays the $1,000 at maturity for an annual risk-free return of 5 percent. Management believes that the cash inflows from the risky investment are only equivalent to 70 percent of the certain investment. Does this information alter the decision in (a)?

Question 68

A firm has three investment opportunities. Each costs $1,000, and the firm's cost of capital is 10 percent. The cash inflow of each investment is as follows:​ $\begin{array}{ccccc}&&\text { Cash Inflow }\\\text { Year } &A&B&C\\1 & \$ 300 & 500 & 100 \\2 & 300 & 400 & 200 \\3 & 300 & 200 & 400 \\4 & 300 & 100 & 500\end{array}$
a. If the net present value method is used, which investment(s) should the firm make?
b. What is the internal rate of retum of investment A ? The internal rate of return of investment B is 10.22% and 6.15% for investment C. Which investment s ) should the firm make?
c. What is the payback period for each investment?

Question 69

A firm with the following investment opportunities has a capital budget of $10,000. According to the net present value technique, which investment(s) should the firm make if the firm's cost of capital is 10%?​ $\begin{array}{lccc} &&\text { Investment }\\& \text { A } & \text { B } & \text { C } \\\text { Cost } & \$ 10,000 & \$ 7,000 & \$ 3,000 \\\text { Cashinflow } & \$ 12.000 & \$ 8.600 & \$ 4.000\end{array}$
​

Question 70

A firm has two $1,000, mutually exclusive investment alternatives with the following cash inflows. The cost of capital is 6 percent.​
​ $\begin{array}{cc}\text { Year }&\text { Cash Inflow }\\&A&B\\1 & \$ 175 &\$1,100\\2 & 175&-- \\3 & 175 &--\\4 & 175&-- \\5 & 175&-- \\6 & 175&-- \\7 & 175 &--\\8 & 175&--\end{array}$
​
a. What is the internal rate of return on each investment? Which investment should the firm make? f sales.
b. What is the net present value of each investment? Which investment should the firm make?
c. If the cash inflows can be reinvested at 8 percent, which investment should be made?

Question 71

​Two mutually exclusive investments cost $10,000 each and have the following cash inflows. The firm's cost of capital is 12%.​ $\text { Investment }$
$\begin{array}{cr}\text { Cash inflow: }&A&B\\\text { Year } & \\1 & \$ 12,407&-- \\2 & -- &--\\3 & --&-- \\4 & --&\$19,390\end{array}$
​
a. What is the net present value of each investment?
b. What is the internal rate of return of each investment? ost of capital is 12%.
c. Which investment(s) should the firm make? y> ost of capital is 12%.
d. Would your answers be different to c if the funds received in year 1 for investment A could be reinvested at 12%, 16%, or 20%?
​