Deck 7: Net Present Value and Other Investment Rules

Question 1

An investment project has the cashflow stream of -250, 75, 125, 100, and 50. The cost of capital is 12%. What is the discount payback period?

A) 2.5 years.
B) 2.7 years.
C) 3.38 years.
D) 1.40 years.
E) 1.25 years.

Answer 1

3.38 years.

Question 2

Accepting positive NPV projects benefits the stockholders because:

A) it most easily understood valuation process.
B) the value of the expected cashflows are equal to the cost.
C) the value of the expected cashflows are greater than the cost.
D) it is the most easily calculated.

Answer 2

the value of the expected cashflows are greater than the cost.

Question 3

Which statement concerning the net present value (NPV) of an investment or a financing project is correct?

A) a financing project should be accepted if, and only if, the NPV is exactly equal to zero.
B) an investment project should be accepted only if the NPV is equal to the initial cash flow.
C) any type of project should be accepted if the NPV is positive and rejected if it is negative.
D) any type of project with greater total cash inflows than total cash outflows, should always be accepted.
E) an investment project that has positive cash flows for every time period after the initial investment should be accepted.

Answer 3

any type of project should be accepted if the NPV is positive and rejected if it is negative.

Question 4

Payback is frequently used to analyze independent projects because:

A) it considers the time value of money.
B) all relevant cash flows are included in the analysis.
C) it is easy and quick to calculate.
D) it is the most desirable of all the available analytical methods from a financial perspective.

Question 5

Ginny is considering an investment which will cost her $120,000. The investment produces no cash flows for the first year. In the second year the cash inflow is $35,000. This inflow will increase to $55,000 and then $75,000 for the following two years before ceasing permanently. Ginny requires a 10% rate of return and has a required discounted payback period of three years. Ginny should _______ this project because the discounted payback period is ______.

A) accept; 2.03 years
B) accept; 2.97 years
C) accept; 3.97 years
D) reject; 3.03 years
E) reject; 3.97 years

Question 6

A $25 investment produces $27.50 at the end of the year with no risk. Which of the following is not true?

A) NPV is positive if the interest rate is less than 10%.
B) NPV is negative if the interest rate is less than 10%.
C) NPV is zero if the interest rate is equal to 10%.

Question 7

The payback period rule:

A) determines a cutoff point so that all projects accepted by the NPV rule will be accepted by the payback period rule.
B) determines a cutoff point so that depreciation is just equal to positive cash flows in the payback year.
C) requires an arbitrary choice of a cut-off point.
D) varies the cut-off point with the interest rate.

Question 8

An investment project is most likely to be accepted by the payback period rule and not accepted by the NPV rule if the project has:

A) a large initial investment with moderate positive cash flows over a very long period of time.
B) a very large negative cash flow at the termination of the project.
C) most of the cash flow at the beginning of the project.
D) All projects approved by the payback period rule will be accepted by the NPV rule.
E) The payback period rule and the NPV rule cannot be used to evaluate the same type of projects.

Question 9

The payback period rule accepts all investment projects in which the payback period for the cash flows is:

A) greater than or equal to the cut-off point.
B) greater than the cut-off point.
C) less than the cut-off point.
D) positive.

Question 10

The difference between the present value of an investment's future cash flows and its initial cost is the:

A) net present value.
B) internal rate of return.
C) pay back period.
D) discounted pay back period.

Question 11

Which of the following does not characterize NPV?

A) NPV is the simplest of all investment rules.
B) NPV incorporates all relevant information.
C) NPV uses all of the project's cash flows.
D) NPV discounts all future cash flows.

Question 12

The discounted payback period rule:

A) considers the time value of money.
B) discounts the cutoff point.
C) ignores uncertain cash flows.
D) is preferred to the NPV rule.

Question 13

If a project is assigned a required rate of return equal to zero, then:

A) the timing of the project's cash flows has no bearing on the value of the project.
B) the project will always be accepted.
C) the project will always be rejected.
D) whether the project is accepted or rejected will depend on the timing of the cash flows.

Question 14

It will cost $3,000 to acquire a small ice cream cart. Cart sales are expected to be $1,400 a year for three years. After the three years, the cart is expected to be worthless as that is the expected remaining life of the cooling system. What is the payback period of the ice cream cart?

A) 0.83 years.
B) 1.14 years.
C) 1.83 years.
D) 2.14 years.
E) 2.83 years.

Question 15

The average accounting rate of return is determined by:

A) dividing the yearly cashflows by the investment.
B) dividing the average cashflows by the investment.
C) dividing the average net income by the average investment.
D) dividing the average net income by the initial investment.
E) dividing the net income by the cashflow.

Question 16

A project has an initial cost of $8,600 and produces cash inflows of $3,200, $4,900, and $1,500 over the next three years, respectively. What is the discounted payback period if the required rate of return is 8%?

A) 2.05 years
B) 2.13 years
C) 2.33 years
D) 3.00 years
E) never

Question 17

Consider an investment with an initial cost of $20,000 and is expected to last for 5 years. The expected cash flow in years 1 and 2 are $5000, in years 3 and 4 are $5,500 and in year 5 is $1,000. The total cash inflow is expected to be $22,000 or an average of $4,400 per year. Compute the payback period in years.

A) 3.18
B) 3.82
C) 4.55
D) 4.00

Question 18

An investment with an initial cost of $16,000 produces cash flows of $5000 annually. If the cash flow is evenly spread out over the year and the firm can borrow at 10%, the discounted payback period is _____ years.

A) 4.55
B) 4.05
C) 3.20
D) 3.52

Question 19

The discounted payback rule states that you should accept projects:

A) which have a discounted payback period that is greater than some pre-specified period of time.
B) if the discounted payback is positive and rejected if it is negative.
C) only if the discounted payback period equals some pre-specified period of time.
D) if the discounted payback period is less than some pre-specified period of time.

Question 20

Which one of the following statements is correct concerning the payback period?

A) An investment is acceptable if its calculated payback period is less than some pre-specified period of time.
B) An investment should be accepted if the payback is positive and rejected if it is negative.
C) An investment should be rejected if the payback is positive and accepted if it is negative.
D) An investment is acceptable if its calculated payback period is greater than some pre-specified period of time.
E) An investment should be accepted any time the payback period is less than the discounted payback period, given a positive discount rate.

Question 21

The Carnation Chemical Company is investing in an incinerator to dispose of PCB waste. The incinerator costs $1.5 million and will generate end of year cash of $1 million for the next 3 years. At the end of 3 years the incinerator will be worthless and must be disposed of at the cost of $500,000. The internal rate of return for this project is:

A) between 10% and 20%.
B) between 20% and 30%.
C) between 30% and 40%.
D) more than 40%.

Question 22

The problem of multiple IRRs can occur when:

A) there is only one sign change in the cash flows.
B) the first cash flow is always positive.
C) the cash flows decline over the life of the project.
D) there is more than one sign change in the cash flows.

Question 23

The internal rate of return tends to be:

A) easier for managers to comprehend than the net present value.
B) extremely accurate even when cash flow estimates are faulty.
C) ignored by most financial analysts.
D) used primarily to differentiate between mutually exclusive projects.

Question 24

An investment that requires initial cash outlay of $100,000 has a useful life of 3 years. In each of these years the before-tax cash flow is $40,000. If the tax rate is 34% and straight-line depreciation is used, the average accounting return is:

A) 40.00%.
B) 26.40%.
C) 13.34%.
D) 8.80%.

Question 25

The investment decision rule that relates average net income to average investment is the:

A) discounted cash flow rule.
B) average accounting rate of return method.
C) average payback rule.
D) average profitability index.

Question 26

The Balistan Rug Company is considering investing in a new loom that will cost $12,000. The new loom will create positive end of year cash flow of $5,000 for the next 3 years. The internal rate of return for this project is:

A) between 10% and 15%.
B) between 15% and 20%.
C) between 20% and 25%.
D) between 25% and 30%.
E) less than 10%.

Question 27

The IRR decision rule can be reversed because:

A) the NPV rule is not the same as the IRR.
B) the IRR is based on a mutually exclusive investment.
C) instead of an investment project it is a financing project.
D) the IRR is greater than 100%.

Question 28

A project will have more than one IRR if:

A) the IRR is positive.
B) the IRR is negative.
C) the NPV is zero.
D) the cash flow pattern exhibits more than one sign change.
E) the cash flow pattern exhibits exactly one sign change.

Question 29

A situation in which accepting one investment prevents the acceptance of another investment is called the:

A) net present value profile.
B) operational ambiguity decision.
C) mutually exclusive investment decision.
D) issues of scale problem.
E) multiple rates of return decision.

Question 30

Which of the following correctly orders the investment rules of average accounting return (AAR), internal rate of return (IRR), and net present value (NPV) from the most desirable to the least desirable?

A) AAR, IRR, NPV.
B) AAR, NPV, IRR.
C) IRR, AAR, NPV.
D) NPV, AAR, IRR.
E) NPV, IRR, AAR.

Question 31

Using the internal rate of return rule, a conventional project should be accepted if the internal rate of return is:

A) only equal to the current weighted average cost of capital.
B) greater than the current weighted average cost of capital.
C) less than the current weighted average cost of capital.
D) negative.
E) positive.

Question 32

The internal rate of return may be defined as:

A) the discount rate that makes the NPV cash flows equal to zero.
B) the difference between the market rate of interest and the NPV.
C) the market rate of interest less the risk-free rate.
D) the project acceptance rate set by management.

Question 33

The profitability index is the ratio of:

A) average net income to average investment.
B) internal rate of return to current market interest rate.
C) net present value of cash flows to internal rate of return.
D) net present value of cash flows to average accounting return.
E) present value of cash flows to initial investment cost.

Question 34

The elements that cause problems with the use of the IRR in projects that are mutually exclusive are:

A) the discount rate and scale problems.
B) timing and scale problems.
C) the discount rate and timing problems.
D) scale and reversing flow problems.
E) timing and reversing flow problems.

Question 35

A mutually exclusive project is a project whose:

A) acceptance or rejection has no effect on other projects.
B) NPV is always negative.
C) IRR is always negative.
D) acceptance or rejection effects other projects.

Question 36

The internal rate of return for a project will increase if:

A) the initial cost of the project can be reduced.
B) the total amount of the cash inflows is reduced.
C) each cash inflow is moved such that it occurs one year later than originally projected.
D) the required rate of return is reduced.

Question 37

You have a choice between two projects, Project1 pays $12,000 back at the end of 1 period on an investment of $10,000. Project 2 pays back $6,500 at the end of 1 period on an investment of $5,000. Which project should be chosen and what is the problem that you must be concerned with in this choice?

A) Project 1; discount rate.
B) Project 2; discount rate.
C) Project 1; project scales.
D) Project 2; project scales.
E) Project 1, cash flow timings.

Question 38

If there is a conflict between mutually exclusive projects due to the IRR, one should:

A) drop the two projects immediately.
B) spend more money on gathering information.
C) depend on the NPV as it will always provide the most value.
D) depend on the AAR because it does not suffer from these same problems.

Question 39

A project will have only one internal rate of return if:

A) all cash flows after the initial expense are positive.
B) average accounting return is positive.
C) net present value is negative.
D) net present value is positive.
E) net present value is zero.

Question 40

The two fatal flaws of the internal rate of return rule are:

A) arbitrary determination of a discount rate and failure to consider initial expenditures.
B) arbitrary determination of a discount rate and failure to correctly analyze mutually exclusive investment projects.
C) arbitrary determination of a discount rate and the multiple rate of return problem.
D) failure to consider initial expenditures and failure to correctly analyze mutually exclusive investment projects.
E) failure to correctly analyze mutually exclusive investment projects and the multiple rate of return problem.

Question 41

Explain the differences and similarities between net present value (NPV) and the profitability index (PI).

Question 42

List and briefly discuss the advantages and disadvantages of the internal rate of return (IRR) rule.

Question 43

Under capital rationing the profitability index is used to select investments because of limited capital by their:

A) excess profit to achieve the highest payoff.
B) reward per dollar cost to achieve the highest incremental NPV.
C) incremental IRR to maximize the total rate of return.
D) capital usage rate to stay within budget.

Question 44

The NPV rule and PI give the same results when there is no conflict. In the case of a mutually exclusive set of investments, explain the potential conflict and the way it should be solved with supporting examples.

Question 45

Suppose that a project has a cash flow pattern (-$2,000, $25,000, -$25000) Its IRR is given by:

A) 12.20%
B) 9.61% or 1040.39%
C) 25.25% or 250.52%
D) 4100.11%

Question 46

The IRR rule is said to be a special case of the NPV rule. Explain why this is so and why it has some limitations NPV does not?

Question 47

The Ziggy Trim and Cut Company can purchase equipment on sale for $4,300. The asset has a three-year life, will produce a cash flow of $1,200 in the first and second year, and $3,000 in the third year. The interest rate is 12%. Calculate the project's payback assuming end of year cash flows. Also, calculate project's IRR. Should the project be taken? Check your answer by computing the project's NPV.

Question 48

The Walker Landscaping Company can purchase a piece of equipment for $3,600. The asset has a two-year life, will produce a cashflow of $600 in the first year and $4200 in the second year. The interest rate is 15%. Calculate the project's payback assuming steady cashflows. Also calculate the project's IRR. Should the project be taken? Check your answer by computing the project's NPV.

Question 49

The Walker Landscaping Company can purchase a piece of equipment for $3,600. The asset has a two-year life, will produce a cashflow of $600 in the first year and $4200 in the second year. The interest rate is 15%. Calculate the project's discounted payback and Profitability Index assuming steady cashflows. Should the project be taken? If the accounting rate of return was positive, how would this affect your decision?

Question 50

Suppose that a project has a cash flow pattern (-$2,000, $25,000,- $25000). For its modified IRR at a discount rate of 10%, the relevant numbers are:

A) (-$2,000, $25,000)
B) (-$2,000, $2,129)
C) (-$5,000, $5,000)
D) (-$2,000, $2,273)

Question 51

Given the goal of maximization of firm value and shareholder wealth, we have stressed the importance of net present value (NPV). And yet, many financial decision-makers at some of the most prominent firms in the world continue to use less desirable measures such as the payback period and the average accounting return (AAR). Why do you think this is the case?

Question 52

Given the cash flow stream of the following mutually exclusive projects, prove through the incremental investment that Project B, with the higher NPV, will be preferred to project
A.
0 1 2 3 NPV IRR
Project A: -500 150 245 320 46.39 17.76
Project B: -800 360 360 360 50.01 16.65
Incremental investment in B: -300 210 115 40 NPV = 3.63

Question 53

Suppose that a project has a cash flow pattern (-$2,000, $25,000, -$25000) and discount rate of 10%, its modified IRR is given by:

A) 12.65%
B) 25.22% or 400%
C) 25.22% or 250%
D) 13.64%

Question 54

The NPV rule and PI give the same results when there is no conflict. In the case of capital rationing, explain the potential conflict and the way it should be solved with supporting examples.

Question 55

Cutler Compacts will generate cash flows of $30,000 in year one, and $65,000 in year two. However, if they make an immediate investment of $20,000, they can expect to have cash streams of $55,000 in year 1 and $63,000 in year 2 instead. The interest rate is 9%. Calculate the NPV of the proposed project. Why would the IRR be a poor choice in this situation?

Question 56

You are considering a project with the following data: Internal rate of return 8.7%
Profitability ratio.98
Net present value -$393
Payback period 2.44 years
Required return 9.5%
Which one of the following is correct given this information?

A) The discount rate used in computing the net present value must have been less than 8.7%.
B) The discounted payback period will have to be less than 2.44 years.
C) The discount rate used to compute the profitability ratio was equal to the internal rate of return.
D) This project should be accepted based on the profitability ratio.
E) This project should be rejected based on the internal rate of return.

Question 57

The Ziggy Trim and Cut Company can purchase equipment on sale for $4,300. The asset has a three-year life, will produce a cashflow of $1,200 in the first and second year, and $3,000 in the third year. The interest rate is 12%. Calculate the project's discounted payback and Profitability Index assuming end of year cash flows. Should the project be taken? If the accounting rate of return was positive, how would this affect your decision?