Question 1

The discount rate that makes the net present value of an investment exactly equal to zero is called the:

Accepted Answer

The discount rate that makes the net present value of an investment exactly equal to zero is called the internal rate of return. Option A, external rate of return, is not a commonly used financial term. Option C, average accounting return, is a measure of the average income earned per year over the life of an investment in accounting terms. Option D, profitability index, is a ratio of the present value of cash inflows to the present value of cash outflows. Option E is not a term commonly used in finance. Therefore, the best choice is B, internal rate of return.

Question 2

An investment's average net income divided by its average book value deﬁnes the average:

Accepted Answer

The definition given in the question is exactly the definition of accounting return, so the correct answer is C. The other options are related to different concepts of capital budgeting, such as net present value (A), internal rate of return (B), profitability index (D), and payback period (E).

Question 3

An investment is acceptable if the proﬁtability index (PI) of the investment is:

Accepted Answer

The profitability index (PI) is a measure used to evaluate the attractiveness of an investment. If the PI is greater than one, it means that the present value of future cash flows is greater than the initial investment, indicating that the investment is expected to generate a profit and is therefore acceptable.

Question 4

The length of time required for an investment to generate cash ﬂows suﬃcient to recover the initial cost of the investment is called the:

Accepted Answer

Payback period is the length of time it takes to recover the initial cost of an investment through its cash flows. Therefore, C is the correct answer.

Question 5

The length of time required for a project's discounted cash ﬂows to equal the initial cost of the project is called the:

Accepted Answer

The discounted payback period is the length of time required for a project's discounted cash flows to equal the initial cost of the project. This method takes into account the time value of money by discounting the cash flows at the project's cost of capital before determining the payback period.

Question 6

An investment is acceptable if its IRR:

Accepted Answer

An investment is acceptable if its IRR exceeds the required return. This means that the project is expected to generate a return that is greater than the cost of capital, which creates value for the investor.

Question 7

The discounted payback rule states that you should accept projects:

Accepted Answer

The discounted payback rule states that you should accept projects if the discounted payback period is less than some pre-specified period of time. Therefore, option D is the correct answer.

Question 8

The difference between the present value of an investment and its cost is the:

Accepted Answer

The present value of an investment is the value of the expected future cash flows discounted at the appropriate interest rate. The cost of the investment is the initial outlay required to make the investment. The difference between the two is the net present value (NPV). If the NPV is positive, the investment is considered worthwhile because it generates more cash inflows than outflows. If it is negative, the investment should not be undertaken because it reduces the value of the firm. Therefore, A is the correct choice.

Question 9

The possibility that more than one discount rate will make the NPV of an investment equal to zero is called the _____ problem.

Accepted Answer

The problem described in the question is known as the multiple rates of return problem, where there is more than one discount rate that can make the NPV of an investment equal to zero. This can happen when there are non-conventional cash flows, such as when there are multiple changes in the sign of the cash flows, or when there are mutually exclusive investment options. It is important to note that this problem does not occur when cash flows are conventional (i.e. there is only one change in the sign of the cash flows). Therefore, option E, multiple rates of return, is the correct answer.

Question 10

All else equal, the payback period for a project will decrease whenever the:

Accepted Answer

The payback period is the amount of time it takes for the initial investment to be recouped through cash inflows. Moving cash inflows earlier in time will decrease the payback period, making option D the correct choice. Increasing the initial cost (option A) or lengthening the duration of the project (option E) will both increase the payback period. The required return (option B) and discount rate (option C) are both factors that can affect the calculation of the payback period, but they do not directly impact the duration of time it takes to recoup the initial investment.

Question 11

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

Accepted Answer

A mutually exclusive investment decision is when accepting one investment option means that another option cannot be accepted. Therefore, this is the appropriate term to describe the situation. The other options listed do not accurately describe this scenario.

Question 12

Which one of the following statements concerning net present value (NPV) is correct?

Accepted Answer

NPV is the difference between the present value of cash inflows and the present value of cash outflows. A positive NPV indicates that the project is expected to generate more cash inflows than outflows and therefore should be accepted. A negative NPV indicates that the project is expected to generate less cash inflows than outflows and therefore should be rejected. Zero NPV means that the project will exactly generate enough cash inflows to cover the initial investment, but it does not necessarily provide a positive return, so it is not the only criteria to accept or reject. Choice A and B are incorrect because they do not consider the magnitude of NPV. Choice D is incorrect because the timing of cash flows is important in determining NPV, not only the absolute amount of cash inflows and outflows. Choice E is also incorrect because it does not consider the discount rate used to calculate the present value of cash flows.

Question 13

Payback is frequently used to analyze independent projects because:

Accepted Answer

Payback is easy and quick to calculate but it does not consider the time value of money, and it ignores cash flows that occur after the payback period. Therefore, it is commonly used for independent projects where the focus is on the time it takes to recoup the initial investment rather than the overall value of the project. However, for projects where the timing and size of cash flows are critical, more sophisticated methods such as NPV or IRR should be used.

Question 14

If a project has a net present value equal to zero, then: I.the present value of the cash inﬂows exceeds the initial cost of the project.
II)the project produces a rate of return that just equals the rate required to accept the project.
III)the project is expected to produce only the minimally required cash inﬂows.
IV)any delay in receiving the projected cash inﬂows will cause the project to have a negative net.

Accepted Answer

The net present value (NPV) of a project is the difference between the present value of the cash inflows and the initial cost of the project. If the NPV is equal to zero, then the present value of the cash inflows is equal to the initial cost of the project. This means that the project is expected to produce a rate of return that just equals the rate required to accept the project. It also means that the project is expected to produce only the minimally required cash inflows. Any delay in receiving the projected cash inflows will cause the project to have a negative NPV.

Question 15

The primary reason that company projects with positive net present values are considered acceptable is that:

Accepted Answer

The primary reason that company projects with positive net present values are considered acceptable is that they create value for the owners of the firm. This means that the project has generated more cash inflows than outflows, leading to an increase in the company's overall wealth. A positive net present value indicates that the project is expected to generate cash inflows that are greater than the cost of the initial investment, leading to an increase in the value of the company.

Question 16

All else constant, the net present value of a typical investment project increases when:

Accepted Answer

The net present value (NPV) of a project increases when the rate of return decreases because a lower discount rate increases the present value of future cash inflows, making the project more attractive.

Question 17

An investment is acceptable if its average accounting return (AAR):

Accepted Answer

An investment is acceptable if its average accounting return (AAR) exceeds the target AAR. A higher AAR indicates a higher profitability of the investment, which is desirable for the firm.

Question 18

The advantages of the payback method of project analysis include the: I.application of a discount rate to each separate cash ﬂow.
II)bias towards liquidity.
III)ease of use.
IV)arbitrary cut-off point.

Accepted Answer

II and III are correct because the payback method is favored for its simplicity and its focus on liquidity, highlighting how quickly an investment can be recouped. It does not involve discounting cash flows (eliminating I) and the cut-off point is indeed arbitrary but generally considered a disadvantage, not an advantage (eliminating IV).

Question 19

Net present value:

Accepted Answer

Net present value (NPV) is more useful than internal rate of return (IRR) when comparing projects of different sizes because it accounts for the time value of money and provides a dollar value for the project's profitability. NPV compares the present value of cash inflows and outflows to determine if the project is profitable. It can be used to decide between mutually exclusive projects by choosing the project with the higher NPV. It is not necessarily the primary method of analysis used by management, and it is not as widely used as payback and discounted payback. Average accounting return is a different financial metric that is calculated differently from NPV.

Question 20

The present value of an investment's future cash ﬂows divided by the initial cost of the investment is called the:

Accepted Answer

The present value of an investment's future cash ﬂows divided by the initial cost of the investment is called the profitability index. This measure takes into account the time value of money and provides information about the value created by an investment relative to its cost. Therefore, option D is the most appropriate choice.

Quiz 6: Net Present Value and Other Investment Rules