Question 1

If two projects are mutually exclusive,then the IRR is more important than the NPV in deciding the project that should be chosen.

Accepted Answer

NPV is generally considered more reliable than IRR for evaluating and comparing mutually exclusive projects because it measures the absolute value of the investment's return, taking into account the project's scale and the cost of capital, whereas IRR can give misleading signals when comparing projects of different sizes and durations.

Question 2

Lithium,Inc.is considering two mutually exclusive projects,A and B.Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two.Project B costs $120,000 and is expected to generate $64,000 in year one,$67,000 in year two,$56,000 in year three,and $45,000 in year four.Lithium,Inc.'s required rate of return for these projects is 10%.The equivalent annual annuity amount for project A is

Accepted Answer

The answer of Lithium,Inc.is considering two mutually exclusive projects,A and...

Question 3

Under what condition would you NOT accept a project that has a positive net present value?

Accepted Answer

If the firm is limited in the capital it has available, it may not be able to finance all projects with positive NPVs, and therefore, may have to reject some projects. This is known as capital rationing.

Question 4

IRR should not be used to choose between mutually exclusive projects.

Accepted Answer

IRR may lead to incorrect decisions when choosing between mutually exclusive projects as it assumes that the investment's cash flows will be reinvested at the same rate as the IRR, which may not be the case. Other methods like net present value (NPV) or profitability index (PI) should be used instead.

Question 5

The mutually exclusive project with the highest positive NPV will also have the highest IRR.

Accepted Answer

The project with the highest NPV does not necessarily have the highest IRR because NPV and IRR are based on different assumptions and calculations. NPV considers the absolute amount of money generated over time, discounted at a specific rate, while IRR is the discount rate that makes the NPV of cash flows equal to zero. Different projects may have different cash flow patterns, leading to different IRRs even if one has a higher NPV.

Question 6

Two projects are mutually exclusive if the accept/reject decision for one project has no impact on the accept/reject decision for the other project.

Accepted Answer

Mutually exclusive projects are those where the acceptance of one project necessitates the rejection of the other(s) because they compete for the same resources or serve the same purpose.

Question 7

When capital rationing exists,the divisibility of projects is ignored and projects are funded in order of their PI's or IRR's.

Accepted Answer

When capital rationing exists, the divisibility of projects becomes important as funds are limited. Therefore, projects may not be funded solely based on their PI's or IRR's, but rather based on the combination of the magnitude and feasibility of the project.

Question 8

The net present value always provides the correct decision provided that

Accepted Answer

Capital rationing not being imposed allows for all projects with a positive NPV to be accepted, ensuring the correct decision is made based on the maximization of shareholder wealth.

Question 9

Positive NPV projects may be rejected when capital must be rationed.

Accepted Answer

When capital must be rationed, companies have to prioritize which projects to invest in, and even positive NPV projects could be rejected if there are not enough funds available to finance them. This is because other projects may have a higher impact on the overall performance of the company or may require more urgent investment.

Question 10

Both the profitability index (PI)and net present value (NPV)are based on the present value of all future free cash flows,but the PI is a relative measure while the NPV is an absolute measure of a project's desirability.

Accepted Answer

The statement is true. PI is a relative measure because it compares the present value of future cash flows to the initial investment, while NPV is an absolute measure because it calculates the value of a project in monetary terms.

Question 11

Finance theory suggests that the IRR criterion is the most favorable capital budgeting decision tool.

Accepted Answer

Finance theory does not suggest that the Internal Rate of Return (IRR) criterion is the most favorable capital budgeting decision tool in all cases. While IRR is widely used and valuable for evaluating the profitability of potential investments, it has limitations and drawbacks, such as its assumption of reinvestment at the IRR rate and potential multiple IRR issues for non-conventional cash flows. Other tools like Net Present Value (NPV) are often considered superior in many respects because they do not have these limitations and directly measure the value added to the firm.

Question 12

Capital rationing may be imposed because of all of the following EXCEPT

Accepted Answer

Capital rationing may be imposed due to poor capital market conditions, management's fear of debt, and stockholder control problems. However, a company's stock price being at an historically high level is not a reason for imposing capital rationing. In fact, a high stock price may indicate that the company has access to capital and may not need to impose capital rationing.

Question 13

The size disparity problem occurs when mutually exclusive projects of unequal size are being examined.

Accepted Answer

The size disparity problem is a real issue when comparing projects of unequal size that cannot be combined.

Question 14

How might capital rationing conflict with the goal of maximizing shareholders' wealth?

Accepted Answer

The answer of How might capital rationing conflict with the...

Question 15

An infinite-life replacement chain allows projects of different lengths to be compared.

Accepted Answer

An infinite-life replacement chain assumes that there is no limit to the life of a project and allows projects of different lengths to be compared. This is useful when trying to decide between two projects with different lifetimes, as the infinite-life replacement chain method allows for a fair comparison by calculating the present value of all future costs and benefits.

Question 16

I301 Motors has several investment projects under consideration,all with positive net present values.However,due to a shortage of trained personnel,a limit of $1,250,000 has been placed on the capital budget for this year.Which of the projects listed below should be included in this year's capital budget? Explain your answer.

Accepted Answer

The answer of I301 Motors has several investment projects under...

Question 17

Capital rationing generally leads to higher stock prices as management is doing the best job it can in selecting only the best capital budgeting projects.

Accepted Answer

Capital rationing may lead to higher stock prices if the selected projects are indeed the best, but it can also result in missed opportunities if good projects are rejected due to budget constraints.

Question 18

A project's equivalent annual annuity (EAA)is the annuity cash flow that yields the same present value as the project's NPV.

Accepted Answer

This is a correct statement describing the concept of Equivalent Annual Annuity (EAA). It represents the equal annual cash flow generated by a project that has an equivalent present value to that of the project's net present value. By calculating the EAA, decision-makers can compare and evaluate projects with different cash flow patterns and lifetimes in order to determine which project offers the best investment opportunity.

Question 19

If a project's IRR is equal to its required return,then the project's NPV is equal to zero and its PI is equal to one.

Accepted Answer

This statement is correct according to the following relationships among IRR, NPV and required return: - If IRR = required return, then NPV = 0 - If NPV > 0, then IRR > required return - If NPV < 0, then IRR < required return Also, the profitability index (PI) is calculated as the present value of future cash flows divided by the initial investment, so if NPV = 0, then PI = 1.

Question 20

You are in charge of one division of Yeti Surplus Inc.Your division is subject to capital rationing.Your division has 4 indivisible projects available,detailed as follows:

If you must select projects subject to a budget constraint of 5 million dollars,which set of projects should be accepted so as to maximize firm value?

Accepted Answer

The total cost of Projects 1 and 4 is $4.6 million, which is less than the budget constraint of $5 million. 
The total net present value (NPV) of Projects 1 and 4 is $2.6 million, which is greater than the NPV of any other combination of projects. 
Therefore, selecting Projects 1 and 4 will maximize firm value under the given budget constraint.

Quiz 10: Capital-Budgeting Techniques and Practice