Question 1

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

Accepted Answer

If the initial cost of the project can be reduced, the cash outflow at the beginning of the project will be lower. This means that the project will have a higher net present value, which will result in a higher internal rate of return. The other options would decrease the internal rate of return.

Question 2

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

Accepted Answer

The payback period rule accepts investment projects if the payback period for the cash flows is less than the cutoff point. The payback period is the time it takes for the project to generate enough cash flows to recover its initial investment. A shorter payback period is generally preferred as it indicates quick cash recovery and lower risk. Therefore, if the payback period is less than the cutoff point, the investment project is accepted.

Question 3

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

Accepted Answer

NPV (Net Present Value) is calculated by discounting the future cash flows to present value using a certain interest rate. If the interest rate is less than 10%, the NPV will be positive as the investment is earning more than the required rate of return. If the interest rate is equal to 10%, the NPV will be zero as the investment is earning exactly the required rate of return. However, if the interest rate is greater than 10%, the NPV will be negative as the investment is not earning enough to justify the cost of capital. So, option B is not true as NPV will be negative if the interest rate is less than 10%.

Question 4

Payback is frequently used to analyze independent projects because:

Accepted Answer

Payback is popular for analyzing independent projects because it is simple and quick to calculate, despite not considering the time value of money or including all relevant cash flows.

Question 5

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:

Accepted Answer

The answer of An investment project is most likely to...

Question 6

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:

Accepted Answer

First, let's calculate the annual depreciation expense:

Depreciation Expense = (Initial Cost - Salvage Value) / Useful Life

Since there is no salvage value mentioned in the problem, we assume it to be zero.

Depreciation Expense = $100,000 / 3 = $33,333.33

Next, let's calculate the before-tax accounting income for each year:

Before-Tax Accounting Income = Before-Tax Cash Flow - Depreciation Expense

Year 1: $40,000 - $33,333.33 = $6,666.67

Year 2: $40,000 - $33,333.33 = $6,666.67

Year 3: $40,000 - $33,333.33 = $6,666.67

Now, let's calculate the average accounting income:

Average Accounting Income = Sum of Before-Tax Accounting Income / Useful Life

Average Accounting Income = ($6,666.67 x 3) / 3 = $6,666.67

Finally, let's calculate the average accounting return:

Average Accounting Return = Average Accounting Income / Initial Cost

Average Accounting Return = $6,666.67 / $100,000 = 6.67%

However, we need to adjust for taxes since the problem gives us the tax rate of 34%.

After-Tax Accounting Income = Before-Tax Accounting Income x (1 - Tax Rate)

After-Tax Accounting Income in each year will be:

Year 1: $6,666.67 x (1 - 0.34) = $4,400

Year 2: $6,666.67 x (1 - 0.34) = $4,400

Year 3: $6,666.67 x (1 - 0.34) = $4,400

The new Average Accounting Income will be:

New Average Accounting Income = Sum of After-Tax Accounting Income / Useful Life

New Average Accounting Income = ($4,400 x 3) / 3 = $4,400

New Average Accounting Return = New Average Accounting Income / Initial Cost

New Average Accounting Return = $4,400 / $100,000 = 4.4%

So, the correct answer is B) 26.4%.

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. This means that the project should pay back its initial investment in a shorter period of time than what is specified. Option D is the only choice that aligns with this principle.

Question 8

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

Accepted Answer

When a project is assigned a required rate of return equal to zero, it means that the present value of its cash flows is simply the sum of the cash flows, without discounting. Therefore, the timing of the cash flows does not affect the project's value, as no discounting is applied.

Question 9

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

Accepted Answer

The average accounting rate of return method is the investment decision rule that relates average net income to average investment. This method calculates the average annual net income expected to be earned by an investment divided by the investment’s average book value.

Question 10

The internal rate of return tends to be:

Accepted Answer

The internal rate of return (IRR) is commonly used in capital budgeting because it is easy for managers to intuitively understand. The IRR is the discount rate that makes the net present value (NPV) of an investment equal to zero. In contrast, managers may struggle to fully comprehend the NPV calculation, which involves discounting all future cash flows to their present value. While the IRR is a useful tool for decision-making, it is not always accurate when cash flow estimates are unreliable or when comparing mutually exclusive projects.

Question 11

Accepting positive NPV projects benefits the stockholders because:

Accepted Answer

Accepting positive NPV projects means that the present value of expected cash inflows exceeds the cost of investment, resulting in increased value for the shareholders. This is because the value of the business is expected to increase, leading to potential increases in cash flows, dividends, and stock prices. Therefore, choice C is the best answer.

Question 12

A mutually exclusive project is a project whose:

Accepted Answer

Mutually exclusive projects are those where the decision to invest in one project affects the decision on other projects, meaning if one project is chosen, the other cannot be chosen due to constraints like budget, resources, or project scope.

Question 13

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?

Accepted Answer

To find the discount payback period, we need to calculate the present value (PV) of each cash flow and find the year in which the sum of the discounted cash flows equals the initial investment. Using a financial calculator or spreadsheet, we can find that:
PV of -250 = -250
PV of 75 = 66.96
PV of 125 = 97.75
PV of 100 = 66.96
PV of 50 = 26.27

The sum of the discounted cash flows for each year is:
Year 1: -250
Year 2: -250 + 66.96 = -183.04
Year 3: -183.04 + 97.75 = -85.29
Year 4: -85.29 + 66.96 = -18.33
Year 5: -18.33 + 26.27 = 7.94

Therefore, the discount payback period is between year 4 and year 5. To find the exact year, we need to calculate the cumulative discounted cash flows:
Year 4: -85.29 + 66.96 + 97.75 + 66.96 = 246.38
Year 5: -18.33 + 26.27 + 66.96 + 97.75 + 66.96 = 239.61

The discount payback period is year 4 plus the difference between the cumulative discounted cash flows and the initial investment divided by the discounted cash flow in year 5:
Payback period = 4 + (250 - 246.38)/(66.96) = 4.56 years

The closest answer choice is C) 3.38 years.

Question 14

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.

Accepted Answer

The answer of Consider an investment with an initial cost...

Question 15

The average accounting rate of return is determined by:

Accepted Answer

The average accounting rate of return is determined by dividing the average net income by the average investment. This ratio is used to determine the profitability of an investment by comparing the average net income to the average investment.

Question 16

The discounted payback period rule:

Accepted Answer

The discounted payback period rule considers the time value of money, which means it takes into account the fact that money today is worth more than the same amount of money in the future. This makes it a more accurate measure of a project's profitability than the regular payback period rule, which ignores the time value of money. The other options are incorrect: B is not a relevant concept, C is a limitation of the payback period rule (not the discounted payback period rule), and D is incorrect because the NPV rule is generally preferred to the payback period rule (but the discounted payback period rule can be a useful supplement to the NPV rule).

Question 17

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.

Accepted Answer

The answer of An investment with an initial cost of...

Question 18

The payback period rule:

Accepted Answer

The payback period rule requires an arbitrary choice of a cutoff point, which means there is no objective basis for setting the maximum acceptable payback period. This can lead to inconsistent decisions and ignores the time value of money. Therefore, it is not considered as a reliable method for evaluating investments.

Question 19

Which of the following does not characterize NPV?

Accepted Answer

NPV is not the simplest of all investment rules, but it is considered to be the most accurate and comprehensive of all investment rules.

Question 20

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

Accepted Answer

The answer of The two fatal flaws of the internal...

Quiz 7: Net Present Value and Other Investment Rules