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Chapter 9

Capital Budgeting Criteria

True/False

1. Errors resulting from a capital budgeting decision are not considered major since the consequences of such errors average out over the life of the investment.

Difficulty: Moderate

Keywords: errors in capital budgeting

2. One drawback of the payback method is that it focuses primarily on breaking even versus measuring total project value.

Difficulty: Easy

Keywords: payback period

3. The required rate of return reflects the costs of funds needed to finance a project.

Difficulty: Easy

Keywords: required rate of return

4. The profitability index provides the same decision result as the net present value (NPV) method.

Difficulty: Easy

Keywords: profitability index

5. The internal rate of return (IRR) will increase as the required rate of return of a project is increased.

Difficulty: Moderate

Keywords: internal rate of return, required return

6. Whenever the IRR on a project equals that project’s required rate of return, the NPV equals zero.

Difficulty: Moderate

Keywords: internal rate of return

7. High required rates of return tend to make long-term projects less attractive than short-term projects.

Difficulty: Moderate

Keywords: long-term vs. short-term projects

8. One of the disadvantages of the payback method is that it ignores cash flows beyond the payback period.

Difficulty: Easy

Keywords: payback method disadvantages

9. Both the IRR rule and the accounting rate of return rule take into consideration the time value of money.

Difficulty: Moderate

Keywords: internal rate of return, accounting rate of return

10. In general, all discounted cash flow criteria are consistent and will give similar accept-reject decisions.

Difficulty: Moderate

Keywords: discounted cash flow criteria, accept-reject decisions

11. When several sign reversals in the cash flow stream occur, the IRR equation can have more than one positive IRR.

Difficulty: Moderate

Keywords: multiple internal rates of return

12. Many firms today continue to use the payback method but employ the NPV or IRR methods as secondary decision methods of control for risk.

Difficulty: Moderate

Keywords: payback, net present value, internal rate of return

13. The required rate of return represents the cost of capital for a project.

Difficulty: Easy

Keywords: required rate of return, cost of capital

14. The IRR assumes that cash flows are reinvested at the cost of capital.

Difficulty: Easy

Keywords: internal rate of return, reinvestment assumption

15. According to the modified internal rate of return (MIRR) technique, when a project’s MIRR is greater than its cost of capital, the project should be accepted.

Difficulty: Moderate

Keywords: MIRR acceptance criteria

16. If the NPV of a project is zero, then the profitability index should equal one.

Difficulty: Moderate

Keywords: net present value, profitability index

17. The net present value profile is a graph showing how a project’s NPV changes as the IRR changes.

Difficulty: Moderate

Keywords: net present value profile

18. If the NPV of a project is positive, the profitability index must be greater than one.

Difficulty: Moderate

Keywords: net present value, profitability index

19. It is possible for a project to have more than one IRR if there is more than one sign change in the after-tax cash flows due to the project.

Difficulty: Moderate

Keywords: multiple IRRs

20. The higher the discount rate, the more valued is the proposal with the early cash flows.

Difficulty: Moderate

Keywords: discount rate and value

21. If the project’s payback period is greater than or equal to zero, the project should be accepted.

Difficulty: Moderate

Keywords: payback period

22. The NPV of a project will equal zero whenever the payback period of a project equals the required rate of return.

Difficulty: Moderate

Keywords: net present value, payback period

23. The NPV of a project will equal zero whenever the average rate of return equals the required rate of return.

Difficulty: Moderate

Keywords: net present value, required rate of return

24. The IRR is the discount rate that equates the present value of the project’s future net cash flows with the project’s initial outlay.

Difficulty: Moderate

Keywords: internal rate of return

25. If a project’s profitability index is less than 0.0, then the project should be rejected.

Difficulty: Moderate

Keywords: profitability index

26. A single project can only have one NPV, PI, and IRR.

Difficulty: Moderate

Keywords: multiple IRRs

27. Competitive market forces make it imperative for a firm to have a systematic strategy for generating capital-budgeting projects.

Difficulty: Moderate

Keywords: capital-budgeting strategies

28. Spending on capital equipment in the U.S. has been growing at an extremely rapid pace.

Difficulty: Moderate

Keywords: capital spending

29. The size of capital investments and the difficulty in reversing them once they are made make capital-budgeting decisions very important to the firm.

Difficulty: Moderate

Keywords: capital budgeting

30. In recent years, more and more capital expenditures have been aimed at introducing new products, rather than being directed at cost-saving and productivity-improving projects.

Difficulty: Moderate

Keywords: capital expenditures

31. Payback period is the least sophisticated capital-budgeting technique.

Difficulty: Easy

Keywords: payback period

32. The discounted payback period is superior to the traditional payback period; however, its use as a capital-budgeting tool is still limited.

Difficulty: Moderate

Keywords: payback period

33. An NPV of zero indicates that a project is expected to provide the required rate of return.

Difficulty: Moderate

Keywords: net present value

34. NPV is the most theoretically correct capital-budgeting method.

Difficulty: Easy

Keywords: net present value

35. There are no disadvantages to the Net Present Value method.

Difficulty: Moderate

Keywords: net present value

36. Capital budgeting is the decision-making process with respect to investment in working capital.

Difficulty: Easy

Keywords: capital budgeting

37. NPV is a better capital-budgeting technique than IRR.

Difficulty: Easy

Keywords: net present value, internal rate of return

38. If NPV equals zero, then the discount rate used to calculate NPV must equal the project’s IRR.

Difficulty: Moderate

Keywords: net present value, discount rate

39. If NPV is negative, then the project’s cost is less than the project’s expected benefit.

Difficulty: Moderate

Keywords: net present value, cost/benefit

40. If NPV is positive, then the project is expected to return more than the required rate of return.

Difficulty: Moderate

Keywords: net present value, required rate of return

41. Currently, most firms use NPV and IRR as their primary capital-budgeting technique.

Difficulty: Easy

Keywords: net present value, internal rate of return

42. Most firms use the payback period as a secondary capital-budgeting technique, which in a sense allows them to control for risk.

Difficulty: Moderate

Keywords: payback period

43. Although discounted cash flow decision techniques have become widely accepted, their use depends to some degree on the size of the project and where within the firm the decision is being made.

Difficulty: Moderate

Keywords: discounted cash flow techniques

Multiple Choice

44. Which of the following methods assumes that cash flows are reinvested at the IRR?

1. MIRR
2. NPV
3. IRR
4. Both a and b
5. All of the above

Difficulty: Moderate

Keywords: internal rate of return, reinvestment rate assumption

45. The firm should accept independent projects if:

a. the payback is less than the IRR.

b. the profitability index is greater than 1.0.

c. the IRR is positive.

d. the NPV is greater than the discounted payback.

Difficulty: Moderate

Keywords: profitability index

46. The NPV method:

a. is consistent with the goal of shareholder wealth maximization.

b. recognizes the time value of money.

c. uses cash flows.

d. all of the above.

Difficulty: Moderate

Keywords: net present value

47. If the IRR is greater than the required rate of return, the:

a. present value of all the cash inflows will be greater than the initial outlay.

1. payback will be less than the life of the investment.
2. project should be rejected.

d. both a and b.

Difficulty: Moderate

Keywords: internal rate of return

48. The NPV assumes cash flows are reinvested at the:

1. IRR.
2. NPV.
3. real rate of return.
4. cost of capital.

Difficulty: Moderate

Keywords: cost of capital, net present value

49. If the cash flow pattern for a project has two sign reversals, then there can be as many as ____________ positive IRR(s).

a. one

b. two

c. three

d. four

Difficulty: Moderate

Keywords: multiple IRRs

50. A project has an initial outlay of $4,000. It has a single payoff at the end of Year 4 of $6,996.46. What is the IRR for the project (round to the nearest percent)?

a. 16%

b. 13%

c. 21%

d. 15%

Difficulty: Moderate

Keywords: internal rate of return

51. ABC Service can purchase a new assembler for $15,052 that will provide an annual net cash flow of $6,000 per year for five years. Calculate the NPV of the assembler if the required rate of return is 12%. (Round your answer to the nearest $1.)

a. $1,056

b. $4,568

c. $7,621

d. $6,577

Difficulty: Moderate

Keywords: net present value

52. Given the following annual net cash flows, determine the IRR to the nearest whole percent of a project with an initial outlay of $1,520.

Year Net Cash Flow

1 $1,000

2 $1,500

3 $ 500

a. 48%

b. 40%

c. 32%

d. 28%

Difficulty: Moderate

Keywords: internal rate of return

53. A machine costs $1,000, has a three-year life, and has an estimated salvage value of $100. It will generate after-tax annual cash flows (ACF) of $600 a year, starting next year. If your required rate of return for the project is 10%, what is the NPV of this investment? (Round your answerwer to the nearest $10.)

a. $490

b. $570

c. $900

d. -$150

Difficulty: Moderate

Keywords: net present value

54. Suppose you determine that the NPV of a project is $1,525,855. What does that mean?

a. In all cases, investing in this project would be better than investing in a project that has an NPV of $850,000.

b. The project would add value to the firm.

c. Under all conditions, the project’s payback would be less than the profitability index.

d. The project’s IRR would have to be less that the firm’s discount rate.

Difficulty: Moderate

Keywords: net present value

55. Initial Outlay Cash Flow in Period

1 2 3 4

-$4,000 $1,546.17 $1,546.17 $1,546.17 $1,546.17

The IRR (to the nearest whole percent) is:

a. 10%.

b. 18%.

c. 20%.

d. 16%.

Difficulty: Moderate

Keywords: internal rate of return

56. We compute the profitability index of a capital-budgeting proposal by:

a. multiplying the IRR by the cost of capital.

b. dividing the present value of the annual after-tax cash flows by the cost of capital.

c. dividing the present value of the annual after-tax cash flows by the cost of the project.

d. multiplying the cash inflow by the IRR.

Difficulty: Moderate

Keywords: profitability index

57. What is the payback period for a $20,000 project that is expected to return $6,000 for the first two years and $3,000 for Years 3 through 5?

a. 3 1/2

b. 4 1/2

c. 4 2/3

d. 5

Difficulty: Moderate

Keywords: payback period

58. Which of the following is NOT an advantage of NPV?

a. It can be used as a rough screening device to eliminate those projects whose returns do not materialize until later years.

b. All positive NPVs will increase the value of the firm.

c. It allows the comparison of benefits and costs in a logical manner.

d. It recognizes the timing of the benefits resulting from the project.

Difficulty: Moderate

Keywords: net present value

59. Which of the following techniques may ignore the terminal cash flow of a project?

1. NPV
2. IRR
3. Payback
4. Both b and c

Difficulty: Moderate

Keywords: payback period

60. The IRR is:

a. the discount rate that makes the NPV positive.

b. the discount rate that equates the present value of the cash inflows with the cost of the project.

c. the discount rate that makes the NPV negative and the profitability index greater than one.

d. the rate of return that makes the NPV positive.

Difficulty: Moderate

Keywords: internal rate of return

61. All of the following criteria for capital-budgeting decisions adjust for the time value of money EXCEPT:

a. IRR.

b. NPV.

c. payback period.

d. profitability index.

Difficulty: Moderate

Keywords: payback period disadvantages

62. Which of the following is NOT a criticism of the payback period criteria?

a. Time value of money is not accounted for.

b. Returns occurring after the payback are ignored.

c. It deals with accounting profits as opposed to cash flows.

d. Both a & c

Difficulty: Moderate

Keywords: payback period disadvantages

63. Artie’s Soccer Ball Company is considering a project with the following cash flows:

Initial outlay = $750,000

Incremental after-tax cash flows from operations Years 1-4 = $250,000 per year

Compute the NPV of this project if the company’s discount rate is 12%.

a. $9,337

b. $7,758

c. $4,337

d. $2,534

Difficulty: Moderate

Keywords: net present value

64. Dieyard Battery Recyclers is considering a project with the following cash flows:

Initial outlay = $13,000

Cash flows: Year 1 = $5,000

Year 2 = $3,000

Year 3 = $9,000

If the appropriate discount rate is 15%, compute the NPV of this project.

a. $4,000

b. -$466

c. $27,534

d. $8,891

Difficulty: Moderate

Keywords: net present value

65. Your company is considering a project with the following cash flows:

Initial outlay = $1,748.80

Cash flows Years 1-6 = $500

Compute the IRR on the project.

a. 9%

b. 11%

c. 18%

d. 24%

Difficulty: Moderate

Keywords: internal rate of return

66. For the NPV criteria, a project is acceptable if the NPV is __________, while for the profitability index, a project is acceptable if the profitability index is __________.

a. less than zero, greater than the required return

b. greater than zero, greater than one

c. greater than one, greater than zero

d. greater than zero, less than one

Difficulty: Moderate

Keywords: profitability index

67. Compute the payback period for a project with the following cash flows, if the company’s discount rate is 12%.

Initial outlay = $450

Cash flows: Year 1 = $325

Year 2 = $ 65

Year 3 = $100

a. 3.43 years

b. 3.17 years

c. 2.88 years

d. 2.6 years

Difficulty: Moderate

Keywords: discounted payback period

68. Consider a project with the following cash flows:

After-Tax After-Tax

Accounting Cash Flow

Year Profits from Operations

1 $799 $ 750

2 $150 $1,000

3 $200 $1,200

Initial outlay = $1,500

Terminal cash flow = 0

Compute the profitability index if the company’s discount rate is 10%.

a. 15.8

b. 1.61

c. 1.81

d. 0.62

Difficulty: Moderate

Keywords: profitability index

69. If the NPV of a project is positive, then the project’s IRR ____________ the required rate of return.

a. must be less than

b. must be greater than

c. could be greater or less than

d. cannot be determined without actual cash flows

Difficulty: Moderate

Keywords: net present value, internal rate of return

70. What is the term for the discount rate that equates the present value of a project’s future net cash flows with the project’s initial cash outlay?

a. The MIRR

b. The hurdle rate

c. The IRR

d. The accounting rate of return

Difficulty: Moderate

Keywords: internal rate of return

71. The ____________ is equal to the present value of inflows less the present value of outflows, discounted at the cost of capital.

a. accounting rate of return

b. profitability index

c. NPV

d. IRR

Difficulty: Moderate

Keywords: net present value

72. You are considering investing in a project with the following year-end after-tax cash flows:

Year 1: $5,000

Year 2: $3,200

Year 3: $7,800

If the initial outlay for the project is $12,113, compute the project’s IRR.

a. 14%

b. 10%

c. 32%

d. 24%

Difficulty: Moderate

Keywords: internal rate of return

73. Which of the following capital-budgeting techniques assume the same reinvestment rate of cash flows?

a. MIRR

b. NPV

c. IRR

d. Both a & b

e. All of the above

Difficulty: Moderate

Keywords: modified internal rate of return

74. Which of the following best describes the payback period?

a. The amount needed to recover the entire IRR

b. The number of years needed to recover the initial cash outlay

c. The value of the cash flows at the end of a project

d. The rate of return that is needed to pay back investors

Difficulty: Moderate

Keywords: payback period

75. Payback period:

a. ignores the time value of money.

b. deals with cash flows rather than accounting profits.

c. measures how quickly the project will return its original investment.

d. does all of the above.

Difficulty: Moderate

Keywords: payback period

76. A project costs $10,000 and is expected to return after-tax cash flows of $3,000 each year for the next 10 years. This project’s payback period is:

a. three years.

b. three and one-third years.

c. four years.

d. 10 years.

Difficulty: Moderate

Keywords: payback period

77. Manheim Candles is considering a project with the following incremental cash flows. Assume a discount rate of 10%.

Year Cash Flow

0 ($20,000)

1 0

2 $30,000

3 $30,000

Calculate the project’s MIRR. (Round to the nearest whole percentage.)

a. 31%

b. 47%

c. 53%

d. 61%

Difficulty: Moderate

Keywords: modified internal rate of return

Use the following information to answer questions 78 through 84. Below are the expected after-tax cash flows for Projects Y and Z. Both projects have an initial cash outlay of $20,000 and a required rate of return of 17%.

Project Y Project Z

Year 1 $12,000 $10,000

Year 2 $8,000 $10,000

Year 3 $6,000 0

Year 4 $2,000 0

Year 5 $2,000 0

78. Payback for Project Y is:

a. two years.

b. one year.

c. three years.

d. four years.

Difficulty: Moderate

Keywords: payback period

79. What is payback for Project Z?

a. Two years

b. One year

c. Zero years

d. Project Z does not payback the original investment.

Difficulty: Moderate

Keywords: payback period

80. Discounted payback for Project Y is:

a. three years.

b. 3.14 years.

c. four years.

d. two years.

Difficulty: Moderate

Keywords: discounted payback period

81. What is discounted payback for Project Z?

a. Two years

b. One year

c. Zero years

d. Project Z does not have a discounted payback because the initial cash outlay is never fully recovered.

Difficulty: Moderate

Keywords: discounted payback period

82. Project Y’s NPV is:

a. less than zero.

b. $1,826.26.

c. $10,000.

d. $4,636.42.

Difficulty: Moderate

Keywords: net present value

83. Project Y’s IRR is:

a. less than zero.

b. less than 17%.

c. 22.51%.

d. 12.51%.

Difficulty: Moderate

Keywords: internal rate of return

84. Project Y’s MIRR is:

a. 22.51%.

b. 19.06%.

c. 11.91%.

d. 10%.

Difficulty: Moderate

Keywords: internal rate of return

85. Who decides upon the acceptable discounted payback period?

a. The IRS

b. The SEC

c. The firm

d. The investment banking firm

Difficulty: Moderate

Keywords: discounted payback period

86. You have been asked to analyze a capital investment proposal. The project’s cost is $2,775,000. Cash inflows are projected to be $925,000 in Year 1; $1,000,000 in Year 2; $1,000,000 in Year 3; $1,000,000 in Year 4; and $1,225,000 in Year 5. Assume that your firm discounts capital projects at 15.5%. What is the project’s discounted payback period?

a. 5.35 years

b. 3.74 years

c. 4.02 years

d. 2.75 years

Difficulty: Moderate

Keywords: discounted payback period

87. Which of the following statements is FALSE?

a. Accepting positive NPV projects is consistent with the goal of shareholder wealth maximization.

b. If NPV is positive, then the project is expected to return more than the required rate of return.

c. If NPV is negative, then the project’s cost is less than the project’s expected benefit.

d. If NPV is negative, then the project is expected to return less than the required rate of return.

Difficulty: Moderate

Keywords: negative net present value

Use the following to answer questions 88-90. The information below describes a project with an initial cash outlay of $10,000 and a required return of 12%.

After-tax cash inflow

Year 1 $6,000

Year 2 $2,000

Year 3 $2,000

Year 4 $2,000

88. Which of the following statements is correct?

a. The project should be accepted since its NPV is $353.87.

b. The project should be rejected since its NPV is -$353.87.

c. The project should be accepted since it has a payback of less than four years.

d. The project should be rejected since its NPV is -$23.91.

Difficulty: Moderate

Keywords: net present value

89. This project:

a. has an IRR of 9.86%.

b. should be accepted based on the IRR criterion.

c. has an IRR of 12%.

d. both a and b.

Difficulty: Moderate

Keywords: internal rate of return

90. The profitability index for this project:

a. is 1.

b. is greater than 1.

c. is 0.96.

d. indicates that the project should be accepted.

Difficulty: Moderate

Keywords: profitability index

91. The IRR of a project increases as the _________ decreases.

1. discount rate
2. initial outlay of the project
3. incremental cash inflow
4. both a and b
5. all of the above

Difficulty: Moderate

Keywords: internal rate of return

92. An increase in the cost of capital will cause __________ to increase.

1. the NPV
2. the IRR
3. the discounted payback period
4. none of the above

Difficulty: Moderate

Keywords: discount payback period

93. The profitability index of the project would increase if ______________ increased.

a. the discount rate

b. the terminal cash flow

c. the NPV

d. both b and c

Difficulty: Moderate

Keywords: profitability index

94. Manheim Candles is considering a project with the following incremental cash flows. Assume a discount rate of 10%.

Year Cash Flow

1. ($15,000)
2. $10,000
3. $20,000
4. $30,000

Calculate the discounted payback period of the project.

a. 2.15 years

b. 2.36 years

c. 2.57 years

d. 2.78 years

Difficulty: Moderate

Keywords: discounted payback period

95. Which method of evaluating capital-budgeting decisions has the superior reinvestment assumption?

a. The payback

b. The NPV

c. The IRR

d. The accounting rate of return

Difficulty: Moderate

Keywords: net present value, reinvestment rate assumption

96. Which of the following investment projects should be undertaken?

a. Those having an IRR that exceeds the firm’s weighted average cost of capital.

b. Those projects that have a discounted payback that exceeds the IRR.

c. Those projects that have a capital asset pricing model that exceeds the weighted average cost of capital.

d. Those having an NPV that exceeds the firm’s average cost of capital.

e. None of the above.

Difficulty: Moderate

Keywords: internal rate of return, acceptance criteria

97. When using the NPV method of evaluating capital investment alternatives, the implicit assumption is that the cash flows generated from the project are reinvested at:

a. the current 90-day T-bill rate.

b. the project’s IRR.

c. the discount rate established by the firm.

d. the current yield on AAA long-term corporate bonds.

e. the firm’s CAPM.

Difficulty: Moderate

Keywords: net present value, reinvestment rate assumption

98. Which of the following capital-budgeting decision criteria are correct?

a. Accept projects that have a positive NPV.

b. Accept projects that generate an IRR that is greater than the firm’s discount rate.

c. Accept projects that have a profitability index of greater than 1.0.

d. Accept projects that generate an MIRR that is greater than the firm’s discount rate.

e. All of the above are correct.

Difficulty: Moderate

Keywords: capital budgeting techniques, acceptance criteria

99. Which of the below would be acceptable projects?

a. Those that generate an IRR that is greater than the firm’s discount rate.

b. Any project that has a positive payback.

c. Ones that generate an IRR that is greater than the accounting rate of return.

d. Any project that produces a profitability index that is greater than the firm’s MIRR.

Difficulty: Moderate

Keywords: internal rate of return, acceptance criteria

100. A negative NPV indicates that a project has a(n):

a. IRR less than the cost of capital.

b. profitability index greater than 1.

c. MIRR more than the discount rate.

d. both b and c.

Difficulty: Moderate

Keywords: net present value, internal rate of return

101. As the cost of capital is increased, the:

1. IRR remains constant.
2. payback period remains the same.
3. discounted payback period increases.
4. both b and c.
5. all of the above.

Difficulty: Hard

Keywords: change in cost of capital and capital-budgeting techniques

102. MacHinery Manufacturing Company is considering a three-year project that has a cost of $75,000. The project will generate after-tax cash flows of $33,100 in Year 1, $31,500 in Year 2, and $31,200 in Year 3. Assume that the firm’s proper rate of discount is 10% and that the firm’s tax rate is 40%. What is the project’s payback?

a. 0.33 years

b. 1.22 years

c. 2.33 years

d. Three years

e. More than three years

Difficulty: Moderate

Keywords: discounted payback

103. Which of the following is the correct equation to solve for the NPV of the project that has an initial outlay of $30,000, followed by three years of $20,000 in incremental cash inflow? Assume a discount rate of 10%.

a. NPV = -$30,000 + $20,000(1.10)¹ + $20,000(1.10)² + $20,000(1.10)³

b. NPV = -$30,000 + $20,000(1.10)^-1 + $20,000(1.10)^-2 + $20,000(1.10)^-3

c. NPV = -$30,000 + $20,000/(1.01)^.10 + $20,000/(1.02)^.10 + $20,000/(1.03)^.10

d. NPV = -$30,000 + $20,000/(1.1)^.10+ $20,000(1.2)^.10 + $20,000(1.3)^.10

Difficulty: Hard

Keywords: net present value formula

104. Frazier Fudge has a project with an initial outlay of $40,000, followed by three years of annual incremental cash flows of $35,000. The terminal cash flow of the project is $10,000. Assuming a cost of capital of 10%, calculate the MIRR of the project.

a. 46.5%

b. 51.3%

c. 62.9%

d. 74.7%

Difficulty: Moderate

Keywords: modified internal rate of return

105. A machine has a cost of $5,375,000. It will produce cash inflows of $1,825,000 (Year 1); $1,775,000 (Year 2); $1,630,000 (Year 3); $1,585,000 (Year 4); and $1,650,000 (Year 5). At a discount rate of 16.25%, what is the NPV?

a. $81,724

b. $257,106

c. $416,912

d. $190,939

Difficulty: Moderate

Keywords: net present value

106. Analysis of a machine indicates that it has a cost of $5,375,000. The machine is expected to produce cash inflows of $1,825,000 in Year 1; $1,775,000 in Year 2; $1,630,000 in Year 3; $1,585,000 in Year 4; and $1,650,000 in Year 5. What is the machine’s IRR?

a. 12.16%

b. 17.81%

c. 23.00%

d. 11.11%

Difficulty: Moderate

Keywords: internal rate of return

107. You have been asked to analyze a capital investment proposal. The project’s cost is $2,775,000. Cash inflows are projected to be $925,000 in Year 1; $1,000,000 in Year 2; $1,000,000 in Year 3; $1,000,000 in Year 4; and $1,225,000 in Year 5. What is the project’s IRR?

a. 8.04%

b. 16.75%

c. 23.78%

d. 19.16%

Difficulty: Moderate

Keywords: internal rate of return

108. When Net Present Value is equal to $0, the discount rate is equal to the project’s:

a. internal rate of return.

b. capital asset pricing model.

c. modified internal rate of return.

d. both a & c.

Difficulty: Moderate

Keywords: net present value

109. Why does the NPV method of evaluating an investment proposal require that the cash inflows of a project be discounted to the present?

a. It is the only way to arrive at the correct amount to divide into the cost in order to determine the rate of return.

b. The IRS requires it.

c. This enables the analyst to determine the amount of the investment outlay.

d. It provides a measurement of the value of an investment proposal in terms of today’s dollars.

Difficulty: Moderate

Keywords: net present value

110. Kannan Enterprise has a project with an initial outlay of $40,000, followed by three years of annual incremental cash flows of $35,000. The terminal cash flow of the project is $10,000. Assuming a discount rate of 10%, which of the following is the correct equation to solve for the IRR of the project?

a. $40,000 = $35,000(1.12)¹ + $35,000(1.12)² + $45,000(1.12)³

b. $40,000 = $35,000(1 + IRR)¹ + $35,000(1+IRR)² + $45,000(1+IRR)³

c. $40,000 = $35,000/(1.12)^IRR + $35,000/(1.12)^IRR + $45,000/(1.12)^IRR

d. $40,000 = $35,000(1+IRR)^-1 + $35,000(1.IRR)^-2 + $45,000(1+IRR)^-3

Difficulty: Hard

Keywords: internal rate of return formula

111. We-Know-Widgets, Inc. is analyzing a project that requires an initial investment of $10,000, followed by cash inflows of $1,000 in Year 1, $4,000 in Year 2, and $15,000 in Year 3. The cost of capital is 10%. What is the profitability index of the project? (Round to the nearest $.)

a. 1.04

b. 1.55

c. 1.78

d. 1.97

Difficulty: Moderate

Keywords: profitability index

112. Mayhem Mines, Inc. is analyzing a project that requires an initial investment of $50,000, followed by cash inflows of $15,000 in Year 1, $60,000 in Year 2, and $75,000 in Year 3. The cost of capital is 10%. Calculate the profitability index of the project. (Round to the nearest $.)

a. 2.14

b. 2.26

c. 2.39

d. 2.47

Difficulty: Moderate

Keywords: profitability index

113. Which of the following capital-budgeting decision criteria are correct?

a. Accept projects that have a positive NPV.

b. Accept projects that generate an IRR that is greater than the firm’s CAPM.

c. Accept projects that have a profitability index of greater than the IRR.

d. Accept projects that generate an MIRR that is greater than the IRR.

e. All of the above are correct.

Difficulty: Moderate

Keywords: capital-budgeting decision criteria, net present value

114. Mayhem Mines, Inc. is analyzing a project that has a profitability index of 2.5. Given the following cash flows for the project, calculate the present value of inflows for the project.

Year Cash Flow

1. ($100,000)
2. $120,000
3. $130,000
4. $200,000

a. $250,000

b. $350,000

c. $450,000

d. $550,000

Difficulty: Moderate

Keywords: profitability index, present value of cash inflows

115. If the NPV of a project is positive, what will occur?

a. The value of the firm will be increased.

b. The IRR will be greater than the payback period.

c. The equivalent annual annuity will exceed the IRR.

d. The discounted payback period will be greater than the payback period.

Difficulty: Moderate

Keywords: net present value, positive net present value

116. You have been asked to analyze a capital investment proposal. The project’s cost is $2,775,000. Cash inflows are projected to be $925,000 in Year 1; $1,000,000 in Year 2; $1,000,000 in Year 3; $1,000,000 in Year 4; and $1,225,000 in Year 5. Assume that your firm discounts capital projects at 15.5%. What is the project’s NPV?

a. $101,247

b. $285,106

c. $473,904

d. $581,880

Difficulty: Moderate

Keywords: net present value

117. Wheatley Estates has evaluated a project with an initial outlay of $100,000 with three years of positive incremental cash flows. The projected cash flow in Year 1 is $40,000 and $90,000 in Year 3. The company determined that the payback period of the project is 1.6 years. Based on their results, what was the incremental cash flow for Year 2?

1. $60,000
2. $100,000
3. $160,000
4. $200,000

Difficulty: Moderate

Keywords: payback period, estimating cash flows

118. So long as money has a time value, the discounted payback will always be greater than the:

a. payback.

b. IRR.

c. NPV.

d. payback.

Difficulty: Moderate

Keywords: discounted payback

119. The Seattle Corporation has been presented with an investment opportunity which will yield cash flows of $30,000 per year in Years 1 through 4, $35,000 per year in Years 5 through 9, and $40,000 in Year 10. This investment will cost the firm $150,000 today, and the firm’s cost of capital is 10%. Assume cash flows occur evenly during the year, 1/365th each day. What is the discounted payback period for this investment?

a. 5.23 years

b. 4.86 years

c. 4.35 years

d. 3.72 years

e. 3.35 years

Difficulty: Moderate

Keywords: discounted payback

120. The director of capital budgeting of South Park Development Corporation is evaluating a project that will cost $200,000; it is expected to last for 10 years and produce after-tax cash flows, including depreciation, of $44,503 per year. If the firm’s cost of capital is 14% and its tax rate is 40%, what is the project’s IRR?

a. 8%

b. 14%

c. 18%

d. -5%

e. 12%

Difficulty: Moderate

Keywords: internal rate of return

121. Dizzyland Enterprises has been presented with an investment opportunity which will yield end-of-year cash flows of $30,000 per year in Years 1 through 4, $35,000 per year in Years 5 through 9, and $40,000 in Year 10. This investment will cost the firm $150,000 today, and the firm’s cost of capital is 10%. What is the profitability index for this investment?

a. 1.28

b. 0.87

c. 1.85

d. 0.21

Difficulty: Moderate

Keywords: profitability index

122. Under which of the following conditions will the IRR of a project be equal to the rate at which projects are discounted?

a. When the discounted payback is equal to MIRR

b. When the profitability index is equal to the CAPM

c. When the NPV is equal to zero

d. When the payback is equal to the IRR

e. None of the above

Difficulty: Moderate

Keywords: net present value, discount rate

123. Suppose you determine that the IRR of a project is 27.99%. What does that mean?

a. The project is acceptable.

b. The project is acceptable only if the IRR is greater than the discounted payback period.

c. The project would be acceptable if the project’s profitability index is positive.

d. The project would be acceptable if the IRR is greater than the firm’s discount rate.

Difficulty: Moderate

Keywords: internal rate of return, acceptance criteria

124. Aroma Candles, Inc. is evaluating a project with the following cash flows. Calculate the IRR of the project. (Round to the nearest whole percentage.)

Year Cash Flows

0 ($120,000)

1 $ 30,000

2 $ 70,000

3 $ 90,000

a. 18%

b. 23%

c. 28%

d. 33%

Difficulty: Moderate

Keywords: internal rate of return

125. What deficiency of the IRR does the MIRR overcome?

a. The fact that the IRR fails to consider risk

b. The possibility of arriving at multiple solutions

c. The fact that the IRR does not take the time value of money into consideration

d. The ranking problem

e. None of the above

Difficulty: Moderate

Keywords: modified internal rate of return

126. Which of the following statements about the MIRR is false?

a. The MIRR has the same reinvestment assumption as the IRR.

b. If a project’s MIRR exceeds the firm’s discount rate, the project is acceptable.

c. The MIRR has the same reinvestment assumption as the NPV.

d. A project’s MIRR could be lower than a project’s IRR.

Difficulty: Moderate

Keywords: modified internal rate of return, reinvestment rate assumption

127. You have been asked to analyze a capital investment proposal. The project’s cost is $2,775,000. Cash inflows are projected to be $925,000 in Year 1; $1,000,000 in Year 2; $1,000,000 in Year 3; $1,000,000 in Year 4; and $1,225,000 in Year 5. Assume that your firm discounts capital projects at 15.5%. What is the project’s MIRR?

a. 12.62%

b. 10.44%

c. 16.73%

d. 19.99%

Difficulty: Moderate

Keywords: modified internal rate of return

128. Which of the following is considered to be a deficiency of the IRR?

a. It fails to properly rank capital projects.

b. It could produce more than one rate of return.

c. It fails to utilize the time value of money.

d. It is not useful in accounting for risk in capital budgeting.

Difficulty: Moderate

Keywords: internal rate of return

129. A firm is considering two projects, A and B. Both have the same initial cash outlay and the same payback period. Project A is expected to generate after-tax cash flows for 10 years, while Project B is expected to generate after-tax cash flows for 15 years. Given that payback is the same for both projects, will the firm be indifferent between these two projects? Explain why or why not.

Difficulty: Easy

Keywords: payback period

130. Tinker Tools, Inc. is considering a project with the following cash flows. Calculate the MIRR of the project assuming a reinvestment rate of 8%.

Year Cash Flows

• 1. ($70,000)
  2. ($55,000)
  3. $40,000
  4. $60,000
  5. $100,000

PV Cash Outflows

Year 0 = -$70,000

Year 1: Calculator Steps -$55,000 FV 1 n 8 I/yr PV = -$50,926

PV Outflows = -$70,000 – $50,926 = -$120,926

PV of Cash Inflows

Year 2: $40,000 PV 2 n 8 Iiyr FV = $46,656

Year 3: $60,000 PV 3 n 8 Iiyr FV = $64,800

FV of Inflows = $46,696 + $64,800 + $100,000 = $211,496

MIRR: -$120,926 PV 4 n $211,496 FV Solve for I/yr = 15% = MIRR

Difficulty: Hard

Keywords: modified internal rate of return

131. Define the reinvestment rate assumption. What is the underlying assumption for NPV and IRR? Which assumption is most acceptable? How does the MIRR adjust the reinvestment rate assumption of IRR?

Difficulty: Hard

Keywords: reinvestment rate assumption of cash flows

132. Carter Paving plans to purchase a new grader. The one under consideration costs $250,000 and has a depreciable life of five years. After-tax cash flows are expected to be $67,124 in each of the five years and nothing thereafter. Calculate the IRR for the grader.

Initial Outlay

Cost of grader $250,000

Calculate IRR

$250,000 = $67,124 PVIFA[IRR%, 5 yr.]

3.725 = PVIFA[IRR%, 5 yr.]

IRR = between 10% and 11%

Difficulty: Moderate

Keywords: internal rate of return

133. What is the NPV of a $45,000 project that is expected to have an after-tax cash flow of $14,000 for the first two years, $10,000 for the next two years, and $8,000 for the fifth year? Use a 10% discount rate. Would you accept the project?

After-tax PVIF Present

Year Cash Flow at 10% Value

1 $14,000 .909 $ 12,726

2 14,000 .826 11,564

3 10,000 .751 7,510

4 10,000 .683 6,830

5 8,000 .621 4,968

Present value cash flow $ 43,598

Initial outlay 45,000

Net present value $ -1,402

Project should be rejected.

Difficulty: Moderate

Keywords: net present value

134. Referring to the above problem, if the discount rate was 8%, what would the NPV be? Would you accept or reject the investment?

After-tax PVIF Present

Year Cash Flow at 8% Value

1 $14,000 .926 $ 12,964

2 14,000 .857 11,998

3 10,000 .794 7,940

4 10,000 .735 7,350

5 8,000 .681 5,448

Present value of cash flows $ 45,700

Initial outlay $ 45,000

Net present value $ 700

The project is acceptable.

Difficulty: Moderate

Keywords: net present value

135. Determine the IRR on the following projects:

a. Initial outlay of $35,000 with an after-tax cash flow at the end of

the year of $5,836 for seven years

b. Initial outlay of $350,000 with an after-tax cash flow at the end

of the year of $70,000 for seven years

c. Initial outlay of $3,500 with an after-tax cash flow at the end of

the year of $1,500 for three years

a. IO = ACFt PVIF[IRR%, t yr.]

$35,000 = $5,836 PVIF[IRR%, 7 yr.]

Thus, IRR = 4%

b. $350,000 = $70,000 PVIF[IRR%, 7 yr.]

Thus, IRR = 9.2%

c. $3,500 = $1,500 PVIF[IRR%, 3 yr.]

Thus, IRR = 13.7%

Difficulty: Moderate

Keywords: internal rate of return