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CHAPTER 10 THE BASICS OF CAPITAL BUDGETING (Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard) We point out to our students that some of the questions can best be analyzed by sketching out a NPV profile graph and then thinking about the question in relation to the graph Please see the preface for information on the AACSB letter indicators (F, M, etc.) on the subject lines Multiple Choice: True/False (10.1) Capital budget F I Answer: b EASY A firm should never accept a project if its acceptance would lead to an increase in the firm's cost of capital (its WACC) a True b False (10.2) PV of cash flows F I Answer: b EASY Because "present value" refers to the value of cash flows that occur at different points in time, a series of present values of cash flows should not be summed to determine the value of a capital budgeting project a True b False (10.2) NPV F I Answer: b EASY Assuming that their NPVs based on the firm's cost of capital are equal, the NPV of a project whose cash flows accrue relatively rapidly will be more sensitive to changes in the discount rate than the NPV of a project whose cash flows come in later in its life a True b False (10.2) NPV F I Answer: b EASY A basic rule in capital budgeting is that If a project's NPV exceeds its IRR, then the project should be accepted a True b False (10.2) Mutually exclusive projects F I Answer: a EASY © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 10: Capital Budgeting True/False Page Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method ranks the other one first In theory, such conflicts should be resolved in favor of the project with the higher positive NPV a True b False (10.2) Mutually exclusive projects F I Answer: b EASY Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method ranks the other one first In theory, such conflicts should be resolved in favor of the project with the higher positive IRR a True b False (10.3) IRR F I Answer: a EASY The internal rate of return is that discount rate that equates the present value of the cash outflows (or costs) with the present value of the cash inflows a True b False (10.3) IRR F I Answer: b EASY Other things held constant, an increase in the cost of capital will result in a decrease in a project's IRR a True b False (10.3) IRR F I Answer: a EASY A project’s IRR is independent of the firm’s cost of capital In other words, a project’s IRR doesn’t change with a change in the firm’s cost of capital a True b False (10.4) Multiple IRRs 10 F I Answer: a EASY Under certain conditions, a project may have more than one IRR One such condition is when, in addition to the initial investment at time = 0, a negative cash flow (or cost) occurs at the end of the project's life a True b False (10.4) Multiple IRRs F I Answer: b EASY © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 10: Capital Budgeting True/False Page 11 The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects that have different lives are compared to one another a True b False © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 10: Capital Budgeting True/False Page (10.5) Reinvestment rate assumption 12 F I Answer: a EASY The NPV method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital a True b False (10.5) Reinvestment rate assumption 13 F I Answer: b EASY The IRR method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital a True b False (10.5) Reinvestment rate assumption 14 F I Answer: a EASY The NPV method's assumption that cash inflows are reinvested at the cost of capital is generally more reasonable than the IRR's assumption that cash flows are reinvested at the IRR This is an important reason why the NPV method is generally preferred over the IRR method a True b False (10.6) Modified IRR 15 F I For a project with one initial cash positive cash inflows, the modified compounding the cash inflows out to summing those compounded cash flows then finding the discount rate that project's cost Answer: a EASY outflow followed by a series of IRR (MIRR) method involves the end of the project's life, to form a terminal value (TV), and causes the PV of the TV to equal the a True b False (10.6) Modified IRR 16 F I Answer: b EASY Both the regular and the modified IRR (MIRR) methods have wide appeal to professors, but most business executives prefer the NPV method to either of the IRR methods a True b False (10.6) Modified IRR 17 F I Answer: b EASY When evaluating mutually exclusive projects, the modified IRR (MIRR) always leads to the same capital budgeting decisions as the NPV method, regardless of the relative lives or sizes of the projects being evaluated a True b False © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 10: Capital Budgeting True/False Page © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 10: Capital Budgeting True/False Page (10.9) Payback period 18 F I Answer: a EASY One advantage of the payback method for evaluating potential investments is that it provides information about a project's liquidity and risk a True b False (10.2) Mutually exclusive projects 19 F I Answer: b MEDIUM When considering two mutually exclusive projects, the firm should always select the project whose internal rate of return is the highest, provided the projects have the same initial cost This statement is true regardless of whether the projects can be repeated or not a True b False (10.6) NPV vs IRR 20 F I Answer: b MEDIUM The primary reason that the NPV method is conceptually superior to the IRR method for evaluating mutually exclusive investments is that multiple IRRs may exist, and when that happens, we don't know which IRR is relevant a True b False (10.6) NPV vs IRR 21 F I Answer: b MEDIUM The NPV and IRR methods, when used to evaluate two independent and equally risky projects, will lead to different accept/reject decisions and thus capital budgets if the projects' IRRs are greater than their cost of capital a True b False (10.6) NPV vs IRR 22 F I Answer: b MEDIUM The NPV and IRR methods, when used to evaluate two equally risky but mutually exclusive projects, will lead to different accept/reject decisions and thus capital budgets if the cost of capital at which the projects' NPV profiles cross is less than the projects' cost of capital a True b False (10.6) NPV vs IRR F I Answer: a MEDIUM © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 10: Capital Budgeting True/False Page 23 No conflict will exist between the NPV and IRR methods, when used to evaluate two equally risky but mutually exclusive projects, if the projects' cost of capital exceeds the rate at which the projects' NPV profiles cross a True b False © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 10: Capital Budgeting True/False Page (10.7) NPV profiles 24 F I Answer: a MEDIUM Project S has a pattern of high cash flows in its early life, while Project L has a longer life, with large cash flows late in its life Neither has negative cash flows after Year 0, and at the current cost of capital, the two projects have identical NPVs Now suppose interest rates and money costs decline Other things held constant, this change will cause L to become preferred to S a True b False (10.9) Discounted payback 25 F I Answer: b MEDIUM The regular payback method is deficient in that it does not take account of cash flows beyond the payback period The discounted payback method corrects this fault a True b False (10.10) Capital budgeting methods 26 F I Answer: a MEDIUM In theory, capital budgeting decisions should depend solely on forecasted cash flows and the opportunity cost of capital The decision criterion should not be affected by managers' tastes, choice of accounting method, or the profitability of other independent projects a True b False (10.10) Capital budgeting methods 27 F I Answer: b MEDIUM If you were evaluating two mutually exclusive projects for a firm with a zero cost of capital, the payback method and NPV method would always lead to the same decision on which project to undertake a True b False (Comp.) NPV and IRR 28 F I Answer: b MEDIUM An increase in the firm's WACC will decrease projects' NPVs, which could change the accept/reject decision for any potential project However, such a change would have no impact on projects' IRRs Therefore, the accept/reject decision under the IRR method is independent of the cost of capital a True b False © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 10: Capital Budgeting True/False Page (10.7) NPV profiles 29 F I Answer: b HARD The IRR of normal Project X is greater than the IRR of normal Project Y, and both IRRs are greater than zero Also, the NPV of X is greater than the NPV of Y at the cost of capital If the two projects are mutually exclusive, Project X should definitely be selected, and the investment made, provided we have confidence in the data Put another way, it is impossible to draw NPV profiles that would suggest not accepting Project X a True b False (10.7) NPV profiles 30 F I Answer: b HARD Normal Projects S and L have the same NPV when the discount rate is zero However, Project S's cash flows come in faster than those of L Therefore, we know that at any discount rate greater than zero, L will have the higher NPV a True b False (10.7) NPV profiles 31 F I Answer: b HARD If the IRR of normal Project X is greater than the IRR of mutually exclusive (and also normal) Project Y, we can conclude that the firm should always select X rather than Y if X has NPV > a True b False Multiple Choice: Conceptual (10.2) NPV 32 C I Answer: c EASY Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows a A project’s NPV is found by compounding the cash inflows at the IRR to find the terminal value (TV), then discounting the TV at the WACC b The lower the WACC used to calculate a project’s NPV, the lower the calculated NPV will be c If a project’s NPV is less than zero, then its IRR must be less than the WACC d If a project’s NPV is greater than zero, then its IRR must be less than zero e The NPV of a relatively low-risk project should be found using a relatively high WACC © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 10: Capital Budgeting True/False Page (10.3) IRR 33 C I Answer: e EASY Which of the following statements is CORRECT? a One defect of the IRR method versus the NPV is that the IRR does not take account of cash flows over a project’s full life b One defect of the IRR method versus the NPV is that the IRR does not take account of the time value of money c One defect of the IRR method versus the NPV is that the IRR does not take account of the cost of capital d One defect of the IRR method versus the NPV is that the IRR values a dollar received today the same as a dollar that will not be received until sometime in the future e One defect of the IRR method versus the NPV is that the IRR does not take proper account of differences in the sizes of projects (10.3) IRR 34 C I Which of the following statements is CORRECT? Answer: d EASY Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows a A project’s regular IRR is found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting this TV at the WACC b A project’s regular IRR is found by discounting the cash inflows at the WACC to find the present value (PV), then compounding this PV to find the IRR c If a project’s IRR is greater than the WACC, then its NPV must be negative d To find a project’s IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project’s costs e To find a project’s IRR, we must find a discount rate that is equal to the WACC (10.3) IRR 35 C I Answer: d EASY Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows a A project’s regular IRR is found by compounding the initial cost at the WACC to find the terminal value (TV), then discounting the TV at the WACC b A project’s regular IRR is found by compounding the cash inflows at the WACC to find the present value (PV), then discounting the TV to find the IRR c If a project’s IRR is smaller than the WACC, then its NPV will be positive © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 10: Capital Budgeting True/False Page 10 (10.2) NPV 88 C I a b c d e $400 a b c d e C I -$1,100 $450 $370 $360 Answer: d EASY/MEDIUM $470 $490 9.70% 10.78% 11.98% 13.31% 14.64% (10.3) IRR $380 Data Computer Systems is considering a project that has the following cash flow data What is the project's IRR? Note that a project's IRR can be less than the WACC (and even negative), in which case it will be rejected Year Cash flows 90 $390 $250.15 $277.94 $305.73 $336.31 $369.94 (10.3) IRR EASY/MEDIUM Barry Company is considering a project that has the following cash flow and WACC data What is the project's NPV? Note that a project's expected NPV can be negative, in which case it will be rejected WACC: 12.00% Year Cash flows -$1,100 89 Answer: b C I Answer: a EASY/MEDIUM Simkins Renovations Inc is considering a project that has the following cash flow data What is the project's IRR? Note that a project's IRR can be less than the WACC (and even negative), in which case it will be rejected Year Cash flows a b c d e -$850 $300 $290 $280 $270 13.13% 14.44% 15.89% 17.48% 19.22% © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 10: Capital Budgeting Problems Page 34 (10.3) IRR 91 C I a b c d e -$9,500 $2,000 $2,075 $2,100 Answer: d MEDIUM Last month, Lloyd's Systems analyzed the project whose cash flows are shown below However, before the decision to accept or reject the project took place, the Federal Reserve changed interest rates and therefore the firm's WACC The Fed's action did not affect the forecasted cash flows By how much did the change in the WACC affect the project's forecasted NPV? Note that a project's expected NPV can be negative, in which case it should be rejected a b c d e New WACC: 11.25% $410 $410 $410 -$18.89 -$19.88 -$20.93 -$22.03 -$23.13 (10.2) NPV sensitivity to WACC $2,050 C I Old WACC: 10.00% Year Cash flows -$1,000 93 $2,025 2.08% 2.31% 2.57% 2.82% 3.10% (10.2) NPV sensitivity to WACC EASY/MEDIUM Maxwell Feed & Seed is considering a project that has the following cash flow data What is the project's IRR? Note that a project's IRR can be less than the WACC (and even negative), in which case it will be rejected Year Cash flows 92 Answer: c C I Answer: a MEDIUM Lasik Vision Inc recently analyzed the project whose cash flows are shown below However, before Lasik decided to accept or reject the project, the Federal Reserve changed interest rates and therefore the firm's WACC The Fed's action did not affect the forecasted cash flows By how much did the change in the WACC affect the project's forecasted NPV? Note that a project's expected NPV can be negative, in which case it should be rejected Old WACC: 8.00% Year Cash flows -$1,000 a b c d New WACC: 11.25% $410 $410 $410 -$59.03 -$56.08 -$53.27 -$50.61 © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 10: Capital Budgeting Problems Page 35 e -$48.08 © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 10: Capital Budgeting Problems Page 36 (10.6) MIRR 94 C I a b c d e $450 $450 $450 9.32% 10.35% 11.50% 12.78% 14.20% (10.6) MIRR MEDIUM Ehrmann Data Systems is considering a project that has the following cash flow and WACC data What is the project's MIRR? Note that a project's MIRR can be less than the WACC (and even negative), in which case it will be rejected WACC: 10.00% Year Cash flows -$1,000 95 Answer: e C I Answer: e MEDIUM Ingram Electric Products is considering a project that has the following cash flow and WACC data What is the project's MIRR? Note that a project's MIRR can be less than the WACC (and even negative), in which case it will be rejected WACC: 11.00% Year Cash flows -$800 $350 $350 $350 a 8.86% b 9.84% c 10.94% d 12.15% e 13.50% (10.6) MIRR 96 C I Answer: b MEDIUM Malholtra Inc is considering a project that has the following cash flow and WACC data What is the project's MIRR? Note that a project's MIRR can be less than the WACC (and even negative), in which case it will be rejected WACC: 10.00% Year Cash flows -$850 a b c d e $300 $320 $340 $360 14.08% 15.65% 17.21% 18.94% 20.83% © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 10: Capital Budgeting Problems Page 37 (10.6) MIRR 97 C I a b c d e -$850 $300 $360 Answer: e MEDIUM Stern Associates is considering a project that has the following cash flow data What is the project's payback? a b c d e 2.31 2.56 2.85 3.16 3.52 -$1,100 $300 $310 $320 $330 $340 years years years years years (10.9) Discounted payback $340 C I Year Cash flows 99 $320 13.42% 14.91% 16.56% 18.22% 20.04% (10.9) Payback MEDIUM Hindelang Inc is considering a project that has the following cash flow and WACC data What is the project's MIRR? Note that a project's MIRR can be less than the WACC (and even negative), in which case it will be rejected WACC: 12.25% Year Cash flows 98 Answer: c C I Answer: b MEDIUM Fernando Designs is considering a project that has the following cash flow and WACC data What is the project's discounted payback? WACC: 10.00% Year Cash flows a b c d e 1.88 2.09 2.29 2.52 2.78 -$900 $500 $500 $500 years years years years years © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 10: Capital Budgeting Problems Page 38 (10.9) Discounted payback 100 C I a b c d e 1.61 1.79 1.99 2.22 2.44 -$950 $525 $485 $445 $405 years years years years years (Comp.) NPV vs IRR MEDIUM Masulis Inc is considering a project that has the following cash flow and WACC data What is the project's discounted payback? WACC: 10.00% Year Cash flows 101 Answer: d C I Answer: a MEDIUM Tesar Chemicals is considering Projects S and L, whose cash flows are shown below These projects are mutually exclusive, equally risky, and not repeatable The CEO believes the IRR is the best selection criterion, while the CFO advocates the NPV If the decision is made by choosing the project with the higher IRR rather than the one with the higher NPV, how much, if any, value will be forgone, i.e., what's the chosen NPV versus the maximum possible NPV? Note that (1) "true value" is measured by NPV, and (2) under some conditions the choice of IRR vs NPV will have no effect on the value gained or lost WACC: Year CFS CFL a b c d e 7.50% -$1,100 -$2,700 $550 $650 $600 $725 $100 $800 $100 $1,400 $138.10 $149.21 $160.31 $171.42 $182.52 © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 10: Capital Budgeting Problems Page 39 (Comp.) NPV vs IRR 102 C I Answer: c MEDIUM/HARD A firm is considering Projects S and L, whose cash flows are shown below These projects are mutually exclusive, equally risky, and not repeatable The CEO wants to use the IRR criterion, while the CFO favors the NPV method You were hired to advise the firm on the best procedure If the wrong decision criterion is used, how much potential value would the firm lose? WACC: Year CFS CFL a b c d e 6.00% -$1,025 -$2,150 $380 $765 $380 $765 $380 $765 $380 $765 $188.68 $198.61 $209.07 $219.52 $230.49 © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 10: Capital Budgeting Problems Page 40 (Comp.) NPV vs IRR 103 C I a b c d e 10.25% -$2,050 -$4,300 $750 $1,500 $760 $1,518 $770 $1,536 $780 $1,554 $134.79 $141.89 $149.36 $164.29 $205.36 (Comp.) NPV vs IRR MEDIUM/HARD Sexton Inc is considering Projects S and L, whose cash flows are shown below These projects are mutually exclusive, equally risky, and not repeatable If the decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under certain conditions choosing projects on the basis of the IRR will not cause any value to be lost because the project with the higher IRR will also have the higher NPV, so no value will be lost if the IRR method is used WACC: Year CFS CFL 104 Answer: c C I Answer: e MEDIUM/HARD Moerdyk & Co is considering Projects S and L, whose cash flows are shown below These projects are mutually exclusive, equally risky, and not repeatable If the decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under certain conditions choosing projects on the basis of the IRR will not cause any value to be lost because the project with the higher IRR will also have the higher NPV, i.e., no conflict will exist WACC: Year CFS CFL a b c d e 10.00% -$1,025 -$1,025 $650 $100 $450 $300 $250 $500 $50 $700 $5.47 $6.02 $6.62 $7.29 $7.82 © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 10: Capital Budgeting Problems Page 41 (Comp.) NPV vs IRR 105 C I a b c d e 7.75% -$1,050 -$1,050 $675 $360 $650 $360 $360 $360 $11.45 $12.72 $14.63 $16.82 $19.35 (Comp.) NPV vs MIRR MEDIUM/HARD Kosovski Company is considering Projects S and L, whose cash flows are shown below These projects are mutually exclusive, equally risky, and are not repeatable If the decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under some conditions choosing projects on the basis of the IRR will cause $0.00 value to be lost WACC: Year CFS CFL 106 Answer: b C I Answer: d MEDIUM/HARD Nast Inc is considering Projects S and L, whose cash flows are shown below These projects are mutually exclusive, equally risky, and not repeatable If the decision is made by choosing the project with the higher MIRR rather than the one with the higher NPV, how much value will be forgone? Note that under some conditions choosing projects on the basis of the MIRR will cause $0.00 value to be lost WACC: Year CFS CFL a b c d e 8.75% -$1,100 -$2,200 $375 $725 $375 $725 $375 $725 $375 $725 $32.12 $35.33 $38.87 $40.15 $42.16 © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 10: Capital Budgeting Problems Page 42 (Comp.) NPV vs payback 107 C I a b c d e 10.25% -$950 -$2,100 $500 $400 $800 $800 $0 $800 $0 $1,000 $24.14 $26.82 $29.80 $33.11 $36.42 (Comp.) IRR vs MIRR MEDIUM/HARD Yonan Inc is considering Projects S and L, whose cash flows are shown below These projects are mutually exclusive, equally risky, and not repeatable If the decision is made by choosing the project with the shorter payback, some value may be forgone How much value will be lost in this instance? Note that under some conditions choosing projects on the basis of the shorter payback will not cause value to be lost WACC: Year CFS CFL 108 Answer: d C I Answer: a HARD Noe Drilling Inc is considering Projects S and L, whose cash flows are shown below These projects are mutually exclusive, equally risky, and not repeatable The CEO believes the IRR is the best selection criterion, while the CFO advocates the MIRR If the decision is made by choosing the project with the higher IRR rather than the one with the higher MIRR, how much, if any, value will be forgone In other words, what's the NPV of the chosen project versus the maximum possible NPV? Note that (1) "true value" is measured by NPV, and (2) under some conditions the choice of IRR vs MIRR will have no effect on the value lost WACC: Year CFS CFL a b c d e 7.00% -$1,100 -$2,750 $550 $725 $600 $725 $100 $800 $100 $1,400 $185.90 $197.01 $208.11 $219.22 $230.32 © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 10: Capital Budgeting Problems Page 43 CHAPTER 10 ANSWERS AND SOLUTIONS © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 10: Capital Budgeting Answers Page 44 (10.1) Capital budget F I Answer: b EASY (10.2) PV of cash flows F I Answer: b EASY (10.2) NPV F I Answer: b EASY (10.2) NPV F I Answer: b EASY (10.2) Mutually exclusive projects F I Answer: a EASY (10.2) Mutually exclusive projects F I Answer: b EASY (10.3) IRR F I Answer: a EASY (10.3) IRR F I Answer: b EASY (10.3) IRR F I Answer: a EASY 10 (10.4) Multiple IRRs F I Answer: a EASY 11 (10.4) Multiple IRRs F I Answer: b EASY 12 (10.5) Reinvestment rate assumption F I Answer: a EASY 13 (10.5) Reinvestment rate assumption F I Answer: b EASY 14 (10.5) Reinvestment rate assumption F I Answer: a EASY 15 (10.6) Modified IRR F I Answer: a EASY 16 (10.6) Modified IRR F I Answer: b EASY 17 (10.6) Modified IRR F I Answer: b EASY 18 (10.9) Payback period F I Answer: a EASY 19 (10.2) Mutually exclusive projects F I Answer: b Think about the following equally risky projects The cost of capital is WACC = 10% S -1,000 1,400 L -1,000 378.34 378.34 378.34 378.34 378.34 IRRS = 40.0% IRRL = 30.0% MEDIUM 378.34 NPVS = $272.73 NPVL = $647.77 S has the higher IRR, but L has a much higher NPV and is therefore preferable 20 If the project could be repeated, though, S would turn out to be better—it would have both a higher NPV and IRR (10.6) NPV vs IRR F I Answer: b MEDIUM 21 (10.6) NPV vs IRR F I Answer: b MEDIUM 22 (10.6) NPV vs IRR F I Answer: b MEDIUM 23 (10.6) NPV vs IRR F I Answer: a MEDIUM 24 (10.7) NPV profiles F I Answer: a MEDIUM 25 (10.9) Discounted payback F I Answer: b MEDIUM The discounted payback corrects the fault of not considering the timing of cash flows, but it does not correct for the nonconsideration of after-payback cash flows 26 (10.10) Capital budgeting methods F I Answer: a MEDIUM 27 (10.10) Capital budgeting methods F I Answer: b MEDIUM One project might have cash flows that extend well past the payback year, leading to different rankings 28 (Comp.) NPV and IRR F I 29 (10.7) NPV profiles F I Answer: b Answer: b MEDIUM HARD Project X may have a negative NPV if r > IRR The NPV profile line crosses the horizontal axis, and the NPV at the cost of capital is in the lower right quadrant 30 (10.7) NPV profiles F I Answer: b HARD Answer: b HARD We can see from the graph that S has the higher NPV if r > 31 (10.7) NPV profiles F I We not know if the cost of capital is to the right or left of the crossover point Therefore, NPVX may be either higher or lower than NPVY 32 (10.2) NPV C I Answer: c EASY 33 (10.3) IRR C I Answer: e EASY The IRR would rank a project that cost $100 and had a 100% IRR ahead of a project that cost $1,000,000 and had an IRR of 90% The larger project would increase the firm's value more, as the NPV would demonstrate 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107 108 ... does not take account of the time value of money c One defect of the IRR method versus the NPV is that the IRR does not take account of the cost of capital d One defect of the IRR method versus... is that it does not take account of the time value of money c One defect of the IRR method is that it does not take account of the cost of capital d One defect of the IRR method is that it values... flows and the opportunity cost of capital The decision criterion should not be affected by managers' tastes, choice of accounting method, or the profitability of other independent projects a
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