Business

Question 1

Which of the following statements is CORRECT?

Answer

For a project with normal cash flows, any change in the WACC will change both the NPV and the IRR.

To find the MIRR, we first compound cash flows at the regular IRR to find the TV, and then we discount the TV at the WACC to find the PV.

The NPV and IRR methods both assume that cash flows can be reinvested at the WACC. However, the MIRR method assumes reinvestment at the MIRR itself.

If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the higher IRR probably has more of its cash flows coming in the later years.

If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the lower IRR probably has more of its cash flows coming in the later years.

2 points

Question 2

Which of the following statements is CORRECT?

Answer

If a project with normal cash flows has an IRR greater than the WACC, the project must also have a positive NPV.

If Project A’s IRR exceeds Project B’s, then A must have the higher NPV.

A project’s MIRR can never exceed its IRR.

If a project with normal cash flows has an IRR less than the WACC, the project must have a positive NPV.

If the NPV is negative, the IRR must also be negative.

2 points

Question 3

Which of the following statements is CORRECT?

Answer

The regular payback method recognizes all cash flows over a project’s life.

The discounted payback method recognizes all cash flows over a project’s life, and it also adjusts these cash flows to account for the time value of money.

The regular payback method was, years ago, widely used, but virtually no companies even calculate the payback today.

The regular payback is useful as an indicator of a project’s liquidity because it gives managers an idea of how long it will take to recover the funds invested in a project.

The regular payback does not consider cash flows beyond the payback year, but the discounted payback overcomes this defect.

2 points

Question 4

Projects S and L both have an initial cost of $10,000, followed by a series of positive cash inflows. Project S’s undiscounted net cash flows total $20,000, while L’s total undiscounted flows are $30,000. At a WACC of 10%, the two projects have identical NPVs. Which project’s NPV is more sensitive to changes in the WACC?

Answer

Project S.

Project L.

Both projects are equally sensitive to changes in the WACC since their NPVs are equal at all costs of capital.

Neither project is sensitive to changes in the discount rate, since both have NPV profiles that are horizontal.

The solution cannot be determined because the problem gives us no information that can be used to determine the projects’ relative IRRs.

2 points

Question 5

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.

Answer

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.

The lower the WACC used to calculate a project’s NPV, the lower the calculated NPV will be.

If a project’s NPV is less than zero, then its IRR must be less than the WACC.

If a project’s NPV is greater than zero, then its IRR must be less than zero.

The NPV of a relatively low-risk project should be found using a relatively high WACC.

2 points

Question 6

Which of the following statements is CORRECT?

Answer

The MIRR and NPV decision criteria can never conflict.

The IRR method can never be subject to the multiple IRR problem, while the MIRR method can be.

One reason some people prefer the MIRR to the regular IRR is that the MIRR is based on a generally more reasonable reinvestment rate assumption.

The higher the WACC, the shorter the discounted payback period.

The MIRR method assumes that cash flows are reinvested at the crossover rate.

2 points

Question 7

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.

Answer

The longer a project’s payback period, the more desirable the project is normally considered to be by this criterion.

One drawback of the regular payback for evaluating projects is that this method does not properly account for the time value of money.

If a project’s payback is positive, then the project should be rejected because it must have a negative NPV.

The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem.

If a company uses the same payback requirement to evaluate all projects, say it requires a payback of 4 years or less, then the company will tend to reject projects with relatively short lives and accept long-lived projects, and this will cause its risk to increase over time.

2 points

Question 8

Which of the following statements is CORRECT?

Answer

The NPV, IRR, MIRR, and discounted payback (using a payback requirement of 3 years or less) methods always lead to the same accept/reject decisions for independent projects.

For mutually exclusive projects with normal cash flows, the NPV and MIRR methods can never conflict, but their results could conflict with the discounted payback and the regular IRR methods.

Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the regular IRR.

If a firm uses the discounted payback method with a required payback of 4 years, then it will accept more projects than if it used a regular payback of 4 years.

The percentage difference between the MIRR and the IRR is equal to the project’s WACC.

2 points

Question 9

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.

Answer

A project’s NPV is generally found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting the TV at the IRR to find its PV.

The higher the WACC used to calculate the NPV, the lower the calculated NPV will be.

If a project’s NPV is greater than zero, then its IRR must be less than the WACC.

If a project’s NPV is greater than zero, then its IRR must be less than zero.

The NPVs of relatively risky projects should be found using relatively low WACCs.

2 points

Question 10

Which of the following statements is CORRECT?

Answer

The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.

The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR.

The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate.

The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period.

The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.

2 points

Question 11

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.

Answer

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.

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.

If a project’s IRR is smaller than the WACC, then its NPV will be positive.

A project’s IRR is the discount rate that causes the PV of the inflows to equal the project’s cost.

If a project’s IRR is positive, then its NPV must also be positive.

2 points

Question 12

Projects C and D are mutually exclusive and have normal cash flows. Project C has a higher NPV if the WACC is less than 12%, whereas Project D has a higher NPV if the WACC exceeds 12%. Which of the following statements is CORRECT?

Answer

Project D probably has a higher IRR.

Project D is probably larger in scale than Project C.

Project C probably has a faster payback.

Project C probably has a higher IRR.

The crossover rate between the two projects is below 12%.

2 points

Question 13

Projects S and L are equally risky, mutually exclusive, and have normal cash flows. Project S has an IRR of 15%, while Project L’s IRR is 12%. The two projects have the same NPV when the WACC is 7%. Which of the following statements is CORRECT?

Answer

If the WACC is 10%, both projects will have positive NPVs.

If the WACC is 6%, Project S will have the higher NPV.

If the WACC is 13%, Project S will have the lower NPV.

If the WACC is 10%, both projects will have a negative NPV.

Project S’s NPV is more sensitive to changes in WACC than Project L’s.

2 points

Question 14

Which of the following statements is CORRECT?

Answer

An NPV profile graph shows how a project’s payback varies as the cost of capital changes.

The NPV profile graph for a normal project will generally have a positive (upward) slope as the life of the project increases.

An NPV profile graph is designed to give decision makers an idea about how a project’s risk varies with its life.

An NPV profile graph is designed to give decision makers an idea about how a project’s contribution to the firm’s value varies with the cost of capital.

We cannot draw a project’s NPV profile unless we know the appropriate WACC for use in evaluating the project’s NPV.

2 points

Question 15

Westchester Corp. is considering two equally risky, mutually exclusive projects, both of which have normal cash flows. Project A has an IRR of 11%, while Project B’s IRR is 14%. When the WACC is 8%, the projects have the same NPV. Given this information, which of the following statements is CORRECT?

Answer

If the WACC is 13%, Project A’s NPV will be higher than Project B’s.

If the WACC is 9%, Project A’s NPV will be higher than Project B’s.

If the WACC is 6%, Project B’s NPV will be higher than Project A’s.

If the WACC is greater than 14%, Project A’s IRR will exceed Project B’s.

If the WACC is 9%, Project B’s NPV will be higher than Project A’s.

2 points

Question 16

Rowell Company spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale or for a new product. Rowell owns the building free and clear–there is no mortgage on it. Which of the following statements is CORRECT?

Answer

Since the building has been paid for, it can be used by another project with no additional cost. Therefore, it should not be reflected in the cash flows for any new project.

If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it.

This is an example of an externality, because the very existence of the building affects the cash flows for any new project that Rowell might consider.

Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new projects.

If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project that used the building.

2 points

Question 17

Which of the following rules is CORRECT for capital budgeting analysis?

Answer

The interest paid on funds borrowed to finance a project must be included in estimates of the project’s cash flows.

Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions.

Sunk costs are not included in the annual cash flows, but they must be deducted from the PV of the project’s other costs when reaching the accept/reject decision.

A proposed project’s estimated net income as determined by the firm’s accountants, using generally accepted accounting principles (GAAP), is discounted at the WACC, and if the PV of this income stream exceeds the project’s cost, the project should be accepted.

If a product is competitive with some of the firm’s other products, this fact should be incorporated into the estimate of the relevant cash flows. However, if the new product is complementary to some of the firm’s other products, this fact need not be reflected in the analysis.

2 points

Question 18

A firm is considering a new project whose risk is greater than the risk of the firm’s average project, based on all methods for assessing risk. In evaluating this project, it would be reasonable for management to do which of the following?

Answer

Increase the estimated IRR of the project to reflect its greater risk.

Increase the estimated NPV of the project to reflect its greater risk.

Reject the project, since its acceptance would increase the firm’s risk.

Ignore the risk differential if the project would amount to only a small fraction of the firm’s total assets.

Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.

2 points

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