CH10 TB Brigham 2ce - M/C with answers PDF

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CHAPTER 10—THE BASICS OF CAPITAL BUDGETING: EVALUATING CASH FLOWS TRUE/FALSE 1. A firm should never undertake an investment if accepting the project would lead to an increase in the firm’s cost of capital. ANS: F PTS: 1 OBJ: (10.1) Capital budget

DIF: EASY

REF: 292–293

2. Because “present value” refers to the value of cash flows that occur at different points in time, a series of present values should not be summed to determine the value of a capital budgeting project. ANS: F PTS: 1 OBJ: (10.2) PV of cash flows

DIF: EASY

REF: 294–296

3. 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. ANS: F OBJ: (10.2) NPV

PTS: 1

DIF: EASY

REF: 295

4. The IRR is that discount rate that equates the present value of the cash outflows (or costs) with the present value of the cash inflows. ANS: T OBJ: (10.3) IRR

PTS: 1

DIF: EASY

REF: 296–297

5. Other things held constant, an increase in the cost of capital will result in a decrease in a project’s IRR. ANS: F OBJ: (10.3) IRR

PTS: 1

DIF: EASY

REF: 296–297

6. If a project’s NPV exceeds its IRR, then the project should be accepted. ANS: F PTS: 1 OBJ: (10.4) NPV and IRR

DIF: EASY

REF: 298–299

7. Conflicts between two mutually exclusive projects, where the NPV method chooses one project but the IRR method chooses the other, should generally be resolved in favour of the project with the higher NPV. ANS: T PTS: 1 OBJ: (10.4) Mutually exclusive projects

DIF: EASY

REF: 299–300

8. The NPV method’s assumption that cash inflows are reinvested at the cost of capital is more reasonable than the IRR’s assumption that cash flows are reinvested at the IRR. This is an important reason that the NPV method is generally preferred over the IRR method.

ANS: T PTS: 1 DIF: EASY OBJ: (10.4) Reinvestment rate assumption

REF: 300

9. 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. ANS: T PTS: 1 OBJ: (10.5) Multiple IRRs

DIF: EASY

REF: 300–301

10. The phenomenon called “multiple internal rates of return” arises when two or more mutually exclusive projects that have different lives are being compared. ANS: F PTS: 1 OBJ: (10.5) Multiple IRRs

DIF: EASY

REF: 300–301

11. The MIRR method has wide appeal for professors, but most business executives prefer the NPV method to either the regular IRR or MIRR. ANS: F PTS: 1 OBJ: (10.6) Modified IRR

DIF: EASY

REF: 302–303

12. When evaluating mutually exclusive projects, the 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. ANS: F PTS: 1 OBJ: (10.6) Modified IRR

DIF: EASY

REF: 302–303

13. One advantage of the payback method for evaluating potential investments is that it provides some information about a project’s liquidity and risk. ANS: T PTS: 1 OBJ: (10.8) Payback

DIF: EASY

REF: 304–306

14. In theory, any capital budgeting investment rule should depend solely on forecasted cash flows and the opportunity cost of capital. The rule itself should not be affected by managers’ tastes, the choice of accounting method, or the profitability of other independent projects. ANS: T PTS: 1 OBJ: (10.1) Ranking methods

DIF: MEDIUM

REF: 293

15. The level of detail needed to determine capital budget expenditures related to compliance with safety and/or environmental issues varies depending on the size and scope of the project(s). ANS: T PTS: 1 OBJ: (10.1) Capital budget analysis

DIF: EASY

REF: 292–293

16. A decision to undertake significant downsizing to control fixed costs is usually made by senior management, with the decision reported to the firm’s board of directors. ANS: F PTS: 1 OBJ: (10.1) Capital budget analysis

DIF: EASY

REF: 293

17. When considering two mutually exclusive projects, the firm should always select that project whose IRR 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. ANS: F Think about the following equally risky projects. The cost of capital is WACC = 10%.

S L

0 –1,000.00 –1,000.00

IRRS = 40.0% IRRL = 30.0%

1 1,400.00 378.34

2

3

4

5

6

378.34

378.34

378.34

378.34

378.34

NPVS = $272.73 NPVL = $647.77

S has the higher IRR, but L has a much higher NPV and is therefore preferable. If the project could be repeated, though, S would turn out to be better—it would have both a higher NPV and IRR. PTS: 1 DIF: MEDIUM OBJ: (10.4) Mutually exclusive projects

REF: 299–300

18. 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. ANS: F PTS: 1 OBJ: (10.4) NPV versus IRR

DIF: MEDIUM

REF: 298–300

19. The NPV and IRR methods, when used to evaluate independent and equally risky projects, will lead to different accept/reject decisions if their IRRs are greater than the cost of capital. ANS: F PTS: 1 OBJ: (10.4) NPV versus IRR

DIF: MEDIUM

REF: 298–300

20. If the IRR of normal Project X is greater than the IRR of mutually exclusive Project Y (also normal), we can conclude that the firm should select X rather than Y if X has NPV > 0. ANS: F We do 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. PTS: 1

DIF: MEDIUM

REF: 298–300

OBJ: (10.4) IRR and NPV

21. Small businesses make less use of DCF capital budgeting techniques than large businesses. This may reflect a lack of knowledge on the part of small firms’ managers, but it may also reflect a rational conclusion that the costs of using DCF analysis outweigh the benefits of these methods for very small firms. ANS: T PTS: 1 OBJ: (10.10) Small business practices

DIF: MEDIUM

REF: 309

22. Financing pressure or liquidity can explain the popular use of payback period in project appraisals for small firms. ANS: T

PTS: 1

DIF: MEDIUM

REF: 309

OBJ: (10.10) Small business practices 23. Selecting the project that has the highest equivalent annual annuity seems to be the rule for comparing projects with different lives. This rule should apply to both independent and mutually exclusive projects. ANS: F Different lives are not a concern for independent projects. Unequal lives become a significant issue only for mutually exclusive projects. PTS: 1 DIF: MEDIUM OBJ: (10.11) Equivalent annual annuity

REF: 310–311

24. If a firm is experiencing no capital rationing, it should accept all investment proposals whose accounting rate of return is equal to or greater than the weighted average cost of capital. ANS: F Accept only projects with a benefit/cost ratio greater than one. PTS: 1

DIF: MEDIUM

REF: 312–313

OBJ: (10.12) capital rationing

25. A decrease in the firm’s discount rate (r, or WACC) will increase projects’ NPVs, which could change the accept/reject decision for any potential project. However, such a change would have no impact on the project’s IRR; therefore, the accept/reject decision under the IRR method is independent of the cost of capital. ANS: F PTS: 1 OBJ: (Comp: 10.2, 10.3) NPV and IRR

DIF: MEDIUM

REF: 295 | 296–297

26. Normal Projects Q and R have the same NPV when the discount rate is zero. However, Project Q’s cash flows come in faster than those of R. Therefore, we know that at any discount rate greater than zero, R will have a higher NPV than Q. ANS: F PTS: 1 OBJ: (Comp: 10.2, 10.4) NPV

DIF: MEDIUM

REF: 295 | 298–300

27. 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. ANS: T PTS: 1 OBJ: (Comp: 10.2, 10.4) NPV

DIF: MEDIUM

REF: 295 | 298–300

28. 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. ANS: F PTS: 1 DIF: MEDIUM OBJ: (Comp: 10.2, 10.8) Ranking methods

REF: 295 | 304–306

29. 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. ANS: F 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. PTS: 1

DIF: HARD

REF: 298

OBJ: (10.4) NPV profile

30. Theoretically speaking, hard capital rationing does not exist. ANS: T If the project return is attractive, firm is so willing to invest and there is always a market for lending. In theory, firms can probably raise the money from the market, at a significant cost. PTS: 1

DIF: MEDIUM

REF: 312–313

OBJ: (10.12) Hard rationing

MULTIPLE CHOICE 1. 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. The lower the WACC used to calculate it, the lower the calculated NPV will be. b. If a project’s NPV is less than zero, then its IRR must be less than the WACC. c. If a project’s NPV is greater than zero, then its IRR must be less than zero. d. The NPV of a relatively low risk project should be found using a relatively high WACC. ANS: B OBJ: (10.2) NPV

PTS: 1 BLM: Remember

DIF: EASY

REF: 294–296

2. Which statement regarding the IRR method is correct? a. One defect of the IRR method is that it does not take account of cash flows over a project’s full life. b. One defect of the IRR method 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 does not assume that the cash flows to be received from a project can be reinvested at a rate other than the IRR itself. ANS: D The IRR assumes reinvestment at the IRR, and that is generally not as valid as assuming reinvestment at the WACC, as with the NPV. PTS: 1 BLM: Remember

DIF: EASY

REF: 296–297

OBJ: (10.3) IRR

3. 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 discounting the cash inflows at the WACC to find the present value (PV), then compounding this PV to find the IRR. b. If a project’s IRR is greater than the WACC, then its NPV must be negative. c. 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.

d. To find a project’s IRR, we must find a discount rate that is equal to the WACC. ANS: C OBJ: (10.3) IRR

PTS: 1 BLM: Understand

DIF: EASY

REF: 296–297

4. 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 to find the IRR. c. If a project’s IRR is smaller than the WACC, then its NPV will be positive. d. A project’s IRR is the discount rate that causes the PV of the inflows to equal the project’s cost. ANS: D OBJ: (10.3) IRR

PTS: 1 BLM: Understand

DIF: EASY

REF: 296–297

5. Which statement regarding normal cash flows is correct? a. If a project has “normal” cash flows, then its IRR must be positive. b. If a project has “normal” cash flows, then its MIRR must be positive. c. If a project has “normal” cash flows, then it will have exactly two real IRRs. d. If a project has “normal” cash flows, then it can have only one real IRR, whereas a project with “non-normal” cash flows might have more than one real IRR. ANS: D PTS: 1 DIF: EASY OBJ: (10.5) Normal versus non-normal cash flows

REF: 300–301 BLM: Remember

6. Which statement regarding normal cash flows is correct? a. Projects with “normal” cash flows can have only one real IRR. b. Projects with “normal” cash flows can have two or more real IRRs. c. The “multiple IRR problem” can arise if a project’s cash flows are “normal.” d. Projects with “non-normal” cash flows are almost never encountered in the real world. ANS: A PTS: 1 DIF: EASY OBJ: (10.5) Normal versus non-normal cash flows

REF: 300–301 BLM: Remember

7. Which statement regarding payback is true? a. The regular payback method recognizes all cash flows over a project’s life. b. 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. c. The regular payback method was widely used years ago, but virtually no companies even calculate the payback today. d. 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. ANS: D The payback does indicate how long it should take to recover the investment; hence, it is a measure of liquidity. PTS: 1 BLM: Remember

DIF: EASY

REF: 304–306

OBJ: (10.8) Payback

8. 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. The longer a project’s payback period, the more desirable the project is normally considered to be by this criterion. b. One drawback of the payback criterion for evaluating projects is that this method does not properly account for the time value of money. c. If a project’s payback is positive, then the project should be rejected because it must have a negative NPV. d. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem. ANS: B PTS: 1 OBJ: (10.8) Payback

DIF: EASY BLM: Understand

REF: 304–306

9. Which statement regarding payback is true? a. The shorter a project’s payback period, the less desirable the project is normally considered to be by this criterion. b. One drawback of the payback criterion for evaluating projects is that this method does not take account of cash flows beyond the payback period. c. If a project’s payback is positive, then the project should be accepted because it must have a positive NPV. d. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem. ANS: B PTS: 1 OBJ: (10.8) Payback

DIF: EASY BLM: Understand

REF: 304–306

10. Assume a project has normal cash flows. All else being equal, which of the following statements is correct? a. The project’s IRR increases as the WACC declines. b. The project’s NPV increases as the WACC declines. c. The project’s MIRR is unaffected by changes in the WACC. d. The project’s regular payback increases as the WACC declines. ANS: B PTS: 1 DIF: EASY OBJ: (Comp: 10.2, 10.3, 10.6, 10.8) Ranking methods

REF: 295–297 | 302–305 BLM: Understand

11. Which of the following statements is correct? a. The IRR is generally regarded by academics as being the best single method for evaluating capital budgeting projects. b. The payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. c. The discounted payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. d. The NPV is generally regarded by academics as being the best single method for evaluating capital budgeting projects. ANS: D PTS: 1 DIF: EASY OBJ: (Comp: 10.2, 10.3, 10.6, 10.8) Ranking methods

REF: 295–297 | 302–305 BLM: Remember

12. Which statement about an NPV profile graph is true? a. An NPV profile graph shows how a project’s payback varies as the cost of capital changes. b. The NPV profile graph for a normal project will generally have a positive (upward) slope as the life of the project increases. c. An NPV profile graph is designed to give decision makers an idea about how a project’s risk varies with its life.

d. 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. ANS: D REF: 300–301 BLM: Remember

PTS: 1 DIF: EASY | MEDIUM OBJ: (10.5) Normal versus non-normal cash flows

13. Which statement about the NPV is true? a. The NPV method was once the favourite of academics and business executives, but today most authorities regard the MIRR as being the best indicator of a project’s profitability. b. The NPV method is regarded by most academics as being the best indicator of a project’s profitability; hence, most academics recommend that firms use only this one method. c. A project’s NPV depends on the total amount of cash flows the project produces, but because the cash flows are discounted at the WACC, it does not matter if the cash flows occur early or late in the project’s life. d. The NPV and IRR methods may give different recommendations regarding which of two mutually exclusive projects should be accepted, but they always give the same recommendation regarding the acceptability of a normal, independent project. ANS: D If you draw an NPV profile for one project, you will see that if the WACC is less than the IRR, the NPV will be positive. PTS: 1 BLM: Understand

DIF: MEDIUM

REF: 294–296

OBJ: (10.2) NPV

14. 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. The higher the WACC used to calculate the NPV, the lower the calculated NPV will be. b. If a project’s NPV is greater than zero, then its IRR must be less than the WACC. c. If a project’s NPV is greater than z...