Chapter 10 - The Basics Of Capital Budgeting Evaluating Cash Flows PDF

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Financial Management: Theory And Practice, Canadian Edition, 3rd ed.
By Nelson Education...

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CHAPTER 10 - THE BASICS OF CAPITAL BUDGETING: EVALUATING CASH FLOWS 1. A firm should never undertake an investment if accepting the project would lead to an increase in the firm’s cost of capital. a. True b. Fals e ANSWER: Fals e 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. a. True b. Fals e ANSWER: Fals e 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. a. True b. Fals e ANSWER: Fals e 4. 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. a. True b. Fals e ANSWER: True 5. 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. Fals e ANSWER: True 6. The phenomenon called “multiple internal rates of return” arises when two or more mutually exclusive projects that have different lives are being compared. a. True b. Fals e ANSWER: Fals Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 10 - THE BASICS OF CAPITAL BUDGETING: EVALUATING CASH FLOWS e 7. The MIRR method has wide appeal for professors, but most business executives prefer the NPV method to either the regular IRR or MIRR. a. True b. Fals e ANSWER: Fals e 8. 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. a. True b. Fals e ANSWER: Fals e 9. 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. a. True b. Fals e ANSWER: True 10. 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). a. True b. Fals e ANSWER: True 11. 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. a. True b. Fals e ANSWER: Fals e 12. 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. a. True b. Fals Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 10 - THE BASICS OF CAPITAL BUDGETING: EVALUATING CASH FLOWS e ANSWER: Fals e 13. 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. a. True b. Fals e ANSWER: Fals e 14. 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. a. True b. Fals e ANSWER: Fals e 15. 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. a. True b. Fals e ANSWER: Fals e 16. 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. a. True b. Fals e ANSWER: True 17. Financing pressure or liquidity can explain the popular use of payback period in project appraisals for small firms. a. True b. Fals e ANSWER: True 18. 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. a. True b. Fals Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 10 - THE BASICS OF CAPITAL BUDGETING: EVALUATING CASH FLOWS e ANSWER: Fals e 19. 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. a. True b. Fals e ANSWER: Fals e 20. 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. a. True b. Fals e ANSWER: Fals e 21. 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. a. True b. Fals e ANSWER: Fals e 22. 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. Fals e ANSWER: Fals e 23. 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. Fals e ANSWER: Fals e Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 10 - THE BASICS OF CAPITAL BUDGETING: EVALUATING CASH FLOWS 24. Theoretically speaking, hard capital rationing does not exist. a. True b. Fals e ANSWER: True 25. 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. ANSWER: b 26. 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. ANSWER: d 27. 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. ANSWER: c 28. 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. ANSWER: d Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 10 - THE BASICS OF CAPITAL BUDGETING: EVALUATING CASH FLOWS 29. 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. ANSWER: d 30. 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. ANSWER: a 31. 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. ANSWER: d 32. 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. ANSWER: b 33. 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 Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 10 - THE BASICS OF CAPITAL BUDGETING: EVALUATING CASH FLOWS have a positive NPV. d.The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem. ANSWER: b 34. 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. ANSWER: b 35. 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. ANSWER: d 36. 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. ANSWER: d 37. 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 Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 10 - THE BASICS OF CAPITAL BUDGETING: EVALUATING CASH FLOWS two mutually exclusive projects should be accepted, but they always give the same recommendation regarding the acceptability of a normal, independent project. ANSWER: d 38. 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 zero, then its IRR must be less than zero. d. The NPVs of relatively risky projects should be found using relatively low WACCs. ANSWER: a 39. Which of the following statements is correct? a. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR. b.The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR. c. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate. d.The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period. ANSWER: a 40. 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. If Project A has a higher IRR than Project B, then Project A must have the lower NPV. b. If Project A has a higher IRR than Project B, then Project A must also have a higher NPV. c. The IRR calculation implicitly assumes that all cash flows are reinvested at the WACC. d. If a project has normal cash flows and its IRR exceeds its WACC, then the project’s NPV must be positive. ANSWER: d 41. With respect to the required level of capital budget analysis, _____would likely require the least level of investigation while ____ would likely require the greatest level of analysis. 1. expansion into new products or markets 2. contract decisions 3. replacement needs to continue profitable operations 4. expansion into existing products or markets a. 4,1 b. 3,2 c. 1,2 d. 4,2 Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 10 - THE BASICS OF CAPITAL BUDGETING: EVALUATING CASH FLOWS ANSWER: b 42. Projects A and B have identical expected lives and identical initial cash outflows (costs). However, most of one project’s cash flows come in the early years, while most of the other project’s cash flows occur in the later years. The two NPV profiles are given below:

Which of the following statements is correct? a. More of Project A’s cash flows occur in the later years. b. More of Project B’s cash flows occur in the later years. c. We must have information on the cost of capital in order to determine which project has the larger early cash flows. d. The NPV profile graph is inconsistent with the statement made in the problem. ANSWER: a 43. 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? a. Project S b. Project L c. Both projects are equally sensitive to changes in the WACC since their NPVs are equal at all costs of capital. d. Neither project is sensitive to changes in the discount rate, since both have NPV profiles that are horizontal. ANSWER: b 44. 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? a. Project D has a higher IRR. b. Project D is probably larger in scale than Project C. c. Project C probably has a faster payback. Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 10 - THE BASICS OF CAPITAL BUDGETING: EVALUATING CASH FLOWS d. Project C has a higher IRR. ANSWER: a 45. Which statement about multiple IRRs is true? a. For a project to have more than one IRR, both IRRs must be greater than the WACC. b. If two projects are mutually exclusive, then they are likely to have multiple IRRs. c. If a project is independent, then it cannot have multiple IRRs. d. Multiple IRRs can occur only if the signs of the cash flows change more than once. ANSWER: d 46. The regular payback method has a number of disadvantages, some of which are listed below. Which of these items is NOT a disadvantage of this method? a. It lacks an objective, market-determined benchmark for making decisions. b. It ignores cash flows beyond the payback period. c. It does not directly account for the time value of money. d. It does not provide any indication regarding a project’s liquidity. ANSWER: d 47. Which of the following statements is correct? a. If a project with normal cash flows has an IRR greater than the WACC, the project must have a positive NPV. b. If Project A’s IRR exceeds Project B’s, then A must have the higher NPV. c. A project’s MIRR can never exceed its IRR. d. If a project with normal cash flows has an IRR less than the WACC, the project must have a positive NPV. ANSWER: a 48. Which of the following statements is correct? a. The MIRR and NPV decision criteria can never conflict. b.The IRR method can never be subject to the multiple IRR problem, while the MIRR method can be. c. One reason some people prefer the MIRR to the regular IRR is that the MIRR is based on what is generally a more reasonable assumption about t...