FM12 Ch 11 Test Bank PDF

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CHAPTER 11 THE BASICS OF CAPITAL BUDGETING: EVALUATING CASH FLOWS True/False Easy: (11.1) Capital budget 1

.

Answer: b

A firm should never undertake an investment if accepting the project would lead to an increase in the firm's cost of capital. a. b.

True False

(11.2) PV of cash flows 2

.

Answer: b

True False

(11.2) NPV .

Answer: b

True False

(11.3) IRR .

Answer: a

True False

(11.3) IRR .

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. b.

5

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. b.

4

EASY

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. b.

3

EASY

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. b.

True False

Chapter 11: Capital Budgeting

True/False

Page 351

(11.4) NPV and IRR 6

.

Answer: b

If a project's NPV exceeds its IRR, then the project should be accepted. a. b.

True False

(11.4) Mutually exclusive projects 7

.

Answer: a

True False

(11.5) Multiple IRRs .

Answer: b

True False

(11.6) Modified IRR .

EASY

The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects that have different lives are being compared. a. b.

11

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. b.

10

EASY

True False

(11.5) Multiple IRRs .

Answer: a

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 why the NPV method is generally preferred over the IRR method. a. b.

9

EASY

True False

(11.4) Reinvestment rate assumption .

Answer: a

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 favor of the project with the higher NPV. a. b.

8

EASY

Answer: b

EASY

The modified IRR (MIRR) method has wide appeal to professors, but most business executives prefer the NPV method to either the regular or modified IRR. a. b.

Page 352

True False

True/False

Chapter 11: Capital Budgeting

(11.6) Modified IRR 12

.

Answer: b

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. b.

True False

(11.8) Payback 13

.

EASY

Answer: a

EASY

One advantage of the payback method for evaluating potential investments is that it provides some information about a project's liquidity and risk. a. b.

True False

Medium: (11.1) Ranking methods 14

.

Answer: a

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. b.

True False

(11.4) Mutually exclusive projects 15

.

Answer: b

True False

(11.4) NPV vs IRR .

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. a. b.

17

MEDIUM

True False

(11.4) NPV vs IRR .

Answer: b

When considering two mutually exclusive projects, the firm should always select that 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. b.

16

MEDIUM

Answer: b

MEDIUM

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. b.

True False

Chapter 11: Capital Budgeting

True/False

Page 353

(11.4) IRR and NPV 18

.

Answer: b

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. b.

True False

(11.10) Small business practices 19

.

Answer: b

True False

(11.11) Replacement chain .

Answer: b

True False

(11.11) Common life comparisons .

MEDIUM

True False

(Comp: 11.2,11.3) NPV and IRR .

Answer: a

Extending projects with different lives to a common life for comparison purposes, while theoretically appealing, is valid only if there is a reasonably high probability that the projects will actually be repeated out beyond their initial lives. a. b.

23

MEDIUM

Although the replacement chain approach is appealing for dealing with mutually exclusive projects that have different lives, it is not used in industry because no projects meet the assumptions the method requires. a. b.

22

MEDIUM

The replacement chain, or common life, approach is required when analyzing projects that have different lives regardless of whether the projects are mutually exclusive or independent. a. b.

21

MEDIUM

True False

(11.11) Replacement chain .

Answer: a

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. b.

20

MEDIUM

Answer: b

MEDIUM

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.

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True True/False

Chapter 11: Capital Budgeting

b. False (Comp: 11.2,11.4) NPV 24

.

Answer: b

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. b.

True False

(Comp: 11.2,11.4) NPV 25

.

Answer: a

True False

(Comp: 11.2,11.8) Ranking methods .

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. b.

26

MEDIUM

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. b.

True False

Hard: (11.4) NPV profile 27

.

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. b.

True False

Chapter 11: Capital Budgeting

True/False

Page 355

Multiple Choice: Conceptual Easy: (11.2) NPV 28

.

Answer: c

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. b. c. d. e.

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 it, 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.

(11.3) IRR 29

.

Answer: e

b. c. d.

e.

One defect of the IRR method is that it does not take account of cash flows over a project’s full life. One defect of the IRR method is that it does not take account of the time value of money. One defect of the IRR method is that it does not take account of the cost of capital. One defect of the IRR method is that it values a dollar received today the same as a dollar that will not be received until some time in the future. One defect of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid.

(11.3) IRR .

EASY

Which of the following statements is CORRECT? a.

30

EASY

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.

b.

c. d. e. Page 356

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. 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. If a project’s IRR is greater than the WACC, then its NPV must be negative. 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. To find a project’s IRR, we must find a discount rate that is equal Conceptual Questions

Chapter 11: Capital Budgeting

to the WACC. (11.3) IRR 31

.

Answer: d

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.

b.

c. d. e.

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 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.

(11.5) Normal vs. nonnormal cash flows 32

.

b. c. d.

e.

EASY

If a project has “normal” cash flows, then its IRR must be positive. If a project has “normal” cash flows, then its MIRR must be positive. If a project has “normal” cash flows, then it will have exactly two real IRRs. The definition of “normal” cash flows is that the cash flow stream has one or more negative cash flows followed by a stream of positive cash flows and then one negative cash flow at the end of the project’s life. If a project has “normal” cash flows, then it can have only one real IRR, whereas a project with “nonnormal” cash flows might have more than one real IRR.

(11.5) Normal vs. nonnormal cash flows .

Answer: e

Which of the following statements is CORRECT? a.

33

EASY

Answer: a

EASY

Which of the following statements is CORRECT? a. b. c.

d. e.

Projects with “normal” cash flows can have only one real IRR. Projects with “normal” cash flows can have two or more real IRRs. Projects with “normal” cash flows must have two changes in the sign of the cash flows, e.g., from negative to positive to negative. If there are more sign changes, then the cash flow stream is “nonnormal.” The “multiple IRR problem” can arise if a project’s cash flows are “normal.” Projects with “nonnormal” cash flows are almost never encountered in the real world.

Chapter 11: Capital Budgeting

Conceptual Questions

Page 357

(11.8) Payback 34

.

Answer: d

Which of the following statements is CORRECT? a. b.

c. d.

e.

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.

(11.8) Payback 35

.

Answer: b

b.

c. d. e.

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

(11.8) Payback .

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.

36

EASY

Answer: b

EASY

Which of the following statements is CORRECT? a. b.

c. d. e.

Page 358

The shorter a project’s payback period, the less desirable the project is normally considered to be by this criterion. One drawback of the payback criterion for evaluating projects is that this method does not take account of cash flows beyond the payback period. If a project’s payback is positive, then the project should be accepted because it must have a positive NPV. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem. One drawback of the discounted payback is that this method does not consider the time value of money, while the regular payback overcomes this drawback.

Conceptual Questions

Chapter 11: Capital Budgeting

(Comp: 11.2,11.3,11.6,11.8) Ranking methods 37

.

Assume a project has normal cash flows. following statements is CORRECT? a. b. c. d. e.

The The The The The

project’s project’s project’s project’s project’s

.

EASY

All else equal, which of the

IRR increases as the WACC declines. NPV increases as the WACC declines. MIRR is unaffected by changes in the WACC. regular payback increases as the WACC declines. discounted payback increases as the WACC declines.

(Comp: 11.2,11.3,11.6,11.8) Ranking methods 38

Answer: b

Answer: d

EASY

Which of the following statements is CORRECT? a.

b. c.

d.

e.

The internal rate of return method (IRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. The payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. The discounted payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. The modified internal rate of return method (MIRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

Easy/Medium: (11.5) Normal vs. nonnormal cash flows 39

.

Answer: d

EASY/MEDIUM

Which of the following statements is CORRECT? a. b. c. d.

e.

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.

Chapter 11: Capital Budgeting

Conceptual Question...