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Chapter 6 Some Alternative Investment Rules Multiple Choice Questions 1. A $25 investment produces $27.50 at the end of the year with no risk. Which of the following is true? A) NPV is positive if the interest rate is less than 10%. B) NPV is negative if the interest rate is less than 10%. C) NPV is zero if the interest rate is equal to 10%. D) Both A and C. E) None of the above. Answer: D Difficulty: Medium Page: 144-145 Rationale: NPV = ($27.50/1.1) - $25.00 = $0 2. Accepting positive NPV projects benefits the stockholders because A) it is the most easily understood valuation process. B) the present value of the expected cash flows are equal to the cost. C) the present value of the expected cash flows are greater than the cost. D) it is the most easily calculated. E) None of the above. Answer: C Difficulty: Easy Page: 145 3. Which of the following does not characterize NPV? A) NPV does not incorporate risk into the analysis. B) NPV incorporates all relevant information. C) NPV uses all of the project's cash flows. D) NPV discounts all future cash flows. E) Using NPV will lead to decisions that maximize shareholder wealth. Answer: A Difficulty: Medium Page: 144-146 4. The payback period rule A) discounts cash flows. B) ignores initial cost. C) always uses all possible cash flows in its calculation. D) Both A and C. E) None of the above. Answer: E Difficulty: Medium Page: 146-148 Ross/Westerfield/Jaffe, Corporate Finance, 7/e 65 5. The payback period rule accepts all investment projects in which the payback period for the cash flows is A) equal to the cutoff point. B) greater than the cutoff point. C) less than the cutoff point. D) positive. E) None of the above. Answer: C Difficulty: Easy Page: 147 6. Consider an investment with an initial cost of $20,000 and is expected to last for 5 years. The expected cash flow in years 1 and 2 are $5,000, in years 3 and 4 are $5,500 and in year 5 is $1,000. The total cash inflow is expected to be $22,000 or an average of $4,400 per year. Compute the payback period in years. A) 3.18 years B) 3.82 years C) 4.00 years D) 4.55 years E) None of the above. Answer: B Difficulty: Medium Page: 146-147 Rationale: Payback Period = ($5,000 + $5,000 + $5,500 = $15,500 for 3 years; remainder $20,000 $15,500 = 4,500. $4,500/$5,500 = .81818 = .82) = Payback Period = 3.82 years 7. An investment project is most likely to be accepted by the payback period rule and not accepted by the NPV rule if the project has A) a large initial investment with moderate positive cash flows over a very long period of time. B) a very large negative cash flow at the termination of the project. C) most of the cash flows at the beginning of the project. D) All projects approved by the payback period rule will be accepted by the NPV rule. E) The payback period rule and the NPV rule cannot be used to evaluate the same type of projects. Answer: B Difficulty: Medium Page: 147 8. The payback period rule is a convenient and useful tool because A) it provides a quick estimate of how rapidly the initial investment will be recouped. B) results of a short payback rule decision will be quickly seen. C) it does not take into account time value of money. D) All of the above. E) None of the above. Answer: D Difficulty: Medium Page: 146-148 66 Test Bank, Chapter 6 9. An investment with an initial cost of $15,000 produces cash flows of $5,000 annually for 5 years. If the cash flow is evenly spread out over the year and the firm can borrow at 10%, the discounted payback period is _____ years. A) 3 B) 3.2 C) 3.75 D) 4 E) 5 Answer: C Difficulty: Medium Page: 149 Rationale: Discounted Payback: A.1,n = $15,000/$5,000 = 3. PMT = 1 PV=-3 FV=0 I/YR=10 N=?=3.75 10. An investment project has the cash flow stream of $-250, $75, $125, $100, and $50. The cost of capital is 12%. What is the discount payback period? A) 3.15 years B) 3.38 years C) 3.45 years D) 3.60 years E) 4.05 years Answer: B Difficulty: Medium Page: 149 Rationale: $75/1.12 = $66.96, $125/1.122 = $99.65, $100/1.123 = $71.18, $50/1.124 = $31.78 3 yr. CF: $250 - $66.96 - $99.65 - $71.18 = $12.21 + Fraction = $12.21/$31.78 = .38 11. The discounted payback period rule A) considers the time value of money. B) discounts the cutoff point. C) ignores uncertain cash flows. D) is preferred to the NPV rule. E) None of the above. Answer: A Difficulty: Easy Page: 149 12. The payback period rule A) determines a cutoff point so that all projects accepted by the NPV rule will be accepted by the payback period rule. B) determines a cutoff point so that depreciation is just equal to positive cash flows in the payback year. C) requires an arbitrary choice of a cutoff point. D) varies the cutoff point with the interest rate. E) Both A and D. Answer: C Difficulty: Easy Page: 147 Ross/Westerfield/Jaffe, Corporate Finance, 7/e 67 13. The average accounting return is determined by A) dividing the yearly cash flows by the investment. B) dividing the average cash flows by the investment. C) dividing the average net income by the average investment. D) dividing the average net income by the initial investment. E) dividing the net income by the cash flow. Answer: C Difficulty: Medium Page: 150 14. The investment decision rule that relates average net income to average investment is the A) discounted cash flow method. B) average accounting return method. C) average payback method. D) average profitability index. E) None of the above. Answer: B Difficulty: Easy Page: 150 15. Modified internal rate of return A) handles the multiple IRR problem by combining cash flows until only one change in sign change remains. B) requires the use of a discount rate. C) does not require the use of a discount rate. D) Both A and B. E) Both A and C. Answer: D Difficulty: Medium Page: 157-158 16. The shortcoming(s) of the average accounting return (AAR) method is (are) A) the use of net income instead of cash flows. B) the pattern of income flows has no impact on the AAR. C) there is no clear-cut decision rule. D) All of the above. E) None of the above. Answer: D Difficulty: Medium Page: 151 17. The two fatal flaws of the internal rate of return rule are A) arbitrary determination of a discount rate and failure to consider initial expenditures. B) arbitrary determination of a discount rate and failure to correctly analyze mutually exclusive investment projects. C) arbitrary determination of a discount rate and the multiple rate of return problem. D) failure to consider initial expenditures and failure to correctly analyze mutually exclusive investment projects. E) failure to correctly analyze mutually exclusive investment projects and the multiple rate of return problem. Answer: E Difficulty: Medium Page: 154-156 68 Test Bank, Chapter 6 18. A mutually exclusive project is a project whose A) acceptance or rejection has no effect on other projects. B) NPV is always negative. C) IRR is always negative. D) acceptance or rejection affects other projects. E) cash flow pattern exhibits more than one sign change. Answer: D Difficulty: Easy Page: 154 19. A project will have more than one IRR if A) the IRR is positive. B) the IRR is negative. C) the NPV is zero. D) the cash flow pattern exhibits more than one sign change. E) the cash flow pattern exhibits exactly one sign change. Answer: D Difficulty: Easy Page: 156 20. Using internal rate of return, a conventional project should be accepted if the internal rate of return is A) equal to the discount rate. B) greater than the discount rate. C) less than the discount rate. D) negative. E) positive. Answer: B Difficulty: Easy Page: 152 21. An investment cost $10,000 with expected cash flows of $3,000 for 5 years. The discount rate is 15.2382%. The NPV is ___ and the IRR is ___ for the project. A) $0; 15.2382%. B) $3.33; 27.2242%. C) $5,000; 0%. D) Can not answer without one or the other value as input. E) None of the above. Answer: A Difficulty: Medium Page: 145 - 153 22. The internal rate of return may be defined as A) the discount rate that makes the NPV cash flows equal to zero. B) the difference between the market rate of interest and the NPV. C) the market rate of interest less the risk-free rate. D) the project acceptance rate set by management. E) None of the above. Answer: A Difficulty: Easy Page: 152 Ross/Westerfield/Jaffe, Corporate Finance, 7/e 69 23. The Balistan Rug Company is considering investing in a new loom that will cost $12,000. The new loom will create positive end of year cash flow of $5,000 for each of the next 3 years. The internal rate of return for this project is A) 10%. B) 11%. C) 12%. D) 13%. E) 14%. Answer: C Difficulty: Medium Page: 153 24. The Carnation Chemical Company is investing in an incinerator to dispose of waste. The incinerator costs $2.5 million and will generate end-of-year cash of $1 million for the next 3 years. The internal rate of return for this project is A) 6.4%. B) 8.6%. C) 9.7%. D) 10.4%. E) 12.0%. Answer: C Difficulty: Medium Page: 153 25. The graph of NPV and IRR shows A) the NPV at different discount rates. B) the NPV of 0 at the IRR as NPV cuts the horizontal axis. C) the NPV at a 0% discount rate D) All of the above. E) None of the above. Answer: D Difficulty: Medium Page: 153-154 26. Two sign changes in the cash flows results in how many internal rates of return? A) 0 B) 1 C) 2 D) 3 E) 4 Answer: C Difficulty: Medium Page: 156 27. Which of the following correctly orders the investment rules of average accounting return (AAR), internal rate of return (IRR), and net present value (NPV) from the most desirable to the least desirable? A) AAR, IRR, NPV B) AAR, NPV, IRR C) IRR, AAR, NPV D) NPV, AAR, IRR E) NPV, IRR, AAR Answer: E Difficulty: Easy Page: 144-158 70 Test Bank, Chapter 6 28. A project will have only one internal rate of return if A) all cash flows after the initial expense are positive. B) average accounting return is positive. C) net present value is negative. D) net present value is positive. E) net present value is zero. Answer: A Difficulty: Easy Page: 152-157 29. LaPorte Company is considering a project that would involve an initial cash outflow of $1,000. At the end of year 1, the cash inflow is $1,500 and at the end of year 2, there is another cash outflow of $200. Calculate the modified internal rate of return if the cost of capital is 10%. A) 22.1% B) 27.6% C) 31.8% D) 35.2% E) None of the above within 1 percentage point. Answer: C Difficulty: Medium Page: 157-158 Rationale: $-200/1.10 = $-181.82; $-181.82 + 1500 = $1,318.18; Cash flow 0 = $-1,000; Cash flow 1 = $1,318.18 30. The problem of multiple IRRs can occur when A) there is only one sign change in the cash flows. B) the first cash flow is always positive. C) the cash flows decline over the life of the project. D) there is more than one sign change in the cash flows. E) None of the above. Answer: D Difficulty: Medium Page: 156 31. The elements that cause problems with the use of the IRR in projects that are mutually exclusive are A) the discount rate and scale problems. B) timing and scale problems. C) the discount rate and timing problems. D) scale and reversing flow problems. E) timing and reversing flow problems. Answer: B Difficulty: Medium Page: 159-163 32. If there is a conflict between mutually exclusive projects due to the IRR, one should A) drop the two projects immediately. B) spend more money on gathering information. C) depend on the NPV as it will always provide the most value. D) depend on the AAR because it does not suffer from these same problems. E) None of the above. Answer: C Difficulty: Easy Page: 159-163 Ross/Westerfield/Jaffe, Corporate Finance, 7/e 71 33. The profitability index is the ratio of A) average net income to average investment. B) internal rate of return to current market interest rate. C) net present value of cash flows to internal rate of return. D) net present value of cash flows to average accounting return. E) present value of cash flows to initial investment cost. Answer: E Difficulty: Easy Page: 164 34. Under capital rationing the profitability index is used to select investments by its A) excess profit to achieve the highest payoff. B) reward per dollar cost to achieve the highest incremental NPV. C) incremental IRR to maximize the total rate of return. D) capital usage rate to stay within budget. E) None of the above. Answer: B Difficulty: Medium Page: 165 35. Which of the following statement is true? A) One must know the discount rate to compute the NPV of a project but one can compute the IRR without referring to the discount rate. B) One must know the discount rate to compute the IRR of a project but one can compute the NPV without referring to the discount rate. C) Payback accounts for time value of money. D) There will always be one IRR regardless of cash flows. E) Average accounting return is the ratio of total assets to total net income. Answer: A Difficulty: Easy Page: 163 36. Graham and Harvey (2001) found that ___ and ___ were the two most popular capital budgeting methods. A) Internal Rate of Return; Payback Period B) Internal Rate of Return; Net Present Value C) Net Present Value; Payback Period D) Modified Internal Rate of Return; Internal Rate of Return E) Modified Internal Rate of Return; Net Present Value Answer: B Difficulty: Easy Page: 166 72 Test Bank, Chapter 6 Essay Questions 37. The Ziggy Trim and Cut Company can purchase equipment on sale for $4,300. The asset has a three-year life, will produce a cash flow of $1,200 in the first and second year, and $3,000 in the third year. The interest rate is 12%. Calculate the project's payback. Also, calculate project's IRR. Should the project be taken? Check your answer by computing the project's NPV. Difficulty: Medium Page: 146; 152 Answer: Payback - 2.63 years. IRR = 10.41%. Do not take project as IRR < 12% Reject the project NPV = ($136.60) 38. The Ziggy Trim and Cut Company can purchase equipment on sale for $4,300. The asset has a three-year life, will produce a cash flow of $1,200 in the first and second year, and $3,000 in the third year. The interest rate is 12%. Calculate the project's Discounted Payback and Profitability Index assuming end of year cash flows. Should the project be taken? If the Average Accounting Return was positive, how would this affect your decision? Difficulty: Medium Page: 149,150,152 Answer: Time 0 – Cash flows = $-4,300, Present Value of Cash flows = $-4,300 Time 1 and 2 – Cash flows = $1,200 each period, Present Value of Cash flows = $2,028.06 for both periods, Sum of Present Value of Cash flows = $-2,271.94 at the end of time 2 Time 3 – Cash flows = $3,000, Present Value of Cash flows = $2,135.34, Sum of Present Value of Cash flows = $-136.60 Discounted Payback cannot be calculated as NPV < 0; NPV = $-136.60 PI = CFATt /Initial Investment = $4,163.40/$4,300 = .968 = .97 Both measures indicate rejection. A positive accounting rate of return should not change the decision. DPP and PI indicate that the cost of capital is not being covered. 39. The Walker Landscaping Company can purchase a piece of equipment for $3,600. The asset has a two-year life, will produce a cash flow of $600 in the first year and $4,200 in the second year. The interest rate is 15%. Calculate the project's payback assuming steady cash flows. Also calculate the project's IRR. Should the project be taken? Check your answer by computing the project's NPV. Difficulty: Medium Page: 146, 152 Answer: Payback = 1.714 years Calculated IRR = 16.67%. Accept the project. NPV = $97.54. Ross/Westerfield/Jaffe, Corporate Finance, 7/e 73 40. The Walker Landscaping Company can purchase a piece of equipment for $3,600. The asset has a two-year life, will produce a cash flow of $600 in the first year and $4,200 in the second year. The interest rate is 15%. Calculate the project's Discounted Payback and Profitability Index assuming steady cash flows. Should the project be taken? If the Average Accounting Return was positive, how would this affect your decision? Difficulty: Medium Page: 149,150,152 Answer: Time 0 – Cash flows = $-3,600, Present Value of Cash flows = $-3,600 Time 1 – Cash flows = $600, Present Value of Cash flows = $571.74, Sum of Present Value of Cash flows = $-3,078.26 Time 2 – Cash flows = $4,200, Present Value of Cash flows = $3,175.80, Sum of Present Value of Cash flows = $97.54 DPP = 1+($3,078.26/$3,175.80) = 1.969 = 1.97 years PI = CFATt /Initial Investment = $3,697.54/$3,600 = 1.027 = 1.03 Both measures indicate acceptance. A positive accounting rate of return would be consistent with this decision. Reliance on AAR should not be the key, as DPP and PI indicate earning a rate greater than cost of capital. 41. Cutler Compacts will generate cash flows of $30,000 in year one, and $65,000 in year two. However, if they make an immediate investment of $20,000, they can expect to have cash streams of $55,000 in year 1 and $63,000 in year 2 instead. The interest rate is 9%. Calculate the NPV of the proposed project. Why would the IRR be a poor choice in this situation? Difficulty: Hard Page: 144,156 Answer: Use incremental cash flow approach: NPV $1,252, accept project. With more than one sign change, there will be more than one IRR. 42. Given the cash flow stream of the following mutually exclusive projects, prove through the incremental investment that Project B, with the higher NPV, will be preferred to project A. Use a discount rate of 13%. Project A: Time 0 = $-500; Time 1 = $150; Time 2: $245; Time 3 = $320; NPV = $46.39; IRR = 17.76% Project B: Time 0 = $-800; Time 1 = $360; Time 2: $360; Time 3 = $360; NPV = $50.01; IRR = 16.65% Difficulty: Hard Page: 159 Answer: Incremental investment in B: $-300 $210 $115 $40 NPV = $3.63 43. The IRR rule is said to be a special case of the NPV rule. Explain why this is so and why it has some limitations NPV does not? Difficulty: Medium Page: 154 Answer: At some K, NPV = $0; by definition, when NPV=0, K=IRR. Problems occur due to conflicts with mutually exclusive projects, timing and size problems, multiple sign changes present problem for IRR NPV always the best choice 74 Test Bank, Chapter 6 44. The NPV and Profitability Index give the same results when there is no conflict. In the case of a mutually exclusive set of investments, explain the potential conflict and the way it should be solved with supporting examples. Difficulty: Hard Page: 165 Answer: Please refer to the text for the answer, page 165. 45. The NPV and Profitability Index give the same results when there is no conflict. In the case of capital rationing, explain the potential conflict and the way it should be solved with supporting examples. Difficulty: Hard Page: 165-166 Answer: Please refer to the text for the answer, pages 165 - 166. Ross/Westerfield/Jaffe, Corporate Finance, 7/e 75