Principles of Corporate Finance Richard Brealey 13e - Test Bank

Principles of Corporate Finance Richard Brealey 13e – Test Bank

 

Instant Download – Complete Test Bank With Answers

 

 

Sample Questions Are Posted Below

 

Principles of Corporate Finance, 13e (Brealey)

Chapter 5   Net Present Value and Other Investment Criteria

 

1) Which of the following investment rules does not use the time value of money concept?

1. A) Net present value
2. B) Internal rate of return
3. C) The payback period
4. D) Profitability index

 

Answer:  C

Difficulty: 1 Easy

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Remember

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

2) Suppose a firm has $100 million in excess cash. It could

1. A) invest the funds in projects with positive NPVs.
2. B) pay high dividends to the shareholders.
3. C) buy another firm.
4. D) do all of the options.

 

Answer:  D

Difficulty: 1 Easy

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Remember

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

3) The following are measures used by firms when making capital budgeting decisions except

1. A) payback period.
2. B) internal rate of return.
3. C) P/E ratio.
4. D) net present value.

 

Answer:  C

Difficulty: 1 Easy

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Remember

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

 

 

4) The survey of CFOs indicates that the NPV method is always, or almost always, used for evaluating investment projects by approximately

1. A) 12 percent of firms.
2. B) 20 percent of firms.
3. C) 57 percent of firms.
4. D) 75 percent of firms.

 

Answer:  D

Difficulty: 1 Easy

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Remember

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

5) The survey of CFOs indicates that the IRR method is used for evaluating investment projects by approximately

1. A) 12 percent of firms.
2. B) 20 percent of firms.
3. C) 76 percent of firms.
4. D) 57 percent of firms.

 

Answer:  C

Difficulty: 1 Easy

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Remember

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

6) Which of the following investment rules has the value additivity property?

1. A) The payback period method
2. B) The net present value method
3. C) The book rate of return method
4. D) The internal rate of return method

 

Answer:  B

Difficulty: 1 Easy

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Remember

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

 

 

7) If the net present value (NPV) of project A is +$100 and that of project B is +$60, then the net present value of the combined projects is

100. A) +$100.
101. B) +$60.
102. C) +$160.
103. D) +$6,000.

 

Answer:  C

Explanation:  NPV(A + B) = NPV(A) + NPV(B) = 100 + 60 = 160.

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

8) If the NPV of project A is + $30 and that of project B is -$60, then the NPV of the combined projects is

30. A) +$30.
31. B) -$60.
32. C) -$30.
33. D) -$1,800.

 

Answer:  C

Explanation:  NPV(A + B) = 30 – 60 = -30.

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

 

 

9) You are given a job to make a decision on project X, which is composed of three independent projects A, B, and C that have NPVs of + $70, -$40 and + $100, respectively. How would you go about making the decision about whether to accept or reject the project?

1. A) Accept project X as it has a positive NPV.
2. B) Reject project X.
3. C) Break up the project into its components: Accept A and C, but reject B.
4. D) Break up the project into its components: Accept C.

 

Answer:  C

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

10) If the NPV of project A is + $120, that of project B is -$40, and that of project C is + $40, what is the NPV of the combined project?

1. A) +$100
2. B) -$40
3. C) +$70
4. D) +$120

 

Answer:  D

Explanation:  NPV(A + B + C) = 120 + 40 – 40 = 120.

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

11) The net present value of a project depends upon the

1. A) company’s choice of accounting method.
2. B) manager’s tastes and preferences.
3. C) project’s cash flows and opportunity cost of capital.
4. D) company’s profitability index.

 

Answer:  C

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

12) Which of the following investment rules may not use all possible cash flows in its calculations?

1. A) NPV
2. B) Payback period
3. C) IRR
4. D) Profitability index

 

Answer:  B

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

13) The payback period rule

1. A) varies the cut-off point with the interest rate.
2. B) determines a cut-off point so that all projects accepted by the NPV rule will be accepted by the payback period rule.
3. C) requires an arbitrary choice of a cut-off point.
4. D) varies the cut-off point with the interest rate and requires an arbitrary choice of a cut-off point.

 

Answer:  C

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

14) The payback period rule accepts all projects for which the payback period is

1. A) greater than the cut-off value.
2. B) less than the cut-off value.
3. C) positive.
4. D) an integer.

 

Answer:  B

Difficulty: 1 Easy

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Remember

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

 

 

15) The main advantage of the payback rule is that it

1. A) adjusts for uncertainty of early cash flows.
2. B) is simple to use.
3. C) does not discount cash flows.
4. D) better accounts for salvage costs at the end of a project.

 

Answer:  B

Difficulty: 1 Easy

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

16) The following are disadvantages of using the payback rule except the rule

1. A) ignores all cash flow after the cut-off date.
2. B) does not use the time value of money.
3. C) is easy to calculate and use.
4. D) does not have the value additivity property.

 

Answer:  C

Difficulty: 1 Easy

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

17) Which of the following statements regarding the discounted payback period measure is true?

1. A) The discounted payback measure uses the time value of money concept.
2. B) The discounted payback measure is better than the NPV rule.
3. C) The discounted payback measure considers all cash flows.
4. D) The discounted payback measure exhibits the value additivity property.

 

Answer:  A

Difficulty: 1 Easy

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

 

 

18) If the cash flows for project A are C0 = −1,000; C1 = +600; C2 = +400; and C3 = +1,500, calculate the payback period.

1. A) One year
2. B) Two years
3. C) Three years
4. D) Cannot be determined

 

Answer:  B

Explanation:  Initial investment: 1,000 = CF1 + CF2 = 600 + 400; payback period = 2 years.

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

19) The cost of a new machine is $250,000. The machine has a five-year life and no salvage value. If the cash flow each year is equal to 25 percent of the cost of the machine, calculate the payback period for the project.

2. A) 2.0 years
3. B) 2.5 years
4. C) 3.0 years
5. D) 4.0 years

 

Answer:  D

Explanation:  Cash flow each year = (0.25)(250,000) = 62,500; Payback period = 4.0 years.

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

 

 

20) If the cash flows for project Z are C0 = -1,000; C1 = 600; C2 = 720; and C3 = 2,000, calculate the discounted payback period for the project at a discount rate of 20 percent.

1. A) 1 year
2. B) 2 years
3. C) 3 years
4. D) >3 years

 

Answer:  B

Explanation:  1,000 = (600/1.2) + (720/1.2^2); Discounted payback = 2 years.

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

21) Internal rate of return (IRR) method is also called the

1. A) discounted payback period method.
2. B) discounted cash flow (DCF) rate of return method.
3. C) modified internal rate of return (MIRR) method.
4. D) book rate of return method.

 

Answer:  B

Difficulty: 1 Easy

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Remember

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

22) The quickest way to calculate the internal rate of return (IRR) of a project is by

1. A) trial and error method.
2. B) using the graphical method.
3. C) using a financial calculator.
4. D) doubling the opportunity cost of capital.

 

Answer:  C

Difficulty: 1 Easy

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

 

 

23) If an investment project (normal project) has an IRR equal to the cost of capital, the NPV for that project is

1. A) positive.
2. B) negative.
3. C) zero.
4. D) unable to be determined.

 

Answer:  C

Difficulty: 1 Easy

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

24) If the cash flows for Project M are C0 = -1,000; C1 = +200; C2 = +700; and C3 = +698, calculate the IRR for the project.

1. A) 23 percent
2. B) 21 percent
3. C) 19 percent
4. D) 17 percent

 

Answer:  A

Explanation:  -1,000 + [200/(1 + IRR)] + [700/(1 + IRR)^2] + [698/(1 + IRR)^3] = 0; IRR = 23%. In Excel: In , arrange cash flows in order starting with -1,000 in cell A1 and ending with +698 in cell A4, then “= IRR(A1:A4)”.

Difficulty: 2 Medium

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

25) The IRR is defined as

1. A) the discount rate that makes a project’s NPV equal to zero.
2. B) the difference between the cost of capital and the present value of the cash flows.
3. C) the discount rate used in the NPV method.
4. D) the discount rate used in the discounted payback period method.

 

Answer:  A

Difficulty: 1 Easy

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Remember

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

26) Which of the following methods of evaluating capital investment projects incorporates the time value of money concept?

1. A) Payback period, discounted payback period, and net present value (NPV) only
2. B) Discounted payback period, net present value (NPV), and internal rate of return only
3. C) Net present value (NPV) and internal rate of return only
4. D) Payback period, discounted payback period, net present value (NPV), and internal rate of return

 

Answer:  B

Difficulty: 1 Easy

Topic:  Internal Rate of Return

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

27) Driscoll Company is considering investing in a new project. The project will need an initial investment of $2,400,000 and will generate $1,200,000 (after-tax) cash flows for three years. Calculate the IRR for the project.

14. A) 14.5 percent
15. B) 18.6 percent
16. C) 20.2 percent
17. D) 23.4 percent

 

Answer:  D

Explanation:  -2,400,000 + [1,200,000/(1 + IRR)] + [1,200,000/(1 + IRR)^2] + [1,200,000/(1 + IRR)^3] = 0; IRR = 23.4%. In Excel, arrange cash flows in order starting with -2,400,000 in cell A1 and 1,200,000 in cells A2 through A4, then “= IRR(A1:A4)”.

Difficulty: 2 Medium

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

 

 

28) The following are some of the shortcomings of the IRR method except

1. A) IRR is conceptually easy to communicate.
2. B) projects can have multiple IRRs.
3. C) IRR cannot distinguish between a borrowing project and a lending project.
4. D) it is very cumbersome to evaluate mutually exclusive projects using the IRR method.

 

Answer:  A

Difficulty: 1 Easy

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

29) Project X has the following cash flows: C0 = +2,000, C1 = -1,300, and C2 = -1,500. If the IRR of the project is 25 percent and if the cost of capital is 18 percent, you would

1. A) accept the project.
2. B) reject the project.

 

Answer:  B

Explanation:  This is a loan project (i.e., borrowing) with IRR greater than the cost of capital. Therefore, reject it.

Difficulty: 2 Medium

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

30) Project X has the following cash flows: C0 = +2,000, C1 = -1,150, and C2 = -1,150. If the IRR of the project is 9.85 percent and if the cost of capital is 12.00 percent, you would

1. A) accept the project.
2. B) reject the project.

 

Answer:  A

Explanation:  This is a loan project (i.e., borrowing) with IRR less than the cost of capital. Therefore, accept it.

Difficulty: 2 Medium

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

 

 

31) If the sign of the cash flows for a project changes two times, then the project likely has

1. A) one IRR.
2. B) two IRRs.
3. C) three IRRs.
4. D) four IRRs.

 

Answer:  B

Difficulty: 2 Medium

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

32) Project Y has following cash flows: C0 = -800, C1 = +5,000, and C2 = -5,000. Calculate the IRRs for the project.

1. A) 25 percent and 400 percent.
2. B) 125 percent and 500 percent.
3. C) -44 percent and 11.6 percent.
4. D) No IRRs exist for this project.

 

Answer:  A

Explanation:  -800 + [5,000/(1 + IRR)] – [5,000/(1 + IRR)^2] = 0,

 

or 800[(1 + IRR)^2] – 5,000(1 + IRR) + 5,000 = 0.

 

This is a quadratic equation and has two roots.

 

1 + IRR = [5,000 + SQRT{5,000^2 – (4) × (800) × (5,000)}]/(2 × 800) = 5; IRR = 4 = 400%.

 

1 + IRR = [5,000 + SQRT{5,000^2 – (4) × (800) × (5,000)}]/(2 × 800) = 1.25; IRR = 0.25 = 25%.

Difficulty: 2 Medium

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

 

 

33) Music Company is considering investing in a new project. The project will need an initial investment of $2,400,000 and will generate $1,200,000 (after-tax) cash flows for three years. Calculate the NPV for the project if the cost of capital is 15 percent.

1. A) $169, 935
2. B) $1,200,000
3. C) $339,870
4. D) $125,846

 

Answer:  C

Explanation:  NPV = -2,400,000 + [(1,200,000)/(1.15)] + [(1,200,000/(1.15)^2] + [1,200,000/(1.15)^3] = 339,870.

Difficulty: 2 Medium

Topic:  Net Present Value

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

34) Muscle Company is investing in a giant crane. It is expected to cost $6.5 million in initial investment, and it is expected to generate an end-of-year cash flow of $3.0 million each year for three years. Calculate the IRR.

14. A) 14.6 percent
15. B) 16.4 percent
16. C) 18.2 percent
17. D) 22.1 percent

 

Answer:  C

Explanation:  0 = -6.5 + ((3/(1 + IRR) + (3/((1 + IRR)^2)) + (3/((1 + IRR)^3)));

 

IRR = 18.2% (by trial & error). In Excel, arrange cash flows in order starting with -6.5 in cell A1 and 3 in cells A2 through A4, then “= IRR(A1:A4)”.

Difficulty: 2 Medium

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

 

 

35) A project will have only one internal rate of return if

1. A) the net present value is positive.
2. B) the net present value is negative.
3. C) the cash flows decline over the life of the project.
4. D) there is a one-sign change in the cash flows.

 

Answer:  D

Difficulty: 2 Medium

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

36) Story Company is investing in a giant crane. It is expected to cost $6 million in initial investment, and it is expected to generate an end-of-year after-tax cash flow of $3 million each year for three years. Calculate the NPV at 12 percent.

2. A) $2.40 million
3. B) $1.20 million
4. C) $0.80 million
5. D) $0.20 million

 

Answer:  B

Explanation:  NPV(millions) = -6.0 + 3/1.12 + 3/(1.12^2) + 3/(1.12^3) = 1.2.

Difficulty: 2 Medium

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

 

 

37) Dry-Sand Company is considering investing in a new project. The project will need an initial investment of $1,200,000 and will generate $600,000 (after-tax) cash flows for three years. However, at the end of the fourth year, the project will generate -$500,000 of after-tax cash flow due to dismantling costs. Calculate the MIRR (modified internal rate of return) for the project if the cost of capital is 15 percent. The reinvestment rate is 12 percent.

11. A) 11.5 percent
12. B) 12.6 percent
13. C) 28.2 percent
14. D) 20.4 percent

 

Answer:  A

Explanation:  In Excel, arrange cash flows in order starting with -1,200,000 in cell A1; 600,000 in cells A2 through A4; and -500,000 in A5. The reinvestment rate, 12%, will be in A6 and the cost of capital, 15%, in A7. The MIRR calculation will be “= MIRR(A1:A5,A7,A6)”.

Difficulty: 3 Hard

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Apply

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

38) Mass Company is investing in a giant crane. It is expected to cost $6 million in initial investment, and it is expected to generate an end-of-year cash flow of $3 million each year for three years. At the end of the fourth year, there will be a $1 million disposal cost. Calculate the MIRR for the project if the cost of capital is 12 percent.

17. A) 17.8 percent
18. B) 15.3 percent
19. C) 23.8 percent
20. D) 22.1 percent

 

Answer:  A

Explanation:  To eliminate the second sign change, combine year 3 and year 4 cash flows:

PV3 = +3 – 1/1.12 = 2.11.

 

-6 + 3/(1 + MIRR) + 3/(1+MIRR)^2 + 2.11/(1+MIRR)^3 = 0;

MIRR = 17.8%.

 

In Excel, arrange cash flows in order starting with -6 in cell A1; 3 in cells A2 through A3; and 2.11 in cell A4; then “= IRR(A1:A4)”.

Difficulty: 3 Hard

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Apply

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

39) If the cash flows for project A are C0 = -3,000, C1 = +500; C2 = +1,500; and C3 = +5,000, calculate the NPV of the project using a 15 percent discount rate.

1. A) $5,000
2. B) $2,352
3. C) $3,201
4. D) $1,857

 

Answer:  D

Explanation:  NPV = -3,000 + (500/1.15) + (1,500/1.15^2) + (5,000/1.15^3) = 1,857.

Difficulty: 3 Hard

Topic:  Net Present Value

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Apply

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

40) One can use the profitability index most usefully for which situation?

1. A) When capital rationing exists
2. B) Evaluation of exceptionally long-term projects
3. C) Evaluation of nonnormal projects
4. D) When a project has unusually high cash flow uncertainty

 

Answer:  A

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-04 Choosing Capital Investments When Resources Are Limited

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

41) The profitability index is the ratio of the

1. A) future value of cash flows to investment.
2. B) net present value of cash flows to investment.
3. C) net present value of cash flows to IRR.
4. D) present value of cash flows to IRR.

 

Answer:  B

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-04 Choosing Capital Investments When Resources Are Limited

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

 

 

42) The following table gives the available projects (in $millions) for a firm.

 

A	B	C	D	E	F	G
90	20	60	50	150	40	20	Initial investment
140	70	65	−10	30	32	10	NPV

 

If the firm has a limit of $210 million to invest, what is the maximum NPV the company can obtain?

1. A) 200
2. B) 283
3. C) 307
4. D) 347

 

Answer:  C

Explanation:  A + B + C + F = 140 + 70 + 65 + 32 = 307; Total investment = 90 + 20 + 60 + 40 = 210.

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-04 Choosing Capital Investments When Resources Are Limited

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

43) The following table gives the available projects (in $millions) for a firm.

 

A	B	C	D	E	F	G
5.0	4.0	5.0	1.0	2.0	7.0	8.0	Initial investment
1.5	−0.5	1.0	0.5	0.5	1.0	1.0	NPV

 

The firm has only $20 million to invest. What is the maximum NPV that the company can obtain?

3. A) 3.5
4. B) 4.0
5. C) 4.5
6. D) 5.0

 

Answer:  C

Explanation:  A + C + D + E + F = 4.5; Total investment = 5 + 5 + 1 + 2 + 7 = $20 million.

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-04 Choosing Capital Investments When Resources Are Limited

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

 

 

44) The benefit-cost ratio is defined as the ratio of

1. A) net present value cash flows to initial investment.
2. B) present value of cash flows to initial investment.
3. C) net present value of cash flows to IRR.
4. D) present value of cash flows to IRR.

 

Answer:  B

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-04 Choosing Capital Investments When Resources Are Limited

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

45) What is the profitability index of an investment with cash flows in years 0 thru 4 of -340, 120, 130, 153, and 166, respectively, and a discount rate of 16 percent?

1. A) .15
2. B) .22
3. C) .35
4. D) .42

 

Answer:  A

Explanation:  NPV = 49.7 PI = 49.7/340 = .15.

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-04 Choosing Capital Investments When Resources Are Limited

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

46) Which investment analysis technique is used the least by CFOs?

1. A) Net present value
2. B) Internal rate of return
3. C) Payback
4. D) Book rate of return

 

Answer:  D

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-04 Choosing Capital Investments When Resources Are Limited

Bloom’s:  Remember

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

 

 

47) How does modified internal rate of return (MIRR) differ from IRR?

1. A) MIRR does not consider cash flows occurring after the cut-off date.
2. B) MIRR uses NPV, IRR does not.
3. C) MIRR calculates the PV of cash inflows and then divides by the PV of the investment.
4. D) MIRR reduces the number of sign changes in a cash flow sequence.

 

Answer:  D

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-04 Choosing Capital Investments When Resources Are Limited

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

48) The profitability index is always less than 1.

 

Answer:  FALSE

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-04 Choosing Capital Investments When Resources Are Limited

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

49) The profitability index of a positive NPV project is always positive.

 

Answer:  TRUE

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-04 Choosing Capital Investments When Resources Are Limited

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

50) Present values have the value additivity property.

 

Answer:  TRUE

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-04 Choosing Capital Investments When Resources Are Limited

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

 

 

51) The payback rule ignores all cash flows after the cut-off date.

 

Answer:  TRUE

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

52) The discounted payback method calculates the payback period and then discounts the payback period at the opportunity cost of capital.

 

Answer:  FALSE

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

53) The internal rate of return is the discount rate that makes the PV of a project’s cash inflows equal to zero.

 

Answer:  FALSE

Difficulty: 2 Medium

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

54) The IRR rule states that firms should accept any investment (normal) project offering an internal rate of return in excess of the cost of capital.

 

Answer:  TRUE

Difficulty: 2 Medium

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

 

 

55) In the case of a loan project (borrowing), one should accept the project if the IRR is more than the cost of capital.

 

Answer:  FALSE

Difficulty: 2 Medium

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

56) There can never be more than one value of the IRR for any sequence of cash flows.

 

Answer:  FALSE

Difficulty: 2 Medium

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

57) Decommissioning and clean-up costs for any project are always insignificant and should typically be ignored.

 

Answer:  FALSE

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-04 Choosing Capital Investments When Resources Are Limited

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

58) The benefit-cost ratio is equal to the profitability index plus one.

 

Answer:  TRUE

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-04 Choosing Capital Investments When Resources Are Limited

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

 

 

59) Soft rationing may be used to control managerial behavior.

 

Answer:  TRUE

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-04 Choosing Capital Investments When Resources Are Limited

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

60) The internal rate of return is the discount rate that makes the NPV of a project’s cash flows equal to zero.

 

Answer:  TRUE

Difficulty: 2 Medium

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

61) A project’s internal rate of return depends on its level of risk.

 

Answer:  FALSE

Difficulty: 2 Medium

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

62) A project’s “book value” represents, essentially, the market valuation of the project.

 

Answer:  FALSE

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

 

 

63) Accounting earnings from a firm’s income statement, prepared according to generally accepted accounting principles (GAAP), are typically the best data source for calculating a project’s NPV.

 

Answer:  FALSE

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

64) The discounted payback method discounts cash flows at the opportunity cost of capital and then calculates the payback period.

 

Answer:  TRUE

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

65) The discounted payback method will never accept a negative-NPV project.

 

Answer:  TRUE

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

66) The denominator of the profitability index is the present value of the investment.

 

Answer:  TRUE

Difficulty: 2 Medium

Topic:  Project Evaluation

Learning Objective:  05-04 Choosing Capital Investments When Resources Are Limited

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

 

 

67) Briefly explain the value additivity property.

 

Answer:  For example, the net present value (NPV) of a combined project—say A and B—is equal to the NPV(A) plus the NPV(B). Naturally, this property holds for present values also. This property is not shared by IRR. The IRR of a combined project does not equal the sum of the individual IRRs. The value additivity property is very useful when making comparative decisions among numerous projects.

Difficulty: 2 Medium

Topic:  Net Present Value

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

68) Discuss some of the advantages of using the payback method.

 

Answer:  It tells you how quickly you can recover your investment. The main advantage is that it is easy to calculate and use.

Difficulty: 1 Easy

Topic:  Payback

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

69) Discuss some of the disadvantages of the payback rule.

 

Answer:  The disadvantages are that it does not take the time value of money into account and also does not consider any cash flows beyond the cut-off point.

Difficulty: 1 Easy

Topic:  Payback

Learning Objective:  05-02 Book Rate of Return and Payback

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

 

 

70) What are some of the disadvantages of using the IRR method?

 

Answer:  There are several disadvantages to the IRR method. It is not useful in evaluating mutually exclusive projects and dependent projects. You can also get multiple IRRS for projects having cash flows with more than one change in sign. Also, IRR cannot distinguish between borrowing and lending projects. In most cases it may be easier to use the NPV method.

Difficulty: 2 Medium

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

71) What are some of the advantages of using the IRR method?

 

Answer:  The main advantage of IRR is that it is easy to communicate. Financial managers tend to think in terms of percentages and find rates of return intuitively easy to grasp.

Difficulty: 2 Medium

Topic:  Internal Rate of Return

Learning Objective:  05-03 Internal (or Discounted Cash Flow) Rate of Return

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

72) Briefly discuss capital rationing.

 

Answer:  There are two types of capital rationing; soft rationing imposed by the company and hard rationing imposed by the capital markets. Capital rationing may result in the firm forgoing some positive NPV projects, thereby reducing a firm’s value.

Difficulty: 2 Medium

Topic:  Capital Rationing

Learning Objective:  05-04 Choosing Capital Investments When Resources Are Limited

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

 

 

73) Briefly explain the term soft rationing.

 

Answer:  Management uses soft rationing to get better financial control over investment decisions. Soft rationing is imposed by management and not by capital markets. Soft rationing is an upper-management technique often used to restrain overoptimistic capital spending requests by midlevel managers.

Difficulty: 2 Medium

Topic:  Capital Rationing

Learning Objective:  05-04 Choosing Capital Investments When Resources Are Limited

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation

 

74) Briefly explain the term hard rationing.

 

Answer:  A firm faces hard rationing when it cannot raise more funding from capital markets. Hard rationing also indicates the existence of market imperfections. Market imperfections do not invalidate the NPV rule as long as the shareholders of the firm have access to well-functioning capital markets so that their portfolio choices are not restricted. The NPV rule is undermined when imperfections restrict shareholders’ portfolio choices. Generally, hard rationing is rare for large corporations in the United States.

Difficulty: 2 Medium

Topic:  Capital Rationing

Learning Objective:  05-04 Choosing Capital Investments When Resources Are Limited

Bloom’s:  Understand

AACSB:  Analytical Thinking

Accessibility:  Keyboard Navigation