1) quantifies in dollar terms how stockholder wealth will be affected by undertaking a project under consideration.


 Silas Booth
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1 Questions in Chapter 9 concept.qz 1) quantifies in dollar terms how stockholder wealth will be affected by undertaking a project under consideration. [A] Discounted payback analysis [B] The average accounting return [C] The internal rate of return [D] Net present value [E] The profitability index [A] :This measures a project in terms of time, not in dollar terms. Review section 9.3. [B] :This measures a project as a ratio of net income to book value, not in dollar terms. Review section 9.4. [C] :This measures a project as a rate of return, not in dollar terms. Review section 9.5. [D] :You are correct! [E] :This measures a project as a benefittocost ratio, not in dollar terms. Review section ) A project has a required return of 15 percent, conventional cash flows and a fiveyear life. Of the following values that have been computed, which value is inconsistent with the other four? [A] The discounted payback is exactly five years. [B] The profitability index is zero. [C] The net present value is zero. [D] The internal rate of return is 15 percent. [E] The present value of the future cash flows is equal to the initial outlay [A] :Since the discounted payback is exactly five years, what is the NPV? Review section 9.3. The PI needs to equal 1 to be consistent with the other four. [C] :Since choices C and E say the same thing, neither one is the correct answer. Also, if the NPV is $0, this would be consistent with the IRR being equal to the required return, so D can't be correct. That only leaves two choices. Which one is not consistent with C, D, and E? Review sections 9.3 and 9.6. [D] :Since choices C and E say the same thing, neither one is the correct choice. Also, if the NPV is $0, this would be consistent with the IRR being equal to the required return, so D can't be correct. That only leaves two choices. Which one is not consistent with C, D, and E? Review sections 9.3 and 9.6. [E] :Since choices C and E say the same thing, neither one is the correct choice. Also, if the NPV is $0, this would be consistent with the IRR being equal to the required return, so D can't be correct. That only leaves two choices. Which one is not consistent with C, D, and E? Review sections 9.3 and ) A disadvantage of the payback rule and the average accounting return is that both ignore the time value of money. [B] :Do you have to discount the cash flows to compute either of these two? Review sections 9.2 and 9.4.
2 4) Which one of the following excludes the time value of money principle? [A] discounted payback [B] profitability index [C] net present value [D] internal rate of return [E] average accounting return [A] :How do you compute the discounted cash flows? Review section 9.3. [B] :How do you compute the present value of the cash inflows? Review section 9.6. [C] :How do you compute net present value? Review section 9.1. [D] :How do you compute the internal rate of return? Review section ) A project costs $475 and has cash flows of $100 for the first three years and $75 in each of the project's last five years. If the discount rate is 10 percent, what is the discounted payback period for the project? [A] The project never pays back on a discounted basis. [B] 6.29 years [C] 6.87 years [D] 7.03 years [E] 7.99 years [B] :Did you find the present value of the first three cash flows to be $ and the present value of the last five cash flows to be $213.61, meaning the project doesn't pay back on a discounted basis? Review section 9.3. [C] :Did you find the present value of the first three cash flows to be $ and the present value of the last five cash flows to be $213.61, meaning the project doesn't pay back on a discounted basis? Review section 9.3. [D] :Did you find the present value of the first three cash flows to be $ and the present value of the last five cash flows to be $213.61, meaning the project doesn't pay back on a discounted basis? Review section 9.3. [E] :Did you find the present value of the first three cash flows to be $ and the present value of the last five cash flows to be $213.61, meaning the project doesn't pay back on a discounted basis? Review section ) To use the payback rule, the average accounting return or the profitability index you must first set an arbitrary cutoff. [A] :This is true for the first two, but not for the profitability index. Review section ) Very few large U.S. firms use the payback rule when making capital budgeting decisions.
3 [A] :On the contrary, the payback rule is one of the most popular decision rules in practice despite its rather significant shortcomings. Review section ) To find the we begin by setting the net present value of a project equal to zero. I. payback II. discounted payback III. profitability index IV. internal rate of return [A] I only [B] II only [C] IV only [D] II and IV only [E] III and IV only [A] :This rule ignores the time value of money so it can't be related to the NPV. Review section 9.2. [B] :This rule does not require all project cash flows be considered but the NPV does. Review section 9.3. [D] :At least one of these choices is incorrect. Review sections 9.3 and 9.5. [E] :At least one of these choices is incorrect. Review sections 9.5 and ) Both the internal rate of return and the profitability index decision rules may lead to incorrect decisions when comparing mutually exclusive investments. [B] :This is a disadvantage of both of these rules. Review sections 9.5 and ) Complete the following decision rule: A project should be accepted if its exceeds the firm's required rate of return. [A] internal rate of return [B] net present value [C] payback [D] discounted payback [E] average accounting return [B] :This decision rule does not require comparisons with the required return. Review section 9.1. [C] :This decision rule does not require comparisons with the required return. Review section 9.2. [D] :This decision rule does not require comparisons with the required return. Review section 9.3.
4 [E] :This decision rule does not require comparisons with the required return. Review section ) For projects with conventional cash flows and positive discount rates, the payback period will be shorter than the discounted payback period. [B] :With a positive discount rate the discounted cash flows will be lower than the undiscounted cash flows. Review sections 9.2 and ) Which of the following statements are correct? I. Net present value (NPV) is the difference between the present value of an asset or project and its cost. II. The financial manager acts in the shareholders' best interests by identifying and implementing positive NPV projects. III. NPVs can normally be directly observed in the market. IV. Investment criteria other than NPV provide additional information about whether or not a project truly has a positive NPV. [A] I and II only [B] II and III only [C] II, III, and IV only [D] I, II, and IV only [E] I, II, III, and IV [A] :Don t the other methods provide additional information that either confirms or conflicts with the NPV decision? Review section 9.8. [B] :Where do you find net present values of projects publicly listed? Review section 9.8. [C] :Where do you find net present values of projects publicly listed? Review section 9.8. [D] :You are correct! [E] :Where do you find net present values of projects publicly listed? Review section ) A net present value (NPV) of zero implies that an investment's: [A] cost exceeds the present value of its cash inflows. [B] cost is equal to the present value of its cash inflows. [C] internal rate of return (IRR) is greater than the firm's required rate of return. [D] present value of cash inflows is positive. [E] present value of cash inflows exceeds the investment's cost. [A] :This statement implies the NPV would be negative. Review section 9.1. [C] :If the NPV is zero, shouldn't the IRR be the same as the required rate of return? Review section 9.5. [D] :This statement ignores the initial investment. Review section 9.1. [E] :This statement implies the NPV would be positive. Review section 9.1.
5 14) Which one of the following is an advantage of a capital budgeting rule? [A] The payback rule ignores the time value of money. [B] The discounted payback rule requires a cutoff hurdle time period be set. [C] The profitability index is closely related to the net present value. [D] The average accounting return is based on accounting data. [E] There may be multiple internal rates of return for a given project [A] :This is a disadvantage, not an advantage. Review section 9.2. [B] :This is a disadvantage, not an advantage. Review section 9.3. [D] :This is a disadvantage, not an advantage. Review section 9.4. [E] :This is a disadvantage, not an advantage. Review section ) Consider a project with an initial investment and positive future cash flows. As the discount rate is increased the internal rate of return while the net present value [A] remains constant; increases. [B] decreases; remains constant. [C] remains constant; decreases. [D] increases; remains constant. [E] decreases; decreases. [A] :You are partially correct. What happens to present values as the discount rate is increased? Review section 9.1. [B] :Why would the IRR change in this case? What happens to present values as the discount rate is increased? Review sections 9.1 and 9.5. [D] :Why would the IRR change in this case? What happens to present values as the discount rate is increased?. Review sections 9.1 and 9.5. [E] :Why would the IRR change in this case? Review section ) From a financial point of view, which one of the following is a correct statement? [A] The internal rate of return is considered to be the best project analysis technique. [B] The average accounting return is preferable to the profitability index method. [C] Discounted payback analysis requires the use of a discount rate. [D] Internal rate of return is the preferred method for comparing mutually exclusive investments. [E] Regular payback analysis is preferable to discounted payback analysis. [A] :Is it the IRR that all of the other decision rules are compared to? Review sections 9.1 and 9.5. [B] :If the PI is closely related to NPV and if the NPV is considered best in principle, why is the AAR better than the PI? Review sections 9.4 and 9.6. [D] :The IRR should not be used for mutually exclusive investment decisions. Review section 9.5. [E] :Since discounted payback incorporates the time value of money and regular payback does not, discounted payback is preferable. Review sections 9.2 and 9.3.
6 17) Which one of the following decision rules is best for evaluating projects when distant cash flows and the time value of money are to be ignored? [A] payback [B] net present value [C] average accounting return [D] profitability index [E] internal rate of return [B] :NPV considers all cash flows in its calculation and considers the time value of money. Review section 9.1. [C] :This ignores the time value of money and is based on net income earned over the entire life of a project. Review section 9.4. [D] :The profitability index considers all cash flows in its calculation and considers the time value of money. Review section 9.6. [E] :The IRR considers all cash flows in its calculation and considers the time value of money. Review section ) Which one of the following statements is true concerning discounted payback analysis for projects which have conventional cash flows and for which the discount rate is positive? [A] Discounted payback is better than simple payback because in simple payback analysis the cutoff payback period is arbitrarily set by management. [B] Any project that never pays back on a discounted basis must have a positive net present value. [C] When comparing two projects, the one with the shorter payback period on a discounted basis will have the larger net present value. [D] Discounted payback is much simpler to calculate than regular payback. [E] The discounted payback period will be longer than the regular payback period. [A] :An arbitrary cutoff point must be set for both discounted and simple payback. Review sections 9.2 and 9.3. [B] :This type of project would have to have a negative NPV. Review section 9.3. [C] :Since the cash flows beyond the cutoff point are ignored by payback, you cannot draw any conclusions regarding the relative NPVs. Review section 9.3. [D] :The regular payback is easier to calculate since it doesn't require any discounting of cash flows. Review section ) You are considering the following two projects: Project : Year 0 : Year 1 : Year 2 : Year 3 A : $200 : $100 : $100 : $100 B : $300 : $175 : $125 : $125 Which of the following statements concerning these projects and the payback method of analysis are correct? I. With a payback cutoff of 1.5 years, both projects are unacceptable. II. With a payback cutoff of 3 years, both projects are acceptable. III. Since both projects pay back, the NPV of both must be positive. IV. Based on the payback criteria, you would be indifferent between the two. [A] I and II only
7 [B] III and IV only [C] I and IV only [D] I, III, and IV only [E] I, II, and IV only [A] :Correct, but there is at least one more correct option. Review section 9.2. [B] :At least one of these is incorrect. Review section 9.2. [C] :Correct, but there is at least one more correct option. Review section 9.2. [D] :At least one of these is incorrect. Review section ) An investment should be accepted if the net present value is positive. [B] :This is the correct statement of the net present value decision rule. Review section ) Which of the following questions are addressed in the capital budgeting process? I. What products or services will we offer or sell? II. In what markets will we compete? III. What new products will we introduce? [A] I only [B] III only [C] I and II only [D] I and III only [E] I, II, and III [A] :Correct, but there is at least one more correct option. Review the introduction to chapter 9. [B] :Correct, but there is at least one more correct option. Review the introduction to chapter 9. [C] :Correct, but why isn't choice III correct as well? Review the introduction to chapter 9. [D] :Correct, but why isn't choice II correct as well? Review the introduction to chapter 9. 22) Which of the following are problems associated with the internal rate of return? I. omission of time value of money considerations II. bias against longterm projects III. inability to rank mutually exclusive or different sized projects IV. multiple results if some future cash flows are negative [A] I and II only [B] I and III only [C] III and IV only [D] II and III only [E] II and IV only [A] :At least one of these is incorrect. Review section 9.5. [B] :At least one of these is incorrect. Review section 9.5.
8 [D] :At least one of these is incorrect. Review section 9.5. [E] :At least one of these is incorrect. Review section ) Which capital investment evaluation technique is described by the attributes below? 1. easy to understand and communicate 2. may result in multiple answers 3. may lead to incorrect decisions when applied to mutually exclusive investments [A] net present value [B] internal rate of return [C] average accounting return [D] payback [E] discounted payback [A] :None of these apply to the NPV rule. Review section 9.1. [C] :None of these apply to the AAR rule. Review section 9.4. [D] :The payback rule neither results in multiple answers nor leads to incorrect decisions in comparing mutually exclusive investments. Review section 9.2. [E] :The discounted payback rule neither results in multiple answers nor leads to incorrect decisions in comparing mutually exclusive investments. Review section ) If a project has conventional cash flows, it may also have more than one IRR. [A] :Projects with conventional cash flows have at most one IRR. Review section ) Which of the following consider the time value of money in their computation? I. payback II. average accounting return III. profitability index [A] I only [B] II only [C] III only [D] I and III only [E] II and III only [A] :This does not consider the time value of money. Review the disadvantages of this rule in section 9.2. [B] :This does not consider the time value of money. Review the disadvantages of this rule in section 9.4. [D] :At least one of these choices is incorrect. Review sections 9.2 and 9.6. [E] :At least one of these choices is incorrect. Review sections 9.4 and 9.6.
9 26) The essence of is determining whether a proposed investment or project will generate positive wealth for the owners of the firm once it is in place. [A] strategic asset allocation [B] capital structure analysis [C] cash flow analysis [D] payback analysis [E] working capital analysis [B] :This choice deals with how a firm is financed not the evaluation of investment opportunities. Review the introduction to chapter 9. [C] :This term is too general to fit the definition stated in the question. Review the introduction to chapter 9. [D] :Payback analysis does not investigate additions to stockholder wealth. Review the introduction to chapter 9. [E] :This choice deals with how a firm manages its shortterm resources, not the evaluation of investment opportunities. Review the introduction to chapter 9. 27) An investment's average net income divided by its average book value is called its: [A] payback. [B] discounted payback. [C] net present value. [D] internal rate of return. [E] average accounting return. [A] :This rule does not relate net income to book value. Review section 9.2. [B] :This rule does not relate net income to book value. Review section 9.3. [C] :This rule does not relate net income to book value. Review section 9.1. [D] :This rule does not relate net income to book value. Review section ) Suppose you are evaluating two mutually exclusive projects, A and B. Project A costs $350 and has cash flows of $250 and $250 in the next 2 years, respectively. B costs $300 and generates cash flows of $300 and $100. What is the crossover rate for these projects? [A] percent [B] percent [C] percent [D] percent [E] percent [A] :You need to review this calculation in section 9.5. [B] :You need to review this calculation in section 9.5. [D] :You need to review this calculation in section 9.5. [E] :You need to review this calculation in section 9.5.
10 29) Ranking conflicts can arise between the internal rate of return (IRR) and the net present value (NPV) when: [A] the first cash flow of a project is negative and the remaining cash flows are positive. [B] projects are independent of one another. [C] a project has more than one NPV. [D] projects are mutually exclusive. [E] the profitability index is greater than one. [A] :These cash flows are considered to be conventional. Doesn t the conflict occur when cash flows are not conventional? Review section 9.5. [B] :If projects are dependent, not independent, then ranking problems may occur. Review section 9.5. [C] :A project cannot have more than one NPV if there is only one required rate of return. Review section 9.1. [D] :You are correct! [E] :This will not create a ranking problem between the IRR and the NPV. Review section ) Which one of the following capital investment evaluation techniques uses readily available information in an easy to compute manner? [A] net present value [B] internal rate of return [C] average accounting return [D] payback period [E] discounted payback period [A] :The NPV is not easy to calculate and the required information normally has to be calculated. Review section 9.1. [B] :The IRR is not easy to calculate and the required information normally has to be calculated. Review section 9.5. [D] :While the payback computation is easy, the information required normally has to be calculated. Review section 9.2. [E] :The discounted payback is not easy to calculate and the required information normally has to be calculated. Review section ) You undertake a project with an initial investment of $10,000. You expect to receive $3,500 a year for the next 4 years. If the required return is 15 percent, what is the NPV? [A] $ [B] $32.48 [C] $7.58 [D] $4.63 [E] $5.49 [A] :You need to review this calculation in section 9.1. [B] :You need to review this calculation in section 9.1. [D] :You need to review this calculation in section 9.1. [E] :You need to review this calculation in section 9.1.
11 32) The use of which of the following could lead to incorrect decisions in comparing mutually exclusive investments? I. internal rate of return II. profitability index III. average accounting return [A] I only [B] II only [C] III only [D] I and II only [E] I and III only [A] :Correct, but there is another correct option also. Review sections 9.4 and 9.6. [B] :Correct, but there is another correct option also. Review sections 9.5 and 9.6. [C] :The inability to compare mutually exclusive investments is not a disadvantage of this decision rule. Review section 9.4. [D] :You are correct! [E] :At least one of these is incorrect. Review sections 9.4 and ) A project that requires an initial cash outlay after which all remaining cash flows are inflows is said to be: [A] independent. [B] conventional. [C] mutually exclusive. [D] valuecreating. [E] short term. [A] :This sentence does not describe an independent project. Review section 9.5. [C] :This sentence does not describe a mutually exclusive project. Review section 9.5. [D] :This sentence does not describe a valuecreating project. Review section 9.5. [E] :This sentence does not describe a shortterm project. Review section ) According to the 1999 capital budgeting survey cited in the text, most chief financial officers of U.S. firms: [A] prefer to rely exclusively on payback analysis to evaluate projects. [B] use the average accounting return as their primary method of evaluating capital budgeting projects. [C] who use payback analysis appear to use it only in conjunction with some other type of analysis. [D] prefer to use the profitability index to analyze their investment projects. [E] make use of payback analysis more heavily than discounted cash flow methods. [A] :There are other methods that are used more heavily than payback. Review section 9.7. [B] :The AAR is used as a primary method of evaluating projects by relatively few of these companies. Review section 9.7.
12 [D] :The PI is the least used of the methods listed. Review section 9.7. [E] :Both IRR and NPV, which are discounted cash flow methods, are preferred over payback. Review section ) Which capital investment evaluation technique is described by the attributes below? 1. closely related to net present value 2. easy to understand and communicate 3. may lead to incorrect decisions in comparing mutually exclusive investments 4. may be useful when the available investment funds are limited [A] discounted payback [B] internal rate of return [C] average accounting return [D] payback period [E] profitability index [A] :The discounted payback is useful for comparing mutually exclusive investments. Review section 9.3. [B] :The IRR does not have the advantage of being useful when investment funds are limited. Review section 9.5. [C] :The AAR does not fit these attributes. Review section 9.4. [D] :The payback period does not fit these attributes. Review section ) The following is a list of the primary disadvantages of which one of the following evaluation methods as compared to the net present value method? 1. ignores cash flows beyond the cutoff date 2. requires an arbitrary cutoff point 3. biased against longterm projects 4. may reject positive NPV projects [A] profitability index [B] internal rate of return [C] average accounting return [D] payback period [E] discounted payback period [A] :None of these are considered to be disadvantages of the PI rule. Review section 9.6. [B] :None of these are considered to be disadvantages of the IRR rule. Review section 9.5. [C] :The only item in this list that is a disadvantage of the AAR is the requirement of an arbitrary cutoff point. Review section 9.4. [D] :One of the primary disadvantages of this rule is that it ignores the time value of money, which is absent from this list. There is a better answer. Review section ) An advantage of the payback rule is that it is easy to understand.
13 [B] :Payback is a measure of how long it takes to recover the initial investment. Isn't that easy to understand? Review section ) A project costs $475 and has cash flows of $100 for the first three years and $75 in each of the project's last five years. What is the payback period of the project? [A] The project never pays back. [B] 4.75 years [C] 5.00 years [D] 5.33 years [E] 6.37 years [A] :Since the cash inflows over the life of the project total $675, it will pay back at some point. Review section 9.2. [B] :After 4.75 years, you have only recovered a total of $ Review section 9.2. [C] :After five years, you have only recovered a total of $450. Review section 9.2. [D] :You are correct! [E] :At the end of six years, the cash inflows total $525, so the project must pay back sometime prior to the end of the sixth year. Review section ) The management of a firm wishes to accept projects with a high degree of liquidity, avoid the higher forecasting error associated with distant cash flows, and avoid projects that require a large amount of research and development. The firm would be justified in using the rule to evaluate its projects. [A] internal rate of return [B] net present value [C] average accounting return [D] payback [E] profitability index [A] :The IRR does not possess these attributes as advantages. Review section 9.5. [B] :The NPV does not possess these attributes as advantages. Review section 9.1. [C] :The AAR does not possess these attributes as advantages. Review section 9.4. [D] :You are correct! [E] :The PI does not possess these attributes as advantages. Review section ) A manager will prefer the internal rate of return rule over the net present value rule if the manager: [A] prefers to talk in terms of rates of return. [B] can accurately forecast future cash flows. [C] dislikes discounting cash flows. [D] is considering different sized projects. [E] is considering mutually exclusive projects. [B] :This does not make the IRR preferable to the NPV. Review sections 9.1 and 9.5.
14 [C] :This does not impact upon the choice of the IRR versus the NPV. Review sections 9.1 and 9.5. [D] :Would you prefer earning $10 which is a 100 percent return on project A or earning $100 which is a 10 percent return on project B? Review sections 9.1 and 9.5. [E] :The NPV is preferred over the IRR when considering mutually exclusive investments. Review section ) According to the net present value (NPV) rule, a firm should accept a project if: [A] the estimated NPV is positive. [B] the estimated NPV exceeds the average accounting net income. [C] the estimated NPV exceeds a project's cost. [D] the NPV exceeds the firm's target accounting rate of return. [E] the NPV is negative. [B] :The NPV rule does not relate project cost to net income. Review section 9.1. [C] :You should review the computation of net present value. Review section 9.1. [D] :The NPV rule is not related in any way to the AAR. Review section 9.1. [E] :According to this choice the project should be rejected, not accepted. Review section ) Which one of the following factors can cause a project to have multiple IRRs? [A] a large initial cash outlay [B] an initial cash investment followed by positive cash flows for three years and a negative cash flow in the final year [C] negative cash flows in the first three years of a project but positive cash flows thereafter [D] conventional cash flows [E] mutually exclusive investments [A] :This will not lead to multiple IRRs. Review section 9.5. [C] :This will not lead to multiple IRRs since the sign on the cash flows changes only once. Review section 9.5. [D] :This will not cause multiple IRRs. Review section 9.5. [E] :This will not cause multiple IRRs. Review section ) Two projects that are mutually exclusive are said to be independent. [A] :Mutually exclusive choices are not independent from one another. Review section ) Which of the following are problems associated with payback analysis? I. omission of time value of money considerations II. bias against longterm projects
15 III. inability to rank mutually exclusive projects IV. multiple results when some future cash flows are negative [A] I and II only [B] II and III only [C] I, II, and IV only [D] I, II, and III only [E] I, II, III, and IV [B] :At least one of these is incorrect. Review section 9.2. [C] :At least one of these is incorrect. Review section 9.2. [D] :At least one of these is incorrect. Review section 9.2. [E] :At least one of these is incorrect. Review section ) You need to borrow $2,000 quickly and Morry, the neighborhood loan shark, will give it to you if you promise to repay him $ a month for the next year. From your viewpoint, what is the percentage cost of this transaction? [A] 1.0 percent per month [B] 1.7 percent per month [C] 2.0 percent per month [D] 2.5 percent per month [E] 3.0 percent per month [A] :From your viewpoint, the initial investment is $2,000 for a project that generates cash outflows of $ per month for twelve months. Review how to compute IRRs in section 9.5. [B] :From your viewpoint, the initial investment is $2,000 for a project that generates cash outflows of $ per month for twelve months. Review how to compute IRRs in section 9.5. [C] :From your viewpoint, the initial investment is $2,000 for a project that generates cash outflows of $ per month for twelve months. Review how to compute IRRs in section 9.5. [D] :From your viewpoint, the initial investment is $2,000 for a project that generates cash outflows of $ per month for twelve months. Review how to compute IRRs in section ) Which of the following methods can be used when choosing between mutually exclusive projects? I. AAR II. PI III. IRR IV. NPV [A] I only [B] II and III only [C] II and IV only [D] I and IV only [E] I and III only [A] :Correct, but there is at least one more correct option. Review sections 9.1, 9.5 and 9.6. [B] :Neither of these can be used for mutually exclusive investment decisions. Review sections 9.5 and 9.6.
16 [C] :At least one of these should not be used for mutually exclusive investment decisions. Review sections 9.1 and 9.6. [D] :You are correct! [E] :At least one of these should not be used for mutually exclusive investment decisions. Review section ) The is equal to the present value of an investment's future cash flows divided by its initial cost. [A] payback [B] profitability index [C] net present value [D] internal rate of return [E] average accounting return [A] :This rule ignores time value of money and therefore, does not relate the present value of the project s cash flows to the initial costs. Review section 9.2. [C] :A NPV is reported in dollars, not as a ratio of benefits to cost. Review section 9.1. [D] :An IRR is reported as a rate of return, not as a ratio of benefits to cost. Review section 9.5. [E] :This rule does not relate project cash flows to the initial cost. Review section ) Which of the following are problems associated with the profitability index? I. omission of time value of money considerations VI. bias against longterm projects III. inability to rank mutually exclusive projects IV. multiple results if some future cash flows are negative [A] I only [B] II only [C] III only [D] IV only [E] III and IV only [A] :This is not a problem associated with the profitability index. Review section 9.6. [B] :This is not a problem associated with the profitability index. Review section 9.6. [D] :This is not a problem associated with the profitability index. Review section 9.6. [E] :At least one of these is incorrect. Review section ) You need to borrow $2,000 quickly and Morry, the neighborhood loan shark, will give it to you if you promise to repay him $ a month for the next year. Suppose that Morry has more customers than funds. Which capital budgeting technique would allow him to rank his potential customers in order to maximize his current wealth? [A] average accounting return [B] payback period [C] profitability index [D] net present value [E] discounted payback
17 [A] :This is not the best technique for ranking projects when funds are limited. Review section 9.4. [B] :This is not the best technique for ranking projects when funds are limited. Review section 9.2. [D] :This is not the best technique for ranking projects when funds are limited. Review section 9.1. [E] :This is not the best technique for ranking projects when funds are limited. Review section ) A financial manager who consistently underestimates the will tend to incorrectly reject projects that would actually create wealth for the stockholders. [A] marginal income tax rate [B] initial cost of projects [C] future cash outlays associated with projects [D] required return on projects [E] future cash inflows associated with projects [A] :Underestimating this would actually lead managers to accept, not reject more projects. Review section 9.1. [B] :Underestimating this would actually lead managers to accept, not reject more projects. Review section 9.1. [C] :Underestimating this would actually lead managers to accept, not reject more projects. Review section 9.1. [D] :Underestimating this would actually lead managers to accept, not reject more projects. Review section ) Your firm needs to generate income from some unused equipment which the company owns. The president presents you with two options. First, you can sell the equipment or second, you can rent out the equipment. This is an example of a decision involving: [A] independent projects. [B] working capital projects. [C] positive NPV projects. [D] tax shields. [E] mutually exclusive projects. [A] :Can you simultaneously both rent and sell the equipment? Review section 9.5. [B] :This decision relates to fixed assets, not net working capital. Review section 9.5. [C] :The projects may have positive NPVs, but that is not the issue here. There is a better answer. Review section 9.5. [D] :Taxes are not the primary issue in this question. There is a better answer. Review section ) Which one of the following is computed using only accounting numbers?
18 [A] payback period [B] profitability index [C] net present value [D] internal rate of return [E] average accounting return [A] :This requires the use of cash flows, not accounting numbers. Review section 9.2. [B] :This requires the use of cash flows, not accounting numbers. Review section 9.6. [C] :This requires the use of cash flows, not accounting numbers. Review section 9.1. [D] :This requires the use of cash flows, not accounting numbers. Review section ) The is the length of time required for an investment's discounted cash flows to equal its initial cost. [A] payback [B] discounted payback [C] net present value [D] internal rate of return [E] average accounting return [A] :This rule ignores the time value of money. Review section 9.2. [C] :The NPV rule considers all project cash flows, not just the ones it takes to recover the initial investment in discounted terms. Review section 9.1. [D] :This is reported as a return in percentage points, not as a length of time. Review section 9.5. [E] :This rule does not relate cash flows to project cost. Review section ) Which one of the following decision rules has the advantage that the information needed for the computation is usually readily available? [A] net present value [B] internal rate of return [C] average accounting return [D] payback [E] discounted payback [A] :In this case the cash flows must be computed. Review section 9.1. [B] :In this case the cash flows must be computed. Review section 9.5. [D] :In this case the cash flows must be computed. Review section 9.2. [E] :In this case the cash flows must be computed. Review section ) An investment is acceptable if the internal rate of return (IRR) exceeds the required return. [B] :This is a correct statement of the IRR decision rule. Review section 9.5.
19 56) The net present value decision rule is considered a better overall method of project analysis than either the internal rate of return (IRR) or the profitability index (PI). [B] :Can you apply the IRR and PI rules to all projects? Review sections 9.1, 9.5 and ) One of the risks a firm takes when it uses the as the investment criterion for proposed projects is that it may reject some profitable projects because of the timing of their cash flows. [A] average accounting return [B] net present value [C] internal rate of return [D] profitability index [E] payback rule [A] :This rule is not based on cash flows. Review section 9.4. [B] :This rule requires all of a project's cash flows be considered. Review section 9.1. [C] :This rule requires all of a project's cash flows be considered. Review section 9.5. [D] :This rule requires all of a project's cash flows be considered. Review section ) A project with a net present value equal to zero: [A] should be rejected. [B] has a profitability index that is greater than one. [C] is expected to yield a return equal to the firm's required return. [D] has a discounted payback period that is shorter than the life of the project. [E] has an internal rate of return that exceeds the required rate. [A] :If the NPV is zero, you are indifferent about the project and should accept it absent other more desirable investment opportunities. Review section 9.1. [B] :Remember, the PI is the present value of the cash flows divided by the initial investment. If the NPV is zero, what must be true about the PI ratio? Review section 9.6. [D] :If the NPV is zero, the discounted payback is equal to the life of the project. Review section 9.3. [E] :What is the net present value when the IRR equals the required return? Review section ) If a project with conventional cash flows has a profitability index (PI) that is less than one, then the: [A] internal rate of return is greater than the required return. [B] discounted payback period is greater than the project's life.
20 [C] average accounting return is greater than the required return. [D] payback period is less than the maximum acceptable period. [E] net present value is positive. [A] :If the IRR exceeds the required return, isn't the PI greater than 1? Review sections 9.5 and 9.6. [C] :The AAR is not related to the PI and the required return. Review section 9.4. [D] :The payback period is not related to the profitability index. Review section 9.2. [E] :You need to review how to interpret the profitability index in section ) If the net present value (NPV) is greater than zero for a project with conventional cash flows, then the: [A] internal rate of return (IRR) is equal to the firm's required rate of return. [B] profitability index is greater than 1. [C] payback period is shorter than required by the firm. [D] average accounting return exceeds the internal rate of return. [E] the project does not pay back on a discounted basis. [A] :What is the NPV when the IRR is equal to the required return? Review section 9.5. [C] :The payback period does not relate directly to the NPV. Review section 9.2. [D] :The AAR does not relate directly to the IRR. Review sections 9.4 and 9.5. [E] :If a project s NPV is greater than zero, the project must pay back on a discounted basis at some point during its life. Review section ) A steep net present value (NPV) profile indicates that a project's NPV is very sensitive to changes in the cost of capital. [B] :This response implies that a large change in the required return will change this project's NPV very little. Is that what a steep NPV profile suggests? Review section ) The length of time required for an investment's undiscounted cash flows to equal its initial cost is called the: [A] payback. [B] discounted payback. [C] average accounting return. [D] profitability index. [E] net present value. [B] :This rule requires the use of discounted cash flows, not undiscounted cash flows as specified in the question. Review section 9.3. [C] :AAR compares net income and book values. Review section 9.4.
21 [D] :PI is not expressed in units of time. Review section 9.6. [E] :NPV is not expressed in units of time. Review section ) When multiple IRR's exist, a project must have a negative NPV at the highest IRR. [A] :By definition, what is the NPV at the IRR? Review section ) If the required return is zero and a project has conventional cash flows, then: [A] the payback period exceeds the discounted payback period. [B] the net present value equals the difference between the undiscounted future cash flows and the initial cash outlay. [C] if the net present value is negative, the internal rate of return will be greater than zero. [D] the profitability index will be less than one. [E] the project will be acceptable according to the average accounting return criteria. [A] :The two payback periods would be identical in this case. Review sections 9.2 and 9.3. [C] :If the NPV is negative at a required return of zero, then the NPV cannot be zero at any discount rate greater than zero. Review section 9.1. [D] :Even though the discount rate is zero, you can't draw any conclusions regarding the PI. Review section 9.6. [E] :The AAR does not relate to the cash flows and required return of a project. Review section ) Rank the following decision rules from worst to best in terms of their overall usefulness in capital budgeting analysis. I. NPV II. Payback III. IRR [A] II, III, I [B] II, I, III [C] III, I, II [D] I, III, II [E] III, II, I [B] :This ranking is irrational if only because the NPV is considered best in principle. Thus, it should be ranked last when ordering from worst to best. Review section 9.1. [C] :This ranking is irrational if only because the NPV is considered best in principle. Thus, it should be ranked last when ordering from worst to best. Review section 9.1. [D] :This ranking is irrational if only because the NPV is considered best in principle. Thus, it should be ranked last when ordering from worst to best. Review section 9.1. [E] :Review the disadvantages of the payback rule as compared to those of the IRR. Review sections 9.2 and 9.5.
22 66) Your boss presents you with two capital budgeting proposals. The first one involves buying a new delivery truck and the second one involves building additional warehouse space. Provided there are sufficient funds for both, this is an example: [A] of mutually exclusive projects. [B] of crossover analysis. [C] where the internal rate of return should not be used as an analytical tool. [D] of two independent projects. [E] where the net present value is unreliable as a decision making tool. [A] :How does acquiring a truck preclude you from acquiring more warehouse space? Review section 9.5. [B] :This response is not descriptive of this type of investment choice. Review section 9.5. [C] :Are these mutually exclusive projects? Review section 9.5. [D] :You are correct! [E] :Why can you not apply the net present value rule to this situation? Review section ) Which one of the following is based on net income rather than on cash flows? [A] profitability index [B] discounted payback [C] payback [D] average accounting return [E] internal rate of return [A] :PI uses cash flows. Review section 9.6. [B] :Discounted payback uses cash flows. Review section 9.3. [C] :Payback uses cash flows. Review section 9.2. [D] :You are correct! [E] :IRR uses cash flows. Review section ) What is the maximum number of internal rates of return (IRRs) that may exist for the following project? Yr0 = $50,000; Yr1 = $5,000; Yr2 = $50,000; Yr3 = $50,000; and Yr4 = $25,000? [A] 0 [B] 1 [C] 2 [D] 3 [E] 4 [A] :Since the signs on the cash flows change twice, negative to positive then positive back to negative, there can be at most 2 IRRs. Review section 9.5. [B] :Since the signs on the cash flows change twice, negative to positive then positive back to negative, there can be at most 2 IRRs. Review section 9.5. [D] :Since the signs on the cash flows change twice, negative to positive then positive back to negative, there can be at most 2 IRRs. Review section 9.5. [E] :Since the signs on the cash flows change twice, negative to positive then positive back to negative, there can be at most 2 IRRs. Review section 9.5.
23 69) If financial managers invest only in projects that have a profitability index greater than one then should increase. I. the value of the firm II. shareholder wealth III. share price [A] I only [B] II only [C] III only [D] I and III only [E] I, II, and III [A] :Correct, but there is at least one other correct option also. Review section 9.6. [B] :Correct, but there is at least one other correct option also. Review section 9.6. [C] :Correct, but there is at least one other correct option also. Review section 9.6. [D] :If the share price increases, why doesn t shareholder wealth also increase? Review section ) Suppose a firm invests $600 in a project. The initial cost is depreciated straightline to zero over 3 years. Net income from the project is $100, $125, and $140 in each of the three years of the project's life. What is the average accounting return? [A] percent [B] percent [C] percent [D] percent [E] percent [A] :To answer this, you must find the average net income and the average book value. Did you find the average book value to be $300? Review section 9.4. [B] :To answer this, you must find the average net income and the average book value. Did you find the average book value to be $300? Review section 9.4. [C] :To answer this, you must find the average net income and the average book value. Did you find the average book value to be $300? Review section 9.4. [D] :You are correct! [E] :To answer this, you must find the average net income and the average book value. Did you find the average book value to be $300? Review section ) Suppose you are considering a project that costs $300 and has expected cash flows of $110, $121 and $ over the next three years, respectively. If the appropriate discount rate is 10 percent, what is the net present value of this project? [A] $19.79 [B] $0.00 [C] $0.71 [D] $19.79 [E] $64.10
24 [A] :You need to review this calculation in section 9.1. [C] :You need to review this calculation in section 9.1. [D] :You need to review this calculation in section 9.1. [E] :You need to review this calculation in section ) The is the difference between an investment's present value and its cost. [A] payback [B] profitability index [C] net present value [D] internal rate of return [E] average accounting return [A] :Payback measures time not differences in dollar values. Review section 9.2. [B] :The profitability index is reported as a benefit to cost ratio, not as a dollar amount. Review section 9.6. [D] :The IRR is reported as a rate of return, not as a dollar value. Review section 9.5. [E] :This rule does not compare market values and costs. Review section ) Which of the following is (are) biased in favor of liquid investments? I. payback period II. average accounting return III. discounted payback [A] I only [B] III only [C] I and II only [D] I and III only [E] I, II, and III [A] :Correct, but there is at least one more correct option. Review sections 9.3 and 9.4. [B] :Correct, but there is at least one more correct option. Review sections 9.2 and 9.4. [C] :At least one of these choices is incorrect. Review sections 9.2 and 9.4. [D] :You are correct! [E] :At least one of these choices is incorrect. Review sections 9.2, 9.3 and ) You are comparing two projects using a net present value profile. At the point where the net present values (NPV) of the two projects are equal, the: [A] internal rate of return (IRR) of each project is equal to zero. [B] IRR of each project is equal to the cost of capital. [C] interest rate that makes the net present values equal is called the crossover rate. [D] projects will both have net present values equal to zero. [E] average accounting return (AAR) exceeds the cost of capital. [A] :Note that the problem states the NPVs will be equal, not necessarily zero. Review section 9.5.
25 [B] :Note that the problem states the NPVs will be equal, not necessarily zero. Review section 9.5. [D] :The NPVs can be equal and still be greater than or less than zero. Review section 9.5. [E] :The AAR is not related to the NPV. Review section ) The profitability index is computed using accounting income and accounting book values. [A] :This describes the average accounting return, not the profitability index. Review sections 9.4 and ) What is the internal rate of return (IRR) decision rule? [A] accept a project when the IRR is greater than zero [B] accept a project if at the IRR the NPV is positive [C] reject any project if the IRR is below 10 percent [D] accept a project if the IRR exceeds the firm's bank borrowing rate [E] accept a project if the IRR exceeds the firm's required rate of return [A] :How does this relate to the required rate of return? Review section 9.5. [B] :By definition, the NPV is zero at the IRR. Review section 9.5. [C] :How does this relate to the required rate of return? Review section 9.5. [D] :The IRR decision rule does not depend on a firm's bank borrowing rate. Review section ) You run a small bagel shop and are considering replacing your four sales clerks with automated machines that allow customers to buy their bagels without any human interaction. Of the following, the most difficult task you face in computing the net present value of this project is estimating the: [A] proposed reduction in wages. [B] tax shield of the new project. [C] cost of the new equipment that will be required. [D] cost of installing the new equipment. [E] total change in sales. [A] :This would be relatively easy since you already know what you are paying the four employees you would replace. Review section 9.1. [B] :This would be relatively easy to identify once you determine the cost of the new machines. Review section 9.1. [C] :You could get this information simply by calling an equipment dealer. Review section 9.1. [D] :You could get this information simply by getting a price quote from a contractor. Review section 9.1.
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