FIN 534 Quiz 6 week 7
Rating A
Question 1
Which of the following statements is CORRECT?
Answer
One advantage of the NPV over the IRR is that NPV takes account of cash flows over a project’s full life whereas IRR does not.
One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at the WACC, whereas IRR assumes that cash flows are reinvested at the IRR. The NPV assumption is generally more appropriate.
One advantage of the NPV over the MIRR method is that NPV takes account of cash flows over a project’s full life whereas MIRR does not.
One advantage of the NPV over the MIRR method is that NPV discounts cash flows whereas the MIRR is based on undiscounted cash flows.
Since cash flows under the IRR and MIRR are both discounted at the same rate (the WACC), these two methods always rank mutually exclusive projects in the same order.
2 points
Question 2
Westchester Corp. is considering two equally risky, mutually exclusive projects, both of which have normal cash flows. Project A has an IRR of 11%, while Project B’s IRR is 14%. When the WACC is 8%, the projects have the same NPV. Given this information, which of the following statements is CORRECT?
Answer
If the WACC is 13%, Project A’s NPV will be higher than Project B’s.
f the WACC is 9%, Project A’s NPV will be higher than Project B’s.
If the WACC is 6%, Project B’s NPV will be higher than Project A’s.
If the WACC is greater than 14%, Project A’s IRR will exceed Project B’s.
If the WACC is 9%, Project B’s NPV will be higher than Project A’s.
Question 3
Four of the following statements are truly disadvantages of the regular payback method, but one is not a disadvantage of this method. Which one is NOT
a disadvantage of the payback method?
Answer
Lacks an objective, market-determined benchmark for making decisions.
Ignores cash flows beyond the payback period.
Does not directly account for the time value of money.
Does not provide any indication regarding a project’s liquidity or risk.
Does not take account of differences in size among projects.
2 points
Question 4
Projects S and L are equally risky, mutually exclusive, and have normal cash flows. Project S has an IRR of 15%, while Project L’s IRR is 12%. The two projects have the same NPV when the WACC is 7%. Which of the following statements is CORRECT?
Answer
If the WACC is 10%, both projects will have positive NPVs.
If the WACC is 6%, Project S will have the higher NPV.
If the WACC is 13%, Project S will have the lower NPV.
If the WACC is 10%, both projects will have a negative NPV.
Project S’s NPV is more sensitive to changes in WACC than Project L’s.
Question 5
Assume that the economy is enjoying a strong boom, and as a result interest rates and money costs generally are relatively high. The WACC for two mutually exclusive projects that are being considered is 12%. Project S has an IRR of 20% while Project L’s IRR is 15%. The projects have the same NPV at the 12% current WACC. However, you believe that the economy will soon fall into a mild recession, and money costs and thus your WACC will soon decline. You also think that the projects will not be funded until the WACC has decreased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT?
Answer
You should reject both projects because they will both have negative NPVs under the new conditions.
You should delay a decision until you have more information on the projects, even if this means that a competitor might come in and capture this market.
You should recommend Project L, because at the new WACC it will have the higher NPV.
You should recommend Project S, because at the new WACC it will have the higher NPV.
You should recommend Project L because it will have both a higher IRR and a higher NPV under the new conditions.
2 points
Question 6
Which of the following statements is CORRECT?
Answer
The MIRR and NPV decision criteria can never conflict.
The IRR method can never be subject to the multiple IRR problem, while the MIRR method can be.
One reason some people prefer the MIRR to the regular IRR is that the MIRR is based on a generally more reasonable reinvestment rate assumption.
The higher the WACC, the shorter the discounted payback period.
The MIRR method assumes that cash flows are reinvested at the crossover rate.
Question 7
Which of the following statements is CORRECT?
Answer
The NPV, IRR, MIRR, and discounted payback (using a payback requirement of 3 years or less) methods always lead to the same accept/reject decisions for independent projects.
For mutually exclusive projects with normal cash flows, the NPV and MIRR methods can never conflict, but their results could conflict with the discounted payback and the regular IRR methods.
Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the regular IRR.
If a firm uses the discounted payback method with a required payback of 4 years, then it will accept more projects than if it used a regular payback of 4 years.
The percentage difference between the MIRR and the IRR is equal to the project’s WACC.
2 points
Question 8
Which of the following statements is CORRECT?
Answer
The shorter a project’s payback period, the less desirable the project is normally considered to be by this criterion.
One drawback of the regular payback is that this method does not take account of cash flows beyond the payback period.
If a project’s payback is positive, then the project should be accepted because it must have a positive NPV.
The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem.
One drawback of the discounted payback is that this method does not consider the time value of money, while the regular payback overcomes this drawback.
Question 9
Which of the following statements is CORRECT?
Answer
The IRR method appeals to some managers because it gives an estimate of the rate of return on projects rather than a dollar amount, which the NPV method provides.
The discounted payback method eliminates all of the problems associated with the payback method.
When evaluating independent projects, the NPV and IRR methods often yield conflicting results regarding a project’s acceptability.
To find the MIRR, we discount the TV at the IRR.
A project’s NPV profile must intersect the X-axis at the project’s WACC.
2 points
Question 10
Which of the following statements is CORRECT?
Answer
The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.
The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR.
The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate.
The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
Question 11
Assume that the economy is in a mild recession, and as a result interest rates and money costs generally are relatively low. The WACC for two mutually exclusive projects that are being considered is 8%. Project S has an IRR of 20% while Project L’s IRR is 15%. The projects have the same NPV at the 8% current WACC. However, you believe that the economy is about to recover, and money costs and thus your WACC will also increase. You also think that the projects will not be funded until the WACC has increased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT?
Answer
You should reject both projects because they will both have negative NPVs under the new conditions.
You should delay a decision until you have more information on the projects, even if this means that a competitor might come in and capture this market.
You should recommend Project L, because at the new WACC it will have the higher NPV.
You should recommend Project S, because at the new WACC it will have the higher NPV.
You should recommend Project S because it has the higher IRR and will continue to have the higher IRR even at the new WACC.
2 points
Question 12
Which of the following statements is CORRECT?
Answer
One defect of the IRR method is that it does not take account of cash flows over a project’s full life.
One defect of the IRR method is that it does not take account of the time value of money.
One defect of the IRR method is that it does not take account of the cost of capital.
One defect of the IRR method is that it values a dollar received today the same as a dollar that will not be received until sometime in the future.
One defect of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid.
Question 13
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
Answer
A project’s NPV is generally found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting the TV at the IRR to find its PV.
The higher the WACC used to calculate the NPV, the lower the calculated NPV will be.
If a project’s NPV is greater than zero, then its IRR must be less than the WACC.
If a project’s NPV is greater than zero, then its IRR must be less than zero.
The NPVs of relatively risky projects should be found using relatively low WACCs.
2 points
Question 14
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
Answer
The longer a project’s payback period, the more desirable the project is normally considered to be by this criterion.
One drawback of the regular payback for evaluating projects is that this method does not properly account for the time value of money.
If a project’s payback is positive, then the project should be rejected because it must have a negative NPV.
The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem.
If a company uses the same payback requirement to evaluate all projects, say it requires a payback of 4 years or less, then the company will tend to reject projects with relatively short lives and accept long-lived projects, and this will cause its risk to increase over time.
Question 15
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
Answer
A project’s regular IRR is found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting this TV at the WACC.
A project’s regular IRR is found by discounting the cash inflows at the WACC to find the present value (PV), then compounding this PV to find the IRR.
If a project’s IRR is greater than the WACC, then its NPV must be negative.
To find a project’s IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project’s costs.
To find a project’s IRR, we must find a discount rate that is equal to the WACC.
2 points
Question 16
Which of the following statements is CORRECT?
Answer
An externality is a situation where a project would have an adverse effect on some other part of the firm’s overall operations. If the project would have a favorable effect on other operations, then this is not an externality.
An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank’s other offices to increase.
The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV.
Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not.
Identifying an externality can never lead to an increase in the calculated NPV.
Question 17
Which of the following statements is CORRECT?
Answer
A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.
A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project.
A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project.
Sunk costs were formerly hard to deal with but now that the NPV method is widely used, it is possible to simply include sunk costs in the cash flows and then calculate the PV of the project.
A good example of a sunk cost is a situation where Home Depot opens a new store, and that leads to a decline in sales of one of the firm’s existing stores.
2 points
Question 18
Which of the following statements is CORRECT?
Answer
An example of a sunk cost is the cost associated with restoring the site of a strip mine once the ore has been depleted.
Sunk costs must be considered if the IRR method is used but not if the firm relies on the NPV method.
A good example of a sunk cost is a situation where a bank opens a new office, and that new office leads to a decline in deposits of the bank’s other offices.
A good example of a sunk cost is money that a banking corporation spent last year to investigate the site for a new office, then expensed that cost for tax purposes, and now is deciding whether to go forward with the project.
If sunk costs are considered and reflected in a project’s cash flows, then the project’s calculated NPV will be higher than it otherwise would be.
Question 19
Which of the following statements is CORRECT?
Answer
In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project’s cash flows will lead to an upward
bias in the NPV.
In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project’s cash flows will lead to a downward
bias in the NPV.
The existence of any type of “externality” will reduce the calculated NPV versus the NPV that would exist without the externality.
If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net after-tax proceeds that could be obtained should be charged as a cost to the project under consideration.
If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored.
2 points
Question 20
Which of the following statements is CORRECT?
Answer
Sensitivity analysis is a good way to measure market risk because it explicitly takes into account diversification effects.
One advantage of sensitivity analysis relative to scenario analysis is that it explicitly takes into account the probability of specific effects occurring, whereas scenario analysis cannot account for probabilities.
Well-diversified stockholders do not need to consider market risk when determining required rates of return.
Market risk is important, but it does not have a direct effect on stock prices because it only affects beta.
Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions.
Question 21
Which of the following factors should be included in the cash flows used to estimate a project’s NPV?
Answer
All costs associated with the project that have been incurred prior to the time the analysis is being conducted.
Interest on funds borrowed to help finance the project.
The end-of-project recovery of any working capital required to operate the project.
Cannibalization effects, but only if those effects increase the project’s projected cash flows.
Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes.
2 points
Question 22
Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project?
Answer
The new project is expected to reduce sales of one of the company’s existing products by 5%.
Since the firm’s director of capital budgeting spent some of her time last year to evaluate the new project, a portion of her salary for that year should be charged to the project’s initial cost.
The company has spent and expensed $1 million on R&D associated with the new project.
The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project.
The firm would borrow all the money used to finance the new project, and the interest on this debt would be $1.5 million per year.
Question 23
The relative risk of a proposed project is best accounted for by which of the following procedures?
Answer
Adjusting the discount rate upward if the project is judged to have above-average risk.
Adjusting the discount rate downward if the project is judged to have above-average risk.
Reducing the NPV by 10% for risky projects.
Picking a risk factor equal to the average discount rate.
Ignoring risk because project risk cannot be measured accurately.
2 points
Question 24
Rowell Company spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale or for a new product. Rowell owns the building free and clear–there is no mortgage on it. Which of the following statements is CORRECT?
Answer
Since the building has been paid for, it can be used by another project with no additional cost. Therefore, it should not be reflected in the cash flows for any new project.
If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it.
This is an example of an externality, because the very existence of the building affects the cash flows for any new project that Rowell might consider.
Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new projects.
If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project that used the building.
Question 25
Suppose Tapley Inc. uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Tapley accept, assuming that the company uses the NPV method when choosing projects?
Answer
Project A, which has average risk and an IRR = 9%.
Project B, which has below-average risk and an IRR = 8.5%.
Project C, which has above-average risk and an IRR = 11%.
Without information about the projects’ NPVs we cannot determine which project(s) should be accepted.
All of these projects should be accepted.
2 points
Question 26
Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product?
Answer
Using some of the firm’s high-quality factory floor space that is currently unused to produce the proposed new product. This space could be used for other products if it is not used for the project under consideration.
Revenues from an existing product would be lost as a result of customers switching to the new product.
Shipping and installation costs associated with a machine that would be used to produce the new product.
The cost of a study relating to the market for the new product that was completed last year. The results of this research were positive, and they led to the tentative decision to go ahead with the new product. The cost of the research was incurred and expensed for tax purposes last year.
It is learned that land the company owns and would use for the new project, if it is accepted, could be sold to another firm.
Question 27
Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product?
Answer
A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes.
A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm’s current products.
A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery.
A firm has spent $2 million on R&D associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected.
A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm’s other products.
2 points
Question 28
A company is considering a new project. The CFO plans to calculate the project’s NPV by estimating the relevant cash flows for each year of the project’s life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flow), then discounting those cash flows at the company’s overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows?
Answer
All sunk costs that have been incurred relating to the project.
All interest expenses on debt used to help finance the project.
The investment in working capital required to operate the project, even if that investment will be recovered at the end of the project’s life.
Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year.
Effects of the project on other divisions of the firm, but only if those effects lower the project’s own direct cash flows.
Question 29
When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT:
Answer
Changes in net working capital attributable to the project.
Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes.
The value of a building owned by the firm that will be used for this project.
A decline in the sales of an existing product, provided that decline is directly attributable to this project.
The salvage value of assets used for the project that will be recovered at the end of the project’s life.
2 points
Question 30
Which of the following statements is CORRECT?
Answer
Using accelerated depreciation rather than straight line would normally have no effect on a project’s total projected cash flows but it would affect the timing of the cash flows and thus the NPV.
Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer.
Corporations must use the same depreciation method (e.g., straight line or accelerated) for stockholder reporting and tax purposes.
Since depreciation is not a cash expense, it has no effect on cash flows and thus no effect on capital budgeting decisions.
Under accelerated depreciation, higher depreciation charges occur in the early years, and this reduces the early cash flows and thus lowers a project’s projected NPV.
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