1. Which of the following statements is CORRECT?
a. The internal rate of return method (IRR) is
generally regarded by academics as being the best single method for evaluating
capital budgeting projects.
b. The payback method is generally regarded by academics
as being the best single method for evaluating capital budgeting projects.
c. The discounted payback method is generally regarded
by academics as being the best single method for evaluating capital budgeting
projects.
d. The net present value method (NPV) is generally
regarded by academics as being the best single method for evaluating capital
budgeting projects.
e. The modified internal rate of return method (MIRR)
is generally regarded by academics as being the best single method for
evaluating capital budgeting projects.
2. Projects A and B have identical expected lives and
identical initial cash outflows (costs). However, most of one project’s cash
flows come in the early years, while most of the other project’s cash flows
occur in the later years. The two NPV profiles are given below:
Which of the following statements is CORRECT?
a. More of Project A’s cash flows occur in the later
years.
b. More of Project B’s cash flows occur in the later
years.
c. We must have information on the cost of capital in
order to determine which project has the larger early cash flows.
d. The NPV profile graph is inconsistent with the
statement made in the problem.
e. The crossover rate, i.e., the rate at which
Projects A and B have the same NPV, is greater than either project’s IRR.
3. Suppose a firm relies exclusively on the payback
method when making capital budgeting decisions, and it sets a 4-year payback
regardless of economic conditions. Other things held constant, which of the
following statements is most likely to be true?
a. It will accept too many short-term projects and
reject too many long-term projects (as judged by the NPV).
b. It will accept too many long-term projects and
reject too many short-term projects (as judged by the NPV).
c. The firm will accept too many projects in all
economic states because a 4-year payback is too low.
d. The firm will accept too few projects in all
economic states because a 4-year payback is too high.
e. If the 4-year payback results in accepting just the
right set of projects under average economic conditions, then this payback will
result in too few long-term projects when the economy is weak.
4. You are on the staff of Camden Inc. The CFO
believes project acceptance should be based on the NPV, but Steve Camden, the
president, insists that no project should be accepted unless its IRR exceeds
the project’s risk-adjusted WACC. Now you must make a recommendation on a
project that has a cost of $15,000 and two cash flows: $110,000 at the end of
Year 1 and -$100,000 at the end of Year 2. The president and the CFO both agree
that the appropriate WACC for this project is 10%. At 10%, the NPV is
$2,355.37, but you find two IRRs, one at 6.33% and one at 527%, and a MIRR of
11.32%. Which of the following statements best describes your optimal
recommendation, i.e., the analysis and recommendation that is best for the
company and least likely to get you in trouble with either the CFO or the
president?
a. You should recommend that the project be rejected
because its NPV is negative and its IRR is less than the WACC.
b. You should recommend that the project be rejected
because, although its NPV is positive, it has an IRR that is less than the
WACC.
c. You should recommend that the project be accepted
because (1) its NPV is positive and (2) although it has two IRRs, in this case
it would be better to focus on the MIRR, which exceeds the WACC. You should
explain this to the president and tell him that the firm’s value will increase
if the project is accepted.
d. You should recommend that the project be rejected.
Although its NPV is positive it has two IRRs, one of which is less than the
WACC, which indicates that the firm’s value will decline if the project is
accepted.
e. You should recommend that the project be rejected
because, although its NPV is positive, its MIRR is less than the WACC, and that
indicates that the firm’s value will decline if it is accepted.
5. A firm is considering Projects S and L, whose cash
flows are shown below. These projects are mutually exclusive, equally risky,
and not repeatable. The CEO wants to use the IRR criterion, while the CFO
favors the NPV method. You were hired to advise the firm on the best procedure.
If the wrong decision criterion is used, how much potential value would the
firm lose?
WACC: 6.00%
Year 0 1 2 3 4
CFS -$1,025 $380 $380 $380 $380
CFL -$2,150 $765 $765 $765 $765
a. $188.68
b. $198.61
c. $209.07
d. $219.52
e. $230.49
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