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Exam 10: The Basics of Capital Budgeting: Evaluating Cash Flows

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Question 21

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Which of the following statements is CORRECT?

A) The NPV method was once the favorite of academics and business executives, but today most authorities regard the MIRR as being the best indicator of a project's profitability.
B) If the cost of capital declines, this lowers a project's NPV.
C) The NPV method is regarded by most academics as being the best indicator of a project's profitability; hence, most academics recommend that firms use only this one method.
D) A project's NPV depends on the total amount of cash flows the project produces, but because the cash flows are discounted at the WACC, it does not matter if the cash flows occur early or late in the project's life.
E) The NPV and IRR methods may give different recommendations regarding which of two mutually exclusive projects should be accepted, but they always give the same recommendation regarding the acceptability of a normal, independent project.

F) A) and B)
G) A) and D)

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Question 22

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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.

F) D) and E)
G) B) and D)

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Question 23

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Taggart Inc. is considering a project that has the following cash flow data. What is the project's payback?

The NPV method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital.

The NPV and IRR methods, when used to evaluate two independent and equally risky projects, will lead to different accept/reject decisions and thus capital budgets if the projects' IRRs are greater than their cost of capital.

Which of the following statements is CORRECT?

Susmel Inc. is considering a project that has the following cash flow data. What is the project's payback?

Ehrmann Data Systems is considering a project that has the following cash flow and WACC data. What is the project's MIRR? Note that a project's MIRR can be less than the WACC (and even negative) , in which case it will be rejected.

Projects S and L both have normal cash flows, and the projects have the same risk, hence both are evaluated with the same WACC, 10%. However, S has a higher IRR than L. Which of the following statements is CORRECT?

Fernando Designs is considering a project that has the following cash flow and WACC data. What is the project's discounted payback?

Moerdyk & Co. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under certain conditions choosing projects on the basis of the IRR will not cause any value to be lost because the project with the higher IRR will also have the higher NPV, i.e., no conflict will exist.

Assuming that their NPVs based on the firm's cost of capital are equal, the NPV of a project whose cash flows accrue relatively rapidly will be more sensitive to changes in the discount rate than the NPV of a project whose cash flows come in later in its life.

The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects that have different lives are compared to one another.

The NPV and IRR methods, when used to evaluate two equally risky but mutually exclusive projects, will lead to different accept/reject decisions and thus capital budgets if the cost of capital at which the projects' NPV profiles cross is less than the projects' cost of capital.

Normal Projects S and L have the same NPV when the discount rate is zero. However, Project S's cash flows come in faster than those of L. Therefore, we know that at any discount rate greater than zero, L will have the higher NPV.

One advantage of the payback method for evaluating potential investments is that it provides information about a project's liquidity and risk.

Project X's IRR is 19% and Project Y's IRR is 17%. The projects have the same risk and the same lives, and each has constant cash flows during each year of their lives. If the WACC is 10%, Project Y has a higher NPV than X. Given this information, which of the following statements is CORRECT?

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.

When considering two mutually exclusive projects, the firm should always select the project whose internal rate of return is the highest, provided the projects have the same initial cost. This statement is true regardless of whether the projects can be repeated or not.

Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method ranks the other one first. In theory, such conflicts should be resolved in favor of the project with the higher positive NPV.