Unformatted text preview: Corporate Finance: The Core (Berk/DeMarzo) Chapter 6  Investment Decision Rules Total 23 Questions Use the information for the question(s) below. Boulderado has come up with a new composite snowboard. Development will take Boulderado four years and cost $250,000 per year, with the first of the four equal investments payable today upon acceptance of the project. Once in production the snowboard is expected to produce annual cash flows of $200,000 each year for 10 years. Boulderadoʹs discount rate is 10%. 1) The NPV for Boulderadoʹs snowboard project is closest to: A) $228,900 B) $46,900 C) $51,600 D) $23,800 6.2 Alternative Decision Rules 2) Which of the following statements is false? A) It is possible that an IRR does not exist for an investment opportunity. B) If the payback period is less than a prespecified length of time you accept the project C) The internal rate of return (IRR) investment rule is based upon the notion that if the return on other alternatives is greater than the return on the investment opportunity you should undertake the investment opportunity. D) It is possible that there is no discount rate that will set the NPV equal to zero. 3) Which of the following statements is false? A) The payback investment rule is based on the notion that an opportunity that pays back its initial investments quickly is a good idea. B) An IRR will always exist for an investment opportunity. C) A NPV will always exist for an investment opportunity. D) In general, there can be as many IRRs as the number of times the projectʹs cash flows change sign over time. 4) Which of the following statements is false? A) The IRR investment rule states you should turn down any investment opportunity where the IRR is less than the opportunity cost of capital. B) The IRR investment rule states that you should take any investment opportunity where the IRR exceeds the opportunity cost of capital. C) Since the IRR rule is based upon the rate at which the NPV equals zero, like the NPV decision rule, the IRR decision rule will always identify the correct investment decisions. D) There are situations in which multiple IRRs exist. 5) Which of the following statements is false? A) In general, the IRR rule works for a standalone project if all of the projectʹs positive cash flows precede its negative cash flows. B) There is no easy fix for the IRR rule when there are multiple IRRs. C) The payback rule is primarily used because of its simplicity. D) No investment rule that ignores the set of alternative investment alternatives can be optimal. 6) Which of the following statements is false? A) The payback rule is useful in cases where the cost of making an incorrect decision might not be large enough to justify the time required for calculating the NPV. B) The payback rule is reliable because it considers the time value of money and depends on the cost of capital. C) For most investment opportunities expenses occur initially and cash is received later. D) Fifty percent of firms surveyed reported using the payback rule for making decisions. Use the table for the question(s) below. Consider the following two projects: Year 0 Year 1 Year 2 Year 3 Year 4 Discount Project Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Rate A 100 40 50 60 N/A .15 B 73 30 30 30 30 .15 7) The payback period for project A is closest to: A) 2.0 years B) 2.4 years C) 2.5 years D) 2.2 years 8) The payback period for project B is closest to: A) 2.5 years B) 2.0 years C) 2.2 years D) 2.4 years 9) Which of the following statements is correct? A) You should accept project A since its IRR > 15% B) You should reject project B since its NPV > 0 C) Your should accept project A since its NPV < 0 D) You should accept project B since its IRR < 15% Use the table for the question(s) below. Consider the following two projects: Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Project C/F C/F C/F C/F C/F C/F Alpha 79 20 25 30 35 40 Beta 80 25 25 25 25 25 10) The payback period for project Alpha is closest to: A) 3.2 years B) 2.9 years C) 3.1 years Year 6 C/F N/A 25 Year 7 Discount C/F Rate N/A 15% 25 16% D) 2.6 years 11) The payback period for project beta is closest to: A) 2.9 years B) 3.1 years C) 2.6 years D) 3.2 years 12) Which of the following statements is correct? A) You should invest in project Beta since NPVBeta > 0 B) You should invest in project Alpha since IRRAlpha > IRRBeta C) Your should invest i project Alpha since NPVAlpha < 0 D) You should invest in project Beta since IRRBeta > 0 Use the information for the question(s) below. Larry the Cucumber has been offered $14 million to star in the lead role of the next three Larry Boy adventure movies. If Larry takes this offer, he will have to forgo acting in other Veggie movies that would pay him $5 million at the end of each of the next three years. Assume Larryʹs personal cost of capital is 10% per year. 13) Larry should: A) Reject the offer because the NPV < 0 B) Accept the offer even though the IRR < 10%, because the NPV > 0 C) Reject the offer because the IRR < 10% D) Accept the offer because the IRR > 0% You are considering an investment in an everlasting gobstopper machine. This machine will cost $10 million 14) and will produce cash flows of $1 million and the end of every year forever. The appropriate cost of capital is 8%. Compute the economic value added (EVA) for this project. The PV of the EVAs for this project is. a) 2.4 b) 2.6 c) 2.5 d) 2.2 : 15) You are considering purchasing a new automated forklift system for your firmʹs warehouse. The automated forklift will cost $500,000 and generate cash flows of $125,000 per year. The forklift will depreciate evenly over the five years, at which point it must be replaced. The cost of capital is 8% per year. Based upon the EVA investment rule, should you invest in the automated forklift? a) Yes, EVA is 1.05 b) Yes, EVA is 0.91 c) No, EVA is ‐1.05 d) No, EVA is ‐0.91 6.3 Mutually Exclusive Investment Opportunities 16) Which of the following statements is false? A) Problems can arise using the IRR method when the mutually exclusive investments have different cash flow patterns. B) The IRR is affected by the scale of the investment opportunity. C) Multiple incremental IRRs might exist. D) The incremental IRR rule assumes that the riskiness of the two projects is the same. 17) Which of the following statements is false? A) The incremental IRR investment rule applies the IRR rule to the difference between the cash flows of the two mutually exclusive alternatives. B) When a manager must choose among mutually exclusive investments, the NPV rule provides a straightforward answer. C) The likelihood of multiple IRRs is greater with the regular IRR rule than with the incremental IRR rule. D) Problems can arise using the IRR method when the mutually exclusive investments have differences in scale. Use the table for the question(s) below. Consider the following two projects: Year 0 Year 1 Year 2 Year 3 Year 4 Discount Project Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Rate A 100 40 50 60 N/A .15 B 73 30 30 30 30 .15 18) Assume that projects A and B are mutually exclusive. The correct investment decision and the best rational for that decision is to? A) Invest in project A since NPVB < NPVA B) Invest in project B since IRRB > IRRA C) Invest in project B since NPVB > NPVA D) Invest in project A since NPVA > 0 19) The incremental IRR of Project B over Project A is closest to: A) 12.6% B) 23.3% C) 1.7% D) 17.3% Use the table for the question(s) below. Consider the following two projects: Project Alpha Beta 20) Assume that projects Alpha and Beta are mutually exclusive. The correct investment decision and the best rational for that decision is to? A) Invest in project Beta since NPVBeta > 0 B) Invest in project Alpha since NPVBeta < NPVAlpha C) Invest in project Beta since IRRB > IRRA D) Invest in project Beta since NPVBeta > NPVAlpha > 0 Use the table for the question(s) below. Consider two mutually exclusive projects with the following cash flows: C/F0 C/F1 C/F2 C/F3 C/F4 C/F5 C/F6 Project A $(41,215) $12,500 $14,000 $16,500 $18,000 20,000 N/A B $(46,775) $15,000 $15,000 $15,000 $15,000 $15,000 $15,000 WS1) You are considering using the incremental IRR approach to decide between the two mutually exclusive projects A & B. How many potential incremental IRRs could there be? A) 3 B) 0 C) 2 D) 1 Answer: A C/F0 C/F1 C/F2 C/F3 C/F4 C/F5 C/F6 Explanation: A) roject P
A B B  A ($41,215) $12,500 $14,000 $16,500 $18,000 20,000 0 ($46,775) $15,000 $15,000 $15,000 $15,000 $15,000 $15,000 ($5,560) $2,500 $1,000 ($1,500) ($3,000) ($5,000) $15,000 Year 0 C/F 79 80 Year 1 C/F 20 25 Year 2 C/F 25 25 Year 3 C/F 30 25 Year 4 C/F 35 25 Year 5 C/F 40 25 Year 6 C/F N/A 25 Year 7 Discount C/F Rate N/A 15% 25 16% Note that there are three sign changes hence there potential IRRs. B) C) D) WS2) What is the incremental IRR for project B over project A? Would you feel comfortable basing your decision on the incremental IRR? C/F0 C/F1 C/F2 C/F3 C/F4 C/F5 C/F6 Answer: Project
A B B  A ($41,215) $12,500 $14,000 $16,500 $18,000 20,000 0 ($46,775) $15,000 $15,000 $15,000 $15,000 $15,000 $15,000 ($5,560) $2,500 $1,000 ($1,500) ($3,000) ($5,000) $15,000 Compute IRR = 8.95%, no since there are multiple sign changes in the incremental cash flows. WS3) Assuming that the discount rate for project A is 16% and the discount rate for B is 15%, then given that these are mutually exclusive projects, which project would you take and why? Answer: NPV A CF0 = 41,215 CF1 = 12,500 CF2 = 14,000 CF3 = 16,500 CF4 = 18,000 CF5 = 20,000 I = 16 Compute NPV = $9,999.50 NPV B CF0 = 46,775 CF1 = 15,000 CF2 = 15,000 CF3 = 15,000 CF4 = 15,000 CF5 = 15,000 CF6 = 15,000 Compute NPV = $9,9992.24 Take A, since NPV of A > NPV of B and both are positive. 6.4 Project Selection with Resource Restraints Use the table for the question(s) below. Consider the following list of projects: Project A B C D E F G H I Investment 135,000 200,000 125,000 150,000 175,000 75,000 80,000 200,000 50,000 NPV 6,000 30,000 20,000 2,000 10,000 10,000 9,000 20,000 4,000 21) Assuming that your capital is constrained, what is the fifth project that you should invest in? A) Project H B) Project I C) Project B D) Project A 22) Assuming that your capital is constrained, so that you only have $600,000 available to invest in projects, which project should you invest in and in what order? A) CBFH B) CBGF C) BCFG D) CBFG 23) Assume that your capital is constrained, so that you only have $600,000 available to invest in projects. If you invest in the optimal combination of projects given your capital constraint, then the total NPV for all the projects you invest in will be closest to: A) $65,000 B) $80,000 C) $69,000 D) $111,000 ...
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