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FIN 350
Sample Test for the Final Examination
Ch. 11: Capital Budgeting
1. Which of the following statements is most correct?
a.
If a project’s internal rate of return (IRR) exceeds the cost of capital, then the
project’s net present value (NPV) must be positive.
b.
If Project A has a higher IRR than Project B, then Project A must also have a
higher NPV.
c.
The IRR calculation implicitly assumes that all cash flows are reinvested at a rate
of return equal to the cost of capital.
d.
Statements a and c are correct.
e.
None of the statements above is correct.
Solution:
1. NPV and IRR
Answer: a
Diff: E
Statement a is true; the other statements are false.
If the projects are mutually exclusive, then project B
may have a higher NPV even though Project A has a higher IRR.
IRR is calculated assuming cash
flows are reinvested at the IRR, not the cost of capital.
2. Which of the following statements is most correct?
a.
The NPV method assumes that cash flows will be reinvested at the cost of capital,
while the IRR method assumes reinvestment at the IRR.
b.
The NPV method assumes that cash flows will be reinvested at the risk-free rate,
while the IRR method assumes reinvestment at the IRR.
c.
The NPV method assumes that cash flows will be reinvested at the cost of capital,
while the IRR method assumes reinvestment at the risk-free rate.
d.
The NPV method does not consider the inflation premium.
e.
The IRR method does not consider all relevant cash flows, particularly, cash
flows beyond the payback period.
Solution:
2. Ranking conflicts
Answer: a
Diff: E
3. O’Leary Lumber Company is considering two mutually exclusive projects, Project X and Project Y.
The two
projects have normal cash flows (an up-front cost followed by a series of positive cash flows), the same risk, and
the same 10 percent WACC.
However, Project X has an IRR of 16 percent, while Project Y has an IRR of 14
percent.
Which of the following statements is most correct?
a.
Project X’s NPV must be positive.
b.
Project X’s NPV must be higher than Project Y’s NPV.
c.
If Project X has a lower NPV than Project Y, then this means that Project X must be a larger
project.
d.
Statements a and c are correct.
e.
All of the statements above are correct.

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Solution:
3.
NPV profiles
Answer: a
Diff: M
N
The correct answer is statement a.
The IRR of Project X exceeds its weighted average cost of capital;
therefore, the project has a positive net present value.
Statement b is incorrect; we do not know where the
crossover point is (if one exists) for these two projects.
Statement c is also incorrect; if anything, existing
information would suggest that Project X was the smaller project.
In addition, the lower NPV could be
the product of the timing of cash flows or the length of the project’s life.
4.

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