Chapter09 - CHAPTER 9 Capital Budgeting Techniques and...

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: CHAPTER 9 Capital Budgeting Techniques and Practice Multiple Choice: Conceptual Ranking methods 1. Answer: b Assume a project has normal cash flows (i.e., the initial cash flow is negative, and all other cash flows are positive). Which of the following statements is most correct? a. All else equal, a declines. b. All else equal, a declines. c. All else equal, a cost of capital. d. Answers a and b are e. Answers b and c are project's IRR increases as the cost of capital project's NPV increases as the cost of capital project's MIRR is unaffected by changes in the correct. correct. Ranking conflicts 2. Diff: E Answer: a Diff: E 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, and particularly cash flows beyond the payback period. Payback period 3. Answer: e Diff: E A major disadvantage of the payback period method is that it a. b. c. d. e. Is useless as a risk indicator. Ignores cash flows beyond the payback period. Does not directly account for the time value of money. All of the answers above are correct. Only answers b and c are correct. Chapter 10- Page 1 NPV and IRR 4. Answer: a Diff: E 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. Answers a and c are correct. e. None of the answers above is correct. NPV and IRR 5. Answer: a Diff: E Project A has an internal rate of return (IRR) of 15 percent. Project B has an IRR of 14 percent. Both projects have a cost of capital of 12 percent. Which of the following statements is most correct? a. Both projects have a positive net present value (NPV). b. Project A must have a higher NPV than Project B. c. If the cost of capital were less than 12 percent, Project B would have a higher IRR than Project A. d. Statements a and c are correct. e. Statements a, b, and c are correct. Post-audit 6. Answer: e Diff: E The post-audit is used to a. Improve cash flow forecasts. b. Stimulate management to improve operations and bring results into line with forecasts. c. Eliminate potentially profitable but risky projects. d. All of the answers above are correct. e. Answers a and b are correct. IRR 7. Answer: b Diff: E Project A has an IRR of 15 percent. Project B has an IRR of 18 percent. Both projects have the same risk. Which of the following statements is most correct? a. If the WACC is 10 percent, both projects will have a positive NPV, and the NPV of Project B will exceed the NPV of Project A. b. If the WACC is 15 percent, the NPV of Project B will exceed the NPV of Project A. c. If the WACC is less than 18 percent, Project B will always have a shorter payback than Project A. d. If the WACC is greater than 18 percent, Project B will always have a shorter payback than Project A. e. If the WACC increases, the IRR of both projects will decline. Chapter 10- Page 2 NPV profiles 8. Answer: b Diff: M Projects L and S each have an initial cost of $10,000, followed by a series of positive cash inflows. Project L has total, undiscounted cash inflows of $16,000, while S has total undiscounted inflows of $15,000. Further, at a discount rate of 10 percent, the two projects have identical NPVs. Which project's NPV will be more sensitive to changes in the discount rate? (Hint: Projects with steeper NPV profiles are more sensitive to discount rate changes.) a. Project S. b. Project L. c. Both projects are equally sensitive to changes in the discount rate since their NPVs are equal at all costs of capital. d. Neither project is sensitive to changes in the discount rate, since both have NPV profiles which are horizontal. e. The solution cannot be determined unless the timing of the cash flows is known. NPV profiles 9. Answer: a Diff: M Two mutually exclusive projects each have a cost of $10,000. total, undiscounted cash flows from Project L are $15,000, while undiscounted cash flows from Project S total $13,000. Their profiles cross at a discount rate of 10 percent. Which of following statements best describes this situation? The the NPV the a. The NPV and IRR methods will select the same project if the cost of capital is greater than 10 percent; for example, 18 percent. b. The NPV and IRR methods will select the same project if the cost of capital is less than 10 percent; for example, 8 percent. c. To determine if a ranking conflict will occur between the two projects the cost of capital is needed as well as an additional piece of information. d. Project L should be selected at any cost of capital, because it has a higher IRR. e. Project S should be selected at any cost of capital, because it has a higher IRR. Chapter 10- Page 3 NPV and IRR 10. Answer: c Assume that you are comparing two mutually exclusive projects. of the following statements is most correct? Diff: M Which a. The NPV and IRR rules will always lead to the same decision unless one or both of the projects are "non-normal" in the sense of having only one change of sign in the cash flow stream, i.e., one or more initial cash outflows (the investment) followed by a series of cash inflows. b. If a conflict exists between the NPV and the IRR, the conflict can always be eliminated by dropping the IRR and replacing it with the MIRR. c. There will be a meaningful (as opposed to irrelevant) conflict only if the projects' NPV profiles cross, and even then, only if the cost of capital is to the left of (or lower than) the discount rate at which the crossover occurs. d. Statements a, b, and c are true. NPV and IRR 11. Answer: a Diff: M Which of the following statements is incorrect? a. Assuming a project has normal cash flows, the NPV will be positive if the IRR is less than the cost of capital. b. If the multiple IRR problem does not exist, any independent project acceptable by the NPV method will also be acceptable by the IRR method. c. If IRR = k (the cost of capital), then NPV = 0. d. NPV can be negative if the IRR is positive. e. The NPV method is not affected by the multiple IRR problem. NPV, IRR, and payback 12. Answer: e Diff: M Project X has an internal rate of return of 20 percent. Project Y has an internal rate of return of 15 percent. Both projects have a positive net present value. Which of the following statements is most correct? a. Project X must have a higher net present value than Project Y. b. If the two projects have the same WACC, Project X must have a higher net present value. c. Project X must have a shorter payback than Project Y. d. Both answers b and c are correct. e. None of the above answers is correct. Chapter 10- Page 4 IRR 13. Answer: e Diff: M The internal rate of return of a capital investment a. Changes when the cost of capital changes. b. Is equal to the annual net cash flows divided by one half of the project's cost when the cash flows are an annuity. c. Must exceed the cost of capital in order for the firm to accept the investment. d. Is similar to the yield to maturity on a bond. e. Answers c and d are correct. Ranking methods 14. Answer: b Diff: M Which of the following statements is correct? a. Because discounted payback takes account of the cost of capital, a project's discounted payback is normally shorter than its regular payback. b. The NPV and IRR methods use the same basic equation, but in the NPV method the discount rate is specified and the equation is solved for NPV, while in the IRR method the NPV is set equal to zero and the discount rate is found. c. If the cost of capital is less than the crossover rate for two mutually exclusive projects' NPV profiles, a NPV/IRR conflict will not occur. d. If you are choosing between two projects which have the same life, and if their NPV profiles cross, then the smaller project will probably be the one with the steeper NPV profile. e. If the cost of capital is relatively high, this will favor larger, longer-term projects over smaller, shorter-term alternatives because it is good to earn high rates on larger amounts over longer periods. Ranking methods 15. Answer: e Diff: M In comparing two mutually exclusive projects of equal size and equal life, which of the following statements is most correct? a. The project with the higher the higher IRR. b. The project with the higher the higher MIRR. c. The project with the higher the higher MIRR. d. All of the answers above are e. Answers a and c are correct. NPV may not always be the project with NPV may not always be the project with IRR may not always be the project with correct. Chapter 10- Page 5 Miscellaneous concepts 16. Answer: e Diff: M Which of the following statements is most correct? a. The IRR method is appealing to some managers because it produces a rate of return upon which to base decisions rather than a dollar amount like the NPV method. b. The discounted payback method solves all the problems associated with the payback method. c. For independent projects, the decision to accept or reject will always be the same using either the IRR method or the NPV method. d. All of the statements above are correct. e. Statements a and c are correct. Miscellaneous concepts 17. Answer: a Diff: M Which of the following statements is most correct? a. One of the disadvantages of choosing between mutually exclusive projects on the basis of the discounted payback method is that you might choose the project with the faster payback period but with the lower total return. b. Multiple IRRs can occur in cases when project cash flows are normal, but they are more common in cases where project cash flows are nonnormal. c. When choosing between mutually exclusive projects, managers should accept all projects with IRRs greater than the weighted average cost of capital. d. All of the statements above are correct. e. Two of the statements above are correct. Miscellaneous concepts 18. Answer: a Diff: M Normal projects C and D are mutually exclusive. Project C has a higher net present value if the WACC is less than 12 percent, whereas Project D has a higher net present value if the WACC exceeds 12 percent. Which of the following statements is most correct? a. b. c. d. e. Project D has a higher internal Project D is probably larger in Project C probably has a faster All of the statements above are Answers a and c are correct. Chapter 10- Page 6 rate of return. scale than Project C. payback. correct. Project selection 19. Answer: a Diff: M A company estimates that its weighted average cost of capital (WACC) is 10 percent. Which of the following independent projects should the company accept? a. Project A requires an up-front expenditure of $1,000,000 generates a net present value of $3,200. b. Project B has a modified internal rate of return of 9.5 percent. c. Project C requires an up-front expenditure of $1,000,000 generates a positive internal rate of return of 9.7 percent. d. Project D has an internal rate of return of 9.5 percent. e. None of the projects above should be accepted. and and Multiple Choice: Problems Payback period 20. Answer: b Diff: E The Seattle Corporation has been presented with an investment opportunity which will yield cash flows of $30,000 per year in Years 1 through 4, $35,000 per year in Years 5 through 9, and $40,000 in Year 10. This investment will cost the firm $150,000 today, and the firm's cost of capital is 10 percent. Assume cash flows occur evenly during the year, 1/365th each day. What is the payback period for this investment? a. b. c. d. e. 5.23 4.86 4.00 6.12 4.35 years years years years years Chapter 10- Page 7 NPV 21. Answer: a Diff: E As the director of capital budgeting for Denver Corporation, you are evaluating two mutually exclusive projects with the following net cash flows: Project X Cash Flow -$100,000 50,000 40,000 30,000 10,000 Year 0 1 2 3 4 Project Z Cash Flow -$100,000 10,000 30,000 40,000 60,000 If Denver's cost of capital is 15 percent, which project would you choose? a. b. c. d. e. Neither Project Project Project Project project. X, since Z, since X, since Z, since it it it it has has has has the the the the higher higher higher higher IRR. NPV. NPV. IRR. NPV 22. Answer: a Two projects being considered following projected cash flows: Year 0 1 2 3 4 5 are Project A Cash Flow -$50,000 15,625 15,625 15,625 15,625 15,625 mutually exclusive and Diff: E have the Project B Cash Flow -$50,000 0 0 0 0 99,500 If the required rate of return on these projects is 10 percent, which would be chosen and why? a. b. c. d. e. Project B because it has the higher NPV. Project B because it has the higher IRR. Project A because it has the higher NPV. Project A because it has the higher IRR. Neither, because both have IRRs less than the cost of capital. Chapter 10- Page 8 Payback period 23. Answer: c Michigan Mattress Company is considering the purchase of land and the construction of a new plant. The land, which would be bought immediately (at t = 0), has a cost of $100,000 and the building, which would be erected at the end of the first year (t = 1), would cost $500,000. It is estimated that the firm's after-tax cash flow will be increased by $100,000 starting at the end of the second year, and that this incremental flow would increase at a 10 percent rate annually over the next 10 years. What is the approximate payback period? a. 2 b. 4 c. 6 d. 8 e. 10 years years years years years Payback period 24. Answer: c Diff: M Haig Aircraft is considering a project which has an up-front cost paid today at t = 0. The project will generate positive cash flows of $60,000 a year at the end of each of the next five years. The project’s NPV is $75,000 and the company’s WACC is 10 percent. What is the project’s simple, regular payback? a. b. c. d. e. 3.22 1.56 2.54 2.35 4.16 years years years years years Discounted payback 25. Diff: M Answer: e Diff: M Lloyd Enterprises has a project which has the following cash flows: Year 0 1 2 3 4 5 The cost of capital is 10 percent. payback? a. b. c. d. e. 1.8763 2.0000 2.3333 2.4793 2.6380 Cash Flow -$200,000 50,000 100,000 150,000 40,000 25,000 What is the project's discounted years years years years years Chapter 10- Page 9 Discounted payback 26. Answer: b Polk Products is considering an investment project with the following cash flows: Year 0 1 2 3 4 Cash Flow -$100,000 40,000 90,000 30,000 60,000 The company has a 10 percent cost of capital. discounted payback ? a. b. c. d. e. 1.67 1.86 2.11 2.49 2.67 What is the project’s years years years years years Discounted payback 27. Diff: M Answer: d Diff: M Davis Corporation is faced with two independent investment opportunities. The corporation has an investment policy which requires acceptable projects to recover all costs within 3 years. The corporation uses the discounted payback method to assess potential projects and utilizes a discount rate of 10 percent. The cash flows for the two projects are: Year 0 1 2 3 4 Project A Cash Flow -$100,000 40,000 40,000 40,000 30,000 Project B Cash Flow -$80,000 50,000 20,000 30,000 0 Which investment project(s) does the company invest in? a. b. c. d. Project Neither Project Project Chapter 10- Page 10 A only. Project A nor Project B. A and Project B. B only. NPV 28. Answer: d The Seattle Corporation has been presented with an investment opportunity which will yield end-of-year cash flows of $30,000 per year in Years 1 through 4, $35,000 per year in Years 5 through 9, and $40,000 in Year 10. This investment will cost the firm $150,000 today, and the firm's cost of capital is 10 percent. What is the NPV for this investment? a. b. c. d. e. $135,984 $ 18,023 $219,045 $ 51,138 $ 92,146 NPV 29. Answer: b Diff: M You are considering the purchase of an investment that would pay you $5,000 per year for Years 1-5, $3,000 per year for Years 6-8, and $2,000 per year for Years 9 and 10. If you require a 14 percent rate of return, and the cash flows occur at the end of each year, then how much should you be willing to pay for this investment? a. b. c. d. e. $15,819.27 $21,937.26 $32,415.85 $38,000.00 $52,815.71 NPV and payback 30. Diff: M Answer: b Diff: M Shannon Industries is considering a project which has the following cash flows: Year 0 1 2 3 4 Cash Flow ? $2,000 3,000 3,000 1,500 The project has a payback of 2.5 years. The firm’s cost of capital is 12 percent. What is the project’s net present value NPV? a. b. c. d. e. $ 577.68 $ 765.91 $1,049.80 $2,761.32 $3,765.91 Chapter 10- Page 11 Before-tax cash flows 31. $1,993 $3,321 $1,500 $4,983 $5,019 IRR Answer: c Diff: E The capital budgeting director of Sparrow Corporation is evaluating a project which costs $200,000, is expected to last for 10 years and produce after-tax cash flows, including depreciation, of $44,503 per year. If the firm's cost of capital is 14 percent and its tax rate is 40 percent, what is the project's IRR? a. b. c. d. e. 8% 14% 18% -5% 12% IRR 33. Diff: M Scott Corporation's new project calls for an investment of $10,000. It has an estimated life of 10 years. The IRR has been calculated to be 15 percent. If cash flows are evenly distributed and the tax rate is 40 percent, what is the annual before-tax cash flow each year? (Assume depreciation is a negligible amount.) a. b. c. d. e. 32. Answer: b Answer: c Diff: E An insurance firm agrees to pay you $3,310 at the end of 20 years if you pay premiums of $100 per year at the end of each year for 20 years. Find the internal rate of return to the nearest whole percentage point. a. 9% b. 7% c. 5% d. 3% e. 11% Chapter 10- Page 12 IRR and mutually exclusive projects 34. Answer: d Diff: E A company is analyzing two mutually exclusive projects, S and L, whose cash flows are shown below: Years 0 1 2 3 | | | 1,000 0 350 300 50 1,500 k = 12% | S -1,100 L -1,100 The company's cost of capital is 12 percent, and it can get an unlimited amount of capital at that cost. What is the regular IRR (not MIRR) of the better project, i.e., the project which the company should choose if it wants to maximize its stock price? a. b. c. d. e. 12.00% 15.53% 18.62% 19.08% 20.46% NPV and IRR 35. Answer: b Diff: E Your company is choosing between the following non-repeatable, equally risky, mutually exclusive projects with the cash flows shown below. Your cost of capital is 10 percent. How much value will your firm sacrifice if it selects the project with the higher IRR? Project S: 3 | | | 500 500 500 k = 10% k = 10% | -2,000 a. b. c. d. e. 2 -1,000 0 1 | Project L: 0 1 | 668.76 2 | 668.76 3 | 668.76 4 | 668.76 5 | 668.76 $243.43 $291.70 $332.50 $481.15 $535.13 Chapter 10- Page 13 NPV and IRR 36. Answer: e Diff: E Green Grocers is deciding among two mutually exclusive projects. two projects have the following cash flows: Project A Cash Flow -$50,000 10,000 15,000 40,000 20,000 Year 0 1 2 3 4 The Project B Cash Flow -$30,000 6,000 12,000 18,000 12,000 The company’s cost of capital is 10 percent (WACC = 10%). What is the net present value (NPV) of the project with the highest internal rate of return (IRR)? a. b. c. d. e. $ 7,090 $ 8,360 $11,450 $12,510 $15,200 NPV, IRR, and payback 37. Answer: d Diff: E Braun Industries is considering an investment project which has the following cash flows: Year 0 1 2 3 4 Cash Flow -$1,000 400 300 500 400 The company’s WACC is 10 percent. What is the project’s payback, internal rate of return, and net present value? a. b. c. d. e. Payback Payback Payback Payback Payback Chapter 10- Page 14 = = = = = 2.4, 2.4, 2.6, 2.6, 2.6, IRR IRR IRR IRR IRR = = = = = 10.00%, 21.22%, 21.22%, 21.22%, 24.12%, NPV NPV NPV NPV NPV = = = = = $600. $260. $300. $260. $300. Replacement chain 38. Answer: d Vanderheiden Inc. is considering two average-risk alternative ways of producing its patented polo shirts. Process S has a cost of $8,000 and will produce net cash flows of $5,000 per year for 2 years. Process L will cost $11,500 and will produce cash flows of $4,000 per year for 4 years. The company has a contract that requires it to produce the shirts for 4 years, but the patent will expire after 4 years, so the shirts will not be produced after 4 years. Inflation is expected to be zero during the next 4 years. If cash inflows occur at the end of each year, and if Vanderheiden's cost of capital is 10 percent, by what amount will the better project increase Vanderheiden's value? a. b. c. d. e. $ 677.69 $1,098.89 $1,179.46 $1,237.76 $1,312.31 Mutually exclusive projects 39. Diff: E Answer: b Diff: M Two projects being considered by a firm are mutually exclusive and have the following projected cash flows: Year 0 1 2 3 Project A Cash Flow ($100,000) 39,500 39,500 39,500 Project B Cash Flow ($100,000) 0 0 133,000 Based only on the information given, which of the two projects would be preferred, and why? a. b. c. d. Project A, because it has a shorter payback period. Project B, because it has a higher IRR. Indifferent, because the projects have equal IRRs. Include both in the capital budget, since the sum inflows exceeds the initial investment in both cases. e. Choose neither, since their NPVs are negative. of the cash Chapter 10- Page 15 IRR 40. Answer: d Diff: M Genuine Products Inc. requires a new machine. Two companies have submitted bids, and you have been assigned the task of choosing one of the machines. Cash flow analysis indicates the following: Machine A Cash Flow -$2,000 0 0 0 3,877 Year 0 1 2 3 4 Machine B Cash Flow -$2,000 832 832 832 832 What is the internal rate of return for each machine? a. b. c. d. e. IRRA IRRA IRRA IRRA IRRA = = = = = 16%; 24%; 18%; 18%; 24%; IRRB IRRB IRRB IRRB IRRB = = = = = 20% 20% 16% 24% 26% IRR 41. Answer: c Whitney Crane Inc. has the opportunities for the coming year: Project A B C D Cost $10,000 5,000 12,000 3,000 following Annual Cash Inflows $11,800 3,075 5,696 1,009 independent Life (Years) 1 2 3 4 The IRRs for Projects A and C, respectively, are: a. b. c. d. e. 16% 18% 18% 18% 16% and and and and and Chapter 10- Page 16 14% 10% 20% 13% 13% IRR 15 13 Diff: M investment NPV and IRR 42. Answer: a Diff: M A company is analyzing two mutually exclusive projects, S and L, whose cash flows are shown below: Years 0 1 2 3 4 S L -1,100 -1,100 900 0 350 300 50 500 10 850 The company's cost of capital is 12 percent, and it can get an unlimited amount of capital at that cost. What is the regular IRR (not MIRR) of the better project? (Hint: Note that the better project may or may not be the one with the higher IRR.) a. b. c. d. e. 13.09% 12.00% 17.46% 13.88% 12.53% IRR of uneven CF stream 43. Diff: M Your company is planning to open a new gold mine which will cost $3 million to build, with the expenditure occurring at the end of the year three years from today. The mine will bring year-end after-tax cash inflows of $2 million at the end of the two succeeding years, and then it will cost $0.5 million to close down the mine at the end of the third year of operation. What is this project's IRR? a. b. c. d. e. 14.36% 10.17% 17.42% 12.70% 21.53% IRR of uneven CF stream 44. Answer: d Answer: e Diff: M As the capital budgeting director for Chapel Hill Coffins Company, you are evaluating construction of a new plant. The plant has a net cost of $5 million in Year 0 (today), and it will provide net cash inflows of $1 million at the end of Year 1, $1.5 million at the end of Year 2, and $2 million at the end of Years 3 through 5. Within what range is the plant's IRR? a. b. c. d. e. 14 15 16 17 18 - 15% 16% 17% 18% 19% Chapter 10- Page 17 NPV profiles 45. Answer: d The following projects: cash flows Year 0 1 2 3 4 are estimated Project A Cash Flow -$100,000 60,000 40,000 20,000 10,000 for two mutually Diff: M exclusive Project B Cash Flow -$110,000 20,000 40,000 40,000 50,000 When is Project B more lucrative than Project A? (That is, over what range of costs of capital (k) does Project B have a higher NPV than Project A?) (Choose the best answer.) a. b. c. d. e. For all Project Project For all For all values of k B is always A is always values of k values of k Replacement chain 46. less than 7.25%. more profitable than Project A. more profitable than Project B. less than 6.57%. greater than 6.57%. Answer: c Diff: M Doherty Industries wants to invest in a new computer system. The company only wants to invest in one system, and has narrowed the choice down to System A and System B. System A requires an up-front cost of $100,000 and then generates positive after-tax cash flows of $60,000 at the end of each of the next two years. The system can be replaced every two years with the cash inflows and outflows remaining the same. System B also requires an up-front cost of $100,000 and then generates positive after-tax cash flows of $48,000 at the end of each of the next three years. System B can be replaced every three years, but each time the system is replaced, both the cash inflows and outflows increase by 10 percent. The company needs a computer system for the six years, after which time the current owners plan on retiring and liquidating the firm. The company's cost of capital is 11 percent. What is the NPV (on a sixyear extended basis) of the system which creates the most value to the company? a. b. c. d. e. $ 17,298.30 $ 22,634.77 $ 31,211.52 $ 38,523.43 $103,065.82 Chapter 10- Page 18 Replacement chain 47. Answer: e Diff: M Johnson Jets is considering two mutually exclusive machines. Machine A has an up-front cost of $100,000 (CF 0 = -100,000), and produces positive after-tax cash inflows of $40,000 a year at the end of each of the next six years. Machine B has an up-front cost of $50,000(CF 0 = -50,000) and produces after-tax cash inflows of $30,000 a year at the end of the next three years. After three years, machine B can be replaced at a cost of $55,000 (paid at t = 3). The replacement machine will produce aftertax cash inflows of $32,000 a year for three years (inflows received at t = 4, 5, and 6). The company’s cost of capital is 10.5 percent. What is the net present value (on a six-year extended basis) of the most profitable machine? a. b. c. d. e. $23,950 $41,656 $56,238 $62,456 $71,687 Chapter 10- Page 19 CHAPTER 10 Answers and Solutions 1. Ranking methods Answer: b Diff: E A project's NPV increases as the cost of capital declines. A project's IRR is independent of its cost of capital, while a project's MIRR is dependent on the cost of capital since the terminal value in the MIRR equation is compounded at the cost of capital. 2. Ranking conflicts Answer: a Diff: E 3. Payback period Answer: e Diff: E 4. NPV and IRR Answer: a Diff: E Statement a is correct; 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. 5. NPV and IRR Answer: a Diff: E Statement a is true; projects with IRRs greater than the cost of capital will have a positive NPV. Statement b is false because you know nothing about the relative magnitudes of the projects. Statement c is false because the IRR is independent of the cost of capital. Therefore, the correct choice is statement a. 6. Post-audit Answer: e Diff: E 7. IRR Answer: b Diff: E The correct statement is b; the other statements are false. Since Project A’s IRR is 15%, at a WACC of 15% NPV A = 0; however, Project B would still have a positive NPV. Given the information in a, we can’t conclude which project’s NPV is going to be greater. Since we are given no details about each project’s cash flows we cannot conclude anything about payback. Finally, IRR is independent of the discount rate, i.e., IRR stays the same no matter what the WACC is. 8. NPV profiles Answer: b Diff: M 9. NPV profiles Answer: a Diff: M 10. NPV and IRR Answer: c Diff: M 11. NPV and IRR Answer: a Diff: M Statement a is the incorrect statement. greater than the cost of capital. Chapter 10- Page 20 NPV is positive if IRR is 12. NPV, IRR, and payback Answer: e Diff: M Statement e is correct; the other statements are incorrect. Statement a is incorrect; the two projects' NPV profiles could cross, consequently, a higher IRR doesn't guarantee a higher NPV. Statement b is incorrect; if the two projects' NPV profiles cross, Y could have a higher NPV. Statement c is incorrect; we don't have enough information. 13. IRR Answer: e Diff: M 14. Ranking methods Answer: b Diff: M This statement reflects exactly the difference between the NPV and IRR methods. 15. Ranking methods Answer: e Diff: M Both statements a and c are correct; therefore, statement e is the correct choice. Due to reinvestment rate assumptions, NPV and IRR can lead to conflicts; however, there will be no conflict between NPV and MIRR if the projects are equal in size (which is one of the assumptions in this question). 16. Miscellaneous concepts Answer: e Diff: M Statements a and c are correct; therefore, statement e is the correct choice. The discounted payback method still ignores cash flows after the payback period. 17. Miscellaneous concepts Answer: a Diff: M Statement a is correct; the other statements are false. Multiple IRRs can occur only for projects with nonnormal cash flows. Mutually exclusive projects imply that only one project should be chosen. The project with the highest NPV should be chosen. 18. Miscellaneous concepts Answer: a Diff: M Statement a is correct; the other statements are false. Sketch the profiles. From the information given, D has the higher IRR. The project’s scale cannot be determined from the information given. As C’s NPV declines more rapidly with an increase in rates, this implies that more of the cash flows are coming later on. So C would have a slower payback than D. 19. Project selection Answer: a Diff: M This is the only project with either a positive NPV or an IRR which exceeds the cost of capital. Chapter 10- Page 21 20. Payback period Time line: Answer: b Diff: E ( In thousands ) 0 1 2 3 4 5 6 7 8 9 10 Yrs k = 10% _________________________________________________________________________________________ CFs -150 30 30 30 30 35 35 35 35 35 40 Cumulative CFs -150 -120 -90 -60 -30 5 Using the even cash flow distribution assumption, the project will completely recover initial investment after 30/35 = 0.86 of Year 5: Payback = 4 + 21. 30 = 4.86 years. 35 NPV Answer: a Time line: 0 CFX Project X (In thousands) 1 2 k = 15% -100 50 3 40 Diff: E 4 Years 30 10 k = 15% NPVx = 43.478 30.246 19.725 5.718 -0.833 = -$833 k = 15% k = 15% k = 15% Project Z (In thousands) 0 1 k = 15% CFX -100 8.696 22.684 26.301 34.305 NPVZ = 2 30 10 3 4 Years 40 60 k = 15% k = 15% k = 15% k = 15% -8.014 = -$8,014. At a cost of capital of 15%, both projects have negative NPVs and, thus, both would be rejected. Numerical solution: (In thousands) NPVX = -100 + 50(1/1.15) + 40(1/1.15 2) + 30(1/1.153) + 10(1/1.154) = -100 + 50(0.8696) + 40(0.7561) + 30(0.6575) + 10(0.5718) = -0.833 = -$833. NPVZ = -100 + 10(1/1.15) + 30(1/1.15 2) + 40(1/1.153) + 60(1/1.154) = -100 + 10(0.8696) + 30(0.7561) + 40(0.6575) + 60(0.5718) = -8.013 = -$8,013. Financial calculator solution: (In thousands) Project X Inputs: CF0 = -100; CF1 = 50; CF2 = 40; CF3 = 30; CF 4 = 10; I = 15. Output: NPV X = -0.833 = -$833. Project Z Inputs: CF0 = -100; CF1 = 10; CF2 = 30; CF3 = 40; CF 4 = 60; I = 15. Output: NPV Z = -8.014 = -$8,014. Chapter 10- Page 22 22. NPV Time line: 0 Answer: a k = 10% CFA -50,000 NPV A = ? CFB -50,000 NPV B = ? 1 2 15,625 3 15,625 4 15,625 Diff: E 5 Years 15,625 15,625 99,500 Numerical solution: NPVA = $15,625[(1/0.10)-(1/(0.10*(1+0.10) 5)] - $50,000 = $15,625(3.7908) - $50,000 = $59,231.25 - $50,000 = $9,231.25. NPVB = $99,500(1/1.10 5) - $50,000 = $99,500(0.6209) - $50,000 = $61,779.55 - $50,000 = $11,779.55. NPVB > NPVA; $11,779.55 > $9,231.25; Choose Project B. Financial calculator solution: Project A Inputs: N = 5; I = 10; PMT = 15,625. Output: PV = -59,231.04. NPV A = $59,231.04 - $50,000 = $9,231.04. Project B Inputs: N = 5; I = 10; FV = 99,500. Output: PV = -61,781.67. NPV B = $61,781.67 - $50,000 = $11,781.67. Alternate method by cash flows: Project A Inputs: CF0 = -50,000; CF 1 = 15,625; Nj = 5; I = 10. Output: NPV = $9,231.04. Project B Inputs: CF0 = -50,000; CF 1 = 0; Nj = 4; CF2 = 99,500; I = 10. Output: NPV = $11,781.67. 23. Payback period Time line: Answer: c (In thousands) 0 CF Cumulative NCF Diff: M 1 2 -100 -500 -100 -600 Payback = 5 + 3 4 5 6 10 100 110 121 133.1 146.41 -500 -390 -269 -135.9 Years 10.51 $135.9 = 5.928 years ≈ 6 years. $146.41 Chapter 10- Page 23 24. Payback period Answer: c Diff: M Step 1 Calculate the PV of the cash flows: PVA5 = $60,000[(1/0.10)-(1/(0.10*(1.10) 5)] = $60,000(3.7908) = $227,448. Step 2 Calculate the Year 0 outflow: The outflow at t = 0 is X where $227,448 - X = $75,000. CF0 = -$152,448. Step 3 Calculate the regular payback: Year CF 0 -$152,448 1 60,000 2 60,000 3 60,000 4 60,000 5 60,000 So the payback is 2 + 25. Cumulative CF -$152,448 -92,448 -32,448 27,552 87,552 147,552 $32 448 , = 2.54 years. $60, 00 0 Discounted payback 0 Answer: e 3 4 5 3 50,000 100,000 150,000 40,000 25,000 50,000 1 .1 Discounted CFs -200,000 100,000 (1.1) 2 1 50,000 ( 1.1) 3 4 0,000 ( 1.1) 4 2 5,000 ( 1.1) 5 27,320.54 15,523.03 45,454.55 Discounted CF -200,000.00 45,454.55 82,644.63 Payback 112,697.22 27,320.54 15,523.03 Cumulative CF -200,000.00 -154,545.45 -71,900.82 Payback period = 2 years + Chapter 10- Page 24 82,644.63 112,697.22 4 Diff: M 2 k = 1 0% CFs -200,000 0 1 2 1 X or +40,796.40 +68,116.94 +83,639.97 $71,900.82 = 2.638 years. $112,697.22 5 26. Discounted payback Year 0 1 2 3 4 Answer: b Answer: d Cash Flow -$100,000 40,000 90,000 30,000 60,000 Discounted Payback = 1 + 27. Discounted Cash Flow -$100,000.00 36,363.64 74,380.17 22,539.44 40,980.81 Diff: M Diff: M Cumulative Cash Flow -$100,000.00 -63,636.36 10,743.81 33,283.25 74,264.06 $63,636.36 = 1.86 years. $74,380.17 Discounted payback The sum of the PVs of the t = 1, t = 2, and t = 3 cash flows at t = 0 for Project A is $99,474.08. Thus, the discounted payback period of Project A exceeds 3 years and Project A is not acceptable. The PVs of the t = 1, t = 2, and t = 3 cash flows at t = 0 for Project B are $45,454.55, $16,528.93, and $22,539.44, respectively. These PVs sum to $84,522.92, which is greater than the cost of the project, indicating that the discounted payback period is less than 3 years. Thus, Project B will be undertaken. 28. NPV Answer: d T ime line: 0 k = 10% -150 Diff: M (In thousands) 1 2 3 4 5 6 7 8 9 10 Yrs. 30 30 30 30 35 35 35 35 35 40 NPV = ? Numerical solution: NPV = $30,000[(1/0.10)-(1/(0.10*(1+0.10) 4)] + $35,000[(1/0.10)-(1/(0.10*(1+0.10) 5)](1/1.104) + $40,000(1/1.10 10) - $150,000 = $30,000(3.1699) + $35,000(3.7908)(0.6830) + $40,000(0.3855) - $150,000 = $51,136.07 ≈ $51,136. Financial calculator solution: (In thousands) Inputs: CF0 = -150; CF1 = 30; Nj = 4; CF 2 = 35; Nj = 5; CF3 = 40; I = 10. Output: NPV = $51.13824 = $51,138.24 ≈ $51,138. Chapter 10- Page 25 29. NPV Answer: b Diff: M Time line: (In thousands) 0 k = 14% PV = ? 1 2 3 4 5 6 7 8 9 5 5 5 5 5 3 3 3 10 Yrs. 2 2 Numerical solution: PV = $5,000[(1/0.14)-(1/(0.14*(1+0.14) 5 + $3,000[(1/0.14)-(1/(0.14*(1+0.14) 3 (1/1.145) + $2,000[(1/0.14)-(1/(0.14*(1+0.14) 2 (1/1.148) = $5,000(3.4331) + $3,000(2.3216)(0.5194) + $2,000(1.6467)(0.3506) = $17,165.50 + $3,617.52 + $1,154.67 = $21,937.69. Financial calculator solution: (In thousands) Inputs: CF0 = 0; CF1 = 5; Nj = 5; CF2 = 3; Nj = 3; CF3 = 2; Nj = 2; I = 14. Output: NPV = 21.93726 = $21,937.26. Note: Numerical solution differs from calculator solution due to rounding. 30. NPV and payback Answer: b Diff: M First, find the missing t = 0 cash flow. If payback = 2.5 years, this implies t = 0 cash flow must be -$2,000 - $3,000 + (0.5)$3,000 = -$6,500. $2 000 , $3, 000 $3, 000 $1, 500 NPV = -$6,500 + + + + 2 3 4 (1.12) (1.12) (1.12) 1.12 = $765.91. 31. Before-tax cash flows T ime line: 0 1 IRR = 15% -10,000 PMT = ? Answer: b 2 3 4 PMT PMT PMT Numerical solution: X = after-tax cash flow. Y = before-tax cash flow. X = Y(1 - T). $10,000 $10,000 X $1,992.51 Y = = = = = X[(1/0.15)-(1/(0.15*(1+0.15) 10)] X(5.0188) $1,992.51. Y(1 - 0.40) $3,320.85 ≈ $3,321. Financial calculator solution: Inputs: N = 10; I = 15; PV = -10,000. Output: PMT = $1,992.52. Before-tax CF = $1,992.52/0.6 = $3,320.87 ≈ $3,321. Chapter 10- Page 26 Diff: M 10 Years PMT 32. IRR Answer: c T ime line: k = 14% 0 IRR = ? -200,000 1 2 44,503 33. 10 Years 44,503 Financial calculator solution: Inputs: CF0 = -200,000; CF 1 = 44,503; Nj = 10. Diff: E 44,503 Output: IRR = 18%. IRR Answer: c T i me l i ne : 0 IRR = ? 1 2 PMT = -100 Diff: E 2 0 Y e a rs - 10 0 -100 FV = 3,310 Financial calculator solution: Inputs: CF0 = 0; CF1 = -100; Nj = 19; CF2 = 3,210. Output: IRR = 5.0%. Alternate method annuity calculation Inputs: N = 20; PMT = -100; FV = 3,310. Output: I = 5.0% 34. IRR and mutually exclusive projects Answer: d Diff: E Because the two projects are mutually exclusive, the project with the higher positive NPV is the "better" project. 0 S k 1 0 2 3 1,000 12% -1,100 NPVS = $107.46. L = 350 50 IRR S = 20.46%. k -1,100 = 12% 1 2 0 3 300 1,500 NPVL = $206.83. IRR L = 19.08%. Project L is the "better" project; its IRR = 19.08%. 35. NPV and IRR Answer: b Diff: E NPVS = $243.43; IRR S = 23.38%. NPVL = $535.13; IRR L = 20.00%. Value sacrificed: $535.13 - $243.43 = $291.70. Chapter 10- Page 27 36. NPV and IRR Answer: e Diff: E Enter the cash flows for each project into the cash flow register on the calculator and get the NPV and IRR. NPVA = $15,200; IRR A = 21.3811%. NPVB = $7,092; IRR B = 19.2783%. Project A has the highest IRR, so the answer is $15,200. 37. NPV, IRR, and payback Answer: d Diff: E 38. Payback = 2 + 300/500 = 2.6 years. Using the cash flow register, calculate NPV and IRR: IRR = 21.22%. NPV = $260.43 ≈ $260. Replacement chain Answer: d Diff: E 0 k = 1 10% 2 3 4 S -8,000 5,000 IRRS = 16.26%. NPVS = $1,237.76. 0 k = 5,000 -8,000 -3,000 5,000 (extended NPV) 1 10% 5,000 2 3 4 L -11,500 4,000 4,000 4,000 4,000 IRRL = 14.66%. NPVL = $1,179.46. 39. Mutually exclusive projects Answer: b Diff: M T ime line: 0 CF A CF B IRR A = ? I RR B = ? - 100,000 - 100,000 1 39,500 0 Financial calculator solution: Project A: Inputs: CF0 = -100,000; Output: IRR A = 8.992% ≈ Project B: Inputs: CF0 = -100,000; Output: IRR B = 9.972% ≈ Chapter 10- Page 28 2 39,500 0 3 Y ears 39,500 133,000 CF 1 = 39,500; Nj = 3. 9.0%. CF 1 = 0; Nj = 2; CF2 = 133,000. 10.0%. 40. IRR Answer: d Diff: M T ime line: IRR A 0 IRR B CF A CF B 41. = = ? ?1 - 2,000 - 2,000 0 832 2 3 0 832 4 Y ears 0 832 3,877 832 Financial calculator solution: Machine A Inputs: CF0 = -2,000; CF 1 = 0; Nj = 3; CF2 = 3877. Output: IRR = 17.996% ≈ 18%. Machine B Inputs: CF0 = -2,000; CF 1 = 832; Nj = 4. Output: IRR = 24.01% ≈ 24%. IRR Answer: c Diff: M Financial calculator solution: Project A Inputs: N = 1; PV = -10,000; FV = 11,800. Output: I = 18% = IRR A. Project C Inputs: N = 3; PV = -12,000; PMT = 5,696. Output: I = 19.99% ≈ 20% = IRRC. 42. NPV and IRR Answer: a Diff: M Time line: 0 k = 12% 1 Cash flows S -1,100 NPV S = ? Cash flows L -1,100 NPV L = ? 900 IRR S = ? 0 IRR L = ? 2 3 4 350 50 10 300 500 Years 850 Financial calculator solution: Calculate the NPV and IRR of each project then select the IRR of the higher NPV project Project S; Inputs: CF0 = -1,100; CF1 = 900; CF2 = 350; CF3 = 50; CF4 = 10; I = 12 Output: NPV S = 24.53; IRR S = 13.88%. Project L; Inputs: CF0 = -1,100; CF1 = 0; CF2 = 300; CF3 = 500; CF4 = 850; I = 12 Output: NPV L = 35.24; IRR L = 13.09%. Project L has the higher NPV and its IRR = 13.09%. Chapter 10- Page 29 43. IRR of uneven CF stream T ime line: 0 1 Answer: d 2 3 IRR = ? 4 5 6 Diff: M Years -3,000,000 2,000,000 2,000,000 -500,000 Financial calculator solution: (In millions) Inputs: CF0 = -3; CF1 = 2; Nj = 2; CF2 = -.5. Output: IRR% = 12.699 ≈ 12.70%. 44. IRR of uneven CF stream Answer: e T ime line: ( In millions) 0 IRR = ? 1 2 3 4 5 -5 2 2 Diff: M 2 1 1.5 Years Financial calculator solution: (In millions) Inputs: CF0 = -5; CF1 = 1.0; CF2 = 1.5; CF3 = 2.0; Nj = 3. Output: IRR% = 18.37%. 45. NPV profiles Answer: d Diff: M First, solve for the crossover rate. If you subtract the cash flows (CFs) of Project A from the CFs of Project B, then the differential CFs are CF0 = -$10,000, CF1 = -$40,000, CF2 = 0, CF3 = $20,000, and CF4 = $40,000. Entering these CFs and solving for IRR/YR yields a crossover rate of 6.57%. Thus, if the cost of capital is 6.57%, then Projects A and B have the same NPV. If the cost of capital is less than 6.57%, then Project B has a higher NPV than Project A, since Project B's cash inflows come comparatively later in the project life. For lower discount rates, Project B's NPV is not penalized as much for having large cash inflows farther in the future than Project A. 46. Replacement chain Answer: c Diff: M To find the NPV of the system we must use the replacement chain approach. Time 0 1 2 3 4 5 6 System A -100,000 60,000 60,000 - 100,000 = -40,000 60,000 60,000 - 100,000 = -40,000 60,000 60,000 System B -100,000 48,000 48,000 48,000 - 110,000 = -62,000 52,800 52,800 52,800 Use the CF key to enter the cash flows for each period. I/YR = 11. This should give the following NPVs: NPV A = $6,796.93. NPV B = $31,211.52. Computer system B creates the most value for the firm, so the correct answer is c. Chapter 10- Page 30 47. Replacement chain Answer: e Diff: M The CFs and NPVs (calculated with I = k = 10.5%) are as follows: t 0 1 2 3 4 5 6 NPV Project A -100,000 40,000 40,000 40,000 40,000 40,000 40,000 $71,687.18 ≈ $71,687 Project B -50,000 30,000 30,000 30,000 - 55,000 = -25,000 32,000 32,000 32,000 $41,655.58 ≈ $41,656 Chapter 10- Page 31 ...
View Full Document

Ask a homework question - tutors are online