Questions and Answers
What is the NPV of a project with an initial investment of $95, a cash flow in one year of $107, and a discount rate of 6%?
5.94
Which of the following present problems when using the IRR method? (Select all that apply)
The present value of the future cash inflows are divided by the __ to calculate the profitability index.
initial investment
What is the basic NPV investment rule?
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The NPV is _______ if the required return is less than the IRR, and it is _______ if the required return is greater than the IRR.
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The Combination of MIRR method is used by the Excel MIRR function and uses which of the following? (Select all that apply)
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In capital budgeting, what determines the dollar value of a project to the company?
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How does specifying variables in the Excel NPV function differ from a financial calculator?
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Why is capital budgeting important to a financial manager?
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If the IRR is greater than the ___ ___, we should accept the project.
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What does the Internal Rate of Return depend on?
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Which of the following are methods of calculating the MIRR of a project? (Select all that apply)
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What is the IRR for a project with an initial investment of $250 and subsequent cash inflows of $100 per year for 3 years?
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If a firm evaluates two projects that require the same production facilities, how are these projects classified?
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Which of the following are reasons why IRR continues to be used in practice? (Select all that apply)
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What should be used if a project has multiple internal rates of return?
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What is a disadvantage of the Profitability Index?
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How does the timing of cash flows affect their value?
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Some projects with cash inflows followed by outflows may have multiple internal rates of return.
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What is the profitability index for a project with an initial cash outflow of $30 and inflows of $80 in year one and $20 in year two, with a discount rate of 12%?
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According to the PI rule for an independent project, we should ___ the project if the PI is greater than 1.
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Which of the following are weaknesses of the payback method? (Select all that apply)
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The payback period rule ___ a project if it has a payback period that is less than or equal to a particular cutoff date.
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An advantage of the AAR is that it is based on book values, not market values.
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What is a disadvantage of the payback period rule?
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According to the average accounting return rule, a project is acceptable if its average accounting return exceeds what?
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What are the advantages of the payback period method for management? (Select all that apply)
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Why can the payback period lead to poor decisions if used too literally?
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The Average Accounting Return is defined as:
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Which forklift system should be purchased using the net present value (NPV) approach?
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According to Graham and Harvey's 1999 survey, which two capital budgeting methods are widely used by firms in the US and Canada?
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Study Notes
NPV Calculation
- NPV for a project with a $95 investment, $107 cash flow in one year, and a 6% discount rate is $5.94.
IRR Method Limitations
- Problems with the IRR method include:
- Mutually exclusive projects complicate decision-making.
- Non-conventional cash flows can result in multiple IRRs.
Profitability Index Calculation
- Profitability index is calculated by dividing present value of future cash inflows by the initial investment.
NPV Investment Rule
- Accept a project if NPV > 0, reject if NPV < 0, and indifference if NPV = 0.
NPV and IRR Relationship
- NPV is positive if required return < IRR and negative if required return > IRR.
MIRR Method
- MIRR combines multiple approaches:
- Reinvestment rate for cash flow compounding.
- Discount cash outflows to time 0.
- Financing rate for discounting and cash inflow compounding to project end.
Net Present Value in Capital Budgeting
- NPV determines the dollar value of a project to a company.
Excel NPV Function Differences
- Excel NPV function requires decimal discount rates and uses cash flow #1, not #0.
- Cash flow #0 must be handled separately, and the NPV function essentially functions as a PV function.
Importance of Capital Budgeting
- Capital budgeting is crucial as it defines the business objectives and prospects of a firm.
IRR Decision Rule
- Accept a project if IRR > required return.
Internal Rate of Return
- IRR is derived from a project's cash flows.
MIRR Calculation Methods
- MIRR can be calculated using:
- Reinvestment Approach
- Combination Approach
- Discounting Approach
Project IRR Example
- For a $250 investment with $100 annual inflow for 3 years, the IRR is 9.70%.
Mutually Exclusive Projects
- Projects that share the same resources or production facilities are considered mutually exclusive.
IRR Practicality
- IRR remains popular because:
- It simplifies communication about proposals.
- Allows calculation without knowing the discount rate.
- Business discussions often focus on rates of return.
Multiple IRRs
- Use MIRR or NPV methods if a project has multiple internal rates of return.
Profitability Index Disadvantages
- Profitability Index cannot effectively rank mutually exclusive projects.
Cash Flow Timing
- Cash flows received earlier in a project's timeline are more valuable than those received later.
Cash Flow Patterns
- Projects with alternating cash inflows and outflows may experience multiple internal rates of return.
Profitability Index Calculation Example
- For a project with a $30 outflow and subsequent cash inflows of $80 and $20 at 12% discount rate, the profitability index is 2.91.
PI Rule for Independent Projects
- Accept independent projects if the profitability index exceeds 1.
Payback Method Weaknesses
- The payback method has weaknesses including:
- Arbitrary cutoff dates.
- Ignoring time value of money.
- Overlooking cash flows after the payback period.
Payback Period Acceptance Rule
- Projects are accepted if they have a payback period within a specified cutoff.
Average Accounting Return (AAR)
- AAR is evaluated using average net income divided by average book value; advantages of AAR are based on market values.
Payback Period Advantages
- Payback method is suitable for small projects, is user-friendly, and empowers lower-level managers in decision-making.
Pitfalls of the Payback Period
- The payback period can lead to poor decisions by neglecting cash flows beyond the cutoff.
Average Accounting Return Definition
- AAR is calculated by averaging net income over average book value.
Forklift Evaluation Case Study
- Otis Forklifts were chosen for purchase based on NPV evaluation at a 12% discount rate.
Capital Budgeting Trends
- According to a survey of CFOs, Net Present Value and Internal Rate of Return are the most commonly used capital budgeting methods in the US and Canada.
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Description
Test your knowledge on Net Present Value (NPV) and Internal Rate of Return (IRR) with this quiz on Unit 10. You'll encounter questions related to cash flows, necessary financial calculations, and potential problems with investment methods. Perfect for finance students looking to solidify their understanding of these concepts.
