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Chapter 007 Net Present Value and Other Investment Criteria

True / False Questions 1. As the opportunity cost of capital decreases, the net present value of a project increases. TRUE

2. The IRR is the rate of return on the cash flows of the investment, also known as the opportunity cost of capital. FALSE 3. Projects with an NPV of zero decrease shareholders' wealth by the cost of the project. FALSE 4. When calculating IRR with a trial and error process, discount rates should be raised when NPV is positive. TRUE 5. Unlike using IRR, selecting projects according to their NPV will always lead to a correct accept-reject decision. TRUE

6. For mutually exclusive projects, the project with the higher IRR (and not the number of profitable years) is the correct selection. FALSE 7. When using a profitability index (ratio of net present value to initial investment) to select projects, a value of 0.63 is preferred over a value of 0.21. TRUE 8. A project's payback period is the length of time necessary to generate an NPV of zero. FALSE

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Chapter 007 Net Present Value and Other Investment Criteria

9. The payback period considers all project cash flows. FALSE

10. Both the NPV and the internal rate of return methods recognize that the timing of cash flows affects project value. TRUE

11. If a project has multiple IRRs, the highest one is assumed to be correct. FALSE

12. Because of deficiencies associated with the payback method, it is seldom used in corporate financial analysis today. FALSE

13. A risky dollar is worth more than a safe one. FALSE 14. When choosing among mutually exclusive projects, the choice is easy using the NPV rule. As long as at least one project has positive NPV, simply choose the project with the highest NPV. TRUE 15. When we compare assets with different lives, we should select the machine that has the lowest equivalent annual annuity. TRUE 16. For many firms the limits on capital funds are "soft." By this we mean that the capital rationing is not imposed by investors. TRUE 17. Soft rationing should never cost the firm anything. TRUE 18. For most managers, discounted cash flow analysis is in fact the dominant tool for project evaluation. TRUE 19. The payback rule states that a project is acceptable if you get your money back within a specified period. TRUE 20. The payback rule always makes shareholders better off. FALSE

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Chapter 007 Net Present Value and Other Investment Criteria


21. When you have to choose between projects with different lives, you should put them on an equal footing by computing the equivalent annual annuity or benefit of the two projects. TRUE

22. When you are considering whether to replace an aging machine with a new one, you should compare the annual cost of operating the old one with the equivalent annual annuity of the new one. TRUE Multiple Choice Questions 23. A project's opportunity cost of capital is: A. the forgone return from investing in the project. B. the return earned by investing in the project. C. equal to the average return on all company projects. D. designed to be less than the project's IRR.

24. Which of the following statements is correct for a project with a positive NPV? A. IRR exceeds the cost of capital. B. Accepting the project has an indeterminate effect on shareholders. C. The discount rate exceeds the cost of capital. D. The profitability index equals one. 25. If the net present value of a project which costs $20,000 is $5,000 when the discount rate is 10%, then the: A. project's IRR equals 10%. B. project's rate of return is greater than 10%. C. net present value of the cash inflows is $4,500. D. project's cash inflows total $25,000.

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Chapter 007 Net Present Value and Other Investment Criteria


26. What is the NPV of a project that costs $100,000 and returns $50,000 annually for three years if the opportunity cost of capital is 14%? A. $3,397.57 B. $4,473.44 C. $16,085.00 D. $35,000.00

27. The decision rule for net present value is to: A. accept all projects with cash inflows exceeding initial cost. B. reject all projects with rates of return exceeding the opportunity cost of capital. C. accept all projects with positive net present values. D. reject all projects lasting longer than 10 years. 28. What should occur when a project's net present value is determined to be negative? A. The discount rate should be decreased. B. The profitability index should be calculated. C. The present value of the project cost should be determined. D. The project should be rejected.

29. Which of the following changes will increase the NPV of a project? A. A decrease in the discount rate B. A decrease in the size of the cash inflows C. An increase in the initial cost of the project D. A decrease in the number of cash inflows 30. What is the maximum that should be invested in a project at time zero if the inflows are estimated at $50,000 annually for three years, and the cost of capital is 9%? A. $101,251.79 B. $109,200.00 C. $126,565.00 D. $130,800.00

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Chapter 007 Net Present Value and Other Investment Criteria

31. When a manager does not accept a positive-NPV project, shareholders face an opportunity cost in the amount of the: A. project's initial cost. B. project's NPV. C. project's discounted cash flows. D. soft capital rationing budget.

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Chapter 007 Net Present Value and Other Investment Criteria


32. What is the approximate maximum amount that a firm should consider paying for a project that will return $15,000 annually for 5 years if the opportunity cost is 10%? A. $33,520 B. $56,860 C. $62,540 D. $75,000

33. Which of the following projects would you feel safest in accepting? Assume the opportunity cost of capital to be 12% for each project. A. "A" has a small, but negative, NPV. B. "B" has a positive NPV when discounted at 10%. C. "C's" cost of capital exceeds its rate of return. D. "D" has a zero NPV when discounted at 14%.

34. As the discount rate is increased, the NPV of a specific project will: A. increase. B. decrease. C. remain constant. D. decrease to zero, then remain constant.

35. If the opportunity cost of capital for a project exceeds the project's IRR, then the project has a(n): A. positive NPV. B. negative NPV. C. acceptable payback period. D. positive profitability index.

36. When the NPV of an investment is positive, then the IRR will be: A. equal to the opportunity cost of capital. B. greater than the opportunity cost of capital. C. less than the opportunity cost of capital. D. less than or equal to the opportunity cost of capital.

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Chapter 007 Net Present Value and Other Investment Criteria


37. Which of the following can be deduced about a three- year investment project that has a two-year payback period? A. The NPV is positive. B. The IRR is greater than the cost of capital. C. Both 'a' and 'b' can be deduced. D. Neither 'a' nor 'b' can be deduced.

38. When a project's internal rate of return equals its opportunity cost of capital, then: A. the project should be rejected. B. the project has no cash inflows. C. the net present value will be positive. D. the net present value will be zero.

39. Firms that make investment decisions based upon the payback rule may be biased toward rejecting projects: A. with short lives. B. with long lives. C. with early cash inflows. D. that have negative NPVs.

40. One method that can be used to increase the NPV of a project is to decrease the: A. project's payback. B. project's cost of capital. C. time until receipt of cash inflows. D. number of project IRRs.

41. What is the approximate IRR for a project that costs $100,000 and provides cash inflows of $30,000 for 6 years? A. 19.9% B. 30.0% C. 32.3% D. 80.0%

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Chapter 007 Net Present Value and Other Investment Criteria


42. What is the IRR of a project that costs $100,000 and provides cash inflows of $17,000 annually for six years? A. 0.57% B. 2.00% C. 5.69% D. 56.87%

43. What is the minimum number of years that an investment costing $500,000 must return $65,000 per year at a discount rate of 13% in order to be an acceptable investment? A. 8.69 years B. 14.00 years C. 27.51 years D. An infinite number of years.

NPV = (65,000/.13) - $500,000 NPV = 500,000 - 500,000 NPV = 0

44. Which of the following statements is most likely correct for a project costing $50,000 and returning $14,000 per year for five years? A. NPV = $3,071.01. B. NPV = $20,000. C. IRR = 2.8%. D. IRR is greater than 10%.

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Chapter 007 Net Present Value and Other Investment Criteria


45. If the IRR for a project is 15%, then the project's NPV would be: A. negative at a discount rate of 10%. B. positive at a discount rate of 20%. C. negative at a discount rate of 20%. D. positive at a discount rate of 15%. 46. As long as the NPV of a project declines smoothly with increases in the discount rate, the project is acceptable if its: A. internal rate of return is positive. B. net present value does not equal zero. C. rate of return exceeds the cost of capital. D. cash inflows exceed the initial cost.

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