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Foundations of Finance, 8e, Global Edition, (Keown/Martin/Petty)
Chapter 10 Capital Investment Decision Analysis-I
Learning Objective 1
1) Free cash flows represent the benefits generated from accepting a capital-budgeting proposal.
Answer: TRUE
Diff: 1
Keywords: Capital Budgeting, Free Cash Flow
AACSB: Reflective thinking skills
Learning Objective 2
1) The most critical aspect in determining the acceptability of a capital budgeting project is the impact the project will have on the company's net income over the projects entire useful life.
Answer: FALSE
Diff: 1
Keywords: Income vs. Cash Flow
AACSB: Reflective thinking skills
2) Advantages of the payback period include that it is easy to calculate, easy to understand, and that it is based on cash flows rather than on accounting profits.
Answer: TRUE
Diff: 1
Keywords: Payback Period
AACSB: Reflective thinking skills
3) If project A generates $10 million of free cash flow over its five year useful life and project B generates $8 million of free cash flow over its useful life, then Project A will have a shorter payback period than Project B, assuming both projects require the same initial investment.
Answer: FALSE
Diff: 1
Keywords: Payback Period
AACSB: Analytic skills
4) A project with a payback period of four years is acceptable as long as the company's target payback period is greater than or equal to four years.
Answer: TRUE
Diff: 1
Keywords: Payback Period
AACSB: Reflective thinking skills
5) Two projects that have the same cost and the same expected cash flows will have the same net present value.
Answer: FALSE
Diff: 1
Keywords: Net Present Value, Discount Rate
AACSB: Analytic skills
6) The profitability index is the ratio of the company's net income (or profits) to the initial outlay or cost of a capital budgeting project.
Answer: FALSE
Diff: 1
Keywords: Profitability Index
AACSB: Reflective thinking skills
7) If a project is acceptable using the net present value criteria, then it will also be acceptable under the less stringent criteria of the payback period.
Answer: FALSE
Diff: 1
Keywords: Net Present Value, Payback Period
AACSB: Analytic skills
8) An acceptable project should have a net present value greater than or equal to zero and a profitability index greater than or equal to one.
Answer: TRUE
Diff: 1
Keywords: Net Present Value, Profitability Index
AACSB: Reflective thinking skills
9) If a project's internal rate of return is greater than the project's required return, then the project's profitability index will be greater than one.
Answer: TRUE
Diff: 2
Keywords: Internal Rate of Return, Profitability Index
AACSB: Analytic skills
10) The net present value profile clearly demonstrates that the NPV of a project increases as the discount rate increases.
Answer: FALSE
Diff: 1
Keywords: Net Present Value Profile, Discount Rate
AACSB: Reflective thinking skills
11) The modified internal rate of return represents the project's internal rate of return assuming that intermediate cash flows from the project can be reinvested at the project's required return.
Answer: TRUE
Diff: 1
Keywords: Modified Internal Rate of Return, Required Return
AACSB: Reflective thinking skills
12) One drawback of the payback method is that some cash flows may be ignored.
Answer: TRUE
Diff: 1
Keywords: Payback Period
AACSB: Reflective thinking skills
13) The required rate of return reflects the costs of funds needed to finance a project.
Answer: TRUE
Diff: 1
Keywords: Required Return
AACSB: Reflective thinking skills
14) The profitability index provides an advantage over the net present value method by reporting the present value of benefits per dollar invested.
Answer: TRUE
Diff: 1
Keywords: Profitability Index, Net Present Value
AACSB: Reflective thinking skills
15) The net present value of a project will increase as the required rate of return is decreased (assume only one sign reversal).
Answer: TRUE
Diff: 1
Keywords: Net Present Value, Required Return
AACSB: Analytic skills
16) Whenever the internal rate of return on a project equals that project's required rate of return, the net present value equals zero.
Answer: TRUE
Diff: 1
Keywords: Internal Rate of Return, Net Present Value, Required Return
AACSB: Analytic skills
17) One of the disadvantages of the payback method is that it ignores time value of money.
Answer: TRUE
Diff: 1
Keywords: Payback Period, Time Value of Money
AACSB: Reflective thinking skills
18) The capital budgeting decision-making process involves measuring the incremental cash flows of an investment proposal and evaluating the attractiveness of these cash flows relative to the project's cost.
Answer: TRUE
Diff: 1
Keywords: Capital Budgeting, Incremental Cash Flows
AACSB: Reflective thinking skills
19) When several sign reversals in the cash flow stream occur, a project can have more than one IRR.
Answer: TRUE
Diff: 1
Keywords: Multiple Internal Rates of Return, Sign Reversals
AACSB: Analytic skills
20) Many firms today continue to use the payback method but also employ the NPV or IRR methods especially when large projects are being analyzed.
Answer: TRUE
Diff: 1
Keywords: Payback Period, NPV, IRR
AACSB: Reflective thinking skills
21) NPV is the most theoretically correct capital budgeting decision tool examined in the text.
Answer: TRUE
Diff: 1
Keywords: NPV
AACSB: Reflective thinking skills
22) If the net present value of a project is zero, then the profitability index will equal one.
Answer: TRUE
Diff: 1
Keywords: Net Present Value, Profitability Index, Decision Rules
AACSB: Analytic skills
23) The internal rate of return will equal the discount rate when the net present value equals zero.
Answer: TRUE
Diff: 1
Keywords: Internal Rate of Return, Discount Rate, Net Present Value
AACSB: Analytic skills
24) Mutually exclusive projects have more than one IRR.
Answer: FALSE
Diff: 1
Keywords: Mutually Exclusive Projects, IRR
AACSB: Reflective thinking skills
25) For a project with multiple sign reversals in its cash flows, the net present value can be the same for two entirely different discount rates.
Answer: TRUE
Diff: 1
Keywords: Sign Reversals, Net Present Value, Discount Rates
AACSB: Analytic skills
26) The internal rate of return is the discount rate that equates the present value of the project's future free cash flows with the project's initial outlay.
Answer: TRUE
Diff: 1
Keywords: Internal Rate of Return
AACSB: Reflective thinking skills
27) If a project's profitability index is less than one then the project should be rejected.
Answer: TRUE
Diff: 1
Keywords: Profitability Index
AACSB: Analytic skills
28) If a project is acceptable using the NPV criteria, it will also be acceptable when using the profitability index and IRR criteria.
Answer: TRUE
Diff: 1
Keywords: NPV, PI, IRR
AACSB: Reflective thinking skills
29) If a firm imposes a capital constraint on investment projects, the appropriate decision criterion is to select the set of projects that has the highest positive net present value subject to the capital constraint.
Answer: TRUE
Diff: 1
Keywords: Capital Constraint, Net Present Value
AACSB: Reflective thinking skills
30) For any individual project, if the project is acceptable based on its internal rate of return, then the project will also be acceptable based on its modified internal rate of return.
Answer: TRUE
Diff: 2
Keywords: Internal Rate of Return, Modified Internal Rate of Return
AACSB: Reflective thinking skills
31) One positive feature of the payback period is it emphasizes the earliest forecasted free cash flows, which are less uncertain than later cash flows and provide for the liquidity needs of the firm.
Answer: TRUE
Diff: 1
Keywords: Payback Period
AACSB: Reflective thinking skills
32) The main disadvantage of the NPV method is the need for detailed, long-term forecasts of free cash flows generated by prospective projects.
Answer: TRUE
Diff: 1
Keywords: NPV, Free Cash Flow
AACSB: Reflective thinking skills
33) The profitability index is the ratio of the present value of the future free cash flows to the initial investment.
Answer: TRUE
Diff: 1
Keywords: Profitability Index
AACSB: Reflective thinking skills
34) Marketing is crucial to capital budgeting success because the goal of a good capital budgeting project is to maximize the company's sales.
Answer: FALSE
Diff: 1
Keywords: Capital Budgeting, Shareholder Wealth Maximization
AACSB: Reflective thinking skills
35) Because the NPV and PI methods both yield the same accept/reject decision, a company attempting to rank capital budgeting projects for funding consideration can use either method and get the same results.
Answer: FALSE
Diff: 2
Keywords: NPV, PI
AACSB: Reflective thinking skills
36) A project's IRR is analogous to the concept of the yield to maturity for bonds.
Answer: TRUE
Diff: 1
Keywords: IRR, Yield to Maturity
AACSB: Reflective thinking skills
37) NPV assumes reinvestment of intermediate free cash flows at the cost of capital, while IRR assumes reinvestment of intermediate free cash flows at the IRR.
Answer: TRUE
Diff: 1
Keywords: NPV, IRR, Reinvestment Rate
AACSB: Reflective thinking skills
38) A project's net present value profile shows how sensitive the project is to the choice of a discount rate.
Answer: TRUE
Diff: 1
Keywords: Net Present Value Profile, Discount Rate
AACSB: Reflective thinking skills
39) If a project has multiple internal rates of return, the lowest rate should be used for decision making purposes.
Answer: FALSE
Diff: 2
Keywords: Internal Rate of Return, Multiple IRRs
AACSB: Reflective thinking skills
40) The payback period ignores the time value of money and therefore should not be used as a screening device for the selection of capital budgeting projects.
Answer: FALSE
Diff: 1
Keywords: Payback Period, Time Value of Money
AACSB: Analytic skills
41) Many financial managers believe the payback period is of limited usefulness because it ignores the time value of money; hence, it is referred to as the discounted payback period.
Answer: FALSE
Diff: 1
Keywords: Discounted Payback Period, Payback Period, Time Value of Money
AACSB: Reflective thinking skills
42) The discounted payback period takes the time value of money into account in that it uses discounted free cash flows rather than actual undiscounted free cash flows in calculating the payback period.
Answer: TRUE
Diff: 1
Keywords: Discounted Payback Period, Time Value of Money
AACSB: Reflective thinking skills
43) Any project deemed acceptable using the discounted payback period will also be acceptable if using the traditional payback period.
Answer: TRUE
Diff: 2
Keywords: Discounted Payback Period, Payback Period
AACSB: Reflective thinking skills
44) A major disadvantage of the discounted payback period is the arbitrariness of the process used to select the maximum desired payback period.
Answer: TRUE
Diff: 1
Keywords: Discounted Payback Period, Arbitrary Decision Rule
AACSB: Reflective thinking skills
45) A project with a NPV of zero should be rejected since even the returns on U.S. Treasury bill are greater than zero.
Answer: FALSE
Diff: 1
Keywords: NPV, Decision Rule
AACSB: Reflective thinking skills
46) NPV may be calculated on an Excel spreadsheet simply by entering the project's free cash flows into Excel's NPV function.
Answer: FALSE
Diff: 1
Keywords: NPV, Excel
AACSB: Reflective thinking skills
47) The internal rate of return is the discount rate that equates the present value of the project's free cash flows with the project's initial cash outlay.
Answer: TRUE
Diff: 1
Keywords: Internal Rate of Return
AACSB: Reflective thinking skills
48) A project that is very sensitive to the selection of a discount rate will have a steep net present value profile.
Answer: TRUE
Diff: 1
Keywords: Net Present Value Profile
AACSB: Reflective thinking skills
49) Because the MIRR assumes reinvestment at the cost of capital while IRR assumes reinvestment at the project's IRR, the MIRR will always be less than the IRR.
Answer: FALSE
Diff: 2
Keywords: IRR, MIRR, Reinvestment Rate
AACSB: Reflective thinking skills
50) Calculating the modified internal rate of return on an Excel spreadsheet involves the use of the IRR function multiple times, once using the financing rate, and once using the reinvestment rate.
Answer: FALSE
Diff: 1
Keywords: MIRR, Excel, Reinvestment Rate
AACSB: Reflective thinking skills
51) The capital budgeting manager for XYZ Corporation, a very profitable high technology company, completed her analysis of Project A assuming 5-year depreciation. Her accountant reviews the analysis and changes the depreciation method to 3-year depreciation. This change will
A) increase the present value of the NCFs.
B) decrease the present value of the NCFs.
C) have no effect on the NCFs because depreciation is a non-cash expense.
D) only change the NCFs if the useful life of the depreciable asset is greater than 5 years.
Answer: A
Diff: 2
Keywords: Net Present Value, Depreciation Expense
AACSB: Analytic skills
52) Project W requires a net investment of $1,000,000 and has a payback period of 5.6 years. You analyze Project W and decide that Year 1 free cash flow is $100,000 too low, and Year 3 free cash flow is $100,000 too high. After making the necessary adjustments
A) the payback period for Project W will be longer than 5.6 years.
B) the payback period for Project W will be shorter than 5.6 years.
C) the IRR of Project W will increase.
D) the NPV of Project W will decrease.
Answer: C
Diff: 2
Keywords: Payback Period, Net Present Value, Internal Rate of Return
AACSB: Analytic skills
53) Project Alpha has an internal rate of return (IRR) of 15 percent. Project Beta has an IRR of 14 percent. Both projects have a required return of 12 percent. Which of the following statements is MOST correct?
A) Both projects have a positive net present value (NPV).
B) Project Alpha must have a higher NPV than Project Beta.
C) If the required return were less than 12 percent, Project Beta would have a higher IRR than Project Alpha.
D) Project Beta has a higher profitability index than Project Alpha.
Answer: A
Diff: 2
Keywords: Internal Rate of Return, Net Present Value, Required Return
AACSB: Reflective thinking skills
54) Which of the following statements is MOST correct?
A) If a project's internal rate of return (IRR) exceeds the required return, then the project's net present value (NPV) must be negative.
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 IRR.
D) A project with a NPV = 0 is not acceptable.
Answer: C
Diff: 1
Keywords: Internal Rate of Return, Net Present Value, Reinvestment Rate
AACSB: Reflective thinking skills
55) DYI Construction Co. is considering a new inventory system that will cost $750,000. The system is expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in year four. DYI's required rate of return is 8%. What is the payback period of this project?
A) 4.00 years
B) 3.09 years
C) 2.91 years
D) 2.50 years
Answer: D
Diff: 1
Keywords: Payback Period
AACSB: Analytic skills
56) DYI Construction Co. is considering a new inventory system that will cost $750,000. The system is expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in year four. DYI's required rate of return is 8%. What is the net present value of this project?
A) $104,089
B) $100,328
C) $96,320
D) $87,417
Answer: A
Diff: 2
Keywords: Net Present Value
AACSB: Analytic skills
57) DYI Construction Co. is considering a new inventory system that will cost $750,000. The system is expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in year four. DYI's required rate of return is 8%. What is the internal rate of return of this project?
A) 10.87%
B) 11.57%
C) 13.68%
D) 15.13%
Answer: D
Diff: 2
Keywords: Internal Rate of Return
AACSB: Analytic skills
58) DYI Construction Co. is considering a new inventory system that will cost $750,000. The system is expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in year four. DYI's required rate of return is 8%. What is the modified internal rate of return of this project?
A) 10.87%
B) 11.57%
C) 13.68%
D) 15.13%
Answer: B
Diff: 2
Keywords: Modified Internal Rate of Return
AACSB: Analytic skills
59) Project LMK requires an initial outlay of $400,000 and has a profitability index of 1.5. The project is expected to generate equal annual cash flows over the next twelve years. The required return for this project is 20%. What is project LMK's net present value?
A) $600,000
B) $150,000
C) $120,000
D) $80,000
Answer: B
Diff: 2
Keywords: Net Present Value, Profitability Index
AACSB: Analytic skills
60) Project LMK requires an initial outlay of $500,000 and has a profitability index of 1.4. The project is expected to generate equal annual cash flows over the next ten years. The required return for this project is 16%. What is project LMK's internal rate of return?
A) 19.88%
B) 22.69%
C) 24.78%
D) 26.12%
Answer: D
Diff: 3
Keywords: Internal Rate of Return, Profitability Index, Ordinary Annuity
AACSB: Analytic skills
61) A capital budgeting project has a net present value of $30,000 and a modified internal rate of return of 15%. The project's required rate of return is 13%. The internal rate of return is
A) greater than $30,000.
B) less than 13%.