TEST BANK CHAPTER 11 THE BASICS OF CAPITAL BUDGETING QUẢN TRỊ TÀI CHÍNH

The IRR method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking STATE

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1 A firm should never accept a project if its acceptance would lead to an increase in the firm's cost of capital (its WACC).

United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking

STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and

cost of capital

2 Because "present value" refers to the value of cash flows that occur at different points in time, a series of present values

of cash flows should not be summed to determine the value of a capital budgeting project

cost of capital

3 Assuming that their NPVs based on the firm's cost of capital are equal, the NPV of a project whose cash flows accrue relatively rapidly will be more sensitive to changes in the discount rate than the NPV of a project whose cash flows come

in later in its life

REFERENCES: 11-2 Net Present Value (NPV)

LEARNING OBJECTIV FOFM.BRIG.16.11.02 - Net Present Value (NPV)

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cost of capital

4 A basic rule in capital budgeting is that if a project's NPV exceeds its IRR, then the project should be accepted

cost of capital

5 Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first In theory, such conflicts should be resolved in favor of the project with the higher NPV

cost of capital

6 Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first In theory, such conflicts should be resolved in favor of the project with the higher IRR

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cost of capital

7 The internal rate of return is that discount rate that equates the present value of the cash outflows (or costs) with the present value of the cash inflows

cost of capital

8 Other things held constant, an increase in the cost of capital will result in a decrease in a project's IRR

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cost of capital

9 Under certain conditions, a project may have more than one IRR One such condition is when, in addition to the initial investment at time = 0, a negative cash flow (or cost) occurs at the end of the project's life

cost of capital

10 The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects that have different lives are being compared

cost of capital

11 The NPV method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost

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cost of capital

12 The IRR method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost

cost of capital

13 The NPV method's assumption that cash inflows are reinvested at the cost of capital is generally more reasonable than the IRR's assumption that cash flows are reinvested at the IRR This is an important reason why the NPV method is generally preferred over the IRR method

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cost of capital

14 For a project with one initial cash outflow followed by a series of positive cash inflows, the modified IRR (MIRR) method involves compounding the cash inflows out to the end of the project's life, summing those compounded cash flows

to form a terminal value (TV), and then finding the discount rate that causes the PV of the TV to equal the project's cost

cost of capital

15 Both the regular and the modified IRR (MIRR) methods have wide appeal to professors, but most business executives prefer the NPV method to either of the IRR methods

cost of capital

16 When evaluating mutually exclusive projects, the modified IRR (MIRR) always leads to the same capital budgeting decisions as the NPV method, regardless of the relative lives or sizes of the projects being evaluated

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cost of capital

17 One advantage of the payback method for evaluating potential investments is that it provides information about a project's liquidity and risk

cost of capital

18 When considering two mutually exclusive projects, the firm should always select the project whose internal rate of return is the highest, provided the projects have the same initial cost This statement is true regardless of whether the projects can be repeated or not

IRRL = 30.0% NPVL = $647.77

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S has the higher IRR, but L has a much higher NPV and is therefore preferable Ifthe project could be repeated, though, S would turn out to be better—it would have both a higher NPV and IRR.

TOPICS: Mutually exclusive projects

KEYWORDS: Bloom's: Comprehension

19 The primary reason that the NPV method is conceptually superior to the IRR method for evaluating mutually exclusive investments is that multiple IRRs may exist, and when that happens, we don't know which IRR is relevant

cost of capital

20 The NPV and IRR methods, when used to evaluate two independent and equally risky projects, will lead to different accept/reject decisions and thus capital budgets if the projects' IRRs are greater than their costs of capital

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cost of capital

21 The NPV and IRR methods, when used to evaluate two equally risky but mutually exclusive projects, will lead to different accept/reject decisions and thus capital budgets if the cost of capital at which the projects' NPV profiles cross is greater than the crossover rate

cost of capital

22 A conflict will exist between the NPV and IRR methods, when used to evaluate two equally risky but mutually exclusive projects, if the projects' cost of capital is less than the rate at which the projects' NPV profiles cross

cost of capital

23 Project S has a pattern of high cash flows in its early life, while Project L has a longer life, with large cash flows late

in its life Neither has negative cash flows after Year 0, and at the current cost of capital, the two projects have identical NPVs Now suppose interest rates and money costs decline Other things held constant, this change will cause L to become preferred to S

a True

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cost of capital

24 The regular payback method is deficient in that it does not take account of cash flows beyond the payback period The discounted payback method corrects this fault

a True

b Fals

e

RATIONALE: The discounted payback corrects the fault of not considering the timing of cash

flows, but it does not account for after-payback cash flows

TOPICS: Discounted payback

KEYWORDS: Bloom’s: Knowledge

25 In theory, capital budgeting decisions should depend solely on forecasted cash flows and the opportunity cost of capital The decision criterion should not be affected by managers' tastes, choice of accounting method, or the profitability

of other independent projects

REFERENCES: 11-9 Conclusions on Capital Budgeting Methods

LEARNING OBJECTIV FOFM.BRIG.16.11.09 - Conclusions on Capital Budgeting Methods

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cost of capital

26 If you were evaluating two mutually exclusive projects for a firm with a zero cost of capital, the payback method and NPV method would always lead to the same decision on which project to undertake

a True

b Fals

e

RATIONALE: One project might have cash flows that extend well past the payback year,

leading to different rankings

KEYWORDS: Bloom's: Comprehension

27 Small businesses make less use of DCF capital budgeting techniques than large businesses This may reflect a lack of knowledge on the part of small firms' managers, but it may also reflect a rational conclusion that the costs of using DCF analysis outweigh the benefits of these methods for very small firms

cost of capital

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28 An increase in the firm's WACC will decrease projects' NPVs, which could change the accept/reject decision for any potential project However, such a change would have no impact on projects' IRRs Therefore, the accept/reject decision under the IRR method is independent of the cost of capital.

cost of capital

29 The IRR of normal Project X is greater than the IRR of normal Project Y, and both IRRs are greater than zero Also, the NPV of X is greater than the NPV of Y at the cost of capital If the two projects are mutually exclusive, Project X should definitely be selected, and the investment made, provided we have confidence in the data Put another way, it is impossible to draw NPV profiles that would suggest not accepting Project X

a True

b Fals

e

ANSWER: False

RATIONALE: Project X may have a negative NPV if r > IRR The NPV profile line crosses the

horizontal axis, and the NPV at the cost of capital is in the lower right quadrant

STATE STAND United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of

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ARDS: capital

TOPICS: NPV profiles

30 Normal Projects S and L have the same NPV when the discount rate is zero However, Project S's cash flows come in faster than those of L Therefore, we know that at any discount rate greater than zero, L will have the higher NPV

cost of capital

31 If the IRR of normal Project X is greater than the IRR of mutually exclusive (and also normal) Project Y, we can conclude that the firm should always select X rather than Y if X has NPV > 0

a True

b Fals

e

RATIONALE: We do not know if the cost of capital is to the right or left of the crossover point

Therefore, NPVX may be either higher or lower than NPVY

DIFFICULTY: CHALLENGING

REFERENCES: 11-7 NPV Profiles

LEARNING OB

JECTIVES: FOFM.BRIG.16.11.07 - NPV Profiles

NATIONAL STA United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking

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32 Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows

a A project's NPV is found by compounding the cash inflows at the IRR to find the

terminal value (TV), then discounting the TV at the WACC

b.The lower the WACC used to calculate it, the lower the calculated NPV will be

c If a project's NPV is less than zero, then its IRR must be less than the WACC

d.If a project's NPV is greater than zero, then its IRR must be less than zero

e The NPV of a relatively low-risk project should be found using a relatively high

United States - BUSPROG.FOFM.BRIG.16.03 - Analytic skills

cost of capital

33 Which of the following statements is CORRECT?

a One defect of the IRR method is that it does not take account of cash flows over a

project's full life

b.One defect of the IRR method is that it does not take account of the time value of

money

c One defect of the IRR method is that it does not take account of the cost of capital

d.One defect of the IRR method is that it values a dollar received today the same as a

dollar that will not be received until sometime in the future

e One defect of the IRR method is that it assumes that the cash flows to be received

from a project can be reinvested at the IRR itself, and that assumption is often not

valid

RATIONALE: The IRR assumes reinvestment at the IRR, and that is generally not as valid as

assuming reinvestment at the WACC, which is the reinvestment rate assumption

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OTHER: Multiple Choice: Conceptual

a One defect of the IRR method versus the NPV is that the IRR does not take account of

cash flows over a project's full life

b.One defect of the IRR method versus the NPV is that the IRR does not take account of

the time value of money

c One defect of the IRR method versus the NPV is that the IRR does not take account of

the cost of capital

d.One defect of the IRR method versus the NPV is that the IRR values a dollar received

today the same as a dollar that will not be received until sometime in the future

e One defect of the IRR method versus the NPV is that the IRR does not take proper

account of differences in the sizes of projects

RATIONALE: The IRR would rank a project that cost $100 and had a 100% IRR ahead of a

project that cost $1,000,000 and had an IRR of 90% The larger project would increase the firm's value more, as the NPV would demonstrate

a A project's regular IRR is found by compounding the cash inflows at the WACC to

find the terminal value (TV), then discounting this TV at the WACC

b.A project's regular IRR is found by discounting the cash inflows at the WACC to find

the present value (PV), then compounding this PV to find the IRR

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c If a project's IRR is greater than the WACC, then its NPV must be negative.

d.To find a project's IRR, we must solve for the discount rate that causes the PV of the

inflows to equal the PV of the project's costs

e To find a project's IRR, we must find a discount rate that is equal to the WACC

cost of capital

a A project's regular IRR is found by compounding the initial cost at the WACC to find

the terminal value (TV), then discounting the TV at the WACC

b.A project's regular IRR is found by compounding the cash inflows at the WACC to

find the present value (PV), then discounting the TV to find the IRR

c If a project's IRR is smaller than the WACC, then its NPV will be positive

d.A project's IRR is the discount rate that causes the PV of the inflows to equal the

cost of capital

a If a project has "normal" cash flows, then its IRR must be positive

b.If a project has "normal" cash flows, then its MIRR must be positive

c If a project has "normal" cash flows, then it will have exactly two real IRRs

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d.The definition of "normal" cash flows is that the cash flow stream has one or more

negative cash flows followed by a stream of positive cash flows and then one negative

cash flow at the end of the project's life

e If a project has "normal" cash flows, then it can have only one real IRR, whereas a

project with "nonnormal" cash flows might have more than one real IRR

cost of capital

a Projects with "normal" cash flows can have only one real IRR

b.Projects with "normal" cash flows can have two or more real IRRs

c Projects with "normal" cash flows must have two changes in the sign of the cash

flows, e.g., from negative to positive to negative If there are more than two sign

changes, then the cash flow stream is "nonnormal."

d.The "multiple IRR problem" can arise if a project's cash flows are "normal."

e Projects with "nonnormal" cash flows are almost never encountered in the real world

cost of capital

a The regular payback method recognizes all cash flows over a project's life

b.The discounted payback method recognizes all cash flows over a project's life, and it

also adjusts these cash flows to account for the time value of money

c The regular payback method was, years ago, widely used, but virtually no companies

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even calculate the payback today.

d.The regular payback is useful as an indicator of a project's liquidity because it gives

managers an idea of how long it will take to recover the funds invested in a project

e The regular payback does not consider cash flows beyond the payback year, but the

discounted payback overcomes this defect

RATIONALE: Statement d is true The payback does indicate how long it should take to

recover the investment; hence, it is a measure of liquidity

a The longer a project's payback period, the more desirable the project is normally

considered to be by this criterion

b.One drawback of the payback criterion for evaluating projects is that this method does

not properly account for the time value of money

c If a project's payback is positive, then the project should be rejected because it must

have a negative NPV

d.The regular payback ignores cash flows beyond the payback period, but the discounted

payback method overcomes this problem

e If a company uses the same payback requirement to evaluate all projects, say it

requires a payback of 4 years or less, then the company will tend to reject projects with

relatively short lives and accept long-lived projects, and this will cause its risk to

increase over time

cost of capital

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a The shorter a project's payback period, the less desirable the project is normally

considered to be by this criterion

b.One drawback of the payback criterion is that this method does not take account of

cash flows beyond the payback period

c If a project's payback is positive, then the project should be accepted because it must

have a positive NPV

d.The regular payback ignores cash flows beyond the payback period, but the discounted

payback method overcomes this problem

e One drawback of the discounted payback is that this method does not consider the time

value of money, while the regular payback overcomes this drawback

cost of capital

42 Assume a project has normal cash flows All else equal, which of the following statements is CORRECT?

a A project's IRR increases as the WACC declines

b A project's NPV increases as the WACC declines

c A project's MIRR is unaffected by changes in the WACC

d A project's regular payback increases as the WACC declines

e A project's discounted payback increases as the WACC declines

cost of capital

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a The internal rate of return method (IRR) is generally regarded by academics as being

the best single method for evaluating capital budgeting projects

b.The payback method is generally regarded by academics as being the best single

method for evaluating capital budgeting projects

c The discounted payback method is generally regarded by academics as being the best

single method for evaluating capital budgeting projects

d.The net present value method (NPV) is generally regarded by academics as being the

best single method for evaluating capital budgeting projects

e The modified internal rate of return method (MIRR) is generally regarded by

academics as being the best single method for evaluating capital budgeting projects

cost of capital

a An NPV profile graph shows how a project's payback varies as the cost of capital

changes

b.The NPV profile graph for a normal project will generally have a positive (upward)

slope as the life of the project increases

c An NPV profile graph is designed to give decision makers an idea about how a

project's risk varies with its life

d.An NPV profile graph is designed to give decision makers an idea about how a

project's contribution to the firm's value varies with the cost of capital

e We cannot draw a project's NPV profile unless we know the appropriate WACC for

use in evaluating the project's NPV

cost of capital

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TOPICS: NPV profiles

a A project's NPV is generally found by compounding the cash inflows at the WACC to

find the terminal value (TV), then discounting the TV at the IRR to find its PV

b.The higher the WACC used to calculate the NPV, the lower the calculated NPV will

be

c If a project's NPV is greater than zero, then its IRR must be less than the WACC

d.If a project's NPV is greater than zero, then its IRR must be less than zero

e The NPVs of relatively risky projects should be found using relatively low WACCs

cost of capital

a For a project to have more than one IRR, then both IRRs must be greater than the

WACC

b.If two projects are mutually exclusive, then they are likely to have multiple IRRs

c If a project is independent, then it cannot have multiple IRRs

d.Multiple IRRs can only occur if the signs of the cash flows change more than once

e If a project has two IRRs, then the smaller one is the one that is most relevant, and it

should be accepted and relied upon

cost of capital

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KEYWORDS: Bloom's: Analysis

a The NPV method assumes that cash flows will be reinvested at the WACC, 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 WACC, while the

IRR method assumes reinvestment at the risk-free rate

d.The NPV method does not consider all relevant cash flows, particularly cash flows

beyond the payback period

e The IRR method does not consider all relevant cash flows, particularly cash flows

beyond the payback period

cost of capital

a If Project A has a higher IRR than Project B, then Project A must have the lower NPV

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 the

WACC

d.The IRR calculation implicitly assumes that cash flows are withdrawn from the

business rather than being reinvested in the business

e If a project has normal cash flows and its IRR exceeds its WACC, then the project's

FOFM.BRIG.16.11.05 - Reinvestment Rate Assumptions

NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.03 - Analytic skills

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cost of capital

49 Assume that the economy is in a mild recession, and as a result interest rates and money costs generally are relatively low The WACC for two mutually exclusive projects that are being considered is 8% Project S has an IRR of 20% while Project L's IRR is 15% The projects have the same NPV at the 8% current WACC However, you believe that the

economy is about to recover, and money costs and thus your WACC will also increase You also think that the projects will not be funded until the WACC has increased, and their cash flows will not be affected by the change in economic conditions Under these conditions, which of the following statements is CORRECT?

a You should reject both projects because they will both have negative NPVs under the

new conditions

b.You should delay a decision until you have more information on the projects, even if

this means that a competitor might come in and capture this market

c You should recommend Project L, because at the new WACC it will have the higher

cost of capital

50 Assume that the economy is enjoying a strong boom, and as a result interest rates and money costs generally are relatively high The WACC for two mutually exclusive projects that are being considered is 12% Project S has an IRR of 20% while Project L's IRR is 15% The projects have the same NPV at the 12% current WACC However, you believe thatthe economy will soon fall into a mild recession, and money costs and thus your WACC will soon decline You also think that the projects will not be funded until the WACC has decreased, and their cash flows will not be affected by the change

in economic conditions Under these conditions, which of the following statements is CORRECT?

a You should reject both projects because they will both have negative NPVs under the

new conditions

b.You should delay a decision until you have more information on the projects, even if

this means that a competitor might come in and capture this market

c You should recommend Project L, because at the new WACC it will have the higher

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d.You should recommend Project S, because at the new WACC it will have the higher

NPV

e You should recommend Project L because it will have both a higher IRR and a higher

NPV under the new conditions

cost of capital

a The NPV method was once the favorite of academics and business executives, but

today most authorities regard the MIRR as being the best indicator of a project's

profitability

b.If the cost of capital declines, this lowers a project's NPV

c The NPV method is regarded by most academics as being the best indicator of a

project's profitability, hence most academics recommend that firms use only this one

method and disregard other methods

d.A project's NPV depends on the total amount of cash flows the project produces, but

because the cash flows are discounted at the WACC, it does not matter if the cash

flows occur early or late in the project's life

e The NPV and IRR methods may give different recommendations regarding which of

two mutually exclusive projects should be accepted, but they always give the same

recommendation regarding the acceptability of a normal, independent project

RATIONALE: Statement e is correct The others are all false If you draw an NPV profile for one

project, you will see that if the WACC is less than the IRR, the NPV will be positive

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TOPICS: NPV and IRR

52 Projects A and B have identical expected lives and identical initial cash outflows (costs) However, most of one project's cash flows come in the early years, while most of the other project's cash flows occur in the later years The two NPV profiles are given below:

Which of the following statements is CORRECT?

a More of Project A's cash flows occur in the later years

b More of Project B's cash flows occur in the later years

c We must have information on the cost of capital in order to determine which project

has the larger early cash flows

d The NPV profile graph is inconsistent with the statement made in the problem

e The crossover rate, i.e., the rate at which Projects A and B have the same NPV, is

greater than either project's IRR

RATIONALE: Statement a is true and the other statements are false Distant cash flows are

more severely penalized by high discount rates, so if the NPV profile line has a steep slope, this indicates that cash flows occur relatively late

KEYWORDS: Bloom's: Application

53 Projects S and L both have an initial cost of $10,000, followed by a series of positive cash inflows Project S's undiscounted net cash flows total $20,000, while L's total undiscounted flows are $30,000 At a WACC of 10%, the two projects have identical NPVs Which project's NPV is more sensitive to changes in the WACC?

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a Project S.

b.Project L

c Both projects are equally sensitive to changes in the WACC 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 that are horizontal

e The solution cannot be determined because the problem gives us no information that

can be used to determine the projects' relative IRRs

RATIONALE: Statement b is true, while the other statements are false Since Project L's

undiscounted CFs are larger, they must occur in the more distant future, and since distant cash flows are impacted more by changes in the discount rate, L's NPV profile must be steeper One can also see this in an NPV profile graph The higher Y-axis intercept indicates more undiscounted CFs, and for the profiles to cross, the one with the higher intercept must be steeper

54 Projects C and D are mutually exclusive and have normal cash flows Project C has a higher NPV if the WACC is less than 12%, whereas Project D has a higher NPV if the WACC exceeds 12% Which of the following statements is

CORRECT?

a Project D probably has a higher IRR

b Project D is probably larger in scale than Project C

c Project C probably has a faster payback

d Project C probably has a higher IRR

e The crossover rate between the two projects is below 12%

RATIONALE: The NPV profiles cross at 12% To the left, or at lower discount rates, C has the

higher NPV, so its slope is steeper, causing its profile to hit the X axis sooner

This means that C has the lower IRR, hence D has the higher IRR

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55 Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a year payback regardless of economic conditions Other things held constant, which of the following statements is most likely to be true?

4-a It will accept too many short-term projects and reject too many long-term projects (as

judged by the NPV)

b.It will accept too many long-term projects and reject too many short-term projects (as

judged by the NPV)

c The firm will accept too many projects in all economic states because a 4-year

payback is too low

d.The firm will accept too few projects in all economic states because a 4-year payback

is too high

e If the 4-year payback results in accepting just the right set of projects under average

economic conditions, then this payback will result in too few long-term projects when

the economy is weak

RATIONALE: Statement e is correct In a weak economy, the interest rates and the WACC are

likely to be low, and these conditions favor long-term projects But the constant year payback would not recognize this situation

KEYWORDS: Bloom's: Analysis

56 Four of the following statements are truly disadvantages of the regular payback method, but one is not a disadvantage

of this method Which one is NOT a disadvantage of the payback method?

a Lacks an objective, market-determined benchmark for making

decisions

b Ignores cash flows beyond the payback period

c Does not directly account for the time value of money

d Does not provide any indication regarding a project's liquidity or risk

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e Does not take account of differences in size among projects.

cost of capital

a If a project with normal cash flows has an IRR greater than the WACC, the project

must also have a positive NPV

b If Project A's IRR exceeds Project B's, then A must have the higher NPV

c A project's MIRR can never exceed its IRR

d If a project with normal cash flows has an IRR less than the WACC, the project must

cost of capital

a The MIRR and NPV decision criteria can never conflict

b.The IRR method can never be subject to the multiple IRR problem, while the MIRR

method can be

c One reason some people prefer the MIRR to the regular IRR is that the MIRR is based

on a generally more reasonable reinvestment rate assumption

d.The higher the WACC, the shorter the discounted payback period

e The MIRR method assumes that cash flows are reinvested at the crossover rate

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cost of capital

a The NPV, IRR, MIRR, and discounted payback (using a payback requirement of 3

years or less) methods always lead to the same accept/reject decisions for independent

projects

b.For mutually exclusive projects with normal cash flows, the NPV and MIRR methods

can never conflict, but their results could conflict with the discounted payback and the

regular IRR methods

c Multiple IRRs can exist, but not multiple MIRRs This is one reason some people

favor the MIRR over the regular IRR

d.If a firm uses the discounted payback method with a required payback of 4 years, then

it will accept more projects than if it used a regular payback of 4 years

e The percentage difference between the MIRR and the IRR is equal to the project's

cost of capital

a For a project with normal cash flows, any change in the WACC will change both the

NPV and the IRR

b.To find the MIRR, we first compound cash flows at the regular IRR to find the TV, and

then we discount the TV at the WACC to find the PV

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c The NPV and IRR methods both assume that cash flows can be reinvested at the

WACC However, the MIRR method assumes reinvestment at the MIRR itself

d.If two projects have the same cost, and if their NPV profiles cross in the upper right

quadrant, then the project with the higher IRR probably has more of its cash flows

coming in the later years

e If two projects have the same cost, and if their NPV profiles cross in the upper right

quadrant, then the project with the lower IRR probably has more of its cash flows

coming in the later years

cost of capital

a One advantage of the NPV over the IRR is that NPV takes account of cash flows over

a project's full life whereas IRR does not

b.One advantage of the NPV over the IRR is that NPV assumes that cash flows will be

reinvested at the WACC, whereas IRR assumes that cash flows are reinvested at the

IRR The NPV assumption is generally more appropriate

c One advantage of the NPV over the MIRR method is that NPV takes account of cash

flows over a project's full life whereas MIRR does not

d.One advantage of the NPV over the MIRR method is that NPV discounts cash flows

whereas the MIRR is based on undiscounted cash flows

e Since cash flows under the IRR and MIRR are both discounted at the same rate (the

WACC), these two methods always rank mutually exclusive projects in the same order

RATIONALE: Statement b is correct, and the others are false Cash flows from a project can be

used to replace funds that would be raised in the market at the WACC, so the WACC is the opportunity cost for reinvested cash flows Since the NPV assumes reinvestment at the WACC while the IRR assumes reinvestment at the IRR, NPV

is generally the better method

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STATE STAND

ARDS:

United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital

TOPICS: Ranking methods: NPV

a The IRR method appeals to some managers because it gives an estimate of the rate of

return on projects rather than a dollar amount, which the NPV method provides

b.The discounted payback method eliminates all of the problems associated with the

payback method

c When evaluating independent projects, the NPV and IRR methods often yield

conflicting results regarding a project's acceptability

d.To find the MIRR, we discount the TV at the IRR

e A project's NPV profile must intersect the X-axis at the project's WACC

cost of capital

63 Projects S and L are equally risky, mutually exclusive, and have normal cash flows Project S has an IRR of 15%, while Project L's IRR is 12% The two projects have the same NPV when the WACC is 7% Which of the following statements is CORRECT?

a If the WACC is 10%, both projects will have positive NPVs

b If the WACC is 6%, Project S will have the higher NPV

c If the WACC is 13%, Project S will have the lower NPV

d If the WACC is 10%, both projects will have a negative NPV

e Project S's NPV is more sensitive to changes in WACC than Project L's

RATIONALE: The easiest way to think about this question is to begin by drawing an NPV profile

as shown below, then using it to decide which statement is correct

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Statement a is true, because both projects have an IRR greater than the WACC and thus will have a positive NPV Statement b is false, because at 6%, the WACC is less than the crossover rate and Project L has a higher NPV than S

Statement c is false, because at 13% the WACC is greater than the crossover rate and S would have a higher NPV than L Statement d is false, because of reasons mentioned for statement a Statement e is false, because Project L's NPV profile is steeper, which means Project L's NPV is more sensitive to changes in WACC

64 Westchester Corp is considering two equally risky, mutually exclusive projects, both of which have normal cash flows Project A has an IRR of 11%, while Project B's IRR is 14% When the WACC is 8%, the projects have the same NPV Given this information, which of the following statements is CORRECT?

a If the WACC is 13%, Project A's NPV will be higher than Project B's

b If the WACC is 9%, Project A's NPV will be higher than Project B's

c If the WACC is 6%, Project B's NPV will be higher than Project A's

d If the WACC is greater than 14%, Project A's IRR will exceed Project B's

e If the WACC is 9%, Project B's NPV will be higher than Project A's

RATIONALE: Statement e is true, while the others are false

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cost of capital

65 You are considering two mutually exclusive, equally risky, projects Both have IRRs that exceed the WACC Which ofthe following statements is CORRECT? Assume that the projects have normal cash flows, with one outflow followed by aseries of inflows

a If the two projects' NPV profiles do not cross, then there will be a sharp conflict as to

which one should be selected

b.If the cost of capital is greater than the crossover rate, then the IRR and the NPV

criteria will not result in a conflict between the projects One project will rank higher

by both criteria

c If the cost of capital is less than the crossover rate, then the IRR and the NPV criteria

will not result in a conflict between the projects One project will rank higher by both

criteria

d.For a conflict to exist between NPV and IRR, the initial investment cost of one project

must exceed the cost of the other

e For a conflict to exist between NPV and IRR, one project must have an increasing

stream of cash flows over time while the other has a decreasing stream If both sets of

cash flows are increasing or decreasing, then it would be impossible for a conflict to

exist, even if one project is larger than the other

RATIONALE: Again, it is useful to draw NPV profiles that fit the description given in the

question Any numbers that meet the criteria will do

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Statement a is false, because if the profiles do not cross, then one will dominate the other, with both a higher IRR and a higher NPV at every discount rate

Statement b is true Statement c is false Statement d is false because a conflict can result from differences in the timing of the cash flows Statement e is false because scale differences can result in profile crossovers and thus conflicts

KEYWORDS: Bloom's: Analysis

66 Project X's IRR is 19% and Project Y's IRR is 17% The projects have the same risk and the same lives, and each has constant cash flows during each year of their lives If the WACC is 10%, Project Y has a higher NPV than X Given this information, which of the following statements is CORRECT?

a The crossover rate must be less than 10%

b The crossover rate must be greater than 10%

c If the WACC is 8%, Project X will have the higher NPV

d If the WACC is 18%, Project Y will have the higher NPV

e Project X is larger in the sense that it has the higher initial cost

RATIONALE: Again, it is useful to draw NPV profiles that fit the description given in the

question Any number that meets the criteria will do

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