2024 – Fin 534 Quiz 6 Question 1 Which of the following statements is CORRECT Answer One defect of the

One defect of the IRR method is that it does not take account of cash flows over a project’s full life.

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

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

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.

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.

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.

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

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.

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.

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.

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.

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

When evaluating independent projects, the NPV and IRR methods often yield conflicting results regarding a project’s acceptability.

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

A project’s NPV profile must intersect the X-axis at the project’s WACC.

For a project with normal cash flows, any change in the WACC will change both the NPV and the IRR.

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.

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.

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.

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.

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.

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.

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

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.

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

The longer a project’s payback period, the more desirable the project is normally considered to be by this criterion.

One drawback of the regular payback for evaluating projects is that this method does not properly account for the time value of money.

If a project’s payback is positive, then the project should be rejected because it must have a negative NPV.

The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem.

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.

The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.

The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR.

The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate.

The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period.

The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.

If a project has “normal” cash flows, then its IRR must be positive.

If a project has “normal” cash flows, then its MIRR must be positive.

If a project has “normal” cash flows, then it will have exactly two real IRRs.

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.

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.

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

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

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

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

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.

You should reject both projects because they will both have negative NPVs under the new conditions.

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.

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

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

You should recommend Project S because it has the higher IRR and will continue to have the higher IRR even at the new WACC.

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.

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.

Multiple IRRs can exist, but not multiple MIRRs.  This is one reason some people favor the MIRR over the regular IRR.

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.

The percentage difference between the MIRR and the IRR is equal to the project’s WACC.

The shorter a project’s payback period, the less desirable the project is normally considered to be by this criterion.

One drawback of the regular payback is that this method does not take account of cash flows beyond the payback period.

If a project’s payback is positive, then the project should be accepted because it must have a positive NPV.

The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem.

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.

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

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

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

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

Project S’s NPV is more sensitive to changes in WACC than Project L’s.

Lacks an objective, market-determined benchmark for making decisions.

Ignores cash flows beyond the payback period.

Does not directly account for the time value of money.

Does not provide any indication regarding a project’s liquidity or risk.

Does not take account of differences in size among projects.

If a project with normal cash flows has an IRR greater than the WACC, the project must also have a positive NPV.

If Project A’s IRR exceeds Project B’s, then A must have the higher NPV.

A project’s MIRR can never exceed its IRR.

If a project with normal cash flows has an IRR less than the WACC, the project must have a positive NPV.

If the NPV is negative, the IRR must also be negative.

Using some of the firm’s high-quality factory floor space that is currently unused to produce the proposed new product.  This space could be used for other products if it is not used for the project under consideration.

Revenues from an existing product would be lost as a result of customers switching to the new product.

Shipping and installation costs associated with a machine that would be used to produce the new product.

The cost of a study relating to the market for the new product that was completed last year.  The results of this research were positive, and they led to the tentative decision to go ahead with the new product.  The cost of the research was incurred and expensed for tax purposes last year.

It is learned that land the company owns and would use for the new project, if it is accepted, could be sold to another firm.

A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes.

A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm’s current products.

A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery.

A firm has spent $2 million on R&D associated with a new product.  These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected.

A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm’s other products.

The proposed new project would have more stand-alone risk than the firm’s typical project.

The proposed new project would increase the firm’s corporate risk.

The proposed new project would increase the firm’s market risk.

The proposed new project would not affect the firm’s risk at all.

The proposed new project would have less stand-alone risk than the firm’s typical project.

In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project’s cash flows will lead to an upward
bias in the NPV.

In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project’s cash flows will lead to a downward
bias in the NPV.

The existence of any type of “externality” will reduce the calculated NPV versus the NPV that would exist without the externality.

If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net after-tax proceeds that could be obtained should be charged as a cost to the project under consideration.

If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored.

Sensitivity analysis is a good way to measure market risk because it explicitly takes into account diversification effects.

One advantage of sensitivity analysis relative to scenario analysis is that it explicitly takes into account the probability of specific effects occurring, whereas scenario analysis cannot account for probabilities.

Well-diversified stockholders do not need to consider market risk when determining required rates of return.

Market risk is important, but it does not have a direct effect on stock prices because it only affects beta.

Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions.

A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.

A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project.

A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project.

Sunk costs were formerly hard to deal with but now that the NPV method is widely used, it is possible to simply include sunk costs in the cash flows and then calculate the PV of the project.

A good example of a sunk cost is a situation where Home Depot opens a new store, and that leads to a decline in sales of one of the firm’s existing stores.

Changes in net working capital.

Shipping and installation costs.

Cannibalization effects.

Opportunity costs.

Sunk costs that have been expensed for tax purposes.

Using accelerated depreciation rather than straight line would normally have no effect on a project’s total projected cash flows but it would affect the timing of the cash flows and thus the NPV.

Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer.

Corporations must use the same depreciation method (e.g., straight line or accelerated) for stockholder reporting and tax purposes.

Since depreciation is not a cash expense, it has no effect on cash flows and thus no effect on capital budgeting decisions.

Under accelerated depreciation, higher depreciation charges occur in the early years, and this reduces the early cash flows and thus lowers a project’s projected NPV.

The new project is expected to reduce sales of one of the company’s existing products by 5%.

Since the firm’s director of capital budgeting spent some of her time last year to evaluate the new project, a portion of her salary for that year should be charged to the project’s initial cost.

The company has spent and expensed $1 million on R&D associated with the new project.

The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project.

The firm would borrow all the money used to finance the new project, and the interest on this debt would be $1.5 million per year.

Adjusting the discount rate upward if the project is judged to have above-average risk.

Adjusting the discount rate downward if the project is judged to have above-average risk.

Reducing the NPV by 10% for risky projects.

Picking a risk factor equal to the average discount rate.

Ignoring risk because project risk cannot be measured accurately.

Project A, which has average risk and an IRR = 9%.

Project B, which has below-average risk and an IRR = 8.5%.

Project C, which has above-average risk and an IRR = 11%.

Without information about the projects’ NPVs we cannot determine which project(s) should be accepted.

All of these projects should be accepted.

The firm’s corporate, or overall, WACC is used to discount all project cash flows to find the projects’ NPVs.  Then, depending on how risky different projects are judged to be, the calculated NPVs are scaled up or down to adjust for differential risk.

Differential project risk cannot be accounted for by using “risk-adjusted discount rates” because it is highly subjective and difficult to justify.  It is better to not risk adjust at all.

Other things held constant, if returns on a project are thought to be positively correlated with the returns on other firms in the economy, then the project’s NPV will be found using a lower discount rate than would be appropriate if the project’s returns were negatively correlated.

Monte Carlo simulation uses a computer to generate random sets of inputs, those inputs are then used to determine a trial NPV, and a number of trial NPVs are averaged to find the project’s expected NPV.  Sensitivity and scenario analyses, on the other hand, require much more information regarding the input variables, including probability distributions and correlations among those variables.  This makes it easier to implement a simulation analysis than a scenario or a sensitivity analysis, hence simulation is the most frequently used procedure.

DCF techniques were originally developed to value passive investments (stocks and bonds).  However, capital budgeting projects are not passive investments–managers can often take positive actions after the investment has been made that alter the cash flow stream.  Opportunities for such actions are called real options.  Real options are valuable, but this value is not captured by conventional NPV analysis.  Therefore, a project’s real options must be considered separately.

All costs associated with the project that have been incurred prior to the time the analysis is being conducted.

Interest on funds borrowed to help finance the project.

The end-of-project recovery of any working capital required to operate the project.

Cannibalization effects, but only if those effects increase the project’s projected cash flows.

Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes.

The company will produce the new product in a vacant building that was used to produce another product until last year.  The building could be sold, leased to another company, or used in the future to produce another of the firm’s products.

The project will utilize some equipment the company currently owns but is not now using.  A used equipment dealer has offered to buy the equipment.

The company has spent and expensed for tax purposes $3 million on research related to the new detergent.  These funds cannot be recovered, but the research may benefit other projects that might be proposed in the future.

The new product will cut into sales of some of the firm’s other products.

If the project is accepted, the company must invest $2 million in working capital.  However, all of these funds will be recovered at the end of the project’s life.

A and B.

A, B, and C.

A.B &D