Test bank corporate finance 8e ros chap009

Chapter 009 Net Present Value and Other Investment Criteria Multiple Choice Questions The difference between an investment's market value and its cost is the: A net present value b internal rate of return c payback period d profitability index e discounted payback period SECTION: 9.1 TOPIC: NET PRESENT VALUE TYPE: DEFINITIONS The process of valuing an investment by determining the present value of its future cash flows is called: a the constant dividend growth model B discounted cash flow valuation c average accounting valuation d the expected earnings model e the Capital Asset Pricing Model SECTION: 9.1 TOPIC: DISCOUNTED CASH FLOW VALUATION TYPE: DEFINITIONS The length of time required for an investment to generate cash flows sufficient to recover the initial cost of the investment is called the: a internal rate of return B payback period c profitability index d discounted cash period e net present value SECTION: 9.2 TOPIC: PAYBACK PERIOD TYPE: DEFINITIONS 9-1 Chapter 009 Net Present Value and Other Investment Criteria The length of time required for a project's discounted cash flows to equal the initial cost of the project is called the: a net present value b internal rate of return c payback period d discounted profitability index E discounted payback period SECTION: 9.3 TOPIC: DISCOUNTED PAYBACK PERIOD TYPE: DEFINITIONS An investment's average net income divided by its average book value defines the average: a net present value b internal rate of return C accounting return d profitability index e payback period SECTION: 9.4 TOPIC: AVERAGE ACCOUNTING RETURN TYPE: DEFINITIONS The discount rate that makes the net present value of an investment exactly equal to zero is called the: a external rate of return B internal rate of return c average accounting return d profitability index e equalizer SECTION: 9.5 TOPIC: INTERNAL RATE OF RETURN TYPE: DEFINITIONS 9-2 Chapter 009 Net Present Value and Other Investment Criteria The possibility that more than one discount rate will make the NPV of an investment equal to zero is called the _ problem a net present value profiling b operational ambiguity c mutually exclusive investment decision d economies of scale E multiple rates of return SECTION: 9.5 TOPIC: MULTIPLE RATES OF RETURN TYPE: DEFINITIONS A situation in which accepting one investment prevents the acceptance of another investment is called the: a net present value profile b operational ambiguity decision C mutually exclusive investment decision d economies of scale decision e multiple choices of operations decision SECTION: 9.5 TOPIC: MUTUALLY EXCLUSIVE INVESTMENT DECISION TYPE: DEFINITIONS The present value of an investment's future cash flows divided by the initial cost of the investment is called the: a net present value b internal rate of return c average accounting return D profitability index e profile period SECTION: 9.6 TOPIC: PROFITABILITY INDEX TYPE: DEFINITIONS 9-3 Chapter 009 Net Present Value and Other Investment Criteria 10 Capital budgeting decisions generally: A have long-term effects on a firm b are of short-duration c revolve around the decision to use either debt or equity securities to finance a project d focus solely on whether or not a particular asset should be purchased e have minimal effects on a firm's operations SECTION: CHAPTER INTRODUCTION TOPIC: CAPITAL BUDGETING DECISIONS TYPE: CONCEPTS 11 Which one of the following is a capital budgeting decision? a deciding whether a bank loan should be secured or if bonds should be issued b determining how many bonds versus how many shares of stock should be issued c ascertaining the minimum amount of cash which should be kept on hand d determining the optimal level of inventory to be maintained E deciding whether or not a newly invented product should be produced SECTION: CHAPTER INTRODUCTION TOPIC: CAPITAL BUDGETING DECISIONS TYPE: CONCEPTS 12 Which one of the following will increase the net present value of a project? a an increase in the discount rate b decreasing the amount of each cash inflow c increasing the amount of the initial cash outflow D decreasing the required rate of return e having all incoming cash flows occur in the final year of a project rather than periodically over a five-year period SECTION: 9.1 TOPIC: NET PRESENT VALUE TYPE: CONCEPTS 9-4 Chapter 009 Net Present Value and Other Investment Criteria 13 A project creates value for a firm's owners: A when the net present value of the project is positive b any time the cash inflows exceed the cash outflows c whenever the internal rate of return is less than the required return d whenever the profitability index is less than one e whenever the payback period exceeds the life of the project SECTION: 9.1 TOPIC: NET PRESENT VALUE TYPE: CONCEPTS 14 If a project has a net present value equal to zero, then: a the present value of the cash inflows must exceed the initial cost of the project b the project produces a rate of return in excess of the required return c the project is expected to produce cash inflows in an amount equal to the initial cash outflow D any delay in receiving the projected cash inflows will cause the project to have a negative net present value e the cash inflows equal the project's initial cost given a positive discount rate SECTION: 9.1 TOPIC: NET PRESENT VALUE TYPE: CONCEPTS 15 When computing the net present value of a project, the net amount received from salvaging the fixed assets used in the project is: a subtracted from the initial cash outlay B included in the final cash flow of the project c excluded from the analysis since it occurs only when the project ends d subtracted from the original cost of the assets e added to the net present value computed based on the other cash flows SECTION: 9.1 TOPIC: NET PRESENT VALUE TYPE: CONCEPTS 9-5 Chapter 009 Net Present Value and Other Investment Criteria 16 Net present value: a when applied properly, can accurately predict the cash flows that will occur if a project is implemented b is highly independent of the rate of return assigned to a particular project C is the preferred method of analyzing a project even though the cash flows are only estimates d is unaffected by the timing of each and every cash flow related to a project e is unaffected by the timing of the purchase of the fixed assets required for a project SECTION: 9.1 TOPIC: NET PRESENT VALUE TYPE: CONCEPTS 17 Net present value: A should be used when deciding between two mutually exclusive projects b is less useful than the internal rate of return when comparing different sized projects c is easy to explain to non-financial, low-level managers d is less useful than the profitability index when comparing mutually exclusive projects e is very similar in its methodology to the average accounting return SECTION: 9.1 TOPIC: NET PRESENT VALUE TYPE: CONCEPTS 18 A project is acceptable when the net present value: a is negative B is positive c is negative provided the only cash outflow occurs at time zero d is positive provided the internal rate of return is less than the required return e is positive provided the profitability index is less than one SECTION: 9.1 TOPIC: NET PRESENT VALUE TYPE: CONCEPTS 9-6 Chapter 009 Net Present Value and Other Investment Criteria 19 Payback is frequently used to analyze independent projects because: a it considers the time value of money b all relevant cash flows are included in the analysis C the cost of the analysis is less than the potential loss from a faulty decision d it is the most desirable of the various financial methods of analysis e it is focused on the long-term impact of a project SECTION: 9.2 TOPIC: PAYBACK TYPE: CONCEPTS 20 The advantages of the payback method of project analysis include the: I application of a discount rate to each separate cash flow II bias towards liquidity III ease of use IV arbitrary cutoff point a I and II only b I and III only C II and III only d II and IV only e II, III, and IV only SECTION: 9.2 TOPIC: PAYBACK TYPE: CONCEPTS 21 According to the payback rule, a project is acceptable when the payback period is: a less than the discounted period b equal to or greater than the prespecified period c positive and greater than the prespecified period d either negative or equal to zero E is less than the prespecified period SECTION: 9.2 TOPIC: PAYBACK TYPE: CONCEPTS 9-7 Chapter 009 Net Present Value and Other Investment Criteria 22 A project has a required payback period of three years In this case, the: a cash flows in each of the three years must exceed one-third of the project's initial cost b cash flow in year three is ignored c project's initial cost is discounted D cash flow in year two is valued just as highly as the cash flow in year one e project is acceptable whenever the payback period exceeds three years SECTION: 9.2 TOPIC: PAYBACK TYPE: CONCEPTS 23 All else equal, the payback period for a project will decrease whenever the: a initial cost increases b required return for a project increases c assigned discount rate decreases D cash inflows are adjusted such that they occur sooner e duration of a project is lengthened SECTION: 9.2 TOPIC: PAYBACK TYPE: CONCEPTS 24 Discounted payback is used less frequently than payback because: a the methodology is less desirable from a financial perspective b it is simpler to calculate c it requires an arbitrary cutoff point d it is biased towards liquidity E it includes time value of money calculations SECTION: 9.3 TOPIC: DISCOUNTED PAYBACK TYPE: CONCEPTS 9-8 Chapter 009 Net Present Value and Other Investment Criteria 25 The discounted payback period of a project will decrease whenever the: a discount rate applied to the project is increased b initial cash outlay of the project is increased c number of cash inflows is increased D amount of each cash inflow is increased e costs of the fixed assets utilized in the project increase SECTION: 9.3 TOPIC: DISCOUNTED PAYBACK TYPE: CONCEPTS 26 The discounted payback rule may cause: A some positive net present value projects to be rejected b the most liquid projects to be rejected in favor of less liquid projects c projects to be incorrectly accepted due to ignoring the time value of money d projects with negative net present values to be accepted e some projects to be accepted which would otherwise be rejected under the payback rule SECTION: 9.3 TOPIC: DISCOUNTED PAYBACK TYPE: CONCEPTS 27 The average accounting rate of return: a considers the time value of money b measures net income as a percentage of the sales generated by a project c is the best method of analyzing mutually exclusive projects from a financial point of view d is the primary methodology used in analyzing independent projects E is similar to the return on assets ratio SECTION: 9.4 TOPIC: AVERAGE ACCOUNTING RETURN TYPE: CONCEPTS 9-9 Chapter 009 Net Present Value and Other Investment Criteria 28 Assuming that straight line depreciation is used, the average accounting return for a project is computed as the average: a net income of a project divided by the average total assets of a firm b book value of a project multiplied by the average profit margin of the project c book value of a project divided by the average net income of the project D net income of a project divided by the average investment in the project e net income of the firm divided by the average investment in a project SECTION: 9.4 TOPIC: AVERAGE ACCOUNTING RETURN TYPE: CONCEPTS 29 Which one of the following is an advantage of the average accounting return? A general ease of obtaining the necessary information to the computation b inclusion of time value of money considerations c the use of a cutoff rate as a benchmark d the use of pre-tax income in the computation e use of a true rate of return SECTION: 9.4 TOPIC: AVERAGE ACCOUNTING RETURN TYPE: CONCEPTS 30 The average accounting return for a project is most comparable to: a one divided by the project's internal rate of return b a project's internal rate of return C the firm's return on assets d the firm's return on equity e one divided by the firm's return on equity SECTION: 9.4 TOPIC: AVERAGE ACCOUNTING RETURN TYPE: CONCEPTS 9-10 Chapter 009 Net Present Value and Other Investment Criteria 81 Corey is considering two projects both of which have an initial cost of $20,000 and total cash inflows of $25,000 The cash inflows of project A are $3,000, $5,000, $8,000, and $9,000 over the next four years, respectively The cash inflows for project B are $9,000, $8,000, $5,000, and $3,000 over the next four years, respectively Which one of the following statements is correct if Corey requires a 10 percent rate of return and has a required discounted payback period of years? a Both projects should be accepted B Both projects should be rejected c Project A should be accepted and project B should be rejected d Project A should be rejected and project B should be accepted e You should be indifferent to accepting either or both projects Discounted paybackA: $20,000 $2,727.27 - $4,132.23 - $6,010.52 - $6,147.12 = $982.86 Project A never pays back on a discounted basis Neither project should be accepted Project A never pays back, and the payback of project B exceeds the required payback period of years AACSB TOPIC: ANALYTIC SECTION: 9.3 TOPIC: DISCOUNTED PAYBACK PERIOD TYPE: PROBLEMS 9-46 Chapter 009 Net Present Value and Other Investment Criteria 82 The Blue Moon is considering a project which will produce sales of $120,000 a year for the next five years The profit margin is estimated at 5.5 percent The project will cost $140,000 and will be depreciated straight-line to a book value of zero over the life of the project The firm has a required accounting return of 9.5 percent This project should be _ because the AAR is _ percent a rejected; 4.71 b rejected; 8.57 C rejected; 9.43 d accepted; 9.67 e accepted; 9.43 ; The project should be rejected AACSB TOPIC: ANALYTIC SECTION: 9.4 TOPIC: AVERAGE ACCOUNTING RETURN TYPE: PROBLEMS 83 A project has an initial cost of $44,000 and a four-year life The company uses straightline depreciation to a book value of zero over the life of the project The projected net income from the project is $1,500, $1,800, $1,900, and $2,000 a year for the next four years, respectively What is the average accounting return? a 4.09 percent b 6.82 percent C 8.18 percent d 8.64 percent e 9.09 percent AACSB TOPIC: ANALYTIC SECTION: 9.4 TOPIC: AVERAGE ACCOUNTING RETURN TYPE: PROBLEMS 9-47 Chapter 009 Net Present Value and Other Investment Criteria 84 A project produces annual net income of $11,500, $13,700, and $16,900 over the three years of its life, respectively The initial cost of the project is $257,000 This cost is depreciated straight-line to a zero book value over three years What is the average accounting rate of return if the required discount rate is 6.75 percent? a 5.33 percent b 5.46 percent c 6.58 percent D 10.92 percent e 13.90 percent AACSB TOPIC: ANALYTIC SECTION: 9.4 TOPIC: AVERAGE ACCOUNTING RETURN TYPE: PROBLEMS 85 A project has average net income of $3,200 a year over its 5-year life The initial cost of the project is $84,000 which will be depreciated using straight-line depreciation to a book value of zero over the life of the project The firm wants to earn a minimal average accounting return of 8.75 percent The firm should _ the project because the AAR is _ percent a accept; 3.81 b accept; 7.62 c accept; 19.05 D reject; 7.62 e reject; 19.05 The firm should reject the project based on the AAR AACSB TOPIC: ANALYTIC SECTION: 9.4 TOPIC: AVERAGE ACCOUNTING RETURN TYPE: PROBLEMS 9-48 Chapter 009 Net Present Value and Other Investment Criteria 86 Colin is analyzing a project and has gathered the following data Based on this data, what is the average accounting rate of return? The firm depreciates it assets using straight-line depreciation to a zero book value over the life of the asset a 6.66 percent B 13.31 percent c 20.66 percent d 26.62 percent e 31.31 percent AACSB TOPIC: ANALYTIC SECTION: 9.4 TOPIC: AVERAGE ACCOUNTING RETURN TYPE: PROBLEMS 9-49 Chapter 009 Net Present Value and Other Investment Criteria 87 You are analyzing the following two mutually exclusive projects and have developed the following information What is the crossover rate? a 6.02 percent b 7.23 percent c 10.92 percent d 12.21 percent E 14.47 percent AACSB TOPIC: ANALYTIC SECTION: 9.5 TOPIC: CROSSOVER RATE TYPE: PROBLEMS 9-50 Chapter 009 Net Present Value and Other Investment Criteria 88 The World Transport Co is considering two mutually exclusive projects with the following cash flows What is the crossover rate? If the required rate of return is lower than the crossover rate, which project should be accepted? a 9.88 percent; A b 9.88 percent; B C 12.30 percent; A d 12.30 percent; B e 14.34 percent; A The crossover rate is 12.30 percent At a rate lower than the crossover rate, such as 11 percent, Project A will have the higher NPV and should be accepted AACSB TOPIC: ANALYTIC SECTION: 9.5 TOPIC: CROSSOVER RATE TYPE: PROBLEMS 9-51 Chapter 009 Net Present Value and Other Investment Criteria You are analyzing a project and have gathered the following data: 89 Based on the profitability index of _ for this project, you should _ the project a .95; accept B 1.04; accept c 1.06; accept d .95; reject e 1.06; reject ; You should accept the project because the PI is greater than AACSB TOPIC: ANALYTIC SECTION: 9.6 TOPIC: PROFITABILITY INDEX TYPE: PROBLEMS 9-52 Chapter 009 Net Present Value and Other Investment Criteria 90 Based on the internal rate of return of _ percent for this project, you should _ the project A 10.44; accept b 19.78; accept c 8.78; reject d 19.78; reject e 10.44; reject You should accept the project because the IRR of 10.44 percent exceeds the required return of 8.50 percent AACSB TOPIC: ANALYTIC SECTION: 9.5 TOPIC: INTERNAL RATE OF RETURN TYPE: PROBLEMS 9-53 Chapter 009 Net Present Value and Other Investment Criteria 91 Based on the net present value of _ for this project, you should _ the project a $15,046.17; reject b $11,089.55; reject c $7,192.14; accept D $7,192.14; accept e $11,089.55; accept You should accept the project because the NPV is positive AACSB TOPIC: ANALYTIC SECTION: 9.1 TOPIC: NET PRESENT VALUE TYPE: PROBLEMS 9-54 Chapter 009 Net Present Value and Other Investment Criteria 92 Based on the payback period of _ years for this project, you should _ the project a 2.10; accept b 2.48; accept c 2.10; reject d 3.48; reject E 2.90; reject Based on payback, the project should be rejected because the payback period of 2.90 years exceeds the required period of 2.5 years AACSB TOPIC: ANALYTIC SECTION: 9.2 TOPIC: PAYBACK PERIOD TYPE: PROBLEMS You are considering the following two mutually exclusive projects Both projects will be depreciated using straight-line depreciation to a zero book value over the life of the project Neither project has any salvage value 9-55 Chapter 009 Net Present Value and Other Investment Criteria 93 What should you based on NPV analysis? A accept project B and reject project A b reject both project A and project B c accept both project A and project B d accept project A and reject project B e It does not matter which project you accept as the projects have equal and positive net present values Project B should be accepted and project A should be rejected AACSB TOPIC: ANALYTIC SECTION: 9.1 TOPIC: NET PRESENT VALUE TYPE: PROBLEMS 9-56 Chapter 009 Net Present Value and Other Investment Criteria 94 What should you based on IRR analysis? a reject both project A and project B b accept project A and reject project B c accept both project A and project B d accept project B and reject project A E ignore the IRR rule and use another method of analysis Because these are mutually exclusive projects with differing required rates of return, you should not apply the IRR rule AACSB TOPIC: ANALYTIC SECTION: 9.5 TOPIC: INTERNAL RATE OF RETURN TYPE: PROBLEMS 95 What should you based on the payback period? a accept project A and reject project B b accept project B and reject project A c accept both project A and project B D reject both project A and project B e extend the payback period for project A since it has a higher initial cost, which would make project A acceptable Neither project pays back within years, thus, they should both be rejected AACSB TOPIC: ANALYTIC SECTION: 9.2 TOPIC: PAYBACK PERIOD TYPE: PROBLEMS 9-57 Chapter 009 Net Present Value and Other Investment Criteria 96 What should you according to the profitability index? A disregard the PI method in this case b accept both project A and project B c accept project A and reject project B d accept project B and reject project A e reject both project A and project B Because these are mutually exclusive projects, the PI rule should not be applied AACSB TOPIC: ANALYTIC SECTION: 9.6 TOPIC: PROFITABILITY INDEX TYPE: PROBLEMS 97 What should you based on the average accounting return? a accept project A because the AAR exceeds the required rate b accept project A because the AAR is less than the required rate c accept both project A and project B d accept whichever project you prefer as they are equivalent from an AAR perspective E not know as the net income was not provided The AAR cannot be computed because the net income was not provided AACSB TOPIC: ANALYTIC SECTION: 9.4 TOPIC: AVERAGE ACCOUNTING RETURN TYPE: PROBLEMS 9-58 Chapter 009 Net Present Value and Other Investment Criteria Essay Questions 98 What can you state with certainty about NPV, IRR, and PI when a project has a zero NPV? A zero NPV indicates that you should be indifferent between accepting and rejecting a project as the project is returning a return which is equal to the project's required rate of return In addition, the present value of the cash inflows is equal to the present value of the cash outflows In other words, IRR is equal to the required rate of return and the PI is equal to one AACSB TOPIC: REFLECTIVE THINKING SECTION: 9.1 TOPIC: NPV 99 What are the key advantages and disadvantages of the internal rate of return method of analysis? The key advantages are IRR's close relationship with NPV and the ease with which IRR is understood and communicated The key disadvantages are the multiple solutions that exist with nonconventional cash flows and the ranking conflict that exists when evaluating mutually exclusive investments AACSB TOPIC: REFLECTIVE THINKING SECTION: 9.5 TOPIC: INTERNAL RATE OF RETURN 100 Explain the differences and similarities between net present value (NPV) and the profitability index (PI) The NPV and PI both consider the time value of money and result in the same accept or reject decision The main difference between the two is that the PI may be useful in determining which projects to accept if funds are limited; however, the PI may lead to incorrect decisions in considering mutually exclusive investments AACSB TOPIC: REFLECTIVE THINKING SECTION: 9.1 AND 9.6 TOPIC: NPV VS PI 9-59 Chapter 009 Net Present Value and Other Investment Criteria 101 How does the NPV rule help ensure that managers create wealth for a firm's shareholders? The NPV rule states that a project should be accepted if the NPV is positive and rejected if the NPV is negative This aligns with the goal of creating wealth for a firm's shareholders as only projects which create wealth are approved for acceptance Managers are indifferent to projects with zero NPVs which is okay because such projects neither create nor destroy shareholder wealth AACSB TOPIC: REFLECTIVE THINKING SECTION: 9.1 AND 9.7 TOPIC: NPV 9-60 ... is greater than the crossover rate c only accept project A if the required return equals the crossover rate D accept project B anytime the required return is less than the crossover rate e accept... cash flows of the two projects SECTION: 9.5 TOPIC: CROSSOVER POINT TYPE: CONCEPTS 38 You are comparing two mutually exclusive projects The crossover point is 11.46 percent You determine that you... percent and accept project A at all other required rates SECTION: 9.5 TOPIC: CROSSOVER POINT TYPE: CONCEPTS 39 Graphing the crossover point helps explain: a why one project is always superior to another