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CHAPTER 11—THE BASICS OF CAPITAL BUDGETING A firm should never accept a project if its acceptance would lead to an increase in the firm's cost of capital (its WACC) a True b Fals e ANSWER: False POINTS: DIFFICULTY: EASY REFERENCES: 11-1 An Overview of Capital Budgeting LEARNING OBJECTIV FOFM.BRIG.16.11.01 - An Overview of Capital Budgeting ES: NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking DS: STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital TOPICS: Capital budget KEYWORDS: Bloom's: Comprehension 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 a True b Fals e ANSWER: False POINTS: DIFFICULTY: EASY REFERENCES: 11-2 Net Present Value (NPV) LEARNING OBJECTIV FOFM.BRIG.16.11.02 - Net Present Value (NPV) ES: NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking DS: STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital TOPICS: PV of cash flows KEYWORDS: Bloom’s: Knowledge 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 a True b Fals e ANSWER: False POINTS: DIFFICULTY: EASY REFERENCES: 11-2 Net Present Value (NPV) LEARNING OBJECTIV FOFM.BRIG.16.11.02 - Net Present Value (NPV) Cengage Learning Testing, Powered by Cognero Page CHAPTER 11—THE BASICS OF CAPITAL BUDGETING ES: NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking DS: STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital TOPICS: NPV KEYWORDS: Bloom's: Comprehension A basic rule in capital budgeting is that if a project's NPV exceeds its IRR, then the project should be accepted a True b Fals e ANSWER: False POINTS: DIFFICULTY: EASY REFERENCES: 11-2 Net Present Value (NPV) LEARNING OBJECTIV FOFM.BRIG.16.11.02 - Net Present Value (NPV) ES: NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking DS: STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital TOPICS: NPV KEYWORDS: Bloom’s: Knowledge 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 a True b Fals e ANSWER: True POINTS: DIFFICULTY: EASY REFERENCES: 11-2 Net Present Value (NPV) LEARNING OBJECTIV FOFM.BRIG.16.11.02 - Net Present Value (NPV) ES: NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking DS: STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital TOPICS: Mutually exclusive projects KEYWORDS: Bloom’s: Knowledge 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 Cengage Learning Testing, Powered by Cognero Page CHAPTER 11—THE BASICS OF CAPITAL BUDGETING a True b Fals e ANSWER: False POINTS: DIFFICULTY: EASY REFERENCES: 11-2 Net Present Value (NPV) LEARNING OBJECTIV FOFM.BRIG.16.11.02 - Net Present Value (NPV) ES: NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking DS: STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital TOPICS: Mutually exclusive projects KEYWORDS: Bloom’s: Knowledge 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 a True b Fals e ANSWER: True POINTS: DIFFICULTY: EASY REFERENCES: 11-3 Internal Rate of Return (IRR) LEARNING OBJECTIV FOFM.BRIG.16.11.03 - Internal Rate of Return (IRR) ES: NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking DS: STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital TOPICS: IRR KEYWORDS: Bloom’s: Knowledge Other things held constant, an increase in the cost of capital will result in a decrease in a project's IRR a True b Fals e ANSWER: False POINTS: DIFFICULTY: EASY REFERENCES: 11-3 Internal Rate of Return (IRR) LEARNING OBJECTIV FOFM.BRIG.16.11.03 - Internal Rate of Return (IRR) ES: NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking DS: Cengage Learning Testing, Powered by Cognero Page CHAPTER 11—THE BASICS OF CAPITAL BUDGETING STATE STANDARDS: TOPICS: KEYWORDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital IRR Bloom's: Comprehension 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 a True b Fals e ANSWER: True POINTS: DIFFICULTY: EASY REFERENCES: 11-4 Multiple Internal Rates of Return LEARNING OBJECTIV FOFM.BRIG.16.11.04 - Multiple Internal Rates of Return ES: NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking DS: STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital TOPICS: Multiple IRRs KEYWORDS: Bloom’s: Knowledge 10 The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects that have different lives are being compared a True b Fals e ANSWER: False POINTS: DIFFICULTY: EASY REFERENCES: 11-4 Multiple Internal Rates of Return LEARNING OBJECTIV FOFM.BRIG.16.11.04 - Multiple Internal Rates of Return ES: NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking DS: STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital TOPICS: Multiple IRRs KEYWORDS: Bloom’s: Knowledge 11 The NPV method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital a True b Fals e Cengage Learning Testing, Powered by Cognero Page CHAPTER 11—THE BASICS OF CAPITAL BUDGETING ANSWER: True POINTS: DIFFICULTY: EASY REFERENCES: 11-5 Reinvestment Rate Assumptions LEARNING OBJECTIV FOFM.BRIG.16.11.05 - Reinvestment Rate Assumptions ES: NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking DS: STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital TOPICS: Reinvestment rate assumption KEYWORDS: Bloom’s: Knowledge 12 The IRR method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital a True b Fals e ANSWER: False POINTS: DIFFICULTY: EASY REFERENCES: 11-5 Reinvestment Rate Assumptions LEARNING OBJECTIV FOFM.BRIG.16.11.05 - Reinvestment Rate Assumptions ES: NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking DS: STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital TOPICS: Reinvestment rate assumption KEYWORDS: Bloom’s: Knowledge 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 a True b Fals e ANSWER: True POINTS: DIFFICULTY: EASY REFERENCES: 11-5 Reinvestment Rate Assumptions LEARNING OBJECTIV FOFM.BRIG.16.11.05 - Reinvestment Rate Assumptions ES: NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking DS: STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and Cengage Learning Testing, Powered by Cognero Page CHAPTER 11—THE BASICS OF CAPITAL BUDGETING TOPICS: KEYWORDS: cost of capital Reinvestment rate assumption Bloom’s: Knowledge 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 a True b Fals e ANSWER: True POINTS: DIFFICULTY: EASY REFERENCES: 11-6 Modified Internal Rate of Return (MIRR) LEARNING OBJECTIV FOFM.BRIG.16.11.06 - Modified Internal Rate of Return (MIRR) ES: NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking DS: STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital TOPICS: Modified IRR KEYWORDS: Bloom’s: Knowledge 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 a True b Fals e ANSWER: False POINTS: DIFFICULTY: EASY REFERENCES: 11-6 Modified Internal Rate of Return (MIRR) LEARNING OBJECTIV FOFM.BRIG.16.11.06 - Modified Internal Rate of Return (MIRR) ES: NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking DS: STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital TOPICS: Modified IRR KEYWORDS: Bloom’s: Knowledge 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 a True b Fals e Cengage Learning Testing, Powered by Cognero Page CHAPTER 11—THE BASICS OF CAPITAL BUDGETING ANSWER: False POINTS: DIFFICULTY: EASY REFERENCES: 11-6 Modified Internal Rate of Return (MIRR) LEARNING OBJECTIV FOFM.BRIG.16.11.06 - Modified Internal Rate of Return (MIRR) ES: NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking DS: STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital TOPICS: Modified IRR KEYWORDS: Bloom's: Comprehension 17 One advantage of the payback method for evaluating potential investments is that it provides information about a project's liquidity and risk a True b Fals e ANSWER: True POINTS: DIFFICULTY: EASY REFERENCES: 11-8 Payback Period LEARNING OBJECTIV FOFM.BRIG.16.11.08 - Payback Period ES: NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking DS: STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital TOPICS: Payback period KEYWORDS: Bloom’s: Knowledge 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 a True b Fals e ANSWER: False RATIONALE: Think about the following equally risky projects The cost of capital is WACC = 10% S L −1000.00 −1000.00 1400.00 378.34 IRRS = 40.0% IRRL = 30.0% Cengage Learning Testing, Powered by Cognero 378.34 378.34 378.34 378.34 378.34 NPVS = $272.73 NPVL = $647.77 Page CHAPTER 11—THE BASICS OF CAPITAL BUDGETING S has the higher IRR, but L has a much higher NPV and is therefore preferable If the project could be repeated, though, S would turn out to be better—it would have both a higher NPV and IRR POINTS: DIFFICULTY: REFERENCES : LEARNING O BJECTIVES: NATIONAL ST ANDARDS: STATE STAND ARDS: TOPICS: KEYWORDS: MODERATE 11-2 Net Present Value (NPV) FOFM.BRIG.16.11.02 - Net Present Value (NPV) United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital Mutually exclusive projects 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 a True b Fals e ANSWER: False POINTS: DIFFICULTY: MODERATE REFERENCES: 11-5 Reinvestment Rate Assumptions LEARNING OBJECTIV FOFM.BRIG.16.11.05 - Reinvestment Rate Assumptions ES: NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking DS: STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital TOPICS: NPV and IRR KEYWORDS: Bloom's: Comprehension 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 a True b Fals e ANSWER: False POINTS: DIFFICULTY: MODERATE REFERENCES: 11-5 Reinvestment Rate Assumptions LEARNING OBJECTIV FOFM.BRIG.16.11.05 - Reinvestment Rate Assumptions ES: NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking DS: Cengage Learning Testing, Powered by Cognero Page CHAPTER 11—THE BASICS OF CAPITAL BUDGETING STATE STANDARDS: TOPICS: KEYWORDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital NPV and IRR Bloom's: Comprehension 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 a True b Fals e ANSWER: False POINTS: DIFFICULTY: MODERATE REFERENCES: 11-7 NPV Profiles LEARNING OBJECTIV FOFM.BRIG.16.11.07 - NPV Profiles ES: NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking DS: STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital TOPICS: NPV profiles KEYWORDS: Bloom's: Comprehension 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 a True b Fals e ANSWER: True POINTS: DIFFICULTY: MODERATE REFERENCES: 11-7 NPV Profiles LEARNING OBJECTIV FOFM.BRIG.16.11.07 - NPV Profiles ES: NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking DS: STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital TOPICS: NPV profiles KEYWORDS: Bloom's: Comprehension 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 Cengage Learning Testing, Powered by Cognero Page CHAPTER 11—THE BASICS OF CAPITAL BUDGETING b Fals e ANSWER: True POINTS: DIFFICULTY: MODERATE REFERENCES: 11-7 NPV Profiles LEARNING OBJECTIV FOFM.BRIG.16.11.07 - NPV Profiles ES: NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking DS: STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital TOPICS: NPV profiles KEYWORDS: Bloom's: Comprehension 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 ANSWER: False 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 POINTS: DIFFICULTY: MODERATE REFERENCES: 11-8 Payback Period LEARNING OB FOFM.BRIG.16.11.08 - Payback Period JECTIVES: NATIONAL STA United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking NDARDS: STATE STANDA United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of RDS: capital 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 a True b Fals e ANSWER: True POINTS: DIFFICULTY: MODERATE REFERENCES: 11-9 Conclusions on Capital Budgeting Methods LEARNING OBJECTIV FOFM.BRIG.16.11.09 - Conclusions on Capital Budgeting Methods Cengage Learning Testing, Powered by Cognero Page 10 CHAPTER 11—THE BASICS OF CAPITAL BUDGETING MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected WACC: 10.00% Year −$1,000 Cash flows a 9.32% b 10.35 % c 11.50% d 12.78% e 14.20 % ANSWER: e WACC: RATIONALE: $450 $450 $450 10.00% Year Cash flows Compounded values, FVs −$1,000 $450 $544.50 $450 $495.00 $450 $450.00 TV = Sum of compounded inflows: $1,489.50 MIRR = 14.20% MIRR = 14.20% Found as discount rate that equates PV of TV to cost, discounted back years @ WACC Alternative calculation, using Excel's MIRR function POINTS: DIFFICULTY: MODERATE REFERENCES: 11-6 Modified Internal Rate of Return (MIRR) LEARNING OBJECT FOFM.BRIG.16.11.06 - Modified Internal Rate of Return (MIRR) IVES: NATIONAL STANDA United States - BUSPROG.FOFM.BRIG.16.03 - Analytic skills RDS: STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital TOPICS: MIRR KEYWORDS: Bloom's: Analysis OTHER: Multiple Choice: Problem 95 Ingram Electric Products is considering a project that has the following cash flow and WACC data What is the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected WACC: Year Cash flows a 8.86% b 9.84% c 10.94 % 11.00% −$800 Cengage Learning Testing, Powered by Cognero $350 $350 $350 Page 55 CHAPTER 11—THE BASICS OF CAPITAL BUDGETING d 12.15 % e 13.50 % ANSWER: RATIONALE: e WACC: Year Cash flows Compounded values, FVs 11.00% −$800 $350 $431.24 $350 $388.50 $350 $350.00 TV = Sum of compounded inflows: $1,169.74 MIRR = 13.50% MIRR = 13.50% Found as discount rate that equates PV of TV to cost, discounted back years @ WACC Alternative calculation, using Excel's MIRR function POINTS: DIFFICULTY: MODERATE REFERENCES: 11-6 Modified Internal Rate of Return (MIRR) LEARNING OBJECT FOFM.BRIG.16.11.06 - Modified Internal Rate of Return (MIRR) IVES: NATIONAL STANDA United States - BUSPROG.FOFM.BRIG.16.03 - Analytic skills RDS: STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital TOPICS: MIRR KEYWORDS: Bloom's: Analysis OTHER: Multiple Choice: Problem 96 Malholtra Inc is considering a project that has the following cash flow and WACC data What is the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected WACC: 10.00% Year −$850 Cash flows a 14.08 % b 15.65 % c 17.21 % d 18.94 % e 20.83 % ANSWER: b WACC: RATIONALE: Year Cash flows Cengage Learning Testing, Powered by Cognero $300 $320 $340 $360 10.00% −$850 $300 $320 $340 $360 Page 56 CHAPTER 11—THE BASICS OF CAPITAL BUDGETING Compounded values $399.30 $387.20 $374.00 $360.00 TV = Sum of comp'ed inflows: $1,520.50 Found as discount rate that equates PV of TV to cost, MIRR = 15.65% discounted back years @ WACC MIRR = 15.65% Alternative calculation, using Excel's MIRR function POINTS: DIFFICULTY: REFERENCES: LEARNING OBJE CTIVES: NATIONAL STAN DARDS: STATE STANDAR DS: TOPICS: KEYWORDS: OTHER: MODERATE 11-6 Modified Internal Rate of Return (MIRR) FOFM.BRIG.16.11.06 - Modified Internal Rate of Return (MIRR) United States - BUSPROG.FOFM.BRIG.16.03 - Analytic skills United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital MIRR Bloom's: Analysis Multiple Choice: Problem 97 Hindelang Inc is considering a project that has the following cash flow and WACC data What is the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected WACC: 12.25% Year −$850 Cash flows a 13.42 % b 14.91 % c 16.56 % d 18.22% e 20.04 % ANSWER: c WACC: RATIONALE: Year Cash flows Compounded values $300 $320 $340 $360 12.25% −$850 $300 $424.31 $320 $403.20 $340 $381.65 $360 $360.00 TV = Sum of comp'ed inflows: $1,569.16 Found as discount rate that equates PV of TV to cost, MIRR = 16.56% discounted back years @ WACC MIRR = 16.56% Alternative calculation, using Excel's MIRR function POINTS: DIFFICULTY: REFERENCES: LEARNING OBJE CTIVES: MODERATE 11-6 Modified Internal Rate of Return (MIRR) FOFM.BRIG.16.11.06 - Modified Internal Rate of Return (MIRR) Cengage Learning Testing, Powered by Cognero Page 57 CHAPTER 11—THE BASICS OF CAPITAL BUDGETING NATIONAL STAN DARDS: STATE STANDAR DS: TOPICS: KEYWORDS: OTHER: United States - BUSPROG.FOFM.BRIG.16.03 - Analytic skills United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital MIRR Bloom's: Analysis Multiple Choice: Problem 98 Stern Associates is considering a project that has the following cash flow data What is the project's payback? Year Cash flows a 2.31 years b 2.56 years c 2.85 years d 3.16 years e 3.52 years ANSWER: RATIONALE: −$1,100 $300 $310 $320 $330 $340 e Year Cash flows Cumulative CF Payback = 3.52 POINTS: DIFFICULTY: REFERENCES: LEARNING OBJE CTIVES: NATIONAL STAN DARDS: STATE STANDAR DS: TOPICS: KEYWORDS: OTHER: −$1,100 −$1,100 $300 −$800 $310 −$490 $320 −$170 $330 $160 $340 $500 − − − − 3.52 − MODERATE 11-8 Payback Period FOFM.BRIG.16.11.08 - Payback Period United States - BUSPROG.FOFM.BRIG.16.03 - Analytic skills United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital Payback Bloom's: Analysis Multiple Choice: Problem 99 Fernando Designs is considering a project that has the following cash flow and WACC data What is the project's discounted payback? WACC: Year Cash flows 10.00% −$900 Cengage Learning Testing, Powered by Cognero $500 $500 $500 Page 58 CHAPTER 11—THE BASICS OF CAPITAL BUDGETING a 1.88 years b 2.09 years c 2.29 years d 2.52 years e 2.78 years ANSWER: RATIONALE: b WACC: 10.00% Year Cash flows −$900 PV of CFs −$900 Cumulative CF −$900 Payback = 2.09 − $500 $455 −$445 − $500 $413 −$32 − $500 $376 $343 2.09 POINTS: DIFFICULTY: MODERATE REFERENCES: 11-8 Payback Period LEARNING OBJECTIV FOFM.BRIG.16.11.08 - Payback Period ES: NATIONAL STANDAR United States - BUSPROG.FOFM.BRIG.16.03 - Analytic skills DS: STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital TOPICS: Discounted payback KEYWORDS: Bloom's: Analysis OTHER: Multiple Choice: Problem 100 Masulis Inc is considering a project that has the following cash flow and WACC data What is the project's discounted payback? WACC: 10.00% Year −$950 Cash flows a 1.61 years b 1.79 years c 1.99 years d 2.22 years e 2.44 years ANSWER: d WACC: RATIONALE: $525 $485 $445 $405 10.00% Year Cash flows Cengage Learning Testing, Powered by Cognero −$950 $525 $485 $445 $405 Page 59 CHAPTER 11—THE BASICS OF CAPITAL BUDGETING PV of CFs Cumulative CF Payback = 2.22 −$950 −$950 − $477 −$473 − $401 −$72 − $334 $262 2.22 $277 $539 − POINTS: DIFFICULTY: MODERATE REFERENCES: 11-8 Payback Period LEARNING OBJEC FOFM.BRIG.16.11.08 - Payback Period TIVES: NATIONAL STANDA United States - BUSPROG.FOFM.BRIG.16.03 - Analytic skills RDS: STATE STANDARDS United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost : of capital TOPICS: Discounted payback KEYWORDS: Bloom's: Analysis OTHER: Multiple Choice: Problem 101 Tesar Chemicals is considering Projects S and L, whose cash flows are shown below These projects are mutually exclusive, equally risky, and not repeatable The CEO believes the IRR is the best selection criterion, while the CFO advocates the NPV If the decision is made by choosing the project with the higher IRR rather than the one with the higher NPV, how much, if any, value will be forgone, i.e., what's the chosen NPV versus the maximum possible NPV? Note that (1) "true value" is measured by NPV, and (2) under some conditions the choice of IRR vs NPV will have no effect on the value gained or lost WACC: 7.50% Year −$1,100 $550 $600 $100 $100 CFS −$2,700 $650 $725 $800 $1,400 CFL a $138.10 b $149.2 c $160.3 d $171.4 e $182.52 ANSWER: a RATIONALE: First, recognize that NPV makes theoretically correct capital budgeting decisions, so the highest NPV tells us how much value could be added We calculate the two projects' NPVs, IRRs, and MIRRs, but the MIRR information is not needed for this problem We then see what NPV would result if the decision were based on the IRR (and the MIRR) The difference between the NPV is the loss incurred if the IRR criterion is used Of course, it's possible that IRR could choose the correct project TV MIRR Year CFS Compounded CFs: CF L Compounded −$1,100 −$2,700 Cengage Learning Testing, Powered by Cognero $550 $600 $100 $100 673.77 686.94 107.00 100.00 $1,567.71 9.5469% $650 $725 $800 $1,400 796.28 830.05 856.00 1400.00 $3,882.33 9.6663% Page 60 CHAPTER 11—THE BASICS OF CAPITAL BUDGETING CFs: MIRR, L = 9.67% IRR, L = 10.71181% MIRR, S = 9.55% IRR, S = 12.24157% MIRR Choice: L IRR Choice: S NPV using MIRR: $224.31 NPV using IRR: $86.20 Lost value using IRR versus MIRR: $138.10 Lost value using MIRR versus NPV: $0.00 Lost value using IRR versus NPV: $138.10 POINTS: DIFFICULTY: REFERENCES : LEARNING O BJECTIVES: NATIONAL ST ANDARDS: STATE STAND ARDS: TOPICS: KEYWORDS: OTHER: NPV, L = $224.3065 NPV, S = $86.2036 NPV Choice: L NPV using NPV: $224.31 Loss below: 7.9850% Loss below: 10.1638% Loss below: 10.1638% MODERATE Comprehensive FOFM.BRIG.16.11.00 - Comprehensive United States - BUSPROG.FOFM.BRIG.16.03 - Analytic skills United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital NPV and IRR Bloom's: Evaluation Multiple Choice: Problem 102 A firm is considering Projects S and L, whose cash flows are shown below These projects are mutually exclusive, equally risky, and not repeatable The CEO wants to use the IRR criterion, while the CFO favors the NPV method You were hired to advise the firm on the best procedure If the wrong decision criterion is used, how much potential value would the firm lose? WACC: 6.00% Year −$1,025 CFS −$2,150 CFL a $188.68 b $198.61 c $209.0 d $219.5 e $230.4 ANSWER: c 6.000% RATIONALE: WACC: Year CFS CFL $380 $765 −$1,025 −$2,150 IRR, L IRR, S NPV, L Cengage Learning Testing, Powered by Cognero 15.781% 17.861% $500.81 $380 $765 $380 $765 $380 $765 $380 $765 $380 $765 $380 $765 $380 $765 $209.07 Page 61 CHAPTER 11—THE BASICS OF CAPITAL BUDGETING NPV, S 0% 2% 4% 6% 8% 10% 12% 13.860% 14% 16% 18% 20% 22% 24% $291.74 $209.07 = Value lost if use the IRR criterion S 291.7 495.0 421.9 354.4 291.7 233.6 179.5 129.2 85.4 82.2 38.3 −2.8 −41.3 −77.4 −111.4 L 500.8 910.0 762.9 626.9 500.8 383.8 274.9 173.6 85.4 79.0 −9.4 −92.1 −169.6 −242.4 −310.7 Note that the WACC is constrained to be less than the crossover point, so there is a conflict between NPV and IRR, hence following the IRR rule results in a loss of value POINTS: DIFFICULTY: REFERENCES : LEARNING O BJECTIVES: NATIONAL ST ANDARDS: STATE STAND ARDS: TOPICS: KEYWORDS: OTHER: MODERATE/CHALLENGING 11-5 Reinvestment Rate Assumptions FOFM.BRIG.16.11.05 - Reinvestment Rate Assumptions United States - BUSPROG.FOFM.BRIG.16.03 - Analytic skills United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital NPV and IRR Bloom's: Evaluation Multiple Choice: Problem 103 Sexton Inc is considering Projects S and L, whose cash flows are shown below These projects are mutually exclusive, equally risky, and not repeatable If the decision is made by choosing the project with the higher IRR, how Cengage Learning Testing, Powered by Cognero Page 62 CHAPTER 11—THE BASICS OF CAPITAL BUDGETING much value will be forgone? Note that under certain conditions choosing projects on the basis of the IRR will not cause any value to be lost because the one with the higher IRR will also have the higher NPV, so no value will be lost if the IRR method is used WACC: 10.25% Year −$2,050 CFS −$4,300 CFL a $134.7 b $141.8 c $149.3 d $164.2 e $205.3 ANSWER: c 10.25% RATIONALE: WACC: Year CFS CFL $750 $1,500 −$2,050 −$4,300 $760 $1,518 13.275% = crossover $750 $760 $1,500 $1,518 $770 $1,536 $770 $1,536 IRR, L IRR, S 15.58% 18.06% NPV, L NPV, S $507.40 $358.05 $149.36 = Value lost if use the IRR criterion $780 $1,554 $780 $1,554 Note that the WACC is not constrained to be less than the crossover point, so there may not be a conflict between NPV and IRR, hence following the IRR rule may not result in a loss of value In that case, the correct answer is $0.00 POINTS: DIFFICULTY: REFERENCES : LEARNING O BJECTIVES: NATIONAL ST ANDARDS: STATE STAND ARDS: TOPICS: KEYWORDS: OTHER: MODERATE/CHALLENGING 11-5 Reinvestment Rate Assumptions FOFM.BRIG.16.11.05 - Reinvestment Rate Assumptions United States - BUSPROG.FOFM.BRIG.16.03 - Analytic skills United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital NPV and IRR Bloom's: Evaluation Multiple Choice: Problem 104 Moerdyk & Co is considering Projects S and L, whose cash flows are shown below These projects are mutually Cengage Learning Testing, Powered by Cognero Page 63 CHAPTER 11—THE BASICS OF CAPITAL BUDGETING exclusive, equally risky, and not repeatable If the decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under certain conditions choosing projects on the basis of the IRR will not cause any value to be lost because the one with the higher IRR will also have the higher NPV, i.e., no conflict will exist WACC: 10.00% Year −$1,025 CFS −$1,025 CFL a $5.4 b $6.02 c $6.62 d $7.2 e $7.82 ANSWER: e 10.000% RATIONALE: WACC: Year CFS CFL $650 $100 $450 $300 10.549% = crossover −$1,025 $650 $450 −$1,025 $100 $300 $250 $500 $250 $500 IRR, L IRR, S 15.66% 19.86% NPV, L NPV, S $167.61 $159.79 $ 7.82 = Value lost if use the IRR criterion $50 $700 $50 $700 Note that the WACC is not constrained to be less than the crossover point, so there may not be a conflict between NPV and IRR, hence following the IRR rule may not result in a loss of value In that case, the correct answer is $0.00 POINTS: DIFFICULTY: REFERENCES : LEARNING O BJECTIVES: NATIONAL ST ANDARDS: STATE STAND ARDS: TOPICS: KEYWORDS: OTHER: MODERATE/CHALLENGING Reinvestment Rate Assumptions FOFM.BRIG.16.11.05 - Reinvestment Rate Assumptions United States - BUSPROG.FOFM.BRIG.16.03 - Analytic skills United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital NPV and IRR Bloom's: Evaluation Multiple Choice: Problem 105 Kosovski Company is considering Projects S and L, whose cash flows are shown below These projects are mutually exclusive, equally risky, and are not repeatable If the decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under some conditions choosing projects on the basis of the IRR will cause $0.00 value to be lost Cengage Learning Testing, Powered by Cognero Page 64 CHAPTER 11—THE BASICS OF CAPITAL BUDGETING WACC: 7.75% Year −$1,050 CFS −$1,050 CFL a $11.45 b $12.72 c $14.6 d $16.82 e $19.3 ANSWER: b 7.75% RATIONALE: WACC: $675 $360 $650 $360 8.994% = crossover −$1,050 $675 $650 −$1,050 $360 $360 Year CFS CFL $360 $360 $360 $360 IRR, L IRR, S 13.95% 17.13% NPV, L NPV, S $149.03 $136.31 $ 12.72 = Value lost if use the IRR criterion Note that the WACC is not constrained to be less than the crossover point, so there may not be a conflict between NPV and IRR, hence following the IRR rule may not result in a loss of value In that case, the correct answer is $0.00 POINTS: DIFFICULTY: REFERENCES : LEARNING O BJECTIVES: NATIONAL ST ANDARDS: STATE STAND ARDS: TOPICS: KEYWORDS: OTHER: MODERATE/CHALLENGING 11-5 Reinvestment Rate Assumptions FOFM.BRIG.16.11.05 - Reinvestment Rate Assumptions United States - BUSPROG.FOFM.BRIG.16.03 - Analytic skills United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital NPV and IRR Bloom's: Evaluation Multiple Choice: Problem 106 Nast Inc is considering Projects S and L, whose cash flows are shown below These projects are mutually exclusive, equally risky, and not repeatable If the decision is made by choosing the project with the higher MIRR rather than the one with the higher NPV, how much value will be forgone? Note that under some conditions choosing projects on the basis of the MIRR will cause $0.00 value to be lost WACC: Year CFS 8.75% −$1,100 Cengage Learning Testing, Powered by Cognero $375 $375 $375 $375 Page 65 CHAPTER 11—THE BASICS OF CAPITAL BUDGETING −$2,200 CFL a $32.1 b $35.3 c $38.87 d $40.1 e $42.1 ANSWER: d RATIONALE: WACC: 8.750% Year CFS $725 $725 Crossover = 10.396% $375 $375 −$1,100 $375 $375 482.30 443.50 407.81 CFL −$2,200 $725 $725 $725 932.45 857.43 788.44 $725 TV 375.00 $1,708.61 $725 MIRR 11.64% $725 725.00 $3,303.31 MIRR, L MIRR, S 10.70% 11.64% NPV, L NPV, S $161.74 $121.59 $ 40.15 = Value lost if use the MIRR criterion 10.70% Note that the WACC is not constrained to be less than the crossover point, so there may not be a conflict between NPV and IRR, hence following the MIRR rule may not result in a loss of value In that case, the correct answer is $0.00 POINTS: DIFFICULTY: REFERENCES : LEARNING O BJECTIVES: NATIONAL ST ANDARDS: STATE STAND ARDS: TOPICS: KEYWORDS: OTHER: MODERATE/CHALLENGING Comprehensive FOFM.BRIG.16.11.00 - Comprehensive United States - BUSPROG.FOFM.BRIG.16.03 - Analytic skills United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital NPV vs MIRR Bloom's: Evaluation Multiple Choice: Problem 107 Yonan Inc is considering Projects S and L, whose cash flows are shown below These projects are mutually exclusive, equally risky, and not repeatable If the decision is made by choosing the project with the shorter payback, some value may be forgone How much value will be lost in this instance? Note that under some conditions choosing projects on the basis of the shorter payback will not cause value to be lost Cengage Learning Testing, Powered by Cognero Page 66 CHAPTER 11—THE BASICS OF CAPITAL BUDGETING WACC: 10.25% Year −$950 $500 $800 CFS −$2,100 $400 $800 CFL a $24.1 b $26.82 c $29.80 d $33.11 e $36.4 ANSWER: d 10.250% Crossover = 11.093% RATIONALE: WACC: Year CFS CFL Cumulative CF, S Cumulative CF, L Payback S = 1.56 Payback L = 3.10 NPV, L = NPV, S = Value lost −$950 −$2,100 −$950 −$2,100 − − $500 $400 −$450 −$1,700 − − $800 $800 $350 −$900 1.56 − $0 $800 $0 $1,000 $0 $800 $350 −$100 − − $0 $1,000 $350 $900 − 3.10 $194.79 $161.68 $ 33.11 Note that the WACC is not constrained to be less than the crossover point, so there may not be a conflict between NPV and payback, hence following the IRR rule may not result in a loss of value, so the correct answer may be $0.00 POINTS: DIFFICULTY: REFERENCES : LEARNING O BJECTIVES: NATIONAL ST ANDARDS: STATE STAND ARDS: TOPICS: KEYWORDS: OTHER: MODERATE/CHALLENGING Comprehensive FOFM.BRIG.16.11.00 - Comprehensive United States - BUSPROG.FOFM.BRIG.16.03 - Analytic skills United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of capital NPV vs payback Bloom's: Evaluation Multiple Choice: Problem 108 Noe Drilling Inc is considering Projects S and L, whose cash flows are shown below These projects are mutually exclusive, equally risky, and not repeatable The CEO believes the IRR is the best selection criterion, while the CFO advocates the MIRR If the decision is made by choosing the project with the higher IRR rather than the one with the higher MIRR, how much, if any, value will be forgone, i.e., what's the NPV of the chosen project versus the maximum possible NPV? Note that (1) "true value" is measured by NPV, and (2) under some conditions the choice of IRR vs MIRR will have no effect on the value lost Cengage Learning Testing, Powered by Cognero Page 67 CHAPTER 11—THE BASICS OF CAPITAL BUDGETING WACC: 7.00% Year −$1,100 $550 $600 $100 $100 CFS −$2,750 $725 $725 $800 $1,400 CFL a $185.9 b $197.0 c $208.11 d $219.2 e $230.3 ANSWER: a RATIONALE: First, recognize that NPV makes theoretically correct capital budgeting decisions, so the higher NPV tells us how much value could be added We calculate the two projects' NPVs, IRRs, and MIRRs We then see what NPV would result if the decision were based on the IRR and the MIRR Under some conditions, MIRR will choose the project with the higher NPV while the IRR chooses the lower NPV project Then, the difference between the NPVs is the loss incurred if the IRR criterion is used Of course, it's possible that both the MIRR and the IRR could choose the wrong project; with this set of cash flows, that happens at WACC > 8.62133% WACC: Year CFS Compounded CFs: CFL Compounded CFs: 7.00% −$1,100 $550 $600 $100 673.77 686.94 107.00 −$2,750 $725 $725 100.00 $800 TV MIRR 12.2416% 100.00 $1,567.71 9.2618% $1,400 10.9810% 888.16 830.05 856.00 1400.00 1400.00 $3,974.21 9.6426% −0.3808% MIRR, S = 9.2618% MIRR, L = 9.6426% MIRR Choice: L IRR, S = 12.2416% IRR, L = 10.9810% IRR Choice: S NPV based on IRR: NPV based on MIRR: $281.90 $96.00 Lost value using IRR versus MIRR: POINTS: DIFFICULTY: REFERENCES : LEARNING O BJECTIVES: NATIONAL ST ANDARDS: STATE STAND $100 NPV, S = $96.00 NPV, L = $281.90 NPV Choice: L NPV using NPV: $281.90 NPVl − NPV s = $185.90 Loss below: 8.6213% CHALLENGING Comprehensive FOFM.BRIG.16.11.00 - Comprehensive United States - BUSPROG.FOFM.BRIG.16.03 - Analytic skills United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and cost of Cengage Learning Testing, Powered by Cognero Page 68 CHAPTER 11—THE BASICS OF CAPITAL BUDGETING ARDS: TOPICS: KEYWORDS: OTHER: capital IRR vs MIRR Bloom's: Evaluation Multiple Choice: Problem Cengage Learning Testing, Powered by Cognero Page 69