CHAPTER 8

        1.     You run a small bagel shop and are considering replacing your 4 employees with automated machines that allow customers to buy their bagels without any human interaction. Of the following, the most difficult task you face in computing the NPV of this change is

        A)        estimation of the reduction in wages you will have from the decrease in work force

        B)        estimation of the reduction in taxes you will get from the increase in depreciation

        C)        estimation of the cost of purchasing the new equipment

        D)        estimation of the cost of installing the new equipment

        E)        estimation of the total change in sales that will result from the change

        2.        Draw a graph that illustrates two mutually exclusive investments, A and B, with a crossover rate of return equal to 10%, and with A having the higher NPV at a discount rate of zero percent. Explain the graph, including under which conditions project A or project B would be chosen using NPV and then using IRR.

        3.     A project which requires an initial cash outlay and for which all remaining cash flows are inflows is said to be ____________.

        A)        independent

        B)        conventional

        C)        mutually exclusive

        D)        value-creating

        E)     short term

        4.        Which capital investment evaluation technique is described by the attributes below?

                1. Closely related to NPV

                2. Easy to understand and communicate

                3. May lead to incorrect decisions when comparing mutually exclusive investments

                4. May be useful when the available investment funds are limited

        A)    NPV

        B)    IRR

        C)    AAR

        D)        Payback period

        E)     PI

        5.        What is the IRR of an investment that costs $77,500 and pays $27,500 a year for 4 years?

        A)        15.6%

        B)        17.8%

        C)        20.1%

        D)        22.3%

        E)        24.4%

        6.     List and briefly discuss the advantages and disadvantages of the IRR rule.

        7.     For which capital investment evaluation technique is the following a complete list of the technique's disadvantages when compared to NPV analysis?

                1. Ignores cash flows beyond the cutoff date

                2. Requires an arbitrary cutoff point

                3. Biased against long-term projects

                4. Ignores the time value of money

        A)    NPV

        B)    IRR

        C)    AAR

        D)        Payback period

        E)        Profitability index

        8.     If an investment has a _____________ of 1.2 it can be said the investment generates $1.20 in present value benefits for each dollar invested.

        A)        profitability index

        B)    net present value

        C)        internal rate of return

        D)        payback period

        E)        average accounting return

        9.        What is the NPV of the following set of cash flows if the required return is 14%?

                        Year Cash Flow

                        0        -$50,000

                        1        -$5,000

                        2        $50,000

                        3        $50,000

                        4        -$25,000

        A)    The NPV is negative

        B)        $3,034

        C)        $9,525

        D)        $10,376

        E)        $41,410

Use the following to answer question 10:

Consider the following possible problems that arise in using alternative capital budgeting decision rules, such as IRR or NPV, etc. Then choose the problems associated with the technique identified.

I. Ignores time value of money

II. Ignores the more distant flows

III. May not correctly distinguish among mutually exclusive projects

IV. May give multiple results if some future cash flows are negative

V. Requires an arbitrary cutoff point

VI. Biased against long-term projects

VII. Not a true rate of return

        10.        What are the problems associated with IRR?

        A)    I only

        B)    II only

        C)    III and IV only

        D)    IV only

        E)     III, IV, and VII only

Use the following to answer question 11:

Project     Year 0      Year 1        Year 2        Year 3

Project A        -$200        $100        $100        $100

Project B        -$275        $125        $125        $125

        11.        Compute the crossover rate for the two projects.

        A)    The NPV profiles of the two do not cross over

        B)        0.0%

        C)        2.2%

        D)        3.5%

        E)        8.7%

        12.   A project whose NPV equals zero

        A)        should be rejected

        B)    has a PI that is greater than one

        C)    is expected to yield a return equal to the firm's required return

        D)    has a payback period that is shorter than the life of the project

        E)        should be accepted even if the firm has other potential investments with positive NPVs

        13.        Suppose a firm invests $600 in a project. The initial cost is depreciated straight-line to zero over 3 years. Net income from the project is $100, $125 and $140 in each of the three years of the project's life. What is the average accounting return?

        A)        18.25%

        B)        20.28%

        C)        35.49%

        D)        40.55%

        E)        60.83%

        14.   The management of a firm wishes to accept projects with a high degree of liquidity, wishes to avoid the higher forecasting error associated with cash flows a long way into the future, and wishes to avoid projects that take a large amount of research and development. The firm would be justified in using the ___________ to evaluate its projects.

        A)    IRR rule

        B)    NPV rule

        C)    AAR rule

        D)        payback period rule

        E)     PI rule

        15.        Which capital investment evaluation technique is described by the attributes below?

                1. Easy to understand and communicate

                2. May result in multiple answers

                3. May lead to incorrect decisions when applied to mutually exclusive investments

        A)    NPV

        B)    IRR

        C)    AAR

        D)        Payback period

        E)        Profitability index

        16.   You are going to choose 1 of 2 investments. Both investments cost $80,000, but investment A pays $35,000 a year for 4 years and investment B pays $30,000 a year for 5 years. If your required return is 13%, which should you choose?

        A)    A because it pays back sooner

        B)    A because its IRR exceeds 13%

        C)    A because it has a higher IRR

        D)    B because its IRR exceeds 13%

        E)     B because it has a higher NPV

Use the following to answer questions 17-18:

Bill plans to open a do-it-yourself dog bathing center in a storefront. The bathing equipment will cost $160,000. Bill expects the after tax cash inflows to be $40,000 annually for 7 years, after which he plans to scrap the equipment and retire to the beaches of Jamaica.

        17.        Assume the required return is 15%. What is the project's PI? Is it acceptable?

        A)    0.88; yes

        B)    0.88; no

        C)    1.0; indifferent

        D)    1.04; yes

        E)     1.04; no

        18.        Assume the required return is 10%. What is the project's NPV?

        A)        $14,111

        B)        $27,322

        C)        $32,556

        D)        $34,737

        E)        $45,001

        19.        According the capital budgeting surveys cited in the text, most financial managers of multinational firms

        A)        prefer to rely exclusively on payback analysis to evaluate projects

        B)    use the AAR as their primary method of evaluating capital budgeting projects

        C)    who use payback analysis use it only in conjunction with some other type of analysis

        D)        prefer to use NPV to analyze their investment projects

        E)        make use of payback analysis more heavily than discounted cash flow methods

Use the following to answer question 20:

You need to borrow $2,000 quickly, and Morry the neighborhood loan shark will give it to you if you promise to repay him $200.92 monthly for the next year.

        20.        Suppose that Morry has more customers than funds. Which capital budgeting technique would allow him to rank his potential customers in order to maximize his current wealth?

        A)    AAR

        B)        Payback period

        C)        Profitability Index

        D)    NPV

        E)        Internal rate of return

Answer Key

        1.     E     

        2.     The student should replicate Figure 8.8.

        3.     B     

        4.     E     

        5.     A    

        6.     The advantages of the rule are the IRR rule's close relationship with NPV and the ease with which it is understood and communicated. The two disadvantages are that there may be multiple solutions and the rule may lead to a ranking conflict in evaluating mutually exclusive investments. The student should add a brief explanation demonstrating their understanding of each.

        7.     D    

        8.     A    

        9.     B     

        10.   C    

        11.   B     

        12.   C    

        13.   D    

        14.   D    

        15.   B     

        16.   E     

        17.   D    

        18.   D    

        19.   C