FIN 534/FIN534 Week 7 Quiz 6

Question
1
Which
of the following statements is CORRECT?
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.
Question
2
Which
of the following statements is CORRECT?
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.
Question
3
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?
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.
Question
4
Which
of the following statements is CORRECT?
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.
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.
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.
One
advantage of the NPV over the MIRR method is that NPV discounts cash flows
whereas the MIRR is based on undiscounted cash flows.
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.
Question
5
Which
of the following statements is CORRECT?
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.
Question
6
Which
of the following statements is CORRECT?
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.
Question
7
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?
Project
S.
Project
L.
Both
projects are equally sensitive to changes in the WACC since their NPVs are
equal at all costs of capital.
Neither
project is sensitive to changes in the discount rate, since both have NPV
profiles that are horizontal.
The
solution cannot be determined because the problem gives us no information that
can be used to determine the projects’ relative IRRs.
Question
8
Which
of the following statements is CORRECT?
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.
Question
9
Which
of the following statements is CORRECT?
An
NPV profile graph shows how a project’s payback varies as the cost of capital
changes.
The
NPV profile graph for a normal project will generally have a positive (upward)
slope as the life of the project increases.
An
NPV profile graph is designed to give decision makers an idea about how a
project’s risk varies with its life.
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.
We
cannot draw a project’s NPV profile unless we know the appropriate WACC for use
in evaluating the project’s NPV.
Question
10
Assume
a project has normal cash flows. All else equal, which of the following
statements is CORRECT?
A
project’s IRR increases as the WACC declines.
A
project’s NPV increases as the WACC declines.
A
project’s MIRR is unaffected by changes in the WACC.
A
project’s regular payback increases as the WACC declines.
A
project’s discounted payback increases as the WACC declines.
Question
11
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
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.
Question
12
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?
Project
D probably has a higher IRR.
Project
D is probably larger in scale than Project C.
Project
C probably has a faster payback.
Project
C probably has a higher IRR.
The
crossover rate between the two projects is below 12%.
Question
13
Which
of the following statements is CORRECT?
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.
Question
14
Which
of the following statements is CORRECT?
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.
One
defect of the IRR method versus the NPV is that the IRR does not take account
of the time value of money.
One
defect of the IRR method versus the NPV is that the IRR does not take account
of the cost of capital.
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.
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.
Question
15
Which
of the following statements is CORRECT?
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.
Question
16
Which
one of the following would NOT result in incremental cash flows and thus should
NOT be included in the capital budgeting analysis for a new product?

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.
Question
17
Which
of the following statements is CORRECT?
An
example of a sunk cost is the cost associated with restoring the site of a
strip mine once the ore has been depleted.
Sunk
costs must be considered if the IRR method is used but not if the firm relies
on the NPV method.
A
good example of a sunk cost is a situation where a bank opens a new office, and
that new office leads to a decline in deposits of the bank’s other offices.
A
good example of a sunk cost is money that a banking corporation spent last year
to investigate the site for a new office, then expensed that cost for tax
purposes, and now is deciding whether to go forward with the project.
If
sunk costs are considered and reflected in a project’s cash flows, then the
project’s calculated NPV will be higher than it otherwise would be.
Question
18
When
evaluating a new project, firms should include in the projected cash flows all
of the following EXCEPT:
Changes
in net working capital attributable to the project.
Previous
expenditures associated with a market test to determine the feasibility of the
project, provided those costs have been expensed for tax purposes.
The
value of a building owned by the firm that will be used for this project.
A
decline in the sales of an existing product, provided that decline is directly
attributable to this project.
The
salvage value of assets used for the project that will be recovered at the end
of the project’s life.
Question
19
Which
of the following factors should be included in the cash flows used to estimate
a project’s NPV?
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.
Question
20
Which
of the following is NOT a relevant cash flow and thus should not be reflected
in the analysis of a capital budgeting project?

Changes
in net working capital.
Shipping
and installation costs.
Cannibalization
effects.
Opportunity
costs.
Sunk
costs that have been expensed for tax purposes.
Question
21
Which
of the following statements is CORRECT?
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.
Question
22
Which
of the following statements is CORRECT?
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.
Question
23
Suppose
Tapley Inc. uses a WACC of 8% for below-average risk projects, 10% for
average-risk projects, and 12% for above-average risk projects. Which of the
following independent projects should Tapley accept, assuming that the company
uses the NPV method when choosing projects?
Project
A, which has average risk and an %.
Project
B, which has below-average risk and an %.
Project
C, which has above-average risk and an %.
Without
information about the projects’ NPVs we cannot determine which project(s)
should be accepted.
All
of these projects should be accepted.
Question
24
Which
of the following should be considered when a company estimates the cash flows
used to analyze a proposed project?
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.
Question
25
Which
of the following statements is CORRECT?
Sensitivity
analysis as it is generally employed is incomplete in that it fails to consider
the probability of occurrence of the key input variables.
In
comparing two projects using sensitivity analysis, the one with the steeper
lines would be considered less risky, because a small error in estimating a
variable such as unit sales would produce only a small error in the project’s
NPV.
The
primary advantage of simulation analysis over scenario analysis is that
scenario analysis requires a relatively powerful computer, coupled with an
efficient financial planning software package, whereas simulation analysis can
be done efficiently using a PC with a spreadsheet program or even with just a
calculator.
Sensitivity
analysis is a type of risk analysis that considers both the sensitivity of NPV
to changes in key input variables and the probability of occurrence of these
variables’ values.
As
computer technology advances, simulation analysis becomes increasingly obsolete
and thus less likely to be used as compared to sensitivity analysis.
Question
26
Dalrymple
Inc. is considering production of a new product. In evaluating whether to go
ahead with the project, which of the following items should NOT be explicitly
considered when cash flows are estimated?
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.
Question
27
The
relative risk of a proposed project is best accounted for by which of the
following procedures?
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.
Question
28
Which
of the following statements is CORRECT?
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.
Question
29
Which
of the following rules is CORRECT for capital budgeting analysis?
The
interest paid on funds borrowed to finance a project must be included in
estimates of the project’s cash flows.
Only
incremental cash flows, which are the cash flows that would result if a project
is accepted, are relevant when making accept/reject decisions.

Sunk
costs are not included in the annual cash flows, but they must be deducted from
the PV of the project’s other costs when reaching the accept/reject decision.
A
proposed project’s estimated net income as determined by the firm’s
accountants, using generally accepted accounting principles (GAAP), is
discounted at the WACC, and if the PV of this income stream exceeds the
project’s cost, the project should be accepted.
If
a product is competitive with some of the firm’s other products, this fact
should be incorporated into the estimate of the relevant cash flows. However,
if the new product is complementary to some of the firm’s other products, this
fact need not be reflected in the analysis.
Question
30
Which
of the following statements is CORRECT?
Since
depreciation is not a cash expense, and since cash flows and not accounting
income are the relevant input, depreciation plays no role in capital budgeting.
Under
current laws and regulations, corporations must use straight-line depreciation
for all assets whose lives are 3 years or longer.
If
firms use accelerated depreciation, they will write off assets slower than they
would under straight-line depreciation, and as a result projects’ forecasted
NPVs are normally lower than they would be if straight-line depreciation were
required for tax purposes.
If
they use accelerated depreciation, firms can write off assets faster than they
could under straight-line depreciation, and as a result projects’ forecasted
NPVs are normally lower than they would be if straight-line depreciation were
required for tax purposes.
If
they use accelerated depreciation, firms can write off assets faster than they
could under straight-line depreciation, and as a result projects’ forecasted
NPVs are normally higher than they would be if straight-line depreciation were
required for tax purposes.