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Exam 11: The Basics of Capital Budgeting

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Question 1

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Maxwell Feed & Seed is considering a project that has the following cash flow data.What is the project's IRR? Note that a project's projected IRR can be less than the WACC (and even negative) ,in which case it will be rejected. $\begin{array} { l c c c c c c } \text { Year } & 0 & 1 & 2 & 3 & 4 & 5 \\\hline \text { Cash flows } & - \$ 6,750 & \$ 2,000 & \$ 2,025 & \$ 2,050 & \$ 2,075 & \$ 2,100\end{array}$

A) 15.45%
B) 17.17%
C) 13.74%
D) 15.61%
E) 12.96%

F) None of the above
G) A) and E)

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Question 2

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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) False

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Question 3

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Which of the following statements is CORRECT?

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. $\begin{array} { l c c c c c } \text { WACC: } & 9.00 \% & & & \\& { 0 } & 1 & 2 & 3 & 4 \\\hline \mathrm { CF } _ { \mathrm { S } } & - \$ 1,100 & \$ 550 & \$ 600 & \$ 100 & \$ 100 \\\mathrm { CF } _ { \mathrm { L } } & - \$ 2,750 & \$ 725 & \$ 725 & \$ 800 & \$ 1,400\end{array}$

You are considering two mutually exclusive,equally risky,projects.Both have IRRs that exceed the WACC.Which of the following statements is CORRECT? Assume that the projects have normal cash flows,with one outflow followed by a series of inflows.

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.

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 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. $\text { WACC: } \quad 9.50 \%$ $\begin{array}{llrrrr}&0&1&2&3&4\\\hline\mathrm{CF}_{\mathrm{S}} & -\$ 2,050 & \$ 750 & \$ 760 & \$ 770 & \$ 780 \\\mathrm{CF}_{\mathrm{L}} & -\$ 4,300 & \$ 1,500 & \$ 1,518 & \$ 1,536 & \$ 1,554\end{array}$

Projects A and B are mutually exclusive and have normal cash flows.Project A has an IRR of 15% and B's IRR is 20%.The company's WACC is 12%,and at that rate Project A has the higher NPV.Which of the following statements is CORRECT?

The IRR of normal Project X is greater than the IRR of normal Project Y,and both IRRs are greater than zero.Also,the NPV of X is greater than the NPV of Y at the cost of capital.If the two projects are mutually exclusive,Project X should definitely be selected,and the investment made,provided we have confidence in the data.Put another way,it is impossible to draw NPV profiles that would suggest not accepting Project X.

Cornell Enterprises is considering a project that has the following cash flow and WACC data.What is the project's NPV? Note that a project's projected NPV can be negative,in which case it will be rejected. $\begin{array} { l c c c c } \text { WACC: } & 10.00 \% \\\text { Year } & 0 & 1 & 2 & 3 \\\hline \text { Cash flows } & - \$ 1,275 & \$ 450 & \$ 460 & \$ 470\end{array}$

Assume that the economy is enjoying a strong boom,and as a result interest rates and money costs generally are relatively high.The WACC for two mutually exclusive projects that are being considered is 12%.Project S has an IRR of 20% while Project L's IRR is 15%.The projects have the same NPV at the 12% current WACC.However,you believe that the economy will soon fall into a mild recession,and money costs and thus your WACC will soon decline.You also think that the projects will not be funded until the WACC has decreased,and their cash flows will not be affected by the change in economic conditions.Under these conditions,which of the following statements is CORRECT?

Barry Company is considering a project that has the following cash flow and WACC data.What is the project's NPV? Note that a project's projected NPV can be negative,in which case it will be rejected. $\begin{array} { l c c c c c c } \text { WACC: } & 11.75 \% & & & & \\\text { Year } & 0 & 1 & 2 & 3 & 4 & 5 \\\hline \text { Cash flows } & - \$ 1,100 & \$ 400 & \$ 390 & \$ 380 & \$ 370 & \$ 360\end{array}$

A basic rule in capital budgeting is that if a project's NPV exceeds its IRR,then the project should be accepted.

Small businesses make less use of DCF capital budgeting techniques than large businesses.This may reflect a lack of knowledge on the part of small firms' managers,but it may also reflect a rational conclusion that the costs of using DCF analysis outweigh the benefits of these methods for very small firms.

An increase in the firm's WACC will decrease projects' NPVs,which could change the accept/reject decision for any potential project.However,such a change would have no impact on projects' IRRs.Therefore,the accept/reject decision under the IRR method is independent of the cost of capital.

If you were evaluating two mutually exclusive projects for a firm with a zero cost of capital,the payback method and NPV method would always lead to the same decision on which project to undertake.

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.

Moerdyk & Co.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 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. $\text { WACC: } \quad 6.75 \%$ $\begin{array}{lllllr}&0&1&2&3&4\\\hline\mathrm{CF}_{\mathrm{S}} & -\$ 1,025 & \$ 650 & \$ 450 & \$ 250 & \$ 50 \\\mathrm{CF}_{\mathrm{L}} & -\$ 1,025 & \$ 100 & \$ 300 & \$ 500 & \$ 700\end{array}$

Harry's Inc.is considering a project that has the following cash flow and WACC data.What is the project's NPV? Note that if a project's projected NPV is negative,it should be rejected. $\begin{array} { l c c c c c c } \text { WACC: } & 9.50 \% & & & & \\\text { Year } & 0 & 1 & 2 & 3 & 4 & 5 \\\hline \text { Cash flows } & - \$ 1,000 & \$ 300 & \$ 300 & \$ 300 & \$ 300 & \$ 300\end{array}$

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.