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Exam 11: The Basics of Capital Budgeting

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Question 41

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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?

A) You should reject both projects because they will both have negative NPVs under the new conditions.
B) 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.
C) You should recommend Project L, because at the new WACC it will have the higher NPV.
D) You should recommend Project S, because at the new WACC it will have the higher NPV.
E) You should recommend Project L because it will have both a higher IRR and a higher NPV under the new conditions.

F) All of the above
G) B) and C)

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Question 42

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Four of the following statements are truly disadvantages of the regular payback method, but one is not a disadvantage of this method. Which one is NOT a disadvantage of the payback method?

A) Lacks an objective, market-determined benchmark for making decisions.
B) Ignores cash flows beyond the payback period.
C) Does not directly account for the time value of money.
D) Does not provide any indication regarding a project's liquidity or risk.
E) Does not take account of differences in size among projects.

F) A) and E)
G) C) and E)

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Question 43

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Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Ehrmann Data Systems 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: $\quad 10.00 \%$ $\begin{array}{c}\begin{array}{lll} \text {Year}\\\text {Cash flows}\end{array}\begin{array}{c} 0 \\\hline -\$1,000\end{array}\begin{array}{c}1 \\\hline \$450\end{array}\begin{array}{c}2 \\\hline \$450\end{array}\begin{array}{c}3 \\\hline \$450\end{array}\end{array}$ a. $9.32 \%$ b. $10.35 \%$ c. $11.50 \%$ d. $12.78 \%$ e. $14.20 \%$

Thorley Inc. 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 or negative, in both cases it will be rejected. $\begin{array}{c}\begin{array}{lll} \text {Year}\\\text {Cash flows}\end{array}\begin{array}{lll} 0 \\\hline -\$1,250\end{array}\begin{array}{lll}1 \\\hline \$325\end{array}\begin{array}{lll}2 \\\hline \$325\end{array}\begin{array}{lll}3 \\\hline \$325\end{array}\begin{array}{lll}4 \\\hline \$325\end{array}\begin{array}{lll}5 \\\hline \$325\end{array}\end{array}$ a. $9.43 \%$ b. $9.91 \%$ c. $10.40 \%$ d. $10.92 \%$ e. $11.47 \%$

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.

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

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.

Projects S and L both have normal cash flows, and the projects have the same risk, hence both are evaluated with the same WACC, 10%. However, S has a higher IRR than L. Which of the following statements is CORRECT?

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?

Datta Computer Systems 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. $\begin{array}{c}\begin{array}{lll} \text {Year}\\\text {Cash flows}\end{array}\begin{array}{lll} 0 \\\hline -\$1,100\end{array}\begin{array}{lll}1 \\\hline \$450\end{array}\begin{array}{lll}2 \\\hline \$470\end{array}\begin{array}{lll}3 \\\hline \$490\end{array}\end{array}$ a. $9.70 \%$ b. $10.78 \%$ c. $11.98 \%$ d. $13.31 \%$ e. $14.64 \%$

Jazz World Inc. 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. WACC: $\quad$$14.00 \%$ $\begin{array}{c}\begin{array}{lll} \text {Year}\\\text {Cash flows}\end{array}\begin{array}{lll} 0 \\\hline -\$1,200 \end{array}\begin{array}{lll}1 \\\hline \$400\end{array}\begin{array}{lll}2 \\\hline \$425\end{array}\begin{array}{lll}3 \\\hline \$450\end{array}\begin{array}{lll}4 \\\hline \$475\end{array}\end{array}$ a $\$ 41.25$ b. $\$ 45.84$ c. $\$ 50.93$ d. $\$ 56.59$ e. $\$ 62.88$

Which of the following statements is CORRECT?

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.

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.

Which of the following statements is CORRECT?

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.

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. WACC: $\quad$$7.75 \%$ $\begin{array}{c}\begin{array}{lll} \text {Year}\\ \text {CF}_{S} \\ \text {CF}_{L} \end{array}\begin{array}{c} 0 \\\hline -\$1,050\\-\$1,050\end{array}\begin{array}{c}1 \\\hline \$675\\360\end{array}\begin{array}{c}2 \\\hline \$650\\\$360\end{array}\begin{array}{c}3 \\\hline \\\$360\end{array}\begin{array}{c}4 \\\hline \\\$360\end{array}\end{array}$ a. $\$ 11.45$ b. $\$ 12.72$ c. $\$ 14.63$ d. $\$ 16.82$ e. $\$ 19.35$