Exam 10: The Basics of Capital Budgeting: Evaluating Cash Flows

Projects S and L are equally risky, mutually exclusive, and have normal cash flows.Project S has an IRR of 15%, while Project L's IRR is 12%.The two projects have the same NPV when the cost of capital is 7%.Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

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.

An increase in the firm's cost of capital 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.

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.

Assume a project has normal cash flows.All else equal, which of the following statements is CORRECT?

Which of the following statements is CORRECT?

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.

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.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Clifford Company is choosing between two projects.The larger project has an initial cost of $100,000, annual cash flows of $30,000 for 5 years, and an IRR of 15.24%.The smaller project has an initial cost of $50,000, annual cash flows of $16,000 for 5 years, and an IRR of 16.63%.The projects are equally risky.Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

You are on the staff of O'Hara Inc.The CFO believes project acceptance should be based on the NPV, but Andrew O'Hara, the president, insists that no project should be accepted unless its IRR exceeds the project's risk-adjusted cost of capital.Now you must make a recommendation on a project that has a cost of $15,000 and two cash flows: $110,000 at the end of Year 1 and −$100,000 at the end of Year 2.The president and the CFO both agree that the appropriate cost of capital for this project is 10%.At 10%, the NPV is $2,355.37, but you find two IRRs, one at 6.33% and one at 527%, and a MIRR of 11.32%.Which of the following statements best describes your optimal recommendation, i.e., the analysis and recommendation that is best for the company and least likely to get you in trouble with either the CFO or the president?

Projects A and B have identical expected lives and identical initial cash outflows (costs).However, most of one project's cash flows come in the early years, while most of the other project's cash flows occur in the later years.The two NPV profiles are given below: Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

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.

Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method ranks the other one first.In theory, such conflicts should be resolved in favor of the project with the higher positive IRR.

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 firm should never accept a project if its acceptance would lead to an increase in the firm's cost of capital (its WACC).