Exam 10: Capital-Budgeting Techniques and Practice

The internal rate of return is the discount rate that equates the present value of the project's future free cash flows with the project's initial outlay.

NPV assumes reinvestment of intermediate free cash flows at the cost of capital,while IRR assumes reinvestment of intermediate free cash flows at the IRR.

Free cash flows represent the benefits generated from accepting a capital-budgeting proposal.

NPV is the most theoretically correct capital budgeting decision tool examined in the text.

A project's IRR is analogous to the concept of the yield to maturity for bonds.

If the NPV (Net Present Value)of a project with multiple sign reversals is positive,then the project's required rate of return ________ its calculated IRR (Internal Rate of Return).

The net present value method

Under what condition would you not accept a project that has a positive net present value?

An infinite-life replacement chain allows projects of different lengths to be compared.

A project that is very sensitive to the selection of a discount rate will have a steep net present value profile.

Your firm is considering an investment that will cost $920,000 today.The investment will produce cash flows of $450,000 in year 1,$270,000 in years 2 through 4,and $200,000 in year 5.The discount rate that your firm uses for projects of this type is 11.25%.What is the investment's profitability index?

A project requires an initial investment of $389,600.The project generates free cash flow of $540,000 at the end of year 4.What is the internal rate of return for the project?

The profitability index can be helpful when a financial manager encounters a situation where capital rationing is required.

A project that requires an initial investment of $340,000 is expected to have an after-tax cash flow of $70,000 per year for the first two years,$90,000 per year for the next two years,and $150,000 for the fifth year? Assume the required return for this project is 10%. a.What is the NPV of the project%? b.What is the IRR of the project? c.What is the MIRR of the project? d.What is the PI of the project? e.What decision would you make regarding this project if the required rate of return is 10%? f.What is the equivalent annual annuity using a 10% required rate of return?

Project XYZ requires an initial outlay of $400,000 and has a profitability index of 1.5.The project is expected to generate equal annual cash flows over the next twelve years.The required return for this project is 20%.What is project XYZ's net present value?

All of the following are sufficient indications to accept a project except (assume that there is no capital rationing constraint,and no consideration is given to payback as a decision tool):

You are in charge of one division of Bigfella Conglomerate Inc.Your division is subject to capital rationing.Your division has 4 indivisible projects available,detailed as follows: If you must select projects subject to a budget constraint of 5 million dollars,which set of projects should be accepted so as to maximize firm value?

Given the complications of capital budgeting,it is much easier to identify profitable projects than it is to analyze or evaluate them using NPV and IRR.

Your firm is considering an investment that will cost $920,000 today.The investment will produce cash flows of $450,000 in year 1,$270,000 in years 2 through 4,and $200,000 in year 5.The discount rate that your firm uses for projects of this type is 11.25%.What is the investment's equivalent annual annuity?

A major disadvantage of the discounted payback period is the arbitrariness of the process used to select the maximum desired payback period.