Deck 8: Investment Decision Rules

Question 1

Martin is offered an investment where for $6000 today, he will receive $6180 in one year. He decides to borrow $6000 from the bank to make this investment. What is the maximum interest rate the bank needs to offer on the loan if Martin is at least to break even on this investment?

A)1%
B)2%
C)3%
D)4%

Answer 1

3%

Question 2

An orcharder spends $110,000 to plant pomegranate bushes. It will take four years for the bushes to provide a usable crop. He estimates that every year for 20 years after that he will receive a crop worth $10,500 per year. If the discount rate is 9%, what is the net present value (NPV)of this investment?

A)-$42,098
B)-$21,049
C)$8420
D)$12,629

Answer 2

-$42,098

Question 3

Preference for cash today versus cash in the future in part determines net present value (NPV).

Answer 3

False

Question 4

The owners of a chain of fast-food restaurants spend $25 million installing donut makers in all their restaurants. This is expected to increase cash flows by $11 million per year for the next five years. If the discount rate is 5.3%, were the owners correct in making the decision to install donut makers?

A)No, as it has a net present value (NPV)of -$4.45 million.
B)No, as it has a net present value (NPV)of -$2.22 million.
C)Yes, as it has a net present value (NPV)of $13.34 million.
D)Yes, as it has a net present value (NPV)of $22.23 million.

Question 5

Use the information for the question(s)below.
The owner of a hair salon spends $1,000,000 to renovate its premises, estimating that this will increase her cash flow by $220,000 per year. She constructs the above graph, which shows the net present value (NPV)as a function of the discount rate. At what discount rate does her decision to renovate become untenable?

A)3.0%
B)3.3%
C)4.0%
D)4.8%

Question 6

The Net Present Value rule implies that we should compare a project's net present value (NPV)to zero.

Question 7

Net present value (NPV)is the difference between the present value (PV)of the benefits and the present value (PV)of the costs of a project or investment.

Question 8

An auto-parts company is deciding whether to sponsor a racing team for a cost of $1 million. The sponsorship would last for three years and is expected to increase cash flows by $570,000 per year. If the discount rate is 6.9%, what will be the change in the value of the company if it chooses to go ahead with the sponsorship?

A)$498,597
B)$747,896
C)$797,756
D)$847,615

Question 9

A security firm is offered $80,000 in one year for providing CCTV coverage of a property. The cost of providing this coverage to the security firm is $74,000, payable now, and the interest rate is 8.5%. Should the firm take the contract?

A)Yes, since net present value (NPV)is positive.
B)It does not matter whether the contract is taken or not, since NPV = 0.
C)Yes, since net present value (NPV)is negative.
D)No, since net present value (NPV)is negative.

Question 10

Should personal preferences for cash today versus cash tomorrow play a role in the net present value (NPV)decision-making process?

Question 11

Most corporations measure the value of a project in terms of which of the following?

A)discount value
B)discount factor
C)future value (FV)
D)present value (PV)

Question 12

A firm has an opportunity to invest $95,000 today that will yield $109,250 in one year. If interest rates are 4%, what is the net present value (NPV)of this investment?

A)$10,048
B)$11,053
C)$16,077
D)$14,250

Question 13

A car dealership offers a car for $14,000, with up to one year to pay for the car. If the interest rate is 5%, what is the net present value (NPV)of this offer to buyers who elect not to pay for the car for one year?

A)$667
B)$1333
C)$13,333
D)$14,000

Question 14

What is the Net Present Value rule?

Question 15

Tanner is choosing between two investment options. He can invest $500 now and get (guaranteed)$550 in one year, or invest $500 now and get (guaranteed)$531.40 back later today. The risk-free rate is 3.5%. Which investment should Tanner prefer?

A)$531.40 later today, since $1 today is worth more than $1 in one year.
B)$550 in one year, since it is $50 more than he invested rather than $31.40 more than he invested.
C)Neither - both investments have a negative NPV.
D)Tanner should be indifferent between the two investments, since both are equivalent to the same amount of cash today.

Question 16

Use the information for the question(s)below.
The owner of a hair salon spends $1,000,000 to renovate its premises, estimating that this will increase her cash flow by $220,000 per year. She constructs the above graph, which shows the net present value (NPV)as a function of the discount rate. If her discount rate is 6%, should she accept the project?

A)Yes, because the NPV is positive at that rate.
B)No, because the NPV is negative at that rate.
C)No, because the NPV is positive at that rate.
D)Cannot be determined from the information given.

Question 17

The present value (PV)of an investment is ________.

A)the amount that an investment would yield if the benefit were realized today
B)the difference between the cost of the investment and the benefit of the investment in dollars today
C)the amount you need to invest at the current interest rate to re-create the cash flow from the investment
D)the amount by which the cash flow of an investment exceeds or falls short of the cash flow generated by the same amount of money invested at market rate

Question 18

Peter has a business opportunity that requires him to invest $10,000 today, and receive $12,000 in one year. He can either use $10,000 that he already has for this investment or borrow the money from his bank at an interest rate of 10%. However, the $10,000 he has right now is needed for urgent repairs to his home, repairs that will cost at least $15,000 if he delays them for a year. What is the best alternative for Peter out of the following choices?

A)No, since the net present value (NPV)of the investment, should he take it, is less than the net present value (NPV)of the home repairs if he delays them for one year.
B)Yes, since he can borrow the $10,000 from a bank, repair his home, invest $10,000 in the business opportunity, which, since it has a NPV > 0 will mean he will still come out ahead after repaying the loan.
C)Yes, since the net present value (NPV)of the investment is greater than zero he can invest the $10,000 in the business opportunity, and then next year use this money plus the benefit from this money to make the necessary home repairs.
D)Yes, since the net present value (NPV)of the investment, should he take it, is greater than the net present value (NPV)of the home repairs if he delays them for one year.

Question 19

A delivery service is buying 600 tires for its fleet of vehicles. One supplier offers to supply the tires for $80 per tire, payable in one year. Another supplier will supply the tires for $20,000 down today, then $45 per tire, payable in one year. What is the difference in PV between the first and the second offer, assuming interest rates are 8.1%?

A)-$860
B)-$229
C)-$574
D)$860

Question 20

A farmer sows a certain crop. It costs $240,000 to buy the seed, prepare the ground, and sow the crop. In one year's time it will cost $93,200 to harvest the crop. If the crop will be worth $350,000, and the interest rate is 7%, what is the net present value (NPV)of this investment?

A)$240,000
B)$87,103
C)$0
D)$567,103

Question 21

Consider the following two projects: The net present value (NPV)of project B is closest to ________.

A)9.3
B)10.2
C)11.6
D)23.2

Question 22

The payback rule is based on the idea that an opportunity that pays back its initial investment quickly is a worthwhile opportunity.

Question 23

Given the cash flows in the table above, the point at which the NPV profile crosses the vertical axis is ________.

A)$0
B)$12,000
C)23%
D)19%

Question 24

Which of the following situations can lead to IRR giving a different decision than NPV?

A)delayed investment
B)multiple IRRs
C)differences in project scale
D)All of the above can lead to IRR giving a different decision than NPV.

Question 25

Which of the following is NOT a limitation of the payback rule?

A)It does not consider the time value of money.
B)Lacks a decision criterion that is economically based.
C)It is difficult to calculate.
D)It does not consider cash flows occurring after the payback period.

Question 26

Under what situation can the net present value (NPV)profile be upward sloping?

Question 27

According to Graham and Harvey's 2001 survey (Figure 8.2 in the text), the most popular decision rules for capital budgeting used by CFOs are ________.

A)NPV, IRR, MIRR
B)MIRR, IRR, Payback period
C)IRR, NPV, Payback period
D)Profitability index, NPV, IRR

Question 28

The internal rate of return (IRR)rule will agree with the Net Present Value rule even when positive cash flows precede negative cash flows.

Question 29

The Sisyphean Company is planning on investing in a new project. This will involve the purchase of some new machinery costing $420,000. The Sisyphean Company expects cash inflows from this project as detailed below: The appropriate discount rate for this project is 16%. The net present value (NPV)for this project is closest to ________.

A)$206,265
B)$144,385
C)$515,661
D)$216,578

Question 30

What is the general shape of the net present value (NPV)profile?

Question 31

Use the information for the question(s)below.
The owner of a hair salon spends $1,000,000 to renovate its premises, estimating that this will increase her cash flow by $220,000 per year. She constructs the above graph, which shows the net present value (NPV)as a function of the discount rate. At what dollar value should the NPV profile cross the vertical axis?

A)$780,000
B)$1,000,000
C)Cannot be determined because inadequate information is given.
D)The vertical axis crossing point cannot be calculated since the cash inflows are in perpetuity.

Question 32

Consider the following two projects: The net present value (NPV)for project beta is closest to ________.

A)$21.67
B)$14.45
C)$18.06
D)$12.64

Question 33

A bakery is deciding whether to buy an extra van to help deliver its products. The van will cost $28,000, but is expected to increase profits by $6,500 per year over the five years of its working life. Which of the following is the correct net present value (NPV)profile for this purchase?

A)
B)
C)
D)

Question 34

Which of the following statements is FALSE?

A)In general, the difference between the cost of capital and the internal rate of return (IRR)is the maximum amount of estimation error in the cost of capital estimate that can exist without altering the original decision.
B)The internal rate of return (IRR)can provide information on how sensitive your analysis is to errors in the estimate of your cost of capital.
C)If you are unsure of your cost of capital estimate, it is important to determine how sensitive your analysis is to errors in this estimate.
D)If the cost of capital estimate is more than the internal rate of return (IRR), the net present value (NPV)will be positive.

Question 35

Consider the following two projects: The net present value (NPV)of project A is closest to ________.

A)20.5
B)22.5
C)25.6
D)51.2

Question 36

Consider the following two projects: The net present value (NPV)for project alpha is closest to ________.

A)$31.35
B)$25.08
C)$37.62
D)$21.32

Question 37

Consider a project with the following cash flows: If the appropriate discount rate for this project is 13%, then the net present value (NPV)is closest to ________.

A)$24,000
B)-$1846
C)-$3077
D)-$2154

Question 38

A convenience store owner is contemplating putting a large neon sign over his store. It would cost $50,000, but is expected to bring an additional $24,000 of profit to the store every year for five years. Would this project be worthwhile if evaluated using a payback period of two years or less and if the cost of capital is 10%?

A)Yes, since it will pay back its initial investment in two years.
B)Yes, since the value of the cash flows into the store, in present dollars, are greater than the initial investment.
C)Yes, since the cash flows after two years are greater than the initial investment.
D)No, since the value of the cash flows over the first two years are less than the initial investment.

Question 39

A manufacturer of video games develops a new game over two years. This costs $830,000 per year with one payment made immediately and the other at the end of two years. When the game is released, it is expected to make $1.20 million per year for three years after that. What is the net present value (NPV)of this decision if the cost of capital is 10%?

A)$950,349
B)$1,045,384
C)$1,520,559
D)$1,805,663

Question 40

How can you calculate the y-intercept of a net present value (NPV)profile without using TVM concepts?

Question 41

Consider the following two projects: The payback period for project A is closest to ________.

A)1.9 years
B)2.3 years
C)2.6 years
D)2.1 years

Question 42

A florist is buying a number of motorcycles to expand its delivery service. These will cost $78,000 but are expected to increase profits by $3000 per month over the next four years. What is the payback period in this case?

A)10.40 months
B)15.60 months
C)19.50 months
D)26.00 months

Question 43

The Sisyphean Company is planning on investing in a new project. This will involve the purchase of some new machinery costing $400,000. The Sisyphean Company expects cash inflows from this project as detailed below: The appropriate discount rate for this project is 15%. The internal rate of return (IRR)for this project is closest to ________.

A)13%
B)16%
C)21%
D)24%

Question 44

Mary is in contract negotiations with a publishing house for her new novel. She has two options. She may be paid $100,000 up front, and receive royalties that are expected to total $26,000 at the end of each of the next five years. Alternatively, she can receive $200,000 up front and no royalties. Which of the following investment rules would indicate that she should take the former deal, given a discount rate of 8%? Rule I: The Net Present Value rule
Rule II: The Payback Rule with a payback period of two years
Rule III: The internal rate of return (IRR)Rule

A)Rule I only
B)Rule III only
C)Rule II and III
D)Rule I and II

Question 45

Which of the following statements is FALSE?

A)The payback rule is useful in cases where the cost of making an incorrect decision might not be large enough to justify the time required for calculating the net present value (NPV).
B)The payback rule is reliable because it considers the time value of money and depends on the cost of capital.
C)For most investment opportunities, expenses occur initially and cash is received later.
D)Fifty percent of firms surveyed reported using the payback rule for making decisions.

Question 46

What is the decision criterion while using the payback rule?

Question 47

When different investment rules give conflicting answers, then decisions should be based on the Net Present Value rule, as it is the most reliable and accurate decision rule.

Question 48

A lottery winner can take $6 million now or be paid $600,000 at the end of each of the next 16 years. The winner calculates the internal rate of return (IRR)of taking the money at the end of each year and, estimating that the discount rate across this period will be 4%, decides to take the money at the end of each year. Was her decision correct?

A)Yes, because it agrees with the Net Present Value rule.
B)Yes, because it agrees with the payback rule.
C)Yes, because it agrees with both the Net Present Value rule and the payback rule.
D)Yes, because it disagrees with the Net Present Value rule.

Question 49

What is the decision criterion using the Net Present Value rule?

Question 50

A local government awards a landscaping company a contract worth $1.5 million per year for five years for maintaining public parks. The landscaping company will need to buy some new machinery before they can take on the contract. If the cost of capital is 6%, what is the most that this equipment could cost if the contract is to be worthwhile for the landscaping company?

A)$5.69 million
B)$6.00 million
C)$6.32 million
D)$6.63 million

Question 51

Consider a project with the following cash flows: Assume the appropriate discount rate for this project is 13%. The payback period for this project is closest to ________.

A)2.88 years
B)2.40 years
C)1.92 years
D)3.60 years

Question 52

Consider the following two projects: The payback period for project B is closest to ________.

A)3.2 years
B)2.3 years
C)2.6 years
D)2.9 years

Question 53

The cash flows for three projects are shown above. The cost of capital is 9.5%. If an investor decided to take projects with a payback period two years or less, which of these projects would he take?

A)Investment A
B)Investment B
C)Investment C
D)none of these investments

Question 54

An investor is considering a project that will generate $900,000 per year for four years. In addition to upfront costs, at the completion of the project at the end of the fifth year there will be shut-down costs of $400,000. If the cost of capital is 4.4%, based on the MIRR, at what upfront costs does this project cease to be worthwhile?

A)$2.62 million
B)$2.91 million
C)$3.21 million
D)$3.50 million

Question 55

Which of the following is NOT a valid method of modifying cash flows to produce a MIRR?

A)Discount all of the negative cash flows to time 0 and leave the positive cash flows alone.
B)Leave the initial cash flow alone and compound all of the remaining cash flows to the final period of the project.
C)Discount all of the negative cash flows to the present and compound all of the positive cash flows to the end of the project.
D)Turn multiple negative cash flows into a single negative cash flow by summing all negative cash flows over the project's lifetime.

Question 56

Use the information for the question(s)below.
If WiseGuy Inc. uses IRR rule to choose projects, which of the projects (Project A or Project B) will rank highest?

A)Project A
B)Project B
C)Project A and Project B have the same ranking.
D)Cannot calculate a payback period without a discount rate.

Question 57

A mining company plans to mine a beach for rutile. To do so will cost $14 million up front and then produce cash flows of $7 million per year for five years. At the end of the sixth year the company will incur shut-down and clean-up costs of $6 million. If the cost of capital is 13.0%, then what is the MIRR for this project?

A)-60.97%
B)-78.39%
C)-87.10%
D)-95.81%

Question 58

Use the information for the question(s)below.
If WiseGuy Inc. uses payback period rule to choose projects, which of the projects (Project A or Project B) will rank highest?

A)Project A
B)Project B
C)Project A and Project B have the same ranking.
D)Cannot calculate a payback period without a discount rate.

Question 59

What is the decision criteria using internal rate of return (IRR)rule?

Question 60

Which of the following statements is FALSE?

A)The payback investment rule is based on the notion that an opportunity that pays back its initial investments quickly is a good idea.
B)An internal rate of return (IRR)will always exist for an investment opportunity.
C)A net present value (NPV)will always exist for an investment opportunity.
D)In general, there can be as many internal rates of return (IRRs)as the number of times the project's cash flows change sign over time.

Question 61

What can you comment about the shape of the net present value (NPV)profile of a multiple IRR project?

Question 62

The cash flows for four projects are shown below, along with the cost of capital for these projects. If these projects are mutually exclusive, which one should be taken?

A)Year: 0 1 2 3 4 5 Cash flow: -$5000 $2000 $2000 $2000 $2000 $2000
Cost of Capital: 6.0%
B)Year: 0 1 2 3 4 5 Cash flow: -$6000 $2500 $2500 $2500 $2500 2,500
Cost of Capital: 7.5%
C)Year: 0 1 2 3 4 5 Cash flow: -$7000 $3000 $3000 $3000 $3000 $3000
Cost of Capital: 7.5%
D)Year: 0 1 2 3 4 5 Cash flow: -$8000 $3200 $3200 $3200 $3200 $3200
Cost of Capital: 9.2%

Question 63

You are trying to decide between three mutually exclusive investment opportunities. The most appropriate tool for identifying the correct decision is ________.

A)net present value (NPV)
B)profitability index
C)internal rate of return (IRR)
D)incremental internal rate of return (IRR)

Question 64

An investor has the opportunity to invest in four new retail stores. The amount that can be invested in each store, along with the expected cash flow at the end of the first year, the growth rate of the concern, and the cost of capital is shown for each case. It is assumed each investment will operate in perpetuity after the initial investment. Which investment should the investor choose?

A)Initial investment: $100,000; Cash flow in year 1: $12,000; Growth Rate: 1.25%; Cost of Capital: 9.1%
B)Initial investment: $90,000; Cash flow in year 1: $10,000; Growth Rate: 1.50%; Cost of Capital: 9.3%
C)Initial investment: $80,000; Cash flow in year 1: $8,000; Growth Rate: 1.75%; Cost of Capital: 8.0%
D)Initial investment: $60,000; Cash flow in year 1: $6,000; Growth Rate: 2.50%; Cost of Capital: 7.2%

Question 65

A company has identified the following investments as looking promising. Each requires an initial investment of $1.2 million. Which is the best investment?

A)a perpetuity that generates a cash flow at the end of year 1 of $100,000, has a growth rate of 1.25%, and a cost of capital of 11.0%
B)a perpetuity that generates a cash flow at the end of year 1 of $800,000, has a growth rate of 2.25%, and a cost of capital of 11.8%
C)an investment that generates a cash flow of $400,000 at the end of each of the next five years, when the cost of capital is 6.1%
D)an investment that generates a cash flow of $200,000 at the end of each of the next ten years, when the cost of capital is 6.1%

Question 66

What is a safe method to use when confronted with mutually exclusive projects?

Question 67

What are some potential problems in using internal rate of return (IRR)for mutually exclusive projects?

Question 68

If WiseGuy Inc is choosing one of the above mutually exclusive projects (Project A or Project B), given a discount rate of 7%, which should the company choose?

A)Project A
B)Project B
C)Neither project - both have negative NPV.
D)Both projects - both have positive NPV.

Question 69

How do you apply the Net Present Value rule when multiple projects are available and you have the added constraint of accepting only one project?

Question 70

When comparing mutually exclusive projects which have different scales, you must know the dollar impact of each investment rather than percentage returns.

Question 71

An investor is considering the two investments shown above. Which of the following statements about these investments is true?

A)The investor should take investment A since it has a greater net present value (NPV).
B)The investor should take investment A since it has a greater internal rate of return (IRR).
C)The investor should take investment B since it has a greater net present value (NPV).
D)Neither investment should be taken since they both have a negative net present value (NPV).

Question 72

Is there a unique way for calculating the MIRR to resolve the multiple IRR situation?

Question 73

The cash flows for four investments have been identified as follows: Based on the above information, and with an interest rate of 5%, which is the best investment?

A)Investment A
B)Investment B
C)Investment C
D)Investment D

Question 74

Two mutually exclusive investment opportunities require an initial investment of $7 million. Investment A pays $2.0 million per year in perpetuity, while investment B pays $1.4 million in the first year, with cash flows increasing by 4% per year after that. At what cost of capital would an investor regard both opportunities as being equivalent?

A)3%
B)7%
C)13%
D)15%

Question 75

An investor is considering the two investments shown above. Her cost of capital is 8%. Which of the following statements about these investments is true?

A)The investor should take investment A since it has a greater net present value (NPV).
B)The investor should take investment A since it has a greater internal rate of return (IRR).
C)The investor should take investment B since it has a greater net present value (NPV).
D)The investor should take investment B since it has a greater internal rate of return (IRR).

Question 76

Consider the following two projects: Assume that projects Alpha and Beta are mutually exclusive. The correct investment decision and the best rationale for that decision is to ________.

A)invest in project Beta, since NPV_Beta > 0
B)invest in project Alpha, since NPV_Beta < NPV_Alpha
C)invest in project Beta, since IRR_B > IRR_A
D)invest in project Beta, since NPV_Beta > NPV_Alpha > 0

Question 77

Internal rate of return (IRR)can reliably be used to choose between mutually exclusive projects.

Question 78

Consider the following two projects: Assume that projects A and B are mutually exclusive. The correct investment decision and the best rationale for that decision is to ________.

A)invest in project A, since NPV_B < NPV_A
B)invest in project B, since IRR_B > IRR_A
C)invest in project B, since NPV_B > NPV_A
D)invest in project A, since NPV_A > 0

Question 79

The cash flows for four projects are shown below, along with the cost of capital for these projects. If these projects are mutually exclusive, which one should be taken?

A)Year: 0 1 2 3 4 5 Cash flow: -$20,000 $6000 $6000 $6000 $6000 $6000
Cost of Capital: 8.2%
B)Year: 0 1 2 3 4 5 Cash flow: -$15,000 $4000 $4000 $4000 $4000 $4000
Cost of Capital: 7.0%
C)Year: 0 1 2 3 4 5 Cash flow: -$18,000 $5000 $5000 $5000 $5000 $5000
Cost of Capital: 7.6%
D)Year: 0 1 2 3 4 5 Cash flow: -$12,000 $4000 $4000 $4000 $4000 $4000
Cost of Capital: 5.0%

Question 80

The following show four mutually exclusive investments. Which one is the best investment?

A)Initial investment: $1.1 million; Cash flow in year 1: $160,000; Annual Growth Rate: 2%; Cost of Capital: 9.1%
B)Initial investment: $1.2 million; Cash flow in year 1: $150,000; Annual Growth Rate: 2%; Cost of Capital: 7.2%
C)Initial investment: $1.3 million; Cash flow in year 1: $160,000; Annual Growth Rate: 1%; Cost of Capital: 5.6%
D)Initial investment: $1.4 million; Cash flow in year 1: $150,000; Annual Growth Rate: 2%; Cost of Capital: 8.4%