Deck 8: Investment Decision Rules

Question 1

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

A)$550 in one year, since it is $50 more than he invested rather than $31.40 more than he invested.
B)$531.40 later today, since $1 today is worth more than $1 in one year.
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.

Answer 1

Tanner should be indifferent between the two investments, since both are equivalent to the same amount of cash today.

Question 2

A farmer spends $100 000 to plant fruit trees. It will take four years for the trees to provide a usable crop. He estimates that every year for 20 years after that he will receive a crop worth $10 000 per year. If the discount rate is 8%, what is the net present value (NPV)of this investment?

A)-$12 897
B)-$27 834
C)$108
D)$3 268

Answer 2

-$27 834

Question 3

A firm has an opportunity to invest $1 000 000 today that will yield $1 100 000 in one year. If interest rates are 7.5%, what is the net present value (NPV)of this investment?

A)$24 151
B)$25 000
C)$29 000
D)$23 256

Answer 3

$23 256

Question 4

Martin is offered an investment where for $50 000 today, he will receive $53 500 in one year. He decides to borrow $50 000 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)6.8%
B)6.2%
C)7.0%
D)7.6%

Question 5

A car dealership offers a car for $15 500, with up to one year to pay. If the interest rate is 10%, what is the net present value (NPV)of this offer to buyers who elect not to pay for the car for one year?

A)$1 409
B)$1 308
C)$1 896
D)$1 400

Question 6

The owners of a chain of fast-food restaurants spend $28 million installing doughnut makers in all their restaurants. This is expected to increase cash flows by $10 million per year for the next five years. If the discount rate is 6.5%, were the owners correct in making the decision to install doughnut makers?

A)Yes, as it has a net present value (NPV)of $8.74 million.
B)No, as it has a net present value (NPV)of -1.68 million.
C)Yes, as it has a net present value (NPV)of $13.56 million.
D)No, as it has a net present value (NPV)of -$2.25 million.

Question 7

Most corporations measure the value of a project in terms of present value (PV).

Question 8

The Net Present Value rule states to accept a project if its net present value (NPV)is greater than zero.

Question 9

A farmer sows a certain crop. It costs $250 000 to buy the seed, prepare the ground and sow the crop. In one year's time it will cost $110 000 to harvest the crop. If the crop will be worth $380 000, and the interest rate is 7.5%, what is the net present value (NPV)of this investment?

A)-$220
B)$1 163
C)$2 310
D)-$2 100

Question 10

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 11

Which of the following best describes the Net Present Value rule?

A)When choosing among any list of investment opportunities where resources are limited, always choose those projects with the highest net present value (NPV).
B)If the difference between the present cost of an investment and the present value (PV)of its benefits after a fixed number of years is positive, the investment should be taken; otherwise it should be rejected.
C)Take any investment opportunity where the net present value (NPV)is not negative; turn down any opportunity when it is negative.
D)Take any investment opportunity where the net present value (NPV)exceeds the opportunity cost of capital; turn down any opportunity where the cost of capital exceeds the net present value (NPV)

Question 12

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

Question 13

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

Question 14

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. If the security firm planned to borrow the funds from a bank, what is the maximum interest rate a bank could charge them so they at least break even on this project?

A)8.2155%
B)8.1081%
C)7.5000%
D)8.1999%

Question 15

A delivery service is buying 600 tyres for its fleet of vehicles. One supplier offers to supply the tyres for $85 per tyre, payable in one year. Another supplier will supply the tyres for $20 000 down today, then $50 per tyre, payable in one year. What is the difference in PV between the first and the second offer, assuming interest rates are 8.5%?

A)-$1 000
B)$645
C)$276
D)$1 000

Question 16

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

Question 17

Personal preferences for cash flow should not affect the decision-making process. A manager should decide based on always maximising the net present value (NPV).

Question 18

The present value (PV)of an investment is the difference between the cost of the investment and the benefit of the investment in dollars today.

Question 19

A car parts company is deciding whether to sponsor a racing team for a cost of $2 million. The sponsorship would last for four years and is expected to increase cash flows by $610 000 per year. If the discount rate is 6.75%, what will be the change in the value of the company if it chooses to go ahead with the sponsorship?

A)$86 300
B)$80 878
C)$74 000
D)$77 914

Question 20

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

Question 21

Use the table for the question(s)below.
Consider a project with the following cash flows:

If the appropriate discount rate for this project is 14%, then the net present value (NPV)is closest to:

A)$867
B)-$867
C)$600
D)$612

Question 22

The net present value (NPV)profile for most projects is a downward sloping graph cutting the x-axis at the project's internal rate of return (IRR).

Question 23

Use the table for the question(s)below.
Consider a project with the following cash flows:

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

A)-$612.
B)22.0%.
C)14.0%.
D)$5 500.

Question 24

Use the table for the question(s)below.
Consider the following two projects:

The net present value (NPV)for project alpha is closest to:

A)$14.41
B)$20.96
C)$16.92
D)$24.01

Question 25

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

Question 26

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

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

Question 27

The y-intercept of a net present value (NPV)profile is the algebraic sum of the project cash flows, since the discount rate is zero at that point.

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

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 30

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

Question 31

According to Truong, Partington, and Peat's 2004 survey (Figure 8.2 in the text), the most popular decision rules for capital budgeting used by CFOs of listed Australian firms are, in order

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

Question 32

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

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

Question 33

A manufacturer of video games develops a new game over two years. This costs $850 000 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 $1.2 million per year for three years after that. What is the net present value (NPV)of this decision if the cost of capital is 9%?

A)$1 564 559
B)$1 071 432
C)$991 220
D)$1 841 093

Question 34

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

Question 35

Use the information for the question(s)below.
The MaRS Company is planning on investing in a new project. This will involve the purchase of some new machinery costing $475 000. The MaRs 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)$184 004
B)$150 000
C)$123 420
D)$179 590

Question 36

If the cost of capital estimate is more than the internal rate of return (IRR), the net present value (NPV)will be positive.

Question 37

Use the table for the question(s)below.
Consider the following two projects:

The net present value (NPV)of project B is closest to:

A)3.3
B)2.0
C)4.5
D)5.0

Question 38

Use the table for the question(s)below.
Consider the following two projects:

The net present value (NPV)for project beta is closest to:

A)$14.41
B)$20.96
C)$24.01
D)$16.92

Question 39

Use the table for the question(s)below.
Consider the following two projects:

The net present value (NPV)of project A is closest to:

A)5.0
B)4.9
C)2.6
D)5.7

Question 40

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

Question 41

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

Question 42

An investor is considering a project that will generate $800 000 per year for four years. In addition to up-front costs, at the completion of the project at the end of the fifth year there will be shut-down costs of $500 000. If the cost of capital is 5%, based on the MIRR, at what up-front costs does this project cease to be worthwhile?

A)$2.84 million
B)$2.44 million
C)$2.32 million
D)$2.58 million

Question 43

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

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

Question 45

Use the information for the question(s)below.

If WiseGuy Ltd uses the 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 46

A mining company plans to mine a beach for zirconium sands. Doing so will cost $10 million up-front and then produce cash flows of $3 million per year for five years. At the end of the sixth year the company will incur shut-down and clean-up costs of $2 million. If the cost of capital is 11%, then what is the MIRR for this project?

A)8.52%
B)12.5%
C)10.92%
D)11.03%

Question 47

A local council awards a landscaping company a contract worth $1.2 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 7%, what is the most that this equipment could cost if the contract is to be worthwhile for the landscaping company?

A)$5.26 million
B)$4.92 million
C)$4.61 million
D)$4.55 million

Question 48

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 cash flows after two years are greater than the initial investment.
C)Yes, since the value of the cash flows into the store, in present dollars, is greater than the initial investment.
D)No, since the value of the cash flows over the first two years is less than the initial investment.

Question 49

Use the table for the question(s)below.
Consider the following two projects:

The payback period for project A is closest to:

A)2.55 years
B)2.05 years
C)2.25 years
D)2.45 years

Question 50

What is the decision criteria while using the payback rule?

Question 51

An internal rate of return (IRR)will always exist for an investment opportunity.

Question 52

Use the information for the question(s)below.

A florist is buying a number of motorbikes to expand its delivery service. These will cost $87 000, but are expected to increase profits by $3 000 per month over the next four years. What is the payback period in this case?

A)29 months
B)18 months
C)12 months
D)24 months

Question 53

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

A)It does not account for changes in the discount rate.
B)It ignores cash flows after payback.
C)It is difficult to calculate.
D)It does not account for the time value of money.

Question 54

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 6%, decides to take the money at the end of each year. Was her decision correct?

A)Yes, because it agrees with both the Net Present Value rule and the payback rule.
B)No, because it disagrees with the Net Present Value rule.
C)Yes, because it agrees with the Net Present Value rule.
D)Yes, because it agrees with the payback rule.

Question 55

Investment A: The cash flows for three projects are shown above. The cost of capital is 7.5%. 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 56

Use the information for the question(s)below.
The Sisyphean Company is planning on investing in a new project. This will involve the purchase of some
new machinery costing $450 000. The Sisyphean Company expects cash inflows from this project as
detailed below:
The appropriate discount rate for this project is 16%.
The internal rate of return (IRR)for this project is closest to:

A)39.1%
B)34.1%
C)18.9%
D)22.7%

Question 57

Which of the following decision rules is best defined as the amount of time it takes to pay back the initial investment?

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

Question 58

Use the information for the question(s)below.

If WiseGuy Ltd uses the 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

Use the table for the question(s)below.
Consider the following two projects:

The payback period for project B is closest to:

A)2.4 years
B)2.0 years
C)2.2 years
D)2.5 years

Question 60

Use the table for the question(s)below.
Consider a project with the following cash flows:

Assume the appropriate discount rate for this project is 15%. The payback period for this project is closest to:

A)2
B)4
C)2.5
D)3

Question 61

The cash flows for four investments have been identified as follows: Based on the above information, and with an interest rate of 6%, which is the best investment?

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

Question 62

Use the information for the question(s)below.

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?

Question 63

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

Question 64

Internal rate of return (IRR)cannot be reliably be used to choose between mutually exclusive projects.

Question 65

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

Question 66

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 $800 000, has a growth rate of 2.25%, and a cost of capital of 12%
B)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%
C)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 10%
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%

Question 67

Use the table for the question(s)below.
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 B, since IRR_B > IRR_A.
B)invest in project B, since NPV_B > NPV_{A > 0}.
C)invest in project A, since NPV_A > 0.
D)invest in project A, since NPV_B < NPV_A.

Question 68

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 69

Use the table for the question(s)below.
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 IRR_B > IRR_A.
B)invest in project Alpha, since NPV_Beta < NPV_Alpha.
C)invest in project Beta, since NPV_Beta > 0.
D)invest in project Beta, since NPV_Beta > NPV_Alpha > 0.

Question 70

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 B 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 A 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 71

Use the information for the question(s)below.

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: 9.0%
B)Initial investment: $90 000; Cash flow in year 1: $10 000; Growth Rate: 1.50%; Cost of Capital: 9.0%
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: 7.5%

Question 72

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

Question 73

Use the information for the question(s)below.

Of the following four mutually exclusive investments, which is the best investment?

A)Initial investment: $1.1 million; Cash flow in year 1: $160 000; Annual Growth Rate: 2%; Cost of Capital: 9.0%
B)Initial investment: $1.2 million; Cash flow in year 1: $150 000; Annual Growth Rate: 2%; Cost of Capital: 7.0%
C)Initial investment: $1.3 million; Cash flow in year 1: $160 000; Annual Growth Rate: 1%; Cost of Capital: 6%
D)Initial investment: $1.4 million; Cash flow in year 1: $150 000; Annual Growth Rate: 2%; Cost of Capital: 8%

Question 74

When trying to decide between three mutually exclusive investment opportunities. The most appropriate tool for identifying the correct decision is the profitability index.

Question 75

Use the information for the question(s)below.

If WiseGuy Ltd is choosing one of the above mutually exclusive projects (Project A or Project B), given a discount rate of 8%, 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 76

When different investment rules give conflicting answers, then decisions should be based on the Internal Rate of Return (IRR)rule, as it is the most reliable and accurate decision rule.

Question 77

Two mutually exclusive investment opportunities require an initial investment of $5 million. Investment A then generates $1.5 million per year in perpetuity, while investment B pays $1 million in the first year, with cash flows increasing by 3% per year after that. At what cost of capital would an investor regard both opportunities as being equivalent?

A)3%
B)9%
C)6%
D)10%

Question 78

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

Question 79

Under what circumstances can problems arise when using the internal rate of return (IRR)to compare mutually exclusive projects?

Question 80

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? Cost of Capital: 5%