Assume a project has normal cash flows

Assume a project has normal cash flows (that is, the initial cash flow is negative, and all other cash flows are positive). Which of the following statements is most correct?

 

1. All else equal, a project’s IRR increases as the cost of capital declines.

 

1. All else equal, a project’s NPV increases as the cost of capital declines.

 

1. All else equal, a project’s MIRR is unaffected by changes in the cost of capital.

 

1. Statements a and b are correct.

 

1. Statements b and c are correct.

 

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[i]. Which of the following statements is most correct?

 

1. The NPV method assumes that cash flows will be reinvested at the cost of capital, while the IRR method assumes reinvestment at the IRR.

 

1. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR.

 

1. The NPV method assumes that cash flows will be reinvested at the cost of capital, while the IRR method assumes reinvestment at the risk-free rate.

 

1. The NPV method does not consider the inflation premium.

 

1. The IRR method does not consider all relevant cash flows, particularly, cash flows beyond the payback period.

 

[ii]. A major disadvantage of the payback period is that it

 

1. Is useless as a risk indicator.

 

1. Ignores cash flows beyond the payback period.

 

1. Does not directly account for the time value of money.

 

1. Statements b and c are correct.

 

1. All of the statements above are correct.

 

 

 

[iii]. Projects A and B have the same expected lives and initial cash outflows. However, one project’s cash flows are larger in the early years, while the other project has larger cash flows in the later years. The two NPV profiles are given below:

 

 

k (%)

 

 

Which of the following statements is most correct?

 

1. Project A has the smaller cash flows in the later years.

 

1. Project A has the larger cash flows in the later years.

 

1. We require information on the cost of capital in order to determine which project has larger early cash flows.

 

1. The NPV profile graph is inconsistent with the statement made in the problem.

 

1. None of the statements above is correct.

 

 

[iv]. Projects A and B both have normal cash flows. In other words, there is an up-front cost followed over time by a series of positive cash flows. Both projects have the same risk and a WACC equal to 10 percent. However, Project A has a higher internal rate of return than Project B. Assume that changes in the WACC have no effect on the projects’ cash flow levels. Which of the following statements is most correct?

 

1. Project A must have a higher net present value than Project B.

 

1. If Project A has a positive NPV, Project B must also have a positive NPV.

 

1. If Project A’s WACC falls, its internal rate of return will increase.

 

1. If Projects A and B have the same NPV at the current WACC, Project B would have a higher NPV if the WACC of both projects was lower.

 

1. Statements b and c are correct.

 

 

 

[v]. Project A and Project B are mutually exclusive projects with equal risk. Project A has an internal rate of return of 12 percent, while Project B has an internal rate of return of 15 percent. The two projects have the same net present value when the cost of capital is 7 percent. (In other words, the “crossover rate” is 7 percent.) Assume each project has an initial cash outflow followed by a series of inflows. Which of the following statements is most correct?

 

1. If the cost of capital is 10 percent, each project will have a positive net present value.

 

1. If the cost of capital is 6 percent, Project B has a higher net present value than Project A.

 

1. If the cost of capital is 13 percent, Project B has a higher net present value than Project A.

 

1. Statements a and b are correct.

 

1. Statements a and c are correct.

 

 

[vi]. Sacramento Paper is considering two mutually exclusive projects. Project A has an internal rate of return (IRR) of 12 percent, while Project B has an IRR of 14 percent. The two projects have the same risk, and when the cost of capital is 7 percent the projects have the same net present value (NPV). Assume each project has an initial cash outflow followed by a series of inflows. Given this information, which of the following statements is most correct?

 

1. If the cost of capital is 13 percent, Project B’s NPV will be higher than Project A’s NPV.

 

1. If the cost of capital is 9 percent, Project B’s NPV will be higher than Project A’s NPV.

 

1. If the cost of capital is 9 percent, Project B’s modified internal rate of return (MIRR) will be less than its IRR.

 

1. Statements a and c are correct.

 

1. All of the statements above are correct.

 

[vii]. O’Leary Lumber Company is considering two mutually exclusive projects, Project X and Project Y. The two projects have normal cash flows (an up-front cost followed by a series of positive cash flows), the same risk, and the same 10 percent WACC. However, Project X has an IRR of 16 percent, while Project Y has an IRR of 14 percent. Which of the following statements is most correct?

 

1. Project X’s NPV must be positive.

 

1. Project X’s NPV must be higher than Project Y’s NPV.

 

1. If Project X has a lower NPV than Project Y, then this means that Project X must be a larger project.

 

1. Statements a and c are correct.

 

1. All of the statements above are correct.

 

 

[viii]. Cherry Books is considering two mutually exclusive projects. Project A has an internal rate of return of 18 percent, while Project B has an internal rate of return of 30 percent. The two projects have the same risk, the same cost of capital, and the timing of the cash flows is similar. Each has an up-front cost followed by a series of positive cash flows. One of the projects, however, is much larger than the other. If the cost of capital is 16 percent, the two projects have the same net present value (NPV); otherwise, their NPVs are different. Which of the following statements is most correct?

 

1. If the cost of capital is 12 percent, Project B will have a higher NPV.

 

1. If the cost of capital is 17 percent, Project B will have a higher NPV.

 

1. Project B is larger than Project A.

 

1. Statements a and c are correct.

 

1. Statements b and c are correct.

 

[ix]. Project X’s IRR is 19 percent. Project Y’s IRR is 17 percent. Both projects have the same risk, and both projects have normal cash flows (an up-front cost followed by a series of positive cash flows). If the cost of capital is 10 percent, Project Y has a higher NPV than Project X. Given this information, which of the following statements is most correct?

 

1. The crossover rate between the two projects (that is, the point where the two projects have the same NPV) is greater than 10 percent.

 

1. If the cost of capital is 8 percent, Project X will have a higher NPV than Project Y.

 

1. If the cost of capital is 10 percent, Project X’s MIRR is greater than 19 percent.

 

1. Statements a and b are correct.

 

1. All of the statements above are correct.

 

 

[x]. Which of the following statements is most correct?

 

1. If a project’s internal rate of return (IRR) exceeds the cost of capital, then the project’s net present value (NPV) must be positive.

 

1. If Project A has a higher IRR than Project B, then Project A must also have a higher NPV.

 

1. The IRR calculation implicitly assumes that all cash flows are reinvested at a rate of return equal to the cost of capital.

 

1. Statements a and c are correct.

 

1. None of the statements above is correct.

 

 

[xi]. Project A has an internal rate of return (IRR) of 15 percent. Project B has an IRR of 14 percent. Both projects have a cost of capital of 12 percent. Which of the following statements is most correct?

 

1. Both projects have a positive net present value (NPV).

 

1. Project A must have a higher NPV than Project B.

 

1. If the cost of capital were less than 12 percent, Project B would have a higher IRR than Project A.

 

1. Statements a and c are correct.

 

1. All of the statements above are correct.

 

 

[xii]. A project has an up-front cost of $100,000. The project’s WACC is 12 percent and its net present value is $10,000. Which of the following statements is most correct?

 

1. The project should be rejected since its return is less than the WACC.

 

1. The project’s internal rate of return is greater than 12 percent.

 

1. The project’s modified internal rate of return is less than 12 percent.

 

1. All of the statements above are correct.

 

1. None of the statements above is correct.

 

[xiii]. A proposed project has normal cash flows. In other words, there is an up-front cost followed over time by a series of positive cash flows. The project’s internal rate of return is 12 percent and its WACC is 10 percent. Which of the following statements is most correct?

 

1. The project’s NPV is positive.

 

1. The project’s MIRR is greater than 10 percent but less than 12 percent.

 

1. The project’s payback period is greater than its discounted payback period.

 

1. Statements a and b are correct.

 

1. All of the statements above are correct.

 

 

[xiv]. Stock C has a beta of 1.2, while Stock D has a beta of 1.6. Assume that the stock market is efficient. Which of the following statements is most correct?

 

1. The required rates of return of the two stocks should be the same.

 

1. The expected rates of return of the two stocks should be the same.

 

1. Each stock should have a required rate of return equal to zero.

 

1. The NPV of each stock should equal its expected return.

 

1. The NPV of each stock should equal zero.

 

 

[xv]. Moynihan Motors has a cost of capital of 10.25 percent. The firm has two normal projects of equal risk. Project A has an internal rate of return of 14 percent, while Project B has an internal rate of return of 12.25 percent. Which of the following statements is most correct?

 

1. Both projects have a positive net present value.

 

1. If the projects are mutually exclusive, the firm should always select Project A.

 

1. If the crossover rate (that is, the rate at which the Project’s NPV profiles intersect) is 8 percent, Project A will have a higher net present value than Project B.

 

1. Statements a and b are correct.

 

1. Statements a and c are correct.

 

[xvi]. Project A has an IRR of 15 percent. Project B has an IRR of 18 percent. Both projects have the same risk. Which of the following statements is most correct?

 

1. If the WACC is 10 percent, both projects will have a positive NPV, and the NPV of Project B will exceed the NPV of Project A.

 

1. If the WACC is 15 percent, the NPV of Project B will exceed the NPV of Project A.

 

1. If the WACC is less than 18 percent, Project B will always have a shorter payback than Project A.

 

1. If the WACC is greater than 18 percent, Project B will always have a shorter payback than Project A.

 

1. If the WACC increases, the IRR of both projects will decline.

 

 

[xvii]. The post-audit is used to

 

1. Improve cash flow forecasts.

 

1. Stimulate management to improve operations and bring results into line with forecasts.

 

1. Eliminate potentially profitable but risky projects.

 

1. Statements a and b are correct.

 

1. All of the statements above are correct.

 

 

 

 

[xviii]. Projects L and S each have an initial cost of $10,000, followed by a series of positive cash inflows. Project L has total, undiscounted cash inflows of $16,000, while S has total undiscounted inflows of $15,000. Further, at a discount rate of 10 percent, the two projects have identical NPVs. Which project’s NPV will be more sensitive to changes in the discount rate?

 

1. Project S.

 

1. Project L.

 

1. Both projects are equally sensitive to changes in the discount rate since their NPVs are equal at all costs of capital.

 

1. Neither project is sensitive to changes in the discount rate, since both have NPV profiles which are horizontal.

 

1. The solution cannot be determined unless the timing of the cash flows is known.

 

 

[xix]. Two mutually exclusive projects each have a cost of $10,000. The total, undiscounted cash flows for Project L are $15,000, while the undiscounted cash flows for Project S total $13,000. Their NPV profiles cross at a discount rate of 10 percent. Which of the following statements best describes this situation?

 

1. The NPV and IRR methods will select the same project if the cost of capital is greater than 10 percent; for example, 18 percent.

 

1. The NPV and IRR methods will select the same project if the cost of capital is less than 10 percent; for example, 8 percent.

 

1. To determine if a ranking conflict will occur between the two projects the cost of capital is needed as well as an additional piece of information.

 

1. Project L should be selected at any cost of capital, because it has a higher IRR.

 

1. Project S should be selected at any cost of capital, because it has a higher IRR.

 

[xx]. A company is comparing two mutually exclusive projects with normal cash flows. Project P has an IRR of 15 percent, while Project Q has an IRR of 20 percent. If the WACC is 10 percent, the two projects have the same NPV. Which of the following statements is most correct?

 

1. If the WACC is 12 percent, both projects would have a positive NPV.

 

1. If the WACC is 12 percent, Project Q would have a higher NPV than Project P.

 

1. If the WACC is 8 percent,ProjectQ would have a lower NPV than ProjectP.

 

1. All of the statements above are correct.

 

1. None of the statements above is correct.

 

[xxi]. Project C and Project D are two mutually exclusive projects with normal cash flows and the same risk. If the WACC were equal to 10 percent, the two projects would have the same positive NPV. However, if the WACC is less than 10 percent, Project C has a higher NPV, whereas if the WACC is greater than 10 percent, Project D has a higher NPV. On the basis of this information, which of the following statements is most correct?

 

1. Project D has a higher IRR, regardless of the cost of capital.

 

1. If the WACC is less than 10 percent, Project C has a higher IRR.

 

1. If the WACC is less than 10 percent, Project D’s MIRR is less than its IRR.

 

1. Statements a and c are correct.

 

1. None of the statements above is correct.

 

[xxii]. Project X and Project Y each have normal cash flows (an up-front cost followed by a series of positive cash flows) and the same level of risk. Project X has an IRR equal to 12 percent, and Project Y has an IRR equal to 14 percent. If the WACC for both projects equals 9 percent, Project X has a higher net present value than Project Y. Which of the following statements is most correct?

 

1. If the WACC equals 13 percent, Project X will have a negative NPV, while Project Y will have a positive NPV.

 

1. Project X probably has a quicker payback than Project Y.

 

1. The crossover rate in which the two projects have the same NPV is greater than 9 percent and less than 12 percent.

 

1. Statements a and b are correct.

 

1. Statements a and c are correct.

 

 

 

[xxiii]. Assume that you are comparing two mutually exclusive projects. Which of the following statements is most correct?

 

1. The NPV and IRR rules will always lead to the same decision unless one or both of the projects are “non-normal” in the sense of having only one change of sign in the cash flow stream, that is, one or more initial cash outflows (the investment) followed by a series of cash inflows.

 

1. If a conflict exists between the NPV and the IRR, the conflict can always be eliminated by dropping the IRR and replacing it with the MIRR.

 

1. There will be a meaningful (as opposed to irrelevant) conflict only if the projects’ NPV profiles cross, and even then, only if the cost of capital is to the left of (or lower than) the discount rate at which the crossover occurs.

 

1. All of the statements above are correct.

 

1. None of the statements above is correct.

 

 

 

[xxiv]. Which of the following statements is incorrect?

 

1. Assuming a project has normal cash flows, the NPV will be positive if the IRR is less than the cost of capital.

 

1. If the multiple IRR problem does not exist, any independent project acceptable by the NPV method will also be acceptable by the IRR method.

 

1. If IRR = k (the cost of capital), then NPV = 0.

 

1. NPV can be negative if the IRR is positive.

 

1. The NPV method is not affected by the multiple IRR problem.

 

 

[xxv]. Project J has the same internal rate of return as Project K. Which of the following statements is most correct?

 

1. If the projects have the same size (scale) they will have the same NPV, even if the two projects have different levels of risk.

 

1. If the two projects have the same risk they will have the same NPV, even if the two projects are of different size.

 

1. If the two projects have the same size (scale) they will have the same discounted payback, even if the two projects have different levels of risk.

 

1. All of the statements above are correct.

 

1. None of the statements above is correct.

 

 

[xxvi]. Which of the following statements is most correct?

 

1. If a project with normal cash flows has an IRR that exceeds the cost of capital, then the project must have a positive NPV.

 

1. If the IRR of Project A exceeds the IRR of Project B, then Project A must also have a higher NPV.

 

1. The modified internal rate of return (MIRR) can never exceed the IRR.

 

1. Statements a and c are correct.

 

1. None of the statements above is correct.

 

 

[xxvii]. Which of the following statements is most correct?

 

1. The MIRR method will always arrive at the same conclusion as the NPV method.

 

1. The MIRR method can overcome the multiple IRR problem, while the NPV method cannot.

 

1. The MIRR method uses a more reasonable assumption about reinvestment rates than the IRR method.

 

1. Statements a and c are correct.

 

1. All of the statements above are correct.

 

 

 

[xxviii]. Jurgensen Medical is considering two mutually exclusive projects with the following characteristics:

 

• The two projects have the same risk and the same cost of capital.

 

• Both projects have normal cash flows. Specifically, each has an up-front cost followed by a series of positive cash flows.

 

• If the cost of capital is 12 percent, Project X’s IRR is greater than its MIRR.

 

• If the cost of capital is 12 percent, Project Y’s IRR is less than its MIRR.

 

• If the cost of capital is 10 percent, the two Project’s have the same NPV.

 

Which of the following statements is most correct?

 

1. Project X’s IRR is greater than 12 percent.

 

1. Project Y’s IRR is less than 12 percent.

 

1. If the cost of capital is 8 percent, Project X has a lower NPV than Project Y.

 

1. All of the statements above are correct.

 

1. None of the statements above is correct.

 

 

[xxix]. Project X has an internal rate of return of 20 percent. Project Y has an internal rate of return of 15 percent. Both projects have a positive net present value. Which of the following statements is most correct?

 

1. Project X must have a higher net present value than Project Y.

 

1. If the two projects have the same WACC, Project X must have a higher net present value.

 

1. Project X must have a shorter payback than Project Y.

 

1. Statements b and c are correct.

 

1. None of the statements above is correct.