Chapter 6 Investment Decision Rules

Corporate Finance, 2e (Berk/DeMarzo)

Chapter 6 Investment Decision Rules

6.1 NPV and Stand-Alone Projects

1) Which of the following statements is false?

A) About 75% of firms surveyed used the NPV rule for making investment decisions.

B) 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.

C) To decide whether to invest using the NPV rule, we need to know the cost of capital.

D) NPV is positive only for discount rates greater than the internal rate of return.

Use the following information to answer the question(s) below.

Sarah Palin reportedly was paid a $11 million advance to write her book Going Rogue. The book took one year to write. In the time she spent writing, Palin could have been paid to give speeches and appear on TV news as a political commentator. Given her popularity, assume that she could have earned $8 million over the year (paid at the end of the year) she spent writing the book. Assume that she was able to write the book while simultaneously fulfilling her media commitments of appearing on TV news as a political commentator and give speeches.

2) Assume that once her book is finished, it is expected to generate royalties of $5 million in the first year (paid at the end of the year) and these royalties are expected to decrease by 40% per year in perpetuity. Assuming that Palin’s cost of capital is 10% and given these royalties payments, the NPV of Palin’s book deal is closest to:

A) $3.75 million

B) $12.20 million

C) $13.00 million

D) $13.75 million

 

3) Which of the following statements is false?

A) In general, the difference between the cost of capital and the IRR is the maximum amount of estimation error in the cost of capital estimate that can exist without altering the original decision.

B) The 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 IRR, the NPV will be positive.

Use the following information to answer the question(s) below.

You are considering investing in a start up project at a cost of $100,000. You expect the project to return $500,000 to you in seven years. Given the risk of this project, your cost of capital is 20%.

4) The NPV for this project is closest to:

A) $29,200

B) $39,500

C) $129,200

D) $139,500

5) The IRR for this project is closest to:

A) 15.60%

B) 18.95%

C) 20.00%

D) 25.85%

 

6) The decision you should take regarding this project is

A) reject the project since the NPV is negative.

B) reject the project since the NPV is positive.

C) accept the project since the IRR < 20%.

D) accept the project since the IRR > 20%.

Use the following information to answer the question(s) below.

Sarah Palin reportedly was paid a $11 million advance to write her book Going Rogue. The book took one year to write. In the time she spent writing, Palin could have been paid to give speeches and appear on TV news as a political commentator. Given her popularity, assume that she could have earned $8 million over the year (paid at the end of the year) she spent writing the book. Assume that she was able to write the book while simultaneously fulfilling her media commitments of appearing on TV news as a political commentator and give speeches.

7) Assuming that Palin’s cost of capital is 10%, then the NPV of her book deal is closest to:

A) $2.00 million

B) $2.20 million

C) $3.00 million

D) $3.75 million

8) The IRR of Palin’s book deal is closest to:

A) -27.25%

B) -37.50%

C) 27.25%

D) 37.50%

 

Use the table for the question(s) below.

Consider a project with the following cash flows:

Year Cash Flow
0 -10,000
1 4,000
2 4,000
3 4,000
4 4,000

9) If the appropriate discount rate for this project is 15%, then the NPV is closest to:

A) $6,000

B) -$867

C) $1,420

D) $867

10) The NPV of project A is closest to:

A) 12.0

B) 12.6

C) 15.0

D) 42.9

11) The NPV of project B is closest to:

A) 12.6

B) 23.3

C) 12.0

D) 15.0

12) The NPV for this project is closest to:

A) $176,270

B) $123,420

C) $450,000

D) $179,590

<pclass=”normaltext”>Use the table for the question(s) below.

Consider the following two projects:

Project Year 0

C/F

Year 1

C/F

Year 2

C/F

Year 3

C/F

Year 4

C/F

Year 5

C/F

Year 6

C/F

Year 7

C/F

Discount

Rate

Alpha -79 20 25 30 35 40 N/A N/A 15%
Beta -80 25 25 25 25 25 25 25 16%

13) The NPV for project alpha is closest to:

A) $20.96

B) $16.92

C) $24.01

D) $14.41

14) The NPV for project beta is closest to:

A) $24.01

B) $16.92

C) $20.96

D) $14.41

:

15) The NPV of Larry’s three movie Larry Boy offer is closest to:

A) 3.5 million

B) -1.6 million Answer

C) 1.6 million

D) -1.0 million

16) The NPV for Boulderado’s snowboard project is closest to:

A) $228,900

B) $46,900

C) $51,600

D) $23,800

17) The NPV profile graphs

A) the project’s NPV over a range of discount rates.

B) the project’s IRR over a range of discount rates.

C) the project’s cash flows over a range of NPVs.

D) the project’s IRR over a range of NPVs.

18) The NPV profile

A) shows the payback period – the point at which NPV is positive.

B) shows the internal rate of return – the point at which NPV is zero.

C) shows the NPV over a range of discount rates.

D) B and C are correct.

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