FIN 534 WEEK 7 QUIZ 6 (100% Solution) - 87624

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Question 1 Which of the following statements is CORRECT? If a project has “normal” cash flows, then its IRR must be positive. If a project has “normal” cash flows, then its MIRR must be positive. If a project has “normal” cash flows, then it will have exactly two real IRRs. The definition of “normal” cash flows is that the cash flow stream has one or more negative cash flows followed by a stream of positive cash flows and then one negative cash flow at the end of the project’s life. If a project has “normal” cash flows, then it can have only one real IRR, whereas a project with “nonnormal” cash flows might have more than one real IRR. Question 2 Which of the following statements is CORRECT? The IRR method appeals to some managers because it gives an estimate of the rate of return on projects rather than a dollar amount, which the NPV method provides. The discounted payback method eliminates all of the problems associated with the payback method. When evaluating independent projects, the NPV and IRR methods often yield conflicting results regarding a project’s acceptability. To find the MIRR, we discount the TV at the IRR. A project’s NPV profile must intersect the X-axis at the project’s WACC. Question 3 Assume that the economy is in a mild recession, and as a result interest rates and money costs generally are relatively low. The WACC for two mutually exclusive projects that are being considered is 8%. Project S has an IRR of 20% while Project L’s IRR is 15%. The projects have the same NPV at the 8% current WACC. However, you believe that the economy is about to recover, and money costs and thus your WACC will also increase. You also think that the projects will not be funded until the WACC has increased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT? You should reject both projects because they will both have negative NPVs under the new conditions. You should delay a decision until you have more information on the projects, even if this means that a competitor might come in and capture this market. You should recommend Project L, because at the new WACC it will have the higher NPV. You should recommend Project S, because at the new WACC it will have the higher NPV. You should recommend Project S because it has the higher IRR and will continue to have the higher IRR even at the new WACC. Question 4 Which of the following statements is CORRECT? One advantage of the NPV over the IRR is that NPV takes account of cash flows over a project’s full life whereas IRR does not. One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at the WACC, whereas IRR assumes that cash flows are reinvested at the IRR. The NPV assumption is generally more appropriate. One advantage of the NPV over the MIRR method is that NPV takes account of cash flows over a project’s full life whereas MIRR does not. One advantage of the NPV over the MIRR method is that NPV discounts cash flows whereas the MIRR is based on undiscounted cash flows. Since cash flows under the IRR and MIRR are both discounted at the same rate (the WACC), these two methods always rank mutually exclusive projects in the same order. Question 5 Which of the following statements is CORRECT? The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate. The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period. The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period. Question 6 Which of the following statements is CORRECT? One defect of the IRR method is that it does not take account of cash flows over a project’s full life. One defect of the IRR method is that it does not take account of the time value of money. One defect of the IRR method is that it does not take account of the cost of capital. One defect of the IRR method is that it values a dollar received today the same as a dollar that will not be received until sometime in the future. One defect of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid. Question 7 Projects S and L both have an initial cost of $10,000, followed by a series of positive cash inflows. Project S’s undiscounted net cash flows total $20,000, while L’s total undiscounted flows are $30,000. At a WACC of 10%, the two projects have identical NPVs. Which project’s NPV is more sensitive to changes in the WACC? Project S. Project L. Both projects are equally sensitive to changes in the WACC since their NPVs are equal at all costs of capital. Neither project is sensitive to changes in the discount rate, since both have NPV profiles that are horizontal. The solution cannot be determined because the problem gives us no information that can be used to determine the projects’ relative IRRs. Question 8 Which of the following statements is CORRECT? The shorter a project’s payback period, the less desirable the project is normally considered to be by this criterion. One drawback of the regular payback is that this method does not take account of cash flows beyond the payback period. If a project’s payback is positive, then the project should be accepted because it must have a positive NPV. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem. One drawback of the discounted payback is that this method does not consider the time value of money, while the regular payback overcomes this drawback. Question 9 Which of the following statements is CORRECT? An NPV profile graph shows how a project’s payback varies as the cost of capital changes. The NPV profile graph for a normal project will generally have a positive (upward) slope as the life of the project increases. An NPV profile graph is designed to give decision makers an idea about how a project’s risk varies with its life. An NPV profile graph is designed to give decision makers an idea about how a project’s contribution to the firm’s value varies with the cost of capital. We cannot draw a project’s NPV profile unless we know the appropriate WACC for use in evaluating the project’s NPV. Question 10 Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT? A project’s IRR increases as the WACC declines. A project’s NPV increases as the WACC declines. A project’s MIRR is unaffected by changes in the WACC. A project’s regular payback increases as the WACC declines. A project’s discounted payback increases as the WACC declines. Question 11 Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. A project’s regular IRR is found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting this TV at the WACC. A project’s regular IRR is found by discounting the cash inflows at the WACC to find the present value (PV), then compounding this PV to find the IRR. If a project’s IRR is greater than the WACC, then its NPV must be negative. To find a project’s IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project’s costs. To find a project’s IRR, we must find a discount rate that is equal to the WACC. Question 12 Projects C and D are mutually exclusive and have normal cash flows. Project C has a higher NPV if the WACC is less than 12%, whereas Project D has a higher NPV if the WACC exceeds 12%. Which of the following statements is CORRECT? Project D probably has a higher IRR. Project D is probably larger in scale than Project C. Project C probably has a faster payback. Project C probably has a higher IRR. The crossover rate between the two projects is below 12%. Question 13 Which of the following statements is CORRECT? For a project with normal cash flows, any change in the WACC will change both the NPV and the IRR. To find the MIRR, we first compound cash flows at the regular IRR to find the TV, and then we discount the TV at the WACC to find the PV. The NPV and IRR methods both assume that cash flows can be reinvested at the WACC. However, the MIRR method assumes reinvestment at the MIRR itself. If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the higher IRR probably has more of its cash flows coming in the later years. If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the lower IRR probably has more of its cash flows coming in the later years. Question 14 Which of the following statements is CORRECT? One defect of the IRR method versus the NPV is that the IRR does not take account of cash flows over a project’s full life. One defect of the IRR method versus the NPV is that the IRR does not take account of the time value of money. One defect of the IRR method versus the NPV is that the IRR does not take account of the cost of capital. One defect of the IRR method versus the NPV is that the IRR values a dollar received today the same as a dollar that will not be received until sometime in the future. One defect of the IRR method versus the NPV is that the IRR does not take proper account of differences in the sizes of projects. Question 15 Which of the following statements is CORRECT? If a project with normal cash flows has an IRR greater than the WACC, the project must also have a positive NPV. If Project A’s IRR exceeds Project B’s, then A must have the higher NPV. A project’s MIRR can never exceed its IRR. If a project with normal cash flows has an IRR less than the WACC, the project must have a positive NPV. If the NPV is negative, the IRR must also be negative. Question 16 Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product? Using some of the firm’s high-quality factory floor space that is currently unused to produce the proposed new product. This space could be used for other products if it is not used for the project under consideration. Revenues from an existing product would be lost as a result of customers switching to the new product. Shipping and installation costs associated with a machine that would be used to produce the new product. The cost of a study relating to the market for the new product that was completed last year. The results of this research were positive, and they led to the tentative decision to go ahead with the new product. The cost of the research was incurred and expensed for tax purposes last year. It is learned that land the company owns and would use for the new project, if it is accepted, could be sold to another firm. Question 17 Which of the following statements is CORRECT? An example of a sunk cost is the cost associated with restoring the site of a strip mine once the ore has been depleted. Sunk costs must be considered if the IRR method is used but not if the firm relies on the NPV method. A good example of a sunk cost is a situation where a bank opens a new office, and that new office leads to a decline in deposits of the bank’s other offices. A good example of a sunk cost is money that a banking corporation spent last year to investigate the site for a new office, then expensed that cost for tax purposes, and now is deciding whether to go forward with the project. If sunk costs are considered and reflected in a project’s cash flows, then the project’s calculated NPV will be higher than it otherwise would be. Question 18 When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT: Changes in net working capital attributable to the project. Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes. The value of a building owned by the firm that will be used for this project. A decline in the sales of an existing product, provided that decline is directly attributable to this project. The salvage value of assets used for the project that will be recovered at the end of the project’s life. Question 19 Which of the following factors should be included in the cash flows used to estimate a project’s NPV? All costs associated with the project that have been incurred prior to the time the analysis is being conducted. Interest on funds borrowed to help finance the project. The end-of-project recovery of any working capital required to operate the project. Cannibalization effects, but only if those effects increase the project’s projected cash flows. Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes. Question 20 Which of the following is NOT a relevant cash flow and thus should not be reflected in the analysis of a capital budgeting project? Changes in net working capital. Shipping and installation costs. Cannibalization effects. Opportunity costs. Sunk costs that have been expensed for tax purposes. Question 21 Which of the following statements is CORRECT? A sunk cost is any cost that must be expended in order to complete a project and bring it into operation. A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project. A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project. Sunk costs were formerly hard to deal with but now that the NPV method is widely used, it is possible to simply include sunk costs in the cash flows and then calculate the PV of the project. A good example of a sunk cost is a situation where Home Depot opens a new store, and that leads to a decline in sales of one of the firm’s existing stores. Question 22 Which of the following statements is CORRECT? In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project’s cash flows will lead to an upward bias in the NPV. In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project’s cash flows will lead to a downward bias in the NPV. The existence of any type of “externality” will reduce the calculated NPV versus the NPV that would exist without the externality. If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net after-tax proceeds that could be obtained should be charged as a cost to the project under consideration. If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored. Question 23 Suppose Tapley Inc. uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Tapley accept, assuming that the company uses the NPV method when choosing projects? Project A, which has average risk and an %. Project B, which has below-average risk and an %. Project C, which has above-average risk and an %. Without information about the projects’ NPVs we cannot determine which project(s) should be accepted. All of these projects should be accepted. Question 24 Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project? The new project is expected to reduce sales of one of the company’s existing products by 5%. Since the firm’s director of capital budgeting spent some of her time last year to evaluate the new project, a portion of her salary for that year should be charged to the project’s initial cost. The company has spent and expensed $1 million on R&D associated with the new project. The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project. The firm would borrow all the money used to finance the new project, and the interest on this debt would be $1.5 million per year. Question 25 Which of the following statements is CORRECT? Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables. In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less risky, because a small error in estimating a variable such as unit sales would produce only a small error in the project’s NPV. The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a relatively powerful computer, coupled with an efficient financial planning software package, whereas simulation analysis can be done efficiently using a PC with a spreadsheet program or even with just a calculator. Sensitivity analysis is a type of risk analysis that considers both the sensitivity of NPV to changes in key input variables and the probability of occurrence of these variables’ values. As computer technology advances, simulation analysis becomes increasingly obsolete and thus less likely to be used as compared to sensitivity analysis. Question 26 Dalrymple Inc. is considering production of a new product. In evaluating whether to go ahead with the project, which of the following items should NOT be explicitly considered when cash flows are estimated? The company will produce the new product in a vacant building that was used to produce another product until last year. The building could be sold, leased to another company, or used in the future to produce another of the firm’s products. The project will utilize some equipment the company currently owns but is not now using. A used equipment dealer has offered to buy the equipment. The company has spent and expensed for tax purposes $3 million on research related to the new detergent. These funds cannot be recovered, but the research may benefit other projects that might be proposed in the future. The new product will cut into sales of some of the firm’s other products. If the project is accepted, the company must invest $2 million in working capital. However, all of these funds will be recovered at the end of the project’s life. Question 27 The relative risk of a proposed project is best accounted for by which of the following procedures? Adjusting the discount rate upward if the project is judged to have above-average risk. Adjusting the discount rate downward if the project is judged to have above-average risk. Reducing the NPV by 10% for risky projects. Picking a risk factor equal to the average discount rate. Ignoring risk because project risk cannot be measured accurately. Question 28 Which of the following statements is CORRECT? Using accelerated depreciation rather than straight line would normally have no effect on a project’s total projected cash flows but it would affect the timing of the cash flows and thus the NPV. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer. Corporations must use the same depreciation method (e.g., straight line or accelerated) for stockholder reporting and tax purposes. Since depreciation is not a cash expense, it has no effect on cash flows and thus no effect on capital budgeting decisions. Under accelerated depreciation, higher depreciation charges occur in the early years, and this reduces the early cash flows and thus lowers a project’s projected NPV. Question 29 Which of the following rules is CORRECT for capital budgeting analysis? The interest paid on funds borrowed to finance a project must be included in estimates of the project’s cash flows. Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions. Sunk costs are not included in the annual cash flows, but they must be deducted from the PV of the project’s other costs when reaching the accept/reject decision. A proposed project’s estimated net income as determined by the firm’s accountants, using generally accepted accounting principles (GAAP), is discounted at the WACC, and if the PV of this income stream exceeds the project’s cost, the project should be accepted. If a product is competitive with some of the firm’s other products, this fact should be incorporated into the estimate of the relevant cash flows. However, if the new product is complementary to some of the firm’s other products, this fact need not be reflected in the analysis. Question 30 Which of the following statements is CORRECT? Since depreciation is not a cash expense, and since cash flows and not accounting income are the relevant input, depreciation plays no role in capital budgeting. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 3 years or longer. If firms use accelerated depreciation, they will write off assets slower than they would under straight-line depreciation, and as a result projects’ forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes. If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects’ forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes. If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects’ forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes.
Solution Description

Question 1

Which of the following statements is CORRECT?

If a project has “normal” cash flows, then its IRR must be positive.

If a project has “normal” cash flows, then its MIRR must be positive.

If a project has “normal” cash flows, then it will have exactly two real IRRs.

The definition of “normal” cash flows is that the cash flow stream has one or more negative cash flows followed by a stream of positive cash flows and then one negative cash flow at the end of the project’s life.

 If a project has “normal” cash flows, then it can have only one real IRR, whereas a project with “nonnormal” cash flows might have more than one real IRR.

Question 2

Which of the following statements is CORRECT?

The IRR method appeals to some managers because it gives an estimate of the rate of return on projects rather than a dollar amount, which the NPV method provides.

The discounted payback method eliminates all of the problems associated with the payback method.

When evaluating independent projects, the NPV and IRR methods often yield conflicting results regarding a project’s acceptability.

To find the MIRR, we discount the TV at the IRR.

A project’s NPV profile must intersect the X-axis at the project’s WACC.

Question 3

Assume that the economy is in a mild recession, and as a result interest rates and money costs generally are relatively low. The WACC for two mutually exclusive projects that are being considered is 8%. Project S has an IRR of 20% while Project L’s IRR is 15%. The projects have the same NPV at the 8% current WACC. However, you believe that the economy is about to recover, and money costs and thus your WACC will also increase. You also think that the projects will not be funded until the WACC has increased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT?

You should reject both projects because they will both have negative NPVs under the new conditions.

You should delay a decision until you have more information on the projects, even if this means that a competitor might come in and capture this market.

You should recommend Project L, because at the new WACC it will have the higher NPV.

You should recommend Project S, because at the new WACC it will have the higher NPV.

You should recommend Project S because it has the higher IRR and will continue to have the higher IRR even at the new WACC.

Question 4

Which of the following statements is CORRECT?

One advantage of the NPV over the IRR is that NPV takes account of cash flows over a project’s full life whereas IRR does not.

One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at the WACC, whereas IRR assumes that cash flows are reinvested at the IRR. The NPV assumption is generally more appropriate.

One advantage of the NPV over the MIRR method is that NPV takes account of cash flows over a project’s full life whereas MIRR does not.

One advantage of the NPV over the MIRR method is that NPV discounts cash flows whereas the MIRR is based on undiscounted cash flows.

Since cash flows under the IRR and MIRR are both discounted at the same rate (the WACC), these two methods always rank mutually exclusive projects in the same order.

Question 5

Which of the following statements is CORRECT?

The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.

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

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

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

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

Question 6

Which of the following statements is CORRECT?

One defect of the IRR method is that it does not take account of cash flows over a project’s full life.

One defect of the IRR method is that it does not take account of the time value of money.

One defect of the IRR method is that it does not take account of the cost of capital.

One defect of the IRR method is that it values a dollar received today the same as a dollar that will not be received until sometime in the future.

One defect of the IRR method is that it assumes that the cash flows to be received from a project can be rein

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