# Solutions to Chapter 5: Why Net Present Value Leads to Better Investment Decisions than Other Criteria

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**Multiple Choice Questions**

1. The following measures are used by firms when making capital budgeting decisions except:

A) Payback period

B) Internal rate of return

C) Net present value

D) P/E ratio

2. Which of the following investment rules does not use the time value of the money concept?

A) The payback period

B) Internal rate of return

C) Net present value

D) All of the above use the time value concept

3. Suppose a firm has a $500 million in excess cash. It could:

A) Invest the funds in projects with positive NPVs

B) Pay high dividends to the shareholders

C) Buy another firm

D) All of the above

4. Which of the following investment rules has value additivity property?

A) The payback period method

B) The internal rate of return method

C) The book rate of return method

D) Net present value method

E) All of the above have value additivity property

5. If the net present value of project A is +$80, and of project B is +$60, then the net present value of the combined project is:

A) +$80

B) +$60

C) +$140

D) None of the above

6. If the NPV of project A is +$100, and that of project B is -$50 and that of project C is +$20, what is the NPV of the combined project?

A) $100

B) -$50

C) $120

D) $70

7. You are given a job to make a decision on project X, which is composed of three independent projects A, B, and C which have NPVs of +$50, -$20 and +$100, respectively. How would you go about making the decision about whether to accept or reject the project?

A) Accept the firm’s joint project as it has a positive NPV

B) Reject the joint project

C) Break up the project into its components: accept A and C and reject B

D) None of the above

8. If the NPV of project A is +$50 and that of project B is -$60, than the NPV of the combined project is:

A) +$50

B) +$60

C) -$10

D) None of the above.

9. The net present value of a project depends upon:

A) forecasted cash flows and opportunity cost of capital

B) manager’s tastes and preferences

C) company’s choice of accounting method

D) all of the above

10. The payback period rule:

A) Varies the cut-off point with the interest rate

B) Determines a cut-off point so that all projects accepted by the NPV rule will be accepted by the payback period rule.

C) Requires an arbitrary choice of a cut-off point

D) Both A and C

11. The payback period rule accepts all projects for which the payback period is:

A) Greater than the cut-off value

B) Less than the cut-off value

C) Is positive

D) An integer

12. Which of the following investment rules may not use all possible cash flows in its calculations?

A) Payback period.

B) NPV

C) IRR

D) All of the above

13. Given the following cash flows for project A: C0 = -2000, C1 = +500 , C2 = +1500 and C3 = +5000, calculate the payback period.

A) One year

B) 2 years

C) 3 years

D) None of the above

14. The main advantage of the payback rule is:

A) Adjustment for uncertainty of early cash flows

B) It is simple to use

C) Does not discount cash flows

D) Both A and C

15. Which of the following statements regarding the discounted payback period rule is true?

A) The discounted payback rule uses the time value of money concept.

B) The discounted payback rule is better than the NPV rule

C) The discounted payback rule considers all cash flows

D) The discounted payback rule exhibits the value additive property

16. The following are disadvantages of using the payback rule except:

A) The payback rule ignores all cash flow after the cutoff date

B) The payback rule does not use the time value of money

C) The payback period is easy to calculate and use

D) The payback rule does not have the value additive property

17. Given the following cash flows for project Z: C0 = -2,000, C1 = 600, C2 = 2160 and C3 = 6000, calculate the discounted payback period for the project at a discount rate of 20%.

A) One year

B) 2 years

C) 3 years

D) None of the above

18. Given the following cash flows for Project M: C0 = -2,000, C1 = +500, C2 = +1,500, C3 = +1455, calculate the IRR for the project.

A) 10%

B) 18%

C) 28%

D) None of the above

19. The quickest way to calculate the IRR of a project is by:

A) Trial and error method

B) Using the graphical method

C) Using a financial calculator

D) Guessing the IRR

20. If an investment project (normal project) has an IRR equal to the cost of capital , the NPV for that project is:

A) Positive

B) Negative

C) Zero

D) Unable to be determined

21. Project Y-File has the following cash flows: C0 = +2000, C1 = -1,200, and C2 = -1,500. If the IRR of the project is 21.65% and if the cost of capital is 15%, you would:

A) Accept the project

B) Reject the project

22. Project Y-File has the following cash flows: C0 = +2000, C1 = -1,200, and C2 = -1,200. If the IRR of the project is 13.1% and if the cost of capital is 15%, you would:

A) Accept the project

B) Reject the project

23. The IRR is defined as:

A) The discount rate that makes the NPV equal to zero

B) The difference between the cost of capital and the present value of the cash flows

C) The discount rate used in the NPV method

D) The discount rate used in the discounted payback period method

24. The following are some of the shortcomings of the IRR method except:

A) IRR is conceptually easy to communicate

B) Projects can have multiple IRRs

C) IRR method cannot distinguish between a borrowing project and a lending project

D) It is very cumbersome to evaluate mutually exclusive projects using the IRR method

25. Valentine Company is considering investing in a new project. The project will need an initial investment of $1,200,000 and will generate $600,000 (after-tax) cash flows for three years. Calculate the IRR for the project.

A) 14.5%

B) 18.6%

C) 23.4%

D) 20.2%

26. Valentine Company is considering investing in a new project. The project will need an initial investment of $1,200,000 and will generate $600,000 (after-tax) cash flows for three years. Calculate the MIRR (modified internal rate of return) for the project if the cost of capital is 15%.

A) 14.5%

B) 18.6%

C) 23.4%

D) 20.2%

27. Valentine Company is considering investing in a new project. The project will need an initial investment of $1,200,000 and will generate $600,000 (after-tax) cash flows for three years. Calculate the NPV for the project if the cost of capital is 15%.

A) $169,935

B) $129,211

C) $600,000

D) $125,846

28. A project will have only one internal rate of return if:

A) The net present value is positive

B) The net present value is negative

C) There is a one fifth change in the cash flows

D) The cash flows decline over the life of the project

29. Elephant company is investing in a giant crane. It is expected to cost 2.2 million in initial investment and it is expected to generate an end of year cash flow of 1.0 million each year for three years. Calculate the IRR approximately.

A) 14.6

B) 16.4

C) 22.1

D) 17.3

30. Elephant company is investing in a giant crane. It is expected to cost 2.2 million in initial investment and it is expected to generate an end of year cash flow of 1.0 million each year for three years. Calculate the MIRR for the project if the cost of capital is 12% APR.

A) 15.3%

B) 17.3%

C) 23.8%

D) 22.1%

31. Elephant company is investing in a giant crane. It is expected to cost 2.2 million in initial investment and it is expected to generate an end of year cash flow of 1.0 million each year for three years. Calculate the NPV at 12% (approximately).

A) 2.4 million

B) 0.20 million

C) 0.80 million

D) 0.40 million

32. Given the following cash flow for project A: C0 = -2000, C1 = +500, C2 = +1500 and C3 = +5000, calculate the NPV of the project using a 15% discount rate.

A) $5000

B) $2857

C) $3201

D) $2352

33. Profitability index is the ratio of:

A) Present value of cash flow to initial investment

B) Net present value cash flow to initial investment

C) Net present value of cash flow to IRR

D) Present value of cash flow to IRR

34. Benefit-cost ratio is defined as the ratio of:

A) Present value of cash flow to initial investment

B) Net present value cash flow to initial investment

C) Net present value of cash flow to IRR

D) Present value of cash flow to IRR

35. Profitability index is useful under:

A) Capital rationing

B) Mutually exclusive projects

C) Non-normal projects

D) None of the above

36. The following table gives the available projects for a firm. If the firm has a limit of 210 million to invest, what is the maximum NPV the company can obtain?

A) 200

B) 307

C) 283

D) None of the above

37. The firm has only twenty million to invest. What is the maximum NPV that the company can obtain?

A) 3.5

B) 4.5

C) 4.0

D) None of the above

38. The profitability index can be used for ranking projects under:

A) Soft capital rationing

B) Hard capital rationing

C) Capital rationing at t = 0

D) Both A and B

**True/False Questions**

T F 39. Present values have value additivity property.

T F 40. The payback rule gives equal weight to all cash flows before the payback date and zero weight to subsequent cash flows.

T F 41. The discounted payback rule calculates the payback period and then discounts it at the opportunity cost of capital.

T F 42. The internal rate of return is the discount rate that makes the PV of a project equal to zero.

T F 43. The IRR rule states that firms should accept any project offering an internal rate of return in excess of the cost of capital.

T F 44. In case of a loan project, one should accept the project if the IRR is less than the cost of capital.

T F 45. MIRRs have the value additivity property and IRRs do not.

T F 46. Soft rationing may be used to control managerial behavior.

**Essay Questions**

47. Briefly explain the value additivity property.

48. Discuss some of the advantages of using the payback method.

49. Discuss some of the disadvantages of the payback rule.

50. What are some of the advantages of using the IRR method?

51. What are some of the disadvantages of using the IRR method?

52. In what way is the modified internal rate of return (MIRR) method better than the IRR method?

53. Briefly discuss capital rationing.

54. Briefly explain how linear programming is useful for solving capital rationing problems.

55. Briefly explain the term “soft rationing”

Answers to Chapter 6: Making Investment Decisions with the Net Present Value Rule