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Exam 10: The Basics of Capital Budgeting: Evaluating Cash Flows

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Question 1

True/False

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The NPV and IRR methods, when used to evaluate INDEPENDENT AND EQUALLY RISKY projects, will lead to different accept/reject decisions if their IRRs are greater than the cost of capital.

A) True
B) False

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False

Question 2

Multiple Choice

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Choi Computer Systems is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be less than the WACC (and even negative) , in which case it will be rejected.

A) 13.89%
B) 15.43%
C) 17.15%
D) 19.05%

E) A) and B)
F) None of the above

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Question 3

Multiple Choice

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Westchester Corp. is considering two equally risky, mutually exclusive projects, both of which have normal cash flows. Project A has an IRR of 11%, while Project B's IRR is 14%. When the WACC is 8%, the projects have the same NPV. Given this information, which of the following statements is correct?

Assuming that their NPVs based on the firm's cost of capital are equal, the NPV of a project whose cash flows accrue relatively rapidly will be more sensitive to changes in the discount rate than the NPV of a project whose cash flows come in later in its life.

Which of the following statements best describes multiple IRRs?

The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects that have different lives are being compared.

Because "present value" refers to the value of cash flows that occur at different points in time, a series of present values should not be summed to determine the value of a capital budgeting project.

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.

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?

Yonan Inc. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the shorter payback, some value may be forgone. How much value will be lost in this instance? Note that under some conditions choosing projects on the basis of the shorter payback will not cause value to be lost.

If a firm is experiencing no capital rationing, it should accept all investment proposals whose accounting rate of return is equal to or greater than the weighted average cost of capital.

Selecting the project that has the highest equivalent annual annuity seems to be the rule for comparing projects with different lives. This rule should apply to both independent and mutually exclusive projects.

Mills Corp. is considering two mutually exclusive machines. Machine A requires an up-front expenditure at t = 0 of $450,000, has an expected life of two years, and will generate positive after-tax cash flows of $350,000 per year (all cash flows are realized at the end of the year) for two years. At the end of two years, the machine will have zero salvage value, but every two years the company can purchase a replacement machine with the same cost and identical cash inflows. Alternatively, it can choose Machine B, which requires an expenditure of $1 million at t = 0, has an expected life of four years, and will generate positive after-tax cash flows of $350,000 per year (all cash flows are realized at year-end) . At the end of four years, Machine B will have an after-tax salvage value of $100,000. The cost of capital is 10%. What is the NPV (on an extended four-year life) of the better machine?

Under certain conditions, a project may have more than one IRR. One such condition is when, in addition to the initial investment at time = 0, a negative cash flow (or cost) occurs at the end of the project's life.

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?

Levin Company is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be negative, in which case it will be rejected.

Pinkerton Truck Rental is considering two mutually exclusive engine development projects. The RPX design has an expected life of four years and projected cash inflows are $3.6 million at the end of each of the first two years and $1.8 million in each of the next two years. The RPB design is more flexible and has an eight-year life. The projected end-of-year flows from the RPB design are $2.4 million in each of the first two years and $2.0 million in each of the next six years. Both projects require an initial investment of $5.4 million, and Pinkerton's cost of capital is 12%. What is the NPV (on an eight-year extended basis) of the project with the most value to the company?

Frye Foods is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be negative, in which case it will be rejected.

Garvin Enterprises is considering a project that has the following cash flow and WACC data. What is the project's discounted payback?

Stewart Associates is considering a project that has the following cash flow data. What is the project's payback?