Capital Budgeting Concepts and Applications part 1

Question 1

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. A project’s MIRR is always greater than its regular IRR.
b. A project’s MIRR is always less than its regular IRR.
c. If a project’s IRR is greater than its WACC, then the MIRR will be less than the
IRR.
d. If a project’s IRR is greater than its WACC, then the MIRR will be greater than the
IRR.
e. To find a project’s MIRR, we compound cash inflows at the IRR and then discount
the terminal value back to t = 0 at the WACC.

Answer 1

c. If a project’s IRR is greater than its WACC, then the MIRR will be less than the
IRR.

Question 2

A company is considering a new project. The CFO plans to calculate the project’s NPV by
estimating the relevant cash flows for each year of the project’s life (i.e., the initial
investment cost, the annual operating cash flows, and the terminal cash flow), then
discounting those cash flows at the company’s overall WACC. Which one of the following
factors should the CFO be sure to INCLUDE in the cash flows when estimating the
relevant cash flows?

a. All sunk costs that have been incurred relating to the project.
b. All interest expenses on debt used to help finance the project.
c. The investment in working capital required to operate the project, even if that
investment will be recovered at the end of the project’s life.
d. Sunk costs that have been incurred relating to the project, but only if those costs
were incurred prior to the current year.
e. Effects of the project on other divisions of the firm, but only if those effects lower
the project’s own direct cash flows.

Answer 2

c. The investment in working capital required to operate the project, even if that
investment will be recovered at the end of the project’s life.

Question 3

Rowell Company spent $3 million two years ago to build a plant for a new product. It then
decided not to go forward with the project, so the building is available for sale or for a new
product. Rowell owns the building free and clear¾there is no mortgage on it. Which of the
following statements is CORRECT?

a. Since the building has been paid for, it can be used by another project with no
additional cost. Therefore, it should not be reflected in the cash flows for any new
project.
b. If the building could be sold, then the after-tax proceeds that would be generated by
any such sale should be charged as a cost to any new project that would use it.
c. This is an example of an externality, because the very existence of the building
affects the cash flows for any new project that Rowell might consider.
d. Since the building was built in the past, its cost is a sunk cost and thus need not be
considered when new projects are being evaluated, even if it would be used by
those new projects.
e. If there is a mortgage loan on the building, then the interest on that loan would have
to be charged to any new project that used the building.

Answer 3

b. If the building could be sold, then the after-tax proceeds that would be generated by
any such sale should be charged as a cost to any new project that would use it.

Question 4

measures the amount by which the value of the firm’s stock will
increase if the project is accepted.

Answer 4

NPV

Question 5

If NPV > 0, then you ________ the project.

Answer 5

accept

Question 6

If NPV < 0, then you ________ the project.

Answer 6

reject

Question 7

If you have several mutually exclusive projects A, B, C, you Choose the project with the _______ NPV

Answer 7

highest