Ch 07: Investment Decision Rules

Question 1

When resources are limited you should select the projects with the:

highest payback period

lowest IRR

highest NPV

Answer 1

highest NPV

Question 1

An NPV profile is __________

Answer 1

a graph of a project’s NPV over a range of different discount rates

Question 2

According to the IRR investment rule you should —– any project where the IRR —— the cost of capital.

Answer 2

accept; exceeds

Question 3

net present value decision rule

Answer 3

According to the net present value decision rule, you should accept any project with a positive NPV. Any project with a positive NPV makes at least the minimum required return.

Question 4

profitability index

Answer 4

NPV / initial investment

Question 5

Software Design Inc. is considering a number of capital budgeting projects. However, the company is currently constrained by the number of programmers that it employs. The company has 20 programmers on its staff and will not be able to hire any new programmers in the near future. Which of the following methods should the company use to choose which projects to accept?

Rank the projects based on payback period and select the shortest paybacks.

Rank the projects based on IRR and select the highest IRRs.

Rank the projects based on profitability index (PI) and select the highest PIs.

Answer 5

Rank the projects based on profitability index (PI) and select the highest PIs.

Software Design, Inc. is considering a number of capital budgeting projects. However, the company is currently constrained by the number of programmers that it employs. The company has 20 programmers on its staff and will not be able to hire any new programmers in the near future. The company should choose which projects to accept by ranking the projects based on profitability index (PI) and selecting the highest PIs.

When you are resource constrained, the PI will give you a metric that tells you how much “bang for the buck” you get. In this case, you would generate a PI that gives you the amount of NPV per programmer and select the highest ones until you have allocated 20 programmers.

The payback period and the IRR do not take into consideration the resource shortage you face. In this case, it is a skilled labor shortage and you need to select the projects that give the highest return per unit of skilled labor.

Question 6

Projects that do not compete with one another so that the acceptance of one project will have no bearing on the acceptance of other projects being considered by the firm are known as;

Answer 6

stand-alone projects

(Accepting an independent project does not automatically reject a competing project so the accept/reject decision is a stand-alone decision.)

Question 7

Mutually exclusive projects

Answer 7

Mutually exclusive projects are projects where the acceptance of one project automatically means we are rejecting other options.

Question 9

Unlike the IRR criteria, the NPV approach assumes an interest rate equal to the:

Answer 9

firm’s cost of capital

The NPV uses the firm’s cost of capital to discount the project cash flows back to the present. Therefore, any positive NPV project earns at least the firm’s cost of capital.

The market rate of interest can be quite different depending on the riskiness of the firm’s business activities and the project’s internal rate of return is the discount rate that makes the project’s NPV = 0. This rate will likely have no resemblance to the firm’s cost of capital for most projects.

Question 10

The payback investment rule states that the firm should only invest in projects that will generate sufficient cash flows to pay back the initial investment within;

Answer 10

a prespecified period of time

Question 11

If your objective is to maximize wealth, the ____ rule always gives the correct answer.

Answer 11

NPV

Question 12

The difference between the cost of capital and the IRR is:

Answer 12

the maximum amount of estimation error that can exist in the cost of capital estimate without altering the original decision

Question 13

IRR investment rule:

Answer 13

Take any investment opportunity whose IRR exceeds the opportunity cost of capital. Turn down any opportunity whose IRR is less than the opportunity cost of capital.

Question 14

Why may we be cautious about the IRR rule?

Answer 14

Unless all of the negative cash flows of the project precede the positive ones, the IRR rule may give the wrong answer and should not be used. Furthermore, there may be multiple IRRs or the IRR may not exist

Question 15

Payback investment rule:

Answer 15

Calculate the amount of time it takes to pay back the initial investment (the payback period). If the payback period is less than a prespecified length of time, accept the project. Otherwise, turn it down.

Question 16

Pro and con of the payback rule

Answer 16

The payback rule is simple, and favors short-term investments. But it is often incorrect.

Question 17

When choosing among mutually exclusive investment opportunities, pick the opportunity with the highest ___

Answer 17

NPV

Question 18

We cannot use the IRR to compare investment opportunities unless the investments have the same ___, ____, and ___

Answer 18

scale, timing, and risk

Question 19

Incremental IRR:

Answer 19

When comparing two mutually exclusive opportunities, the incremental IRR is the IRR of the difference between the cash flows of the two alternatives. The incremental IRR indicates the discount rate at which the optimal project choice changes.

Question 20

When choosing among projects competing for the same resource…

Answer 20

, rank the projects by their profitability indices and pick the set of projects with the highest profitability indices that can still be undertaken given the limited resource.

Question 21

When is the profitability index completely reliable

Answer 21

The profitability index is only completely reliable if the set of projects taken following the profitability index ranking completely exhausts the available resource and there is only a single relevant resource constraint.