Ch. 5: NPV & Other Investment Criteria

Question 1

Following statement is NOT true about book rate of return:
A) book/ accounting rate of return looks at the prospective book income from the investment relative to the book value of the investment
B) calculated as book value of income divided by book value of assets
C) the book rate of return is typically compared to the book rate of return that the firm is currently earning
D) it is a good alternative measure for true profitability compared to NPV
E) it is a relevant measure since shareholders pay considerable attention to book measures of profitability

Answer 1

False:
D) it is a good alternative measure for true profitability compared to NPV

Question 2

The book rate of return may not be a good measure of true profitability. Why?

Answer 2

The measure essentially provides an average profitability figure for past investments, which is usually not an appropriate hurdle for new investments

Question 3

Projects that would reduce the company’s current book rate of return are typically scutinized more carefully

True/False

Answer 3

True

Question 4

Book rate of return depends on which items are treated as CAPEX and how rapidly they are depreciated. Why?

Answer 4

The book income (numerator of the book rate of return) label some cash outflow as CAPEX and others as OPEX. The two expenses are treated differently, and therefore, the ratio depends on how accountants classify the cash flows

Question 5

Following statement is true about CAPEX:
A) it is deducted immediately form each year’s income
B) it is put on the balance sheet and depreciated, with the annual depreciation charge being deducted from each year’s income

Answer 5

B)
CAPEX is put on the balance sheet and depreciated, with the annual depreciation charge being deducted from each year’s income

OPEX is deducted immediately from each year’s income (A)

Question 6

Book rate of return depends on which items the accountant treat as CAPEX/ OPEX and the adopted depreciation scheme

True/ False

Answer 6

True

Question 7

Cash flows entail that merits of an investment project do not depend on how accountants classify cash flows

True/ False

Answer 7

True

Due to the opposite being the case for book income, the book rate of return is seldomly used as the exclusive measure for determining whether to pursue investment decisions

Question 8

Following statement is NOT true about the payback period criterium
A) project payback period is found by counting the number of years it takes before the cumulative cash flow equals the initial investment
B) the payback rule states that a project should be accepted if its payback period is lower than some specified cut-off period
C) the payback should never be the driving measure for investment assessment
D) Regardless of cut-off period, the payback rule tends to give different answers from the NPV rule

Answer 8

All answers are correct

Question 9

Why can the payback rule as a measure for investment assessment give misleading answers?

Hint: 2 reasons

Answer 9

1) The payback rule ignores CFs after the cut-off date, regardless of size of the beyond cash flows

2) the payback rule gives equal weight to all CFs before the cut-off date, thus disregarding the year in which the larger CFs occur (i.e., neglects time value of money)

Question 10

To use the payback rule, a firm must decide on an appropriate cut-off date: If the same cut-off is used regardless of project life, the firm will tend to accept many poor short-lived projects and reject many good long-lived ones.

True/ False

Answer 10

True

Question 11

Why may the pay-back period measure adopted in practice in light of its limitations?

A) it is a simple way to communicate and understand the profitability of a project
B) managers of larger corporations may opt for project with short paybacks due to quicker profits leading to quicker promotion
C) smaller firms with limited access to capital may worry about their future ability to raise capital, and thus favor rapid payback projects, even thought long-term ventures may have higher NPVs

Answer 11

All of the above

Question 12

Why may a manager of a larger corporation adopt the payback rule for investment assessment?

Answer 12

Quicker profits from from rapid payback period projects may lead to faster promotion

Question 13

Why may owners/ managers of smaller firms adopt the payback rule for investment assessment?

Answer 13

Smaller firms may have difficulty in capital raise, and worry about their future ability to raise capital may lead them to favor rapid payback projects even though long-term ventures may have higher NPV

Question 14

Which of the following statements are true about discounted payback method for investment assessment?

A) cashflows are discounted before the payback period is computed
B) it asks how many years a project has to last in order to generate positive NPV
C) different from the payback period rule, it will not accept a negative NPV project
D) like the payback period rule, it still takes no account for CFs after the cut-off date
E) Long-term projects are rejected if the discounted payback period exceeds the determined cut-off date

Answer 14

All options are correct

Question 15

Yield to maturity is the discount rate that makes the PV of future interest and principal payments equal to a bond’s ____

Answer 15

price

Question 16

IRR is the discount rate that gives a positive/ negative/ zero NPV

Choose the right option

Answer 16

Zero NPV

Question 17

What does the IRR rule state as the project acceptance criterium?

Answer 17

IRR Rule: firms should accept an investment project if the opportunity cost of capital is lower than the IRR, because this implies a positive NPV when discounted at the opportunity cost of capital

Question 18

If the opportunity cost of capital = IRR, the NPV is:
A) negative
B) positive
C) zero

Answer 18

C) zero

Question 19

If the opportunity cost of capital is higher than IRR, the NPV is:
A) negative
B) positive
C) zero

Answer 19

A) negative

Question 20

What is the main advantage of the IRR rule when firms are unable to precisely estimate the project’s cost of capital?

Answer 20

When firms are unable to precisely estimate the project cost of capital, the IRR rule helps managers be more confident that the project will generate positive NPV as long as the actual discount rate turns out to be lower than IRR

Question 21

In which cases is the IRR rule inapplicable (pitfalls of the IRR rule)?
A) Multiple rates of return/ no IRR
B) Less useful in case of lending or borrowing
C) Mutually exclusive projects
D) Very long payback periods
E) When there is more than one opportunity cost of capital

Answer 21

A) Multiple rates of return/ no IRR
B) Less useful in case of lending or borrowing
C) Mutually exclusive projects
E) When there is more than one opportunity cost of capital

Question 22

Related to Pitfall 1 of the IRR rule: Lending or borrowing, which of the following statements are true?
A) The IRR rule does not work properly in cases of lending or borrowing
B) If a project entails lending, the higher the IRR, the higher the NPV
C) If a project entails borrowing, the lower the IRR, the higher the NPV due to lower borrowing expenses

Answer 22

All are true

Question 23

Related to Pitfall 2 of the IRR rule: multiple rates of return/ no IRR, which of the following statements are true?
A) Descarte’s rule of signs: there can be as many different solutions to a polynomial as there are changes of signs
B) there can be as many IRRs for a project as there are changes in the sign of CFs
C) The IRR rule does not work when there is no IRR that results in an NPV of zero
D) In cases of multiple/no IRRs, the NPV rule is the simplest and most accurate solution

Answer 23

All are true

Question 24

Related to Pitfall 3 of the IRR rule: mutually exclusive projects, which of the following statements are true?
A) The IRR rule may be misleading when firms have to choose between mutually exclusive projects (often the case)
B) Unless when looking at incremental expenditure, IRR is unreliable in ranking projects of different scales
C) IRR rule is unreliable in ranking projects with different patterns of CFs over time
D) Relying on the IRR rule, one project may have a higher IRR, but the other may have higher NPV

Answer 24

All are true

Question 25

Related to Pitfall 4 of the IRR rule: when there is more than one opportunity cost of capital, which of the following statements are true?
A) It is difficult to compare multiple opportunity costs with IRR, and one would have to compute a complex weighted average of these rates to obtain a number comparable to IRR
B) The diff. between short- and long-term discount rates can be important when the term structure of interest rates is not flat
C) The extra precision from building the term structure of discount rates into discount rates for risky capital investments is rarely worth the trouble
D) The gains from accurately forecasting project cash flows far outweigh the gains from more precise discounting, wherefore the IRR usually survives even when term structure is not flat

Answer 25

All are true

Question 26

In short-lived projects requiring a little up-front investment, the IRR is typically ______

high/ low

Answer 26

In short-lived projects requiring a little up-front investment, the IRR is typically HIGH

Note that such projects may not add much value to the firm, rendering the IRR rule sometimes being inferior to the NPV rule

Question 27

What is a project’s profitability index?

Answer 27

The project’s NPV per dollar of investment

Question 28

If capital is rationed in only one period, the firm should calculate each potential project’s profitability index, which is the project’s net present value per dollar of investment. Then pick the projects with the highest profitability indexes until you run out of capital.

True/ False

Answer 28

True

Question 29

If capital is rationed in more than one period, the firm should calculate each potential project’s profitability index, which is the project’s net present value per dollar of investment. Then pick the projects with the highest profitability indexes until you run out of capital.

True/ False

Answer 29

Unfortunately, the explained procedure fails when capital is rationed in more than one period or when there are other constraints on project choice. The only general solution is linear programming.

Question 30

Following statement are true about the profitability index:
A) When money is limited, firms should not choose between projects based solely on NPV
B) When money is limited, firms need to concentrate on picking the projects that offer the highest NPV per dollar of initial outlay
C) If a project has a positive profitability index, it must also have a positive NPV
D) The measure can be misleading when firms need to choose between mutually exclusive projects

Answer 30

All are true

Question 31

Project A entails investment of $100 and offers PV pay-off of $200

Project B entails $1m investment offering a PV pay-off of $1.5m

Which investment has a higher profitability index?
Which investment generates the superior monetary payoff?

Answer 31

Profitability index:

PI(A)= 200/100=2
PI(B)= 1m/1.5m=0.6667

PI(A)>PI(B)

Superior monetary payoff:
A = 200-100=100
B = 1.5m - 1m =500k

B>A

Question 32

Which of the following statements are NOT a limitation of the profitability index?
A) The index breaks down whenever more than one resource is rationed
B) the measure is inadequate when projects are mutually exclusive and if they are dependent on another
C) It may be better to spend all available cash, even if it involves accepting a project with a slightly lower PI
D) It is inapplicable when cash flows have multiple signs

Answer 32

False:
D) It is inapplicable when cash flows have multiple signs

Question 33

Which of the following cases is not an example of “soft rationing”?
A) when rationing doesn’t reflect imperfect financial markets, but are provisional limits adopted by management as an aid to financial control
B) Upper limit on divisional expenditure imposed by HQ forcing divisions to set priorities
C) lack of managerial time
D) market imperfection leading to inability to get access to funding

Answer 33

False: D) market imperfection leading to inability to get access to funding

This is an example of hard rationing

Question 34

Soft rationing should never cost the firm anything. If capital constraints become tight enough to hurt—in the sense that projects with significant positive NPVs are passed up—then the firm raises more money and loosens the constraint.

True/ false

Answer 34

True

Question 35

Which of the following statements are NOT true about “hard rationing”?
A) It refers to when additional needed capital to invest in positive NPV projects cannot be raised due to market imperfections
B) It leads to the NPV criterion no longer being useful
C) The NPV rule is undermined when market imperfections restrict shareholders’ portfolio choice
D) Hard rationing is rare for corporations in US

Answer 35

False: B) It leads to the NPV criterion no longer being useful

It does not necessarily mean that the NPV criterion for capital budgeting shall be disregarded as long as shareholders have free access to well-functioning financial markets