Ch. 5: NPV & Other Investment Criteria Flashcards
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
False:
D) it is a good alternative measure for true profitability compared to NPV
The book rate of return may not be a good measure of true profitability. Why?
The measure essentially provides an average profitability figure for past investments, which is usually not an appropriate hurdle for new investments
Projects that would reduce the company’s current book rate of return are typically scutinized more carefully
True/False
True
Book rate of return depends on which items are treated as CAPEX and how rapidly they are depreciated. Why?
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
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
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)
Book rate of return depends on which items the accountant treat as CAPEX/ OPEX and the adopted depreciation scheme
True/ False
True
Cash flows entail that merits of an investment project do not depend on how accountants classify cash flows
True/ False
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
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
All answers are correct
Why can the payback rule as a measure for investment assessment give misleading answers?
Hint: 2 reasons
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)
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
True
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
All of the above
Why may a manager of a larger corporation adopt the payback rule for investment assessment?
Quicker profits from from rapid payback period projects may lead to faster promotion
Why may owners/ managers of smaller firms adopt the payback rule for investment assessment?
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
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
All options are correct
Yield to maturity is the discount rate that makes the PV of future interest and principal payments equal to a bond’s ____
price
IRR is the discount rate that gives a positive/ negative/ zero NPV
Choose the right option
Zero NPV
What does the IRR rule state as the project acceptance criterium?
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
If the opportunity cost of capital = IRR, the NPV is:
A) negative
B) positive
C) zero
C) zero
If the opportunity cost of capital is higher than IRR, the NPV is:
A) negative
B) positive
C) zero
A) negative
What is the main advantage of the IRR rule when firms are unable to precisely estimate the project’s cost of capital?
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
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
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
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
All are true
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
All are true
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
All are true
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
All are true
In short-lived projects requiring a little up-front investment, the IRR is typically ______
high/ low
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
What is a project’s profitability index?
The project’s NPV per dollar of investment
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
True
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
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.
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
All are true
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?
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
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
False:
D) It is inapplicable when cash flows have multiple signs
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
False: D) market imperfection leading to inability to get access to funding
This is an example of hard rationing
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
True
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
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
