Chapter 10 Present Value and Internal Rate of Return

Question 1

Define the time value of money.

Answer 1

The time value of money is the concept that a rate of return can be expected from capital invested over a period of time.

Question 2

Why is the internal rate of return used and what is it particularly adaptable to?

Answer 2

The IRR is used to know the actual rate of return on an investment. It is particularly adaptable to evaluating irregular income streams.

Question 3

Define Net Present Value.

Answer 3

The Net Present Value is the difference between the present value of capital outlays and the present value of all future cash benefits.

initial investment subtracted from the present value

Question 4

An investment of $250,000 generated the following annual cash flows. Calculate the net present value if the expected rate of return is 13%.

Year 1 $35,000
Year 2 $42,000
Year 3 $45,000
Year 4 $38,000
Year 5 $40,000
Year 6 $51,000
Year 7 $57,000
Year 8 $53,000
Year 9 $48,000
Year 10 $ 310,000

Answer 4

$66,031.41

Question 5

What is the internal rate of return given an investment of $250,000 generated the following annual cash flows if the expected rate of return is 13%.

Year 1 $35,000
Year 2 $42,000
Year 3 $45,000
Year 4 $38,000
Year 5 $40,000
Year 6 $51,000
Year 7 $57,000
Year 8 $53,000
Year 9 $48,000
Year 10 $ 310,000

Answer 5

17.6

Question 6

Which is a component of a cash return on an investment?

a. earned interest
b. principal amount
c. down payment
d. sales proceeds

Answer 6

a. earned interest

Question 7

At the end of one year, an investment balance is $440. Given an interest rate of 10%, the present value of the investment is:

a. $484
b. $440
c. $400
d. $40

Answer 7

c. $400

Question 8

Which symbol designates the initial investment in an internal rate of return calculation?

a. [CFo]
b. [N]
c. [CFj]
d. [I]

Answer 8

c. [CFj]

Question 9

Based on the following information below, what is the present value of the investment’s future cash flows?

Initial investment $375,000
Expected rate of return 14.5%
Annual cash flows
Year 1 $40,000
Year 2 $47,000
Year 3 $50,000
Year 4 $46,000
Year 5 $49,000
Year 6 $58,000
Year 7 $55,000
Year 8 $51,000
Year 9 $53,000
Year 10 $415,000

Answer 9

$32,107.76

Question 10

The present value of an income stream of future cash flows will increase if the:

a. down payment is increased
b. sales price is increased
c. annual cash flows are decreased
d. expected rate of return is increased

Answer 10

b. sales price is increased

Question 11

Which component in a real estate sensitivity analysis has the greatest effect on the internal rate of return calculation?

a. down payment
b. annual cash flows
c. sales price
d. interest rate

Answer 11

a. down payment

Question 12

Negative cash flows in a stream of future cash flows imply that:

a. the investment will generate a loss
b. internal rate of return analysis cannot be used
c. borrowing must occur
d. the investment should not be made

Answer 12

c. borrowing must occur

Question 13

Investors expect to be compensated for taking an increased risk in real estate investment by an increase in the:

a. rate of return
b. sales proceeds
c. holding period
d. amount of the investment

Answer 13

a. rate of return

Question 14

What is the present value?

Answer 14

The discounted value of a stream of future cash flows computed at an expected rate of return.

Question 15

When is the internal rate of return greater than the expected rate of return?

Answer 15

When the present value component (cash flows) is greater than the initial investment.

Question 16

What is the present value of an investment opportunity with an interest rate of 10% that is projected to earn $40 interest and be worth $440 at the end of one year?

Answer 16

$400

Question 17

Calculate the NPV of the investment’s future cash flow if the initial investment was $375,000 with an expected 14.5% rate of return and annual cash flows as follows:

Year 1 $40,000
Year 2 $47,000
Year 3 $50,000
Year 4 $46,000
Year 5 $49,000
Year 6 $58,000
Year 7 $ 55,000
Year 8 $51,000
Year 9 $53,000
Year 10 $415,000

Answer 17

-$32,107.76

Question 18

What can be said about the expected rate of return for an investment if the initial investment was $200,000 and the present value is $185,000?

Answer 18

The expected rate of return on the investment was not achieved.

Question 19

Calculate the internal rate of return on an investment of $250,000 at a 13% expected rate of return and annual cash flows as follows:

Year 1 $35,000
Year 2 $42,000
Year 3 $45,000
Year 4 $38,000
Year 5 $40,000
Year 6 $51,000
Year 7 $ 57,000
Year 8 $53,000
Year 9 $48,000
Year 10 $310,000

Answer 19

17.6%

Question 20

When does the IRR become disproportionately large?

Answer 20

When the equity contribution to a project is small relative to the level of financing the IRR become disproportionately large and is not a fair measure of performance

Question 21

Which investment alternative is likely to generate uniform, conservative future cash flows?

Answer 21

One which pays a simple fixed interest rate for a period of years,

Question 22

What will happen to the net present value of a stream of future cash flows if the down payment is increased?

Answer 22

It will decrease.

Question 23

If the sales price is increased what will happen to the present value of a stream of future cash flows?

Answer 23

It will increase.

Question 24

How do investors expect to be compensated for their investment risk?

Answer 24

By a higher IRR.