CHAPTER 7

Question 1

NPV is positive only for discount rates greater than the internal rate of return.

Answer 1

NO

Question 2

To decide whether to invest using the NPV rule, we need to know the cost of capital.

Answer 2

YES

Question 3

About 75% of firms surveyed used the NPV rule for making investment decisions.

Answer 3

YES

Question 4

If you are unsure of your cost of capital estimate, it is important to determine how sensitive your analysis is to errors in this estimate.

Answer 4

YES

Question 5

The IRR can provide information on how sensitive your analysis is to errors in
the estimate of your cost of capital.

Answer 5

YES

Question 6

In general, the difference between the cost of capital and the IRR is the maximum
amount of estimation error in the cost of capital estimate that can exist without
altering the original decision.

Answer 6

YES

Question 7

If you are unsure of your cost of capital estimate, it is important to determine
how sensitive your analysis is to errors in this estimate.

Answer 7

YES

Question 8

If the cost of capital estimate is more than the IRR, the NPV will be positive.

Answer 8

NO

Question 9

Assuming that Dewey’s cost of capital is 12% EAR, then the number of potential IRRs that exist for this problem is equal to 1.

Answer 9

YES

Question 10

The IRR investment rule states that you should take any investment opportunity
where the IRR exceeds the opportunity cost of capital.

Answer 10

YES

Question 11

The IRR investment rule states you should turn down any investment opportunity where the IRR is less than the opportunity cost of capital.

Answer 11

YES

Question 12

There are situations in which multiple IRRs exist.

Answer 12

YES

Question 13

Since the IRR rule is based upon the rate at which the NPV equals zero, like the
NPV decision rule, the IRR decision rule will always identify the correct investment decisions.

Answer 13

NO

Question 14

When using the internal rate of return (IRR) investment rule, we compare the NPV of the investment opportunity to the average return on the investment
opportunity.

Answer 14

NO

Question 15

When using the internal rate of return (IRR) investment rule, we compare the average return on the investment opportunity to returns on all other
investment opportunities in the market.

Answer 15

NO

Question 16

When using the internal rate of return (IRR) investment rule, we compare the average return on the investment opportunity to the risk-free rate of return.

Answer 16

NO

Question 17

When using the internal rate of return (IRR) investment rule, we compare the average return on the investment opportunity to returns on other alternatives
in the market with equivalent risk and maturity.

Answer 17

YES

Question 18

In general, there can be as many IRRs as the number of times the project’s cash
flows change sign over time.

Answer 18

YES

Question 19

A NPV will always exist for an investment opportunity.

Answer 19

YES

Question 20

An IRR will always exist for an investment opportunity.

Answer 20

NO

Question 21

The payback investment rule is based on the notion that an opportunity that
pays back its initial investments quickly is a good idea.

Answer 21

YES

Question 22

For most investment opportunities expenses occur initially and cash is received
later.

Answer 22

YES

Question 23

Fifty percent of firms surveyed reported using the payback rule for making
decisions.

Answer 23

YES

Question 24

The payback rule is useful in cases where the cost of making an incorrect
decision might not be large enough to justify the time required for calculating the
NPV.

Answer 24

YES

Question 25

The payback rule is reliable because it considers the time value of money and
depends on the cost of capital.

Answer 25

NO

Question 26

Problems can arise using the IRR method when the mutually exclusive
investments have different cash flow patterns.

Answer 26

YES

Question 27

Multiple incremental IRRs might exist.

Answer 27

YES

Question 28

The incremental IRR rule assumes that the riskiness of the two projects is the same.

Answer 28

YES

Question 29

The IRR is affected by the scale of the investment opportunity.

Answer 29

NO

Question 30

Picking one project over another simply because it has a larger IRR can lead to
mistakes.

Answer 30

YES

Question 31

When the risks of two projects are different, only the NPV rule will give a
reliable answer.

Answer 31

YES

Question 32

Problems arise using the IRR method when the mutually exclusive investments
have differences in scale.

Answer 32

YES

Question 33

When using the incremental IRR rule, you must keep track of which project is the
incremental project and ensure that the incremental cash flows are initially positive and then become negative.

Answer 33

NO

Question 34

Consider two mutually exclusive projects A & B. If you subtract the cash flows of opportunity B from the cash flows of opportunity A, then you should take opportunity A if the regular IRR exceeds the cost of capital.

Answer 34

NO

Question 35

Consider two mutually exclusive projects A & B. If you subtract the cash flows of opportunity B from the cash flows of opportunity A, then you should take opportunity B if the incremental IRR exceeds the cost of capital.

Answer 35

NO

Question 36

Consider two mutually exclusive projects A & B. If you subtract the cash flows of opportunity B from the cash flows of opportunity A, then you should take opportunity B if the regular IRR exceeds the cost of capital.

Answer 36

NO

Question 37

Consider two mutually exclusive projects A & B. If you subtract the cash flows of opportunity B from the cash flows of opportunity A, then you should take opportunity A if the incremental IRR exceeds the cost of capital.

Answer 37

YES

Question 38

The profitability index is calculated as the NPV divided by the resources
consumed by the project.

Answer 38

YES

Question 39

If there is a fixed supply of resources available, so that you cannot undertake all
possible opportunities, then simply picking the highest NPV opportunity might
not lead to the best decision.

Answer 39

YES

Question 40

Practitioners often use the profitability index to identify the optimal combination
of projects when there is a fixed supply of resources.

Answer 40

YES

Question 41

If there is a fixed supply of resource available, you should rank projects by the
profitability index, selecting the project with the lowest profitability index first and working your way down the list until the resource is consumed.

Answer 41

NO

Question 42

You are opening up a brand new retail strip mall. You presently have more potential retail outlets wanting to locate in your mall than you have space available. Profitability index is the most appropriate tool to use if you are trying to determine the optimal allocation of your retail space.

Answer 42

YES