Course Packet Gap Coverage P2 Flashcards
Net Present Value (NPV) is the difference between the market value of a project and its cost.
FALSE
Explain how to calculate NPV for a given project.
NPV is calculated by discounting the future cash flows of a project to their present value using a specific discount rate and subtracting the initial investment.
A positive NPV indicates that a project’s return exceeds the anticipated costs, making it unprofitable.
FALSE
Increasing the discount rate generally increases the NPV of a project.
FALSE
How does NPV compare to other project evaluation techniques like IRR or Payback Period?
NPV provides a dollar value estimation of a project’s profitability, considering the time value of money, unlike the Payback Period. It also provides a more consistent measure of profitability compared to IRR, especially for non-standard cash flows.
The accuracy of NPV highly depends on external market factors such as interest rates and inflation.
FALSE
Describe the concept of incremental cash flows in the context of NPV.
Incremental cash flows are the net additional cash flows expected from a project, representing the difference in the firm’s cash flows with and without the project.
Changes in discount rates have a more significant impact on the NPV of short-term cash flows than long-term ones.
FALSE
What role does risk play in determining the appropriate discount rate for NPV?
Risk influences the choice of discount rate in NPV calculations, with higher risk projects requiring a higher discount rate to account for the uncertainty in cash flows.
NPV is not suitable for comparing two or more investment opportunities when the projects have different durations.
TRUE
The Internal Rate of Return (IRR) is always an accurate measure for decision-making in mutually exclusive projects.
FALSE
IRR is calculated by setting the NPV equal to zero and solving for the discount rate.
TRUE
What is the decision rule based on IRR for accepting or rejecting a project?
A. Accept if IRR > cost of capital; Reject if IRR < cost of capital
In what ways is IRR different from NPV?
IRR is a rate of return measure, while NPV gives the actual dollar value of the project. IRR does not consider the scale of investment, whereas NPV does.
How does IRR help in comparing different projects?
IRR helps to understand the efficiency of the investment by providing a percentage return, making it easier to compare projects of different sizes.
What are the limitations of using IRR for project evaluation?
D. All of the above
How do multiple IRRs occur and how are they interpreted?
Multiple IRRs occur in projects with unconventional cash flows and are interpreted as the project having different rates of return depending on the investment period.
Explain the concept of the reinvestment rate assumption in IRR.
The reinvestment rate assumption in IRR is that future cash flows from the project are reinvested at the IRR itself, which might not be realistic.
How can IRR be used for ranking projects in terms of profitability?
IRR can rank projects by their percentage return, allowing investors to see which projects yield the highest return on a percentage basis.
Describe the scenario where IRR and NPV might give conflicting signals.
D. All of the above
What is the payback period in capital budgeting?
The payback period is the time it takes for the initial investment of a project to be recovered from the cash inflows generated by the project.
How is the payback period calculated?
The payback period is calculated by adding up the project’s cash inflows until the initial investment amount is fully recovered.
What are the advantages of using the payback period as a project evaluation tool?
Advantages include simplicity, ease of understanding, and focus on liquidity and risk.
