Net Present Value and Other Investment Criteria
Question 1. An investment project requires an initial investment of $400 and produces a cash inflow of $460 in 1 year. The internal rate of return (IRR) on this project is 15%. If the cost of capital is 10%, then the NPV of the project is
A) greater than zero
B) less than zero
C) equal to zero
Question 2. Consider a project with an initial investment and positive future cash flows. As the discount rate is decreased,
a. the IRR remains constant while the NPV increases.
b. the IRR decreases while the NPV remains constant.
c. the IRR remains constant while the NPV decreases.
d. the IRR increases while the NPV remains constant.
e. the IRR decreases while the NPV increases.
Question 3. You are presented with the following information on two mutually exclusive projects.
Period: 0 1 2 3 IRR NPV 23.4% $3.498 9
Period 0 1 2 3 IRR NPV
Project A -50 +25 +25 +25 23.4% $3.498
Project B -20 +11.5 +11.5 +11.5 33.1% $4.609
If we use NPV as the decision rule:
a. Accept project A and B
b. Reject project A, and B
c. Reject project A and B
d. Reject project A, Accept B
e. Accept project A, Reject B
Question 4. An investment has a cost of $20M. Given the following cash flow estimates, calculate the projects payback period (we assume CF's occur throughout the year).
Year Cash Flow
1 $10
2 $15
3 $30
a. 1.8 years
b. 2.0 years
c. 1.67 years
d. 1.96 years
e. 2.40 years
Question 5. The Ford Motor Company selects projects based on one criterion, whether projects increase the dollar value of the firm. Which of the following criteria does Ford use in its analysis?
a. internal rate of return
b. payback period
c. net present value
d. average accounting return
e. profitability index
Question 6. Which of the following statements is false with regard to estimating cash flows for capital budgeting purposes?
a. Cash flows should be measured on an after tax basis.
b. Financing costs should be incorporated into the estimation of cash flows.
c. Cash flows should be estimated on an incremental basis.
d. Cash flows must incorporate depreciation, even though depreciation is a non-cash expense.
Question 7. What is the IRR of an investment that costs $77,500 and pays $27,500 a year for 5 years:
a. 22.75%
b. 16.54%
c. 20.00%
d. 22.49%
e. 23.56%
Question 8. A project with conventional cash flows has an NPV of $300. The cost of capital for this project is 15%. Intuitively, which of the following could be the IRR for this project?
a. 10%
b. 12%
c. 13.5%
d. 17.0%
e. cannot be determined
9-11: Your best friend graduated from UMKC five years ago, and after paying back student loans, she finally has some money to invest. There are two investment opportunities that her dad has told her about, and you are trying to help her decide between the two. Investment A requires her to invest $2,000 today, and investment B requires $3,500. The cash flows for these two investments are likely to be as follows:
Year Investment A Investment B
1 0 600
2 750 800
3 750 800
4 750 1,000
5 250 1,000
6 250 2,000
Question 9. What are the payback periods for Investments A and B (we assume CF's occur throughout the year)?
Question 10. If you require a rate of return of 15%, what is the NPV of each investment?
Question 11. Which project would you choose? Why?
12-16: Due to increasing demand for amusement parks in Missouri, Mr. Entrepreneur is choosing between two projects to build an amusement park in lower Missouri. The initial outlay for the theme park planned in Lake Ozark is $50 million, while for the Flushing amusement park, the initial outlay is $100 million. The cost of capital is 10 percent. After-tax cash flows (in millions of dollars) for each project are as follows:
Year Lake Fenton Flushing
1 25 35
2 20 35
3 15 30
4 5 30
5 5 15
6 5 5
Question 12. What is the IRR for each project?
Question 13. What is the NPV for each project?
Question 14. Using the IRR rule, which project should you choose?
Question 15. Do you see any problem with this choice? Explain.
Question 16. What is the crossover rate?
17-18: You are pitching a project to your boss that has the following cash flows. Your boss is a big believer in the profitability index (PI).
Year Cash Flow
0 -$500,000
1 100,000
2 75,000
3 150,000
4 150,000
5 100,000
6 200,000
Question 17. What is the profitability index if the discount rate is 12%? Should you accept the project using the PI decision rule?
Question 18. What is the profitability index if the discount rate is 18%? Should you accept the project using the PI decision rule?