Practice Problems Chapter 11

(11-5) Reinvestment rate assumption 1. FI Answer: a EASY The NPV method's assumption that cash inflows are reinvested at the cost of capital is generally more reasonable than the IRR's assumption that cash flows are reinvested at the IRR. This is an important reason why the NPV method is generally preferred over the IRR method. a. True b. False (11-6) Modified IRR 2. FI Answer: a EASY

For a project with one initial cash outflow followed by a series of positive cash inflows, the modified IRR (MIRR) method involves compounding the cash inflows out to the end of the project's life, summing those compounded cash flows to form a terminal value (TV), and then finding the discount rate that causes the PV of the TV to equal the project's cost. a. True b. False

(11-3) IRR 3.

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Answer: e EASY

Which of the following statements is CORRECT? a. One defect of the IRR method is that it does not take account of cash flows over a projects full life. b. One defect of the IRR method is that it does not take account of the time value of money. c. One defect of the IRR method is that it does not take account of the cost of capital. d. One defect of the IRR method is that it values a dollar received today the same as a dollar that will not be received until sometime in the future. e. One defect of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid.

(Comp.) Ranking methods 4.

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Answer: b EASY

Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT? a. A projects IRR increases as the WACC declines. b. A projects NPV increases as the WACC declines. c. A projects MIRR is unaffected by changes in the WACC. d. A projects regular payback increases as the WACC declines. e. A projects discounted payback increases as the WACC declines.

(11-4) Multiple IRRs 5.

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Answer: d MEDIUM

Which of the following statements is CORRECT? a. For a project to have more than one IRR, then both IRRs must be greater than the WACC. b. If two projects are mutually exclusive, then they are likely to have multiple IRRs. c. If a project is independent, then it cannot have multiple IRRs. d. Multiple IRRs can only occur if the signs of the cash flows change more than once. e. If a project has two IRRs, then the smaller one is the one that is most relevant, and it should be accepted and relied upon.

(11-5) NPV vs. IRR 6.

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Answer: e MEDIUM

Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a 4-year payback regardless of economic conditions. Other things held constant, which of the following statements is most likely to be true? a. It will accept too many short-term projects and reject too many long-term projects (as judged by the NPV).

b. It will accept too many long-term projects and reject too many short-term projects (as judged by the NPV). c. The firm will accept too many projects in all economic states because a 4year payback is too low. d. The firm will accept too few projects in all economic states because a 4year payback is too high. e. If the 4-year payback results in accepting just the right set of projects under average economic conditions, then this payback will result in too few long-term projects when the economy is weak.

(Comp.) NPV, IRR, and MIRR 7.

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Answer: a MEDIUM

Which of the following statements is CORRECT? a. If a project with normal cash flows has an IRR greater than the WACC, the project must also have a positive NPV. b. If Project As IRR exceeds Project Bs, then A must have the higher NPV. c. A projects MIRR can never exceed its IRR. d. If a project with normal cash flows has an IRR less than the WACC, the project must have a positive NPV. e. If the NPV is negative, the IRR must also be negative.

(11-2) NPV 8.

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Answer: c EASY

Tuttle Enterprises is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that if a project's projected NPV is negative, it should be rejected. WACC: 11.00%

Year Cash flows

0 -$1,000

1 $350

2 $350

3 $350

4 $350

a. $77.49 b. $81.56 c. $85.86 d. $90.15 e. $94.66

(11-3) IRR 9.

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Answer: d EASY

Warr Company is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be less than the WACC or negative, in both cases it will be rejected. Year Cash flows a. 14.05% b. 15.61% c. 17.34% d. 19.27% e. 21.20% 0 -$1,050 1 $400 2 $400 3 $400 4 $400

(11-6) MIRR 10.

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Answer: e MEDIUM

Ehrmann Data Systems is considering a project that has the following cash flow and WACC data. What is the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected. WACC: 10.00% Year Cash flows a. 9.32% 0 -$1,000 1 $450 2 $450 3 $450

b. 10.35% c. 11.50% d. 12.78% e. 14.20%

(11-8) Payback 11.

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Answer: e MEDIUM

Stern Associates is considering a project that has the following cash flow data. What is the project's payback? Year Cash flows a. 2.31 years b. 2.56 years c. 2.85 years d. 3.16 years e. 3.52 years 0 -$1,100 1 $300 2 $310 3 $320 4 $330 5 $340

(11-8) Discounted payback 12.

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Answer: b MEDIUM

Fernando Designs is considering a project that has the following cash flow and WACC data. What is the project's discounted payback? WACC: 10.00% Year Cash flows a. 1.88 years b. 2.09 years c. 2.29 years d. 2.52 years e. 2.78 years 0 -$900 1 $500 2 $500 3 $500