CONCEPT CHECKERS

1. Which of the following statements concerning the principles underlying the

capital budgeting process is most accurate?
A. Cash flows should be based on opportunity costs.
B. Financing costs should be reflected in a project’s incremental cash
flows.
C. The net income for a project is essential for making a correct capital
budgeting decision.
2. Which of the following statements about the payback period method is least
accurate? The payback period:
A. provides a rough measure of a project’s liquidity.
B. considers all cash flows throughout the entire life of a project.
C. is the number of years it takes to recover the original cost of the
investment.
3. Which of the following statements about NPV and IRR is least accurate?
A. The IRR is the discount rate that equates the present value of the cash
inflows with the present value of outflows.
B. For mutually exclusive projects, if the NPV method and the IRR
method give conflicting rankings, the analyst should use the IRRs to
select the project.
C. The NPV method assumes that cash flows will be reinvested at the cost
of capital, while IRR rankings implicitly assume that cash flows are
reinvested at the IRR.
4. Which of the following statements is least accurate? The discounted payback
period:
A. frequently ignores terminal values.
B. is generally shorter than the regular payback.
C. is the time it takes for the present value of the project’s cash inflows to
equal the initial cost of the investment.
5. Which of the following statements about NPV and IRR is least accurate?
A. The IRR can be positive even if the NPV is negative.
B. When the IRR is equal to the cost of capital, the NPV will be zero.
C. The NPV will be positive if the IRR is less than the cost of capital.
Use the following data to answer Questions 6 through 10.
A company is considering the purchase of a copier that costs $5,000. Assume a
required rate of return of 10% and the following cash flow schedule:
Year 1: $3,000. 2727,27 -2727.73
Year 2: $2,000. 1652.89 -619.84
Year 3: $2,000. 1502.63 882.79

6. What is the project’s payback period?

A. 1.5 years.
B. 2.0 years.
C. 2.5 years.
7. The project’s discounted payback period is closest to:
A. 1.4 years.
B. 2.0 years.
C. 2.4 years.
8. What is the project’s NPV?
A. −$309.
B. +$883.
C. +$1,523.
9. The project’s IRR is closest to:
A. 10%.
B. 15%.
C. 20%.
10. What is the project’s profitability index (PI)?
A. 0.72.
B. 1.18.
C. 1.72.
11. An analyst has gathered the following information about a project:
Cost: $10,000
Annual cash inflow: $4,000
Life: 4 years
Cost of capital: 12%
Which of the following statements about the project is least accurate?
A. The discounted payback period is 3.5 years.
B. The IRR of the project is 21.9%; accept the project.
C. The NPV of the project is +$2,149; accept the project.
Use the following data for Questions 12 and 13.
An analyst has gathered the following data about two projects, each with a 12%
required rate of return.

Project Y Project Z

Initial cost
$15,000 $20,000

Life 5 years 4 years

Cash inflows $5,000/year $7,500/year

NPV Y=3023.88 IRR= 19.86 NPV Z= 2780.12 IRR=18.45

12. If the projects are independent, the company should:
A. accept Project Y and reject Project Z.
B. reject Project Y and accept Project Z.
C. accept both projects. (Because they both have positive NPV)
13. If the projects are mutually exclusive, the company should:
A. reject both projects.
B. accept Project Y and reject Project Z.
C. reject Project Y and accept Project Z.
14. The NPV profiles of two projects will intersect:
A. at their internal rates of return.
B. if they have different discount rates.
C. at the discount rate that makes their net present values equal.
15. The post−audit is used to:
A. improve cash flow forecasts and stimulate management to
improve operations and bring results into line with forecasts.
B. improve cash flow forecasts and eliminate potentially profitable but
risky projects.
C. stimulate management to improve operations, bring results into line
with forecasts, and eliminate potentially profitable but risky projects.
16. Fullen Machinery is investing $400 million in new industrial equipment. The
present value of the future after−tax cash flows resulting from the equipment
is $700 million. Fullen currently has 200 million shares of common stock
outstanding, with a current market price of $36 per share. Assuming that this
project is new information and is independent of other expectations about
the company, what is the theoretical effect of the new equipment on Fullen’s
stock price? The stock price will:
A. decrease to $33.50.
B. increase to $37.50.(1.5+.36)
C. increase to $39.50.
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