CHAPTER 9.

NET PRESENT VALUE AND OTHER INVESTMENT RULES

A. True/ False Questions (5)

1. An investment with a short payback period is almost certain to have a positive net
present value.
2. If a project's cash flows are discounted at the internal rate of return, the NPV will be
zero.
3. All three major discounted cash flow methods of evaluation will consistently give
the same desirability ranking to a series of projects.
4. Calculation of the internal rate of return incorporates the implicit assumption that
net cash flows from a project can be reinvested at the internal rate of return.
5. In the absence of capital rationing, a firm should undertake all projects with a
profitability index greater than zero.
6. One problem with the profitability index is that it ignores the time value of money.

B. Multiple Choice Questions (25)

1. A profitability index of .85 for a project means that:

A. the present value of benefits is 85% greater than the project's costs.
B. the project's NPV is greater than zero.
C. the project returns 85 cents in present value for each current dollar invested.
D. the payback period is less than one year.

2. Which of the following statements is correct?

A. If the NPV of a project is greater than 0, its PI will equal 0.
B. If the IRR of a project is 0%, its NPV, using a discount rate, k, greater than 0, will
be 0.
C. If the PI of a project is less than 1, its NPV should be less than 0.
D. If the IRR of a project is greater than the discount rate, k, its PI will be less than
1 and its NPV will be greater than 0.

3. Assume that a firm has accurately calculated the net cash flows relating to an
investment proposal. If the net present value of this proposal is greater than zero
and the firm is not under the constraint of capital rationing, then the firm should:
A. calculate the IRR of this investment to be certain that the IRR is greater than the
cost of capital.
B. compare the profitability index of the investment to those of other possible
investments.
C. calculate the payback period to make certain that the initial cash outlay can be
recovered within an appropriate period of time.
D. accept the proposal, since the acceptance of value-creating investments should
increase shareholder wealth.

4. The …….. method provides correct rankings of mutually exclusive projects, when
the firm is not subject to capital rationing.
A. net present value
B. internal rate of return
C. payback period
D. profitability index

5. If a project is assigned a required rate of return of zero, then:

A. the timing of the project's cash flows has no bearing on the value of the project.
B. the project will always be accepted.
C. the project will always be rejected.
D. whether the project is accepted or rejected will depend on the timing of the cash
flows.

6. All else constant, the net present value of a typical investment project increases
when:
A. the discount rate increases.
B. the initial cost of a project increases.
C. the required rate of return decreases.
D. all cash inflows occur during the last year instead of periodically throughout the
project's life

7. Proposed projects should be accepted when those projects:

A. create value for the owners of the firm.
B. have a positive rate of return.
C. return the initial cash outlay within the life of the project.
D. have required cash inflows that exceed the actual cash inflows.

8. The payback method:

A. is the most frequently used method of capital budgeting analysis.
B. is a more sophisticated method of analysis than the profitability index.
C. considers the time value of money.
D. applies mainly to projects where the actual results will be known relatively soon.

9. One characteristic of the payback method of project analysis is the:

A. use of variable discount rates.
B. standardized cutoff point for cash flow consideration.
C. bias towards liquidity.
D. consideration of the risk level of each project.

10. The internal rate of return is:

A. more reliable than net present value whenever you are considering mutually
exclusive projects.
B. equivalent to the discount rate that makes the net present value equal to 1.0.
C. computed using a project's cash flows as the only source of inputs.
D. dependent on the interest rates offered in the marketplace.

11. The elements that cause problems with the use of the IRR in projects that are
mutually exclusive are referred to as the:
A. discount rate and scale problems.
B. timing and scale problems.
C. discount rate and timing problems.
D. scale and reversing flow problems

12. Which one of the following is the best example of two mutually exclusive
projects?
A. Planning to build a warehouse and a retail outlet side by side
B. Buying sufficient equipment to manufacture both desks and chairs simultaneously
C. Renting out a company warehouse or selling it outright
D. Using the company's sales force to promote sales of both shoes and socks

13. How should a profitability index of zero be interpreted?

A. The present value of the cash flows subsequent to the initial cash flow is equal to
(−1 × Initialcash flow).
B. The project has an internal rate of return equal to the discount rate.
C. The project produces a net income of zero for every year of its life.
D. The project's cash flows subsequent to the initial cash flow have a present value of
zero.

14. The profitability index:

A. rule often results in decisions that conflict with the decisions based on the net
present value rule.
B. is useful as a decision tool when investment funds are limited and all available
funds are allocated.
C. method is most commonly used when deciding between mutually exclusive
projects of varying size.
D. rule states that the project with the lower index value should be accepted

15. No matter how many forms of investment analysis you employ:

A. the actual results from a project may vary significantly from the expected results.
B. the internal rate of return will always produce the most reliable results.
C. a project will never be accepted unless the payback period is met.
D. the initial costs will generally vary considerably from the estimated costs.

16. What is the net present value of a project with an initial cost of $36,900 and cash
inflows of $13,400, $21,600, and $10,000 for Years 1 to 3, respectively? The discount
rate is 13 percent.
A. −$287.22
B. −$1,195.12
C. −$1,350.49
D. $204.36

17. A food cart costs $4,500 and is expected to return $1,750 a year for three years
and then be worthless. What is the payback period for this cart?
A. 2.83 years
B. 3.14 years
C. 2.78 years
D. 2.57 years

18. Jack is considering adding toys to his general store. He estimates the cost of toy
inventory will be $4,200. The remodeling and shelving costs are estimated at $1,500.
Toy sales are expected to produce net annual cash inflows of $1,200, $1,500, $1,600,
and $1,750 over the next four years, respectively. Should Jack add toys to his
merchandise if he requires a three-year payback period? Why or why not?
A. Yes; because the payback period is 2.02 years
B. Yes; because the payback period is 3.80 years
C. No; because the payback period is 2.02 years
D. No; because the payback period is 3.80 years
19. An investment project has an initial cost of $260 and cash flows $75, $105, $100,
and $50 for Years 1 to 4, respectively. The cost of capital is 12 percent. What is the
discounted payback period?
A. 3.76 years
B. Never
C. 3.42 years
D. 3.68 years
20. An investment costing $25 returns $27.50 at the end of one year with no risk.
Given this, youknow that the NPV:
A. is zero at any given discount rate.
B. is negative if the required return is less than 10 percent.
C. equals 1.0 if the required return is 10 percent.
D. is zero if the required rate of return is 10 percent.

21. Lucie is reviewing a project with an initial cost of $38,700 and cash inflows of
$9,800, $16,400, and $21,700 for Years 1 to 3, respectively. Should the project be
accepted if it has been assigned a required return of 9.75 percent? Why or why not?
A. Yes; because the IRR exceeds the required return by .34 percent
B. Yes; because the IRR exceeds the required return by .28 percent
C. No; because the IRR exceeds the required return by .34 percent
D. No; because the IRR is only 9.69 percent

22. BackInSoon, Inc., has estimated that a proposed project's 10-year annual net cash
benefit, received each year end, will be $2,500 with an additional terminal benefit of
$5,000 at the end of the tenth year. Assuming that these cash inflows satisfy exactly
BackInSoon's required rate of return of 8 percent, calculate the initial cash outlay.
(Hint: With a desired IRR of 8%, use the IRR formula: ICO = discounted cash flows.)
A. $16,775
B. $19,090
C. $25,000
D. $30,000
23. Project A has an initial cost of $75,000 and annual cash flows of $33,000 for three
years. Project B costs $60,000 and has cash flows of $25,000, $30,000, and $25,000
for Years 1 to 3, respectively. Projects A and B are mutually exclusive. The
incremental IRR is ________ and if the required rate is higher than the crossover
rate then Project ________ should be accepted.
A. 13.94 percent; A
B. 12.89 percent; B
C. 12.89 percent; A
D. 13.94 percent; B

24. A financing project has an initial cash inflow of $42,000 and cash flows of
−$15,600, −$22,200, and −$18,000 for Years 1 to 3, respectively. The required rate of
return is 13 percent. What is the internal rate of return? Should the project be
accepted?
A. 15.26 percent; accept
B. 15.26 percent; reject
C. 13.44 percent; reject
D. 13.44 percent; accept

25. Roy's Welding projects cash flows of $13,500, $20,400, and $32,900 for Years 1 to
3 for a project with an initial cost of $45,000. What is the profitability index given an
assigned discount rate of 15 percent?
A. 0.92
B. 0.97
C. 1.03
D. 1.08
C.Short answer (5)

1. Suppose a project has conventional cash flows and a positive NPV. What do you
know about its payback? Its discounted payback? Its profitability index? Its IRR?
Explain.

2. What difficulties might come up in actual applications of the various criteria we

discussed in this chapter? Which one would be the easiest to implement in actual
applications? The most difficult?

3. Are the capital budgeting criteria we discussed applicable to not-for-profit

corporations? How should such entities make capital budgeting decisions?

4. A project has perpetual cash flows of C per period, a cost of I, and a required
return of R. What is the relationship between the project’s payback and its IRR?
What implications does your answer have for long-lived projects with relatively
constant cash flows?

5. If a project with conventional cash flows has a payback period less than the
project’s life, can you definitively state the algebraic sign of the NPV? Why or why
not? If you know that the discounted payback period is less than the project’s life,
what can you say about the NPV? Explain.

6. If a project with conventional cash flows has a payback period less than the
project’s life, can you definitively state the algebraic sign of the NPV? Why or why
not? If you know that the discounted payback period is less than the project’s life,
what can you say about the NPV?

7. Define each of the following investment rules anddiscuss any potential

shortcomings of each. In your definition, state the criterion for accepting or rejecting
independent projects under each rule.
a. Payback period.
b. Internal rate of return.
c. Net present value.
D. Excersice : 5

1. NPV versus IRR (12R9) Mahjong, Inc., has identified the following two mutually
exclusive projects:

Year Cash Flow (A) Cash Flow (B)

0 -$43,000 -$43,000

1 23,000 7,000

2 17,900 13,800

3 12,400 24,000

4 9,400 26,000

a. What is the IRR for each of these projects? Using the IRR decision rule, which
project should the company accept? Is this decision necessarily correct?

b. If the required return is 11 percent, what is the NPV for each of these projects?
Which project will the company choose if it applies the NPV decision rule?

c. Over what range of discount rates would the company choose project A? Project
B? At what discount rate would the company be indifferent between these two
projects? Explain.

2. Discounted Payback (5R9) An investment project costs $15,000 and has annual
cash flows of $4,300 for six years. What is the discounted payback period if the
discount rate is zero percent? What if the discount rate is 5 percent? If it is 19
percent?

3. Profitability Index (16R9) The Weiland Computer Corporation is trying to choose

between the following two mutually exclusive design projects:

Year Cash Flow (I) Cash Flow (II)

0 -$53,000 -$16,000

1 27,000 9,100
 2 27,000 9,100

3 27,000 9,100

a. If the required return is 10 percent and the company applies the profitability index
decision rule, which project should the firm accept?
b. If the company applies the NPV decision rule, which project should it take?
c. Explain why your answers in (a) and (b) are different.

4. Comparing Investment Criteria (17R9) Consider the following two mutually

exclusive projects.

Year Cash Flow (A) Cash Flow (B)

0 -$300,000 -$40,000

1 20,000 19,000

2 50,000 12,000

3 50,000 18,000

4 390,000 10,500

Whichever project you choose, if any, you require a 15 percent return on your
investment.

a. If you apply the payback criterion, which investment will you choose? Why?

b. If you apply the discounted payback criterion, which investment will you choose?
Why?

c. If you apply the NPV criterion, which investment will you choose? Why?

d. If you apply the IRR criterion, which investment will you choose? Why?

e. If you apply the profitability index criterion, which investment will you choose?
Why?

f. Based on your answers in (a) through (e), which project will you finally choose?
Why?
5. Multiple IRR (19R9) Slow Ride Corp. is evaluating a project with the following cash
flows:

Year Cash Flow

0 -$16,000

1 6,100

2 7,800

3 8,400

4 6,500

5 -5,100

The company uses a 10 percent interest rate on all of its projects. Calculate the MIRR
of the project using all three methods.

Suppose the company in the previous problem uses an 11 percent discount rate.
Calculate the MIRR of the project using discounting method.