CHAPTER 10

THE BASICS OF CAPITAL BUDGETING

(Difficulty: E = Easy, M = Medium, and T = Tough)

Multiple Choice: Conceptual

Easy:
Ranking methods Answer: b Diff: E
1. Assume a project has normal cash flows (that is, the initial cash flow is
negative, and all other cash flows are positive). Which of the following
statements is most correct?

a. All else equal, a project’s IRR increases as the cost of capital

declines.
b. All else equal, a project’s NPV increases as the cost of capital
declines.
c. All else equal, a project’s MIRR is unaffected by changes in the cost
of capital.
d. Statements a and b are correct.
e. Statements b and c are correct.

Ranking conflicts Answer: a Diff: E

2. Which of the following statements is most correct?

a. The NPV method assumes that cash flows will be reinvested at the cost
of capital, while the IRR method assumes reinvestment at the IRR.
b. The NPV method assumes that cash flows will be reinvested at the risk-
free rate, while the IRR method assumes reinvestment at the IRR.
c. The NPV method assumes that cash flows will be reinvested at the cost
of capital, while the IRR method assumes reinvestment at the risk-free
rate.
d. The NPV method does not consider the inflation premium.
e. The IRR method does not consider all relevant cash flows, particularly,
cash flows beyond the payback period.

Payback period Answer: d Diff: E

3. A major disadvantage of the payback period is that it

a. Is useless as a risk indicator.

b. Ignores cash flows beyond the payback period.
c. Does not directly account for the time value of money.
d. Statements b and c are correct.
e. All of the statements above are correct.

Chapter 10 - Page 1
NPV profiles Answer: b Diff: E
4. Projects A and B have the same expected lives and initial cash outflows.
However, one project’s cash flows are larger in the early years, while the
other project has larger cash flows in the later years. The two NPV
profiles are given below:

NPV
($)

k (%)

Which of the following statements is most correct?

a. Project A has the smaller cash flows in the later years.

b. Project A has the larger cash flows in the later years.
c. We require information on the cost of capital in order to determine
which project has larger early cash flows.
d. The NPV profile graph is inconsistent with the statement made in the
problem.
e. None of the statements above is correct.

NPV profiles Answer: d Diff: E

5. Projects A and B both have normal cash flows. In other words, there is an
up-front cost followed over time by a series of positive cash flows. Both
projects have the same risk and a WACC equal to 10 percent. However,
Project A has a higher internal rate of return than Project B. Assume that
changes in the WACC have no effect on the projects’ cash flow levels.
Which of the following statements is most correct?

a. Project A must have a higher net present value than Project B.

b. If Project A has a positive NPV, Project B must also have a positive
NPV.
c. If Project A’s WACC falls, its internal rate of return will increase.
d. If Projects A and B have the same NPV at the current WACC, Project B
would have a higher NPV if the WACC of both projects was lower.
e. Statements b and c are correct.

Chapter 10 - Page 2