DSM 9

An NPV profile is __________.

- a graph of a project’s NPV over a range of different discount rates

When resources are limited you should select the projects with the:

- When resources are limited you should select the projects with the:

The profitability index is a ratio of the:

- the present value of benefits to the present value of costs.

A firm has undertaken a project with an initial investment of $100,000. The firm’s cost of capital
is 14%

Year Cash Inflow

1 $50,000
2 $65,000
3 $90,000

What is the NPV for this project?

- $54,623

A firm is evaluating an investment proposal, which has an initial investment of $8,000 and
discounted cash flows valued at $6,000. The net present value of this investment is:

- -$2,000
o Present value of the project's cash flows minus the initial investment. $6,000-
$8,000 = - $2,000
o Project should be rejected since it has a negative NPV

Assume that you expect to sell a stock for $50 in two years and your required return is 8%. If the
stock is currently selling for $41, what is its NPV?

- Net present value = 50/1.08^2 - 41

net present value = 42.8669 - 41

net present value = 1.8669

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 A firm is evaluating a proposal which has an initial investment of $45,000 and has cash flows of
$5,000 in year 1, $20,000 in year 2, $15,000 in year 3, and $10,000 in year 4. The payback
period of the project is:

- 3.5 years

Assume you have two projects with different lives. Project A is expected to generate present
value cash flows of $5.2 million and will last 7 years. Project B is expected to generate present
value cash flows of $3.8 million and will last 5 years. Given a required return of 9%, Project A
has an equivalent annual annuity of __________ which is __________ than Project B.

- $1.03319 million, better

Project A:
PV = -$5.2; N = 7; I / Y = 9%; FV = 0; CPT PMT and you get $1.03319 million

What is the discounted payback of a project that has an initial outlay of $20,000 and will
generate $6,000 in year 1, $12,000 in year 2, $9,000 in year 3, and $14,000 in year 4 assuming
the cost of capital is 10%?

- he discounted payback of a project that has an initial outlay of $20,000 and will generate
$6,000 in year 1, $12,000 in year 2, $9,000 in year 3, and $14,000 in year 4 assuming the
cost of capital is 10% is 2.68 years.

o PV of year 1 = $6,000/(1.1) = $5,455

o PV of year 2 = $12,000/(1.1)2 = $9,917
o PV of year 3 = $9,000/(1.1)3 = $6,762
o PV of year 4 = $14,000/(1.1)4 = $9,562

The IRR can lead to incorrect project rankings because projects with much higher NPVs may also
have:

- Longer project lives

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 A firm must choose from 5 capital budgeting proposals outlined below. The firm is subject to
capital rationing and has a capital budget of $500,000. The firm’s cost of capital is 12%.

Project Initial Investment IRR NPV

1 $100,000 17% $50,000
2 $200,000 15% $10,000
3 $125,000 14% $30,000
4 $100,000 11% -$2,500
5 $75,000 19% $25,000

Using the internal rate of return approach to ranking projects, which projects should the firm
accept?

- 1,2,3 and 5; Accept any project that produces without a negative NPV

The discounted payback period method takes __________ into consideration.

- Time value of money

Unlike the IRR criteria, the NPV approach assumes an interest rate equal to the:

- Firm’s cost of capital

As you increase the required return used in an NPV calculation, the likelihood of a __________
NPV __________.

- Negative; increases

Chris has been offered the chance to invest $120,000 in a partnership, which is expected to
return $25,000 per year. If Chris is in the 30% tax bracket and limits investments to those with a
payback of six years, should Chris invest?

- No, because the payback period is 6.86 years.

o To calculate the payback you need to calculate Chris' annual cash return which is
equal to $25,000(1-0.30)=$17,500 per year in after-tax proceeds from the
investment. Given that annual amount, his payback is equal to $120,000/$17,500
= 6.86 years. Since the payback exceeds his six year cut off he should not make
the investment

A firm’s minimum required return on a capital budgeting project is known as the:

- Hurdle rate

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 What is the NPV of a project expected to generate $1,000 a year for 5 years assuming a discount
rate of 10% and an initial outlay of $3,250?

- What is the NPV of a project expected to generate $1,000 a year for 5 years assuming a
discount rate of 10% and an initial outlay of $3,250?

In order to calculate a project’s NPV, you need to know the appropriate discount rate, the
amount of the initial outlay, and:

- In order to calculate a project’s NPV, you need to know the appropriate discount rate,
the amount of the initial outlay, and:

Jenna is considering an investment which has a price of $16,000. She expects to receive $3,000
for eight years. What is the investment’s internal rate of return?

- 10%;
PV = -16000
N=8
PMT = 3000
CPT I/Y = 10%

When using the net present value (NPV) to evaluate capital budgeting projects, you should:

- accept all projects with a positive NPV

MIRR is used when:

- cash flows of a project change sign

One method that can be used to evaluate capital budgeting projects with different lives is to
convert the project’s cash flows to a level annual cash flow that has the same present value as
the project’s overall cash flows. This annual cash flow is known as the:

- Equivalent annual annuity

Capital budgeting is the process of:

- Evaluating a firm’s investment choices

Which of the following decision rules is always correct because it is directly tied to the goal of
maximizing shareholder wealth?

- NPV rule

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 Projects that do not compete with one another so that the acceptance of one project will have
no bearing on the acceptance of other projects being considered by the firm are known as:

- Independent projects

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