# Finance 3003Chapter 8

 International Rate of Return The discount rate at which NPV equals zero The discount rate used to value capital investments is often referred to as ________. Opportunity Cost of Capital A positive NPV investment _______________ which a negative NPV investment ____________________ builds shareholder value; destroys shareholder value Since a risky dollar is worth less than a safe one, returns for risky projects must be ____________ than those of a risk-free investment. higher What is the NPV of a project with an initial investment of \$95, a cash flow in one year of \$107, and a discount rate of 6%? (Be sure to record initial investment as a negative number.) \$5.94 If two projects (investments) A and B are said to be mutually exclusive then we know that the firm ______________ must choose to invest in either A or B, but not both When choosing mutually exclusive projects, choose the one that offers the ____________________ highest NPV A project has an initial investment of \$125,000 and cash flows of \$50,000 per year for 3 years. What is the project’s internal rate of return (IRR)? 9.7% A projects IRR measures the _________ whereas the opportunity cost of capital is equal to the _________________. profitability of a project; return offered by equivalent-risk investment in the capital market. Under which situations should the IRR decision rule be avoided? Mutually Exclusive ProjectsMultiple Rates of ReturnA project NPV does not decline smoothly as discount rate increases The NPV rule states that managers increase shareholder wealth by: accepting all projects with a positive NPV A project with an initial investment of \$5 million and cash flows for 6 years of \$1.5 million per year. What is the project’s internal rate of return (IRR)? 19.9% Profitability Index (PI) Formula NPV/Initial Investment When the firm’s budget is limited, then the firm should select the project with the ______________ highest PI ratio The limit set on the amount of funds available for investment is referred to as: capital rationing Capital rationing that is imposed by top management of a firm is called ___________ rationing. _____________ rationing occurs when a firm cannot raise the money it needs from outside sources. Soft, Hard In simple cases of capital rationing, the _____________ can tell a firm which projects to accept Profitability index (PI) What are problems that managers may encounter when deciding between mutually exclusive projects? When equipment should be replacedThe choice between short and long-lived equipmentThe timing of investments Making the choice to invest today or to postpone that investment to a future date is a choice between mutually exclusive projects. When making this choice, what is the correct criterion to use? Choose the investment date that produces the highest NPV today The cash flow per period with the same present value as the cost of buying and operating a machine is called the: Equivalent annual annuity Equivalent annual annuity formula (PV of costs)/(# of years annuity factor) When comparing investments in assets with different lives you should: select the project with the lowest equivalent annual annuity of costs A machine that costs \$20,000 today has annual operating costs of \$1,500, \$1,600, \$1,700, and \$1,800 in each of the next four years. The discount rate is 10 percent. The PV of costs is _________ and the equivalent annual annuity is __________. \$25,192.61; \$7,947.53 what are the Investment criterion methods most used by firms NPVIRR The IRR rule specifies that a firm should select any project whose IRR is ___________ the firm’s ____________ higher than; opportunity cost of capital What are three limitations of the Payback Rule for accepting projects? Gives equal weight to all cash flows arriving before the cutoff period Biases the firm against long-term projects in favor of short-term onesDoes not consider cash flows after the payback period What capital budgeting decision method finds the present value of each cash flow before calculating a payback period? Discounted payback period True or False: the payback rule states that a project should be accepted if its payback period is greater than a specified cutoff period False: payback period is LESS than a specified cutoff period The payback period for a project can best be defined as: the length of time before you can recover you initial investment The rate of return rule states that a firm should invest in any project offering a rate of return that is higher than the: opportunity cost of capital Which of the following is the capital investment decision criterion that will always lead management to make the value-maximizing choice? NPV True or false: when choosing among mutually exclusive projects, choose the one that offers the highest NPV True When evaluating a single project for acceptance, the NPV and IRR decision rules will give the same result when ______________ the graph of NPV versus discount rate declines smoothly as discount rate increases
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