The goal of the capital budgeting decisions is to select capital projects that will decrease the value of the firm.(True/False) |
False |

When two projects have cash flows that are tied to each other, the projects may be classified as independent.(True/False) |
False |

When two projects are independent, accepting one project implicitly eliminates the other.(True/False) |
False |

When two projects are mutually exclusive, accepting one project implicitly eliminates the other.(True/False) |
True |

The net present value technique is an approach that goes against the goal of shareholder wealth maximization.(True/False) |
False |

The NPV method determines how much the present value of cash inflows exceeds the present value of costs.(True/False) |
True |

The payback method is consistent with the goal of shareholder wealth maximization.(True/False) |
False |

The discounted payback period calculation calls for the future cash flows to be discounted by a firm’s cost of capital.(True/False) |
True |

The accounting rate of return is not a true return because it simply utilizes some average figures from a firm’s balance sheet and income statement.(True/False) |
True |

The decision criterion for the accounting rate of return is consistent with the goal of shareholder wealth maximization.(True/False) |
False |

The IRR and NPV decisions are consistent with each other when a project’s cash flows follow a conventional pattern.(True/False) |
True |

Unconventional cash flow patterns could lead to conflicting decisions by NPV and IRR.(True/False) |
True |

When mutually exclusive projects are considered, both NPV and IRR will always produce the same acceptance decision.(True/False) |
False |

When evaluating two projects that require different outlays, the IRR does not recognize the difference in the size of the investments.(True/False) |
True |

What is true of an independent project? |
cash flows are unrelated. |

Two projects are considered to be mutually exclusive if |
both selecting one would automatically eliminate accepting the other and the projects perform the same function. |

The cost of capital is |
minimum return that a capital project must earn to be accepted |

Capital rationing implies that |
a firm has constraint to fund all of the available projects. |

Advantage of the payback method |
Both the technique is simple for managers to compute and interpret and it is a good measure of liquidity risk. |

disadvantage of the payback method? |
-It is inconsistent with the goal of maximizing shareholder wealth.-It ignores cash flows beyond the payback period.-It ignores the time value of money. |

Which of the following statements about IRR is NOT true? |
The IRR is the discount rate that makes the NPV greater than zero. |

The internal rate of return is |
discount rate that makes the NPV equal to zero. |

When evaluating capital projects, the decisions using the NPV method and the IRR method will agree if |
both the projects are independent and the cash flow pattern is conventional. |

Which of the following cash flow patterns is NOT an unconventional cash flow pattern? |
A negative initial cash flow is followed by positive future cash flows. |

Which of the following rates should be used to calculate a project’s net present value? |
Cost of capital |

One of the main reasons why the discounted payback period is not widely used by managers is that: |
it ignores all cash flows that occur after the arbitrary cutoff period |

The IRR is the discount rate that makes the NPV positive(True/False) |
False*The IRR is the discount rate that makes the NPV equal to zero. |

Which of the following capital budgeting techniques, is the most appropriate one for evaluating projects? |
Net present value |

A weakness of the accounting rate of return technique is, it: |
does not distinguish between revenue and cash flows. |

The IRR and NPV methods always rank projects in the same order.(True/False) |
False*The IRR and NPV methods can give conflicting results |

If a project’s IRR exceeds its _____, the project should be _____. |
cost of capital; accepted |

The NPV and IRR methods will always agree when you are evaluating _____ projects and the project’s cash flows are _____. |
independent; conventional |

The cost of capital for a project is its return on equity.(True/False) |
False*The cost of capital is the rate of return that a capital project must earn to be accepted by management. |

key disadvantage of the IRR method? |
With mutually exclusive projects, the IRR method can lead to incorrect investment decisions. |

Capital investments |
large cash outlays, long-term commitments, not easily reversed, and primary factors in a firm’s long-run performance |

Capital budgeting |
techniques help management systematically analyze potential opportunities in order to decide which are worth undertaking |

Independent Projects |
Projects for which the decision to accept or reject is not influenced by decisions about other projects being considered by the firm |

Mutually exclusive projects |
Projects for which the decision to accept one project is simultaneously a decision to reject another project |

Contingent projects |
Projects for which the decision to accept one project depends on acceptance of another project |

Basic Capital Budgeting |
-Capital rationing-Capital Asset-Cost of Capital |

Capital rationing |
firm with limited funds chooses the best projects to undertake |

Capital Asset |
long-term assets |

Cost of Capital |
rate of return that a project must earn to be accepted by management |

Net Present Value (NPV) |
-goal of maximizing shareholder wealth-compares the present value of expected benefits and cash flows from a project to the present value of the expected costs; if the benefits are larger, the project is feasible |

Valuation of Real Assets |
1.Estimate future cash flows2.Estimate cost of capital/required-rate-of return3.Calculate present value of future cash flows |

Practical difficulties in valuing real assets |
-Cash flow estimates must be prepared in-house and are not as readily available as those for financial assets with legal contracts-Estimating required-rates-of-return for real assets is more difficult than estimating required return for financial assets because no market data is available |

Advantages of NPV 3 |
1.uses discounted cash flow valuation technique to adjust for time value of money.2.Provides direct (dollar) measure of how much a capital project will increase the value of the firm.3.Consistent with the goal of maximizing stockholder value. |

Disadvantage of NPV |
Can be difficult to understand without an accounting and finance backround. |

Payback Period |
-The Payback Period is the amount of time it takes for the sum of the net cash flows from a project to equal the project’s initial investment*Projects with shorter payback periods are more desirable |

Negatives about Payback rule |
There is no economic rationale that makes the payback method consistent with shareholder wealth maximization-It ignores the time value of money-Does not account for differences in the overall risk of projects-Cash flows occurring after the payback period are not considered |

ARR Flaws |
-is not a true rate of return; it is generated from the income statement and balance sheet-It ignores the time value of money-There is no economic rationale that makes it consistent with the goal of maximizing shareholder wealth |

What method should be used when dealing with unconventional cash flows, IRR or NPV? |
NPVBecause,With unconventional cash flows, the IRR technique may provide more than one rate of return. This makes the calculation unreliable and it should not be used to determine whether a project should be accepted or rejected |

Advantages of IRR Method |
1.Intutive and easy to understand2.Based on discounted cash flow technique |

Disadvantages of IRR |
1.with non-conventional cash flows, IRR approach can yield no usable answer or multiple answers.2.A lower IRR can be better if a cash inflow is followed by cash outflows3.With mutually exclusive projects, IRR leadto incorrect investment descisions4.IRR calculation assumes cash flows are reinvested at the IRR. |

Profitability Index (PI) |
The PI provides a measure of the value of project generates for each dollar invested in that project |

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