Net Present Value and Other Investment Rules: Multiple Choice Questions

Chapter 07 - Net Present Value and Other Investment Rules
Chapter 07
Net Present Value and Other Investment Rules
Multiple Choice Questions

1. A $25 investment produces $27.50 at the end of the year with no risk. Which of the
following is not true?
A. NPV is positive if the interest rate is less than 10%.
B. NPV is negative if the interest rate is less than 10%.
C. NPV is zero if the interest rate is equal to 10%.
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Blooms: Apply
Difficulty: Medium
Topic: 07-01 Why Use Net Present Value?

2. The difference between the present value of an investment's future cash flows and its initial
cost is the:
A. net present value.
B. internal rate of return.
C. pay back period.
D. discounted pay back period.

Blooms: Remember
Difficulty: Easy

7-1
3. Accepting positive NPV projects benefits the stockholders because:

A. it most easily understood valuation process.
B. the value of the expected cashflows are equal to the cost.
C. the value of the expected cashflows are greater than the cost.
D. it is the most easily calculated.

Blooms: Understand
Difficulty: Easy

4. Which statement concerning the net present value (NPV) of an investment or a financing
project is correct?
A. a financing project should be accepted if, and only if, the NPV is exactly equal to zero.
B. an investment project should be accepted only if the NPV is equal to the initial cash flow.
C. any type of project should be accepted if the NPV is positive and rejected if it is negative.
D. any type of project with greater total cash inflows than total cash outflows, should always
be accepted.
E. an investment project that has positive cash flows for every time period after the initial
investment should be accepted.

Blooms: Understand
Difficulty: Medium

5. Which of the following does not characterize NPV?

A. NPV is the simplest of all investment rules.
B. NPV incorporates all relevant information.
C. NPV uses all of the project's cash flows.
D. NPV discounts all future cash flows.

Blooms: Understand
Difficulty: Easy

7-2
6. If a project is assigned a required rate of return equal to 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.

Blooms: Understand
Difficulty: Easy

7. Payback is frequently used to analyze independent projects because:

A. it considers the time value of money.
B. all relevant cash flows are included in the analysis.
C. it is easy and quick to calculate.
D. it is the most desirable of all the available analytical methods from a financial perspective.

Blooms: Understand
Difficulty: Easy
Topic: 07-02 The Payback Period Rule

8. The payback period rule accepts all investment projects in which the payback period for the
cash flows is:
A. greater than or equal to the cut-off point.
B. greater than the cut-off point.
C. less than the cut-off point.
D. positive.

Blooms: Understand
Difficulty: Easy

7-3
9. Consider an investment with an initial cost of $20,000 and is expected to last for 5 years.
The expected cash flow in years 1 and 2 are $5000, in years 3 and 4 are $5,500 and in year 5
is $1,000. The total cash inflow is expected to be $22,000 or an average of $4,400 per year.
Compute the payback period in years.
A. 3.18
B. 3.82
C. 4.55
D. 4.00

Blooms: Apply
Difficulty: Medium

10. An investment project is most likely to be accepted by the payback period rule and not
accepted by the NPV rule if the project has:
A. a large initial investment with moderate positive cash flows over a very long period of
time.
B. a very large negative cash flow at the termination of the project.
C. most of the cash flow at the beginning of the project.
D. All projects approved by the payback period rule will be accepted by the NPV rule.
E. The payback period rule and the NPV rule cannot be used to evaluate the same type of
projects.

Blooms: Understand
Difficulty: Medium

11. The discounted payback rule states that you should accept projects:
A. which have a discounted payback period that is greater than some pre-specified period of
time.
B. if the discounted payback is positive and rejected if it is negative.
C. only if the discounted payback period equals some pre-specified period of time.
D. if the discounted payback period is less than some pre-specified period of time.

Blooms: Understand
Difficulty: Easy
Topic: 07-03 Defining the Rule

7-4
12. An investment with an initial cost of $16,000 produces cash flows of $5000 annually. If
the cash flow is evenly spread out over the year and the firm can borrow at 10%, the
discounted payback period is _____ years.
A. 4.55
B. 4.05
C. 3.20
D. 3.52

Blooms: Apply
Difficulty: Medium

13. An investment project has the cashflow stream of -250, 75, 125, 100, and 50. The cost of
capital is 12%. What is the discount payback period?
A. 2.5 years.
B. 2.7 years.
C. 3.38 years.
D. 1.40 years.
E. 1.25 years.

Blooms: Apply
Difficulty: Medium

14. The discounted payback period rule:

A. considers the time value of money.
B. discounts the cutoff point.
C. ignores uncertain cash flows.
D. is preferred to the NPV rule.

Blooms: Remember
Difficulty: Easy

7-5
15. The payback period rule:

A. determines a cutoff point so that all projects accepted by the NPV rule will be accepted by
the payback period rule.
B. determines a cutoff point so that depreciation is just equal to positive cash flows in the
payback year.
C. requires an arbitrary choice of a cut-off point.
D. varies the cut-off point with the interest rate.

Blooms: Understand
Difficulty: Easy

16. Which one of the following statements is correct concerning the payback period?
A. An investment is acceptable if its calculated payback period is less than some pre-specified
period of time.
B. An investment should be accepted if the payback is positive and rejected if it is negative.
C. An investment should be rejected if the payback is positive and accepted if it is negative.
D. An investment is acceptable if its calculated payback period is greater than some pre-
specified period of time.
E. An investment should be accepted any time the payback period is less than the discounted
payback period, given a positive discount rate.

Blooms: Understand
Difficulty: Easy

7-6
17. It will cost $3,000 to acquire a small ice cream cart. Cart sales are expected to be $1,400 a
year for three years. After the three years, the cart is expected to be worthless as that is the
expected remaining life of the cooling system. What is the payback period of the ice cream
cart?
A. 0.83 years.
B. 1.14 years.
C. 1.83 years.
D. 2.14 years.
E. 2.83 years.

Blooms: Apply
Difficulty: Medium

18. A project has an initial cost of $8,600 and produces cash inflows of $3,200, $4,900, and
$1,500 over the next three years, respectively. What is the discounted payback period if the
required rate of return is 8%?
A. 2.05 years
B. 2.13 years
C. 2.33 years
D. 3.00 years
E. never

Blooms: Apply
Difficulty: Medium

7-7
19. Ginny is considering an investment which will cost her $120,000. The investment
produces no cash flows for the first year. In the second year the cash inflow is $35,000. This
inflow will increase to $55,000 and then $75,000 for the following two years before ceasing
permanently. Ginny requires a 10% rate of return and has a required discounted payback
period of three years. Ginny should _______ this project because the discounted payback
period is ______.
A. accept; 2.03 years
B. accept; 2.97 years
C. accept; 3.97 years
D. reject; 3.03 years
E. reject; 3.97 years

Blooms: Apply
Difficulty: Medium

20. The average accounting rate of return is determined by:

A. dividing the yearly cashflows by the investment.
B. dividing the average cashflows by the investment.
C. dividing the average net income by the average investment.
D. dividing the average net income by the initial investment.
E. dividing the net income by the cashflow.

Blooms: Remember
Difficulty: Medium
Topic: 07-04 Problems with the Payback Method

21. The investment decision rule that relates average net income to average investment is the:
A. discounted cash flow rule.
B. average accounting rate of return method.
C. average payback rule.
D. average profitability index.

Blooms: Remember
Difficulty: Easy

7-8
22. An investment that requires initial cash outlay of $100,000 has a useful life of 3 years. In
each of these years the before-tax cash flow is $40,000. If the tax rate is 34% and straight-line
depreciation is used, the average accounting return is:
A. 40.00%.
B. 26.40%.
C. 13.34%.
D. 8.80%.

Blooms: Apply
Difficulty: Medium

23. The internal rate of return for a project will increase if:

A. the initial cost of the project can be reduced.
B. the total amount of the cash inflows is reduced.
C. each cash inflow is moved such that it occurs one year later than originally projected.
D. the required rate of return is reduced.

Blooms: Understand
Difficulty: Medium
Topic: 07-05 Managerial Perspective

24. The internal rate of return tends to be:

A. easier for managers to comprehend than the net present value.
B. extremely accurate even when cash flow estimates are faulty.
C. ignored by most financial analysts.
D. used primarily to differentiate between mutually exclusive projects.

Blooms: Understand
Difficulty: Easy

7-9
25. The two fatal flaws of the internal rate of return rule are:
A. arbitrary determination of a discount rate and failure to consider initial expenditures.
B. arbitrary determination of a discount rate and failure to correctly analyze mutually
exclusive investment projects.
C. arbitrary determination of a discount rate and the multiple rate of return problem.
D. failure to consider initial expenditures and failure to correctly analyze mutually exclusive
investment projects.
E. failure to correctly analyze mutually exclusive investment projects and the multiple rate of
return problem.

Blooms: Understand
Difficulty: Easy
Topic: 07-06 Summary of Payback

26. A mutually exclusive project is a project whose:

A. acceptance or rejection has no effect on other projects.
B. NPV is always negative.
C. IRR is always negative.
D. acceptance or rejection effects other projects.

Blooms: Understand
Difficulty: Easy

27. A project will have more than one IRR if:

A. the IRR is positive.
B. the IRR is negative.
C. the NPV is zero.
D. the cash flow pattern exhibits more than one sign change.
E. the cash flow pattern exhibits exactly one sign change.

Blooms: Understand
Difficulty: Easy

7-10
28. Using the internal rate of return rule, a conventional project should be accepted if the
internal rate of return is:
A. only equal to the current weighted average cost of capital.
B. greater than the current weighted average cost of capital.
C. less than the current weighted average cost of capital.
D. negative.
E. positive.

Blooms: Understand
Difficulty: Easy

29. The internal rate of return may be defined as:

A. the discount rate that makes the NPV cash flows equal to zero.
B. the difference between the market rate of interest and the NPV.
C. the market rate of interest less the risk-free rate.
D. the project acceptance rate set by management.

Blooms: Understand
Difficulty: Easy

30. The Balistan Rug Company is considering investing in a new loom that will cost $12,000.
The new loom will create positive end of year cash flow of $5,000 for the next 3 years. The
internal rate of return for this project is:
A. between 10% and 15%.
B. between 15% and 20%.
C. between 20% and 25%.
D. between 25% and 30%.
E. less than 10%.

Blooms: Apply
Difficulty: Medium

7-11
31. The Carnation Chemical Company is investing in an incinerator to dispose of PCB waste.

The incinerator costs $1.5 million and will generate end of year cash of $1 million for the next
3 years. At the end of 3 years the incinerator will be worthless and must be disposed of at the
cost of $500,000. The internal rate of return for this project is:
A. between 10% and 20%.
B. between 20% and 30%.
C. between 30% and 40%.
D. more than 40%.

Blooms: Apply
Difficulty: Medium

32. The IRR decision rule can be reversed because:

A. the NPV rule is not the same as the IRR.
B. the IRR is based on a mutually exclusive investment.
C. instead of an investment project it is a financing project.
D. the IRR is greater than 100%.

Blooms: Understand
Difficulty: Hard

33. Which of the following correctly orders the investment rules of average accounting return
(AAR), internal rate of return (IRR), and net present value (NPV) from the most desirable to
the least desirable?
A. AAR, IRR, NPV.
B. AAR, NPV, IRR.
C. IRR, AAR, NPV.
D. NPV, AAR, IRR.
E. NPV, IRR, AAR.

Blooms: Apply
Difficulty: Easy

7-12
34. A project will have only one internal rate of return if:
A. all cash flows after the initial expense are positive.
B. average accounting return is positive.
C. net present value is negative.
D. net present value is positive.
E. net present value is zero.

Blooms: Understand
Difficulty: Easy

35. You have a choice between two projects, Project1 pays $12,000 back at the end of 1
period on an investment of $10,000. Project 2 pays back $6,500 at the end of 1 period on an
investment of $5,000. Which project should be chosen and what is the problem that you must
be concerned with in this choice?
A. Project 1; discount rate.
B. Project 2; discount rate.
C. Project 1; project scales.
D. Project 2; project scales.
E. Project 1, cash flow timings.

Blooms: Apply
Difficulty: Medium

36. The problem of multiple IRRs can occur when:

A. there is only one sign change in the cash flows.
B. the first cash flow is always positive.
C. the cash flows decline over the life of the project.
D. there is more than one sign change in the cash flows.

Blooms: Understand
Difficulty: Medium

7-13
37. The elements that cause problems with the use of the IRR in projects that are mutually
exclusive are:
A. the discount rate and scale problems.
B. timing and scale problems.
C. the discount rate and timing problems.
D. scale and reversing flow problems.
E. timing and reversing flow problems.

Blooms: Understand
Difficulty: Medium

38. A situation in which accepting one investment prevents the acceptance of another
investment is called the:
A. net present value profile.
B. operational ambiguity decision.
C. mutually exclusive investment decision.
D. issues of scale problem.
E. multiple rates of return decision.

Blooms: Understand
Difficulty: Easy

39. You are trying to determine whether to accept project A or project B. These projects are
mutually exclusive. As part of your analysis, you should compute the incremental IRR by
determining:
A. the internal rate of return for the cash flows of each project.
B. the net present value of each project using the internal rate of return as the discount rate.
C. the discount rate that equates the discounted payback periods for each project.
D. the discount rate that makes the net present value of each project equal to 1.
E. the internal rate of return for the differences in the cash flows of the two projects.

Blooms: Understand
Difficulty: Medium

7-14
40. If there is a conflict between mutually exclusive projects due to the IRR, one should:
A. drop the two projects immediately.
B. spend more money on gathering information.
C. depend on the NPV as it will always provide the most value.
D. depend on the AAR because it does not suffer from these same problems.

Blooms: Understand
Difficulty: Easy

41. The profitability index is the ratio of:

A. average net income to average investment.
B. internal rate of return to current market interest rate.
C. net present value of cash flows to internal rate of return.
D. net present value of cash flows to average accounting return.
E. present value of cash flows to initial investment cost.

Blooms: Understand
Difficulty: Easy
Topic: 07-07 The Discounted Payback Period Rule

42. Under capital rationing the profitability index is used to select investments because of
limited capital by their:
A. excess profit to achieve the highest payoff.
B. reward per dollar cost to achieve the highest incremental NPV.
C. incremental IRR to maximize the total rate of return.
D. capital usage rate to stay within budget.

Blooms: Understand
Difficulty: Medium

7-15
43. You are considering a project with the following data:
Internal rate of return 8.7%

Profitability ratio.98
Net present value -$393
Payback period 2.44 years
Required return 9.5%
Which one of the following is correct given this information?

A. The discount rate used in computing the net present value must have been less than 8.7%.
B. The discounted payback period will have to be less than 2.44 years.
C. The discount rate used to compute the profitability ratio was equal to the internal rate of
return.
D. This project should be accepted based on the profitability ratio.
E. This project should be rejected based on the internal rate of return.

Blooms: Understand
Difficulty: Medium
Topic: 07-08 The Average Accounting Return

44. Suppose that a project has a cash flow pattern (-$2,000, $25,000, -$25000) Its IRR is
given by:
A. 12.20%
B. 9.61% or 1040.39%
C. 25.25% or 250.52%
D. 4100.11%

Blooms: Apply
Difficulty: Medium

7-16
45. Suppose that a project has a cash flow pattern (-$2,000, $25,000,- $25000). For its
modified IRR at a discount rate of 10%, the relevant numbers are:
A. (-$2,000, $25,000)
B. (-$2,000, $2,129)
C. (-$5,000, $5,000)
D. (-$2,000, $2,273)

Blooms: Apply
Difficulty: Medium

46. Suppose that a project has a cash flow pattern (-$2,000, $25,000, -$25000) and discount
rate of 10%, its modified IRR is given by:
A. 12.65%
B. 25.22% or 400%
C. 25.22% or 250%
D. 13.64%

Blooms: Apply
Difficulty: Medium

Short Answer Questions

47. Explain the differences and similarities between net present value (NPV) and the
profitability index (PI).
The NPV and PI are basically the same calculation, and both rules lead to the same
accept/reject decision. The main difference between the two is that the PI may be useful in
determining which projects to accept if funds are limited; however, the PI may lead to
incorrect decisions in considering mutually exclusive investments.

Blooms: Understand
Difficulty: Easy

7-17
48. The Ziggy Trim and Cut Company can purchase equipment on sale for $4,300. The asset
has a three-year life, will produce a cash flow of $1,200 in the first and second year, and
$3,000 in the third year. The interest rate is 12%. Calculate the project's payback assuming
end of year cash flows. Also, calculate project's IRR. Should the project be taken? Check your
answer by computing the project's NPV.
Payback-2.633 Years.
Trial and error produces IRR = 10.41%. Do not take project as IRR < 12% Reject the project
NPV = ($136.60)

Blooms: Analyze
Difficulty: Medium

49. The Ziggy Trim and Cut Company can purchase equipment on sale for $4,300. The asset
has a three-year life, will produce a cashflow of $1,200 in the first and second year, and
$3,000 in the third year. The interest rate is 12%. Calculate the project's discounted payback
and Profitability Index assuming end of year cash flows. Should the project be taken? If the
accounting rate of return was positive, how would this affect your decision?
T CF PVCF ∑PVCF
0 -4,300 -4,300
1.2 +1200 2028.06 -2,271.94
3 +3000 2135.34 -1365.599
DPP cannot be calculated as NPV < 0.

PI = åCFATt/Initial Investment = 4163.40/4300 = .968 = .97
- Both measures indicate rejection. A positive accounting rate of return should not change the
decision. DPP and PI indicate that your cost of capital is not being covered.

Blooms: Analyze
Difficulty: Medium

7-18
50. The Walker Landscaping Company can purchase a piece of equipment for $3,600. The
asset has a two-year life, will produce a cashflow of $600 in the first year and $4200 in the
second year. The interest rate is 15%. Calculate the project's payback assuming steady
cashflows. Also calculate the project's IRR. Should the project be taken? Check your answer
by computing the project's NPV.
Payback = 1.714 years

Calculated IRR = 16.67. Accept the project. NPV = $97.54.

Blooms: Analyze
Difficulty: Medium

51. The Walker Landscaping Company can purchase a piece of equipment for $3,600. The
asset has a two-year life, will produce a cashflow of $600 in the first year and $4200 in the
second year. The interest rate is 15%. Calculate the project's discounted payback and
Profitability Index assuming steady cashflows. Should the project be taken? If the accounting
rate of return was positive, how would this affect your decision?
T CF PVCF ∑PVCF
0 -3,600 -3,600
1 +600 521.74 -3,078.26
2 +4200 3175.80 97.54
DPP = 1 + 3078.26/3175.80 = 1.969 = 1.97 years

PI = åCFATt/Initial Investment = 3697.54/3600 = 1.027 = 1.03
Both measures indicate acceptance. A positive accounting rate of return would be consistent
with this decision. Reliance on AAR should not be the key, as DPP and PI indicate earning a
rate greater than cost of capital.

Blooms: Analyze
Difficulty: Medium

7-19
52. Cutler Compacts will generate cash flows of $30,000 in year one, and $65,000 in year
two. However, if they make an immediate investment of $20,000, they can expect to have
cash streams of $55,000 in year 1 and $63,000 in year 2 instead. The interest rate is 9%.
Calculate the NPV of the proposed project. Why would the IRR be a poor choice in this
situation?
Use incremental cash flow approach: NPV-1,252, accept project.

With more than one sign change, there will be more than one IRR.

Blooms: Analyze
Difficulty: Hard

53. Given the cash flow stream of the following mutually exclusive projects, prove through
the incremental investment that Project B, with the higher NPV, will be preferred to project
A.
0 1 2 3 NPV IRR
Project A: -500 150 245 320 46.39 17.76

Project B: -800 360 360 360 50.01 16.65
Incremental investment in B: -300 210 115 40 NPV = 3.63

Blooms: Analyze
Difficulty: Hard

7-20
54. The IRR rule is said to be a special case of the NPV rule. Explain why this is so and why
it has some limitations NPV does not?
At some K NPV = 0; by definition, when NPV = 0

K = IRR.
Problems occur conflicts with mutually exclusive projects timing and size problems
NPV always the best choice

Blooms: Understand
Difficulty: Medium

55. The NPV rule and PI give the same results when there is no conflict. In the case of a
mutually exclusive set of investments, explain the potential conflict and the way it should be
solved with supporting examples.
Please refer to section 7.7 (The Profitability Index) of the text for the answer.

Blooms: Understand
Difficulty: Hard

56. The NPV rule and PI give the same results when there is no conflict. In the case of capital
rationing, explain the potential conflict and the way it should be solved with supporting
examples.
Please refer to section 7.7 (The Profitability Index) of the text for the answer.

Blooms: Understand
Difficulty: Hard

7-21
57. List and briefly discuss the advantages and disadvantages of the internal rate of return
(IRR) rule.
The advantages of the rule are its close relationship with NPV and the ease with which it is
understood and communicated. The two disadvantages are that there may be multiple
solutions and the rule may lead to a ranking conflict in evaluating mutually exclusive
investments. The student should add a brief explanation demonstrating their understanding of
each.

Blooms: Understand
Difficulty: Medium

58. Given the goal of maximization of firm value and shareholder wealth, we have stressed
the importance of net present value (NPV). And yet, many financial decision-makers at some
of the most prominent firms in the world continue to use less desirable measures such as the
payback period and the average accounting return (AAR). Why do you think this is the case?
This is an open-ended question which allows the creative student to speculate on the value of
non-discounted cash flow evaluation measures. We use it as a springboard to stress that even
rational financial managers sometimes find it expedient to use a group of measures. For
example, firms may rely on the IRR because it is easier to explain to board members than
NPV. Also, for large projects, AAR provides shareholders with some insights as to the
project's impact on net income and earnings per share.

Blooms: Understand
Difficulty: Hard
Topic: 07-08 The Average Accounting Return

7-22

Net Present Value and Other Investment Rules: Multiple Choice Questions

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Chapter 07 - Net Present Value and Other Investment Rules

Multiple Choice Questions

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3. Accepting positive NPV projects benefits the stockholders because:

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5. Which of the following does not characterize NPV?

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6. If a project is assigned a required rate of return equal to zero, then:

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7. Payback is frequently used to analyze independent projects because:

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14. The discounted payback period rule:

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15. The payback period rule:

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20. The average accounting rate of return is determined by:

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23. The internal rate of return for a project will increase if:

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24. The internal rate of return tends to be:

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26. A mutually exclusive project is a project whose:

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27. A project will have more than one IRR if:

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29. The internal rate of return may be defined as:

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31. The Carnation Chemical Company is investing in an incinerator to dispose of PCB waste.

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32. The IRR decision rule can be reversed because:

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36. The problem of multiple IRRs can occur when:

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41. The profitability index is the ratio of:

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43. You are considering a project with the following data:

Internal rate of return 8.7%

Which one of the following is correct given this information?