Chapter 09

Financial Management: Core Concepts, 3e, GE (Brooks)
Chapter 9 Capital Budgeting Decision Models
9.1 Short-Term and Long-Term Decisions
1) ________ is at the heart of corporate finance, because it is concerned with making the best choices about
project selection.
A) Capital budgeting
B) Capital structure
C) Payback period
D) Short-term budgeting
Answer: A
Diff: 2
Topic: 9.1 Short-Term and Long-Term Decisions
AACSB: 6 Reflective Thinking
LO: 9.1 Explain capital budgeting and differentiate between short-term and long-term budgeting decisions.
Hmwrk Questions: * Taken from "Prepping for Exams" questions at the end of the chapter.
2) The ________ model is usually considered the best of the capital budgeting decision-making models.
A) internal rate of return (IRR)
B) net present value (NPV)
C) profitability index (PI)
D) discounted payback period
Answer: B
Diff: 1
3) We can separate short-term and long-term decisions into three dimensions. Which of the below is NOT
one of these?
A) Degree of information gathering prior to the decision
B) Cost
C) Personality of CEO making the decisions
D) Length of impact
Answer: C
Explanation: C) We can separate short-term and long-term decisions into three dimensions: 1. Length of
impact; 2. Cost; 3. Degree of information gathering prior to the decision.
Diff: 1
1
Copyright © 2016, Pearson Education, Ltd.
4) Because money is often limited, companies must be careful to choose projects that are feasible and
profitable.
Answer: TRUE
Diff: 1
5) Capital budgeting decisions are typically long-term decisions.

Answer: TRUE
Diff: 1
6) Name and describe three key observations that we can make about the capital budgeting decision.
Answer: There are three key observations we can make about the capital budgeting decision:
1) A capital budgeting decision is typically a go or no-go decision on a product, service, facility, or
activity of the firm. That is, we either accept the business proposal or we reject it. The choice of accepting
or rejecting a proposed project is the cornerstone of financial management at all levels of a business.
2) A capital budgeting decision will require sound estimates of the time and amount of appropriate cash
flow for the proposal. Thus, the appropriate future cash flow is a necessary input into all capital
budgeting decisions.
3) The capital budgeting model has predetermined accept or reject criteria. We need to examine the
validity of these criteria within each decision model.
Diff: 3
9.2 Payback Period
1) The ________ model answers one basic question: How soon will I recover my initial investment?
A) payback period
B) IRR
C) NPV
D) profitability index
Answer: A
Diff: 1
Topic: 9.2 Payback Period
LO: 9.2 Explain the payback period model and its two significant weaknesses and how the discounted payback
period model addresses one of the problems.
2
2) The ________ model determines at what point in time cash outflow is recovered by the corresponding
future cash inflow.
A) NPV
B) buyback
C) net present value
D) payback period
Answer: D
Diff: 1
3) Consider the following four-year project. The initial after-tax outlay or after-tax cost is $1,000,000. The
future after-tax cash inflows for years 1, 2, 3 and 4 are: $400,000, $300,000, $200,000 and $200,000,
respectively. What is the payback period without discounting cash flows?
A) 2.5 years
B) 3.0 years
C) 3.5 years
D) 4.0 years
Answer: C
Explanation: C) We can see that after three years, we will have paid back $900,000. Thus, we only need
$100,000 in after-tax cash flows in the 4th year. Because we get $200,000 in the fourth year, the rule of
thumb is to divide what is needed by the cash inflows we will get next period and add the results to the
number of previous periods of cash inflows, e.g., ($100,000 divided by $200,000) + 3 which gives 3.500.
Thus, the payback period is 3.5 years.
Diff: 2
AACSB: 3 Analytical Thinking
4) Consider the following ten-year project. The initial after-tax outlay or after-tax cost is $1,000,000. The
future after-tax cash inflows each year for years 1 through 10 are $200,000 per year. What is the payback
period without discounting cash flows?
A) 10 years
B) 5 years
C) 2.5 years
D) 0.5 years
Answer: B
Explanation: B) $1,000,000/$200,000 per year = 5 years.
Diff: 1
3
5) The initial outlay or cost is $1,000,000 for a four-year project. The respective future cash inflows for
years 1, 2, 3 and 4 are: $500,000, $300,000, $300,000 and $300,000. What is the payback period without
discounting cash flows?
A) About 2.50 years
B) About 2.67 years
C) About 3.67 years
D) About 4.50 years
Answer: B
Explanation: B) We can see that after two years, we will have paid back $800,000. Thus, we only need
$200,000 in after-tax cash flows in the third year. Since we get $300,000 in the third year, the rule of thumb
is to divide what is needed by the cash inflows we will get next period and add the results to the number
of previous periods of cash inflows, e.g., ($200,000 divided by $300,000) + 2, which gives about 2.67. Thus,
the payback period is about .
Diff: 3
6) Acme, Inc. is considering a four-year project that has an initial outlay or cost of $100,000. The respective
future cash inflows from its project for years 1, 2, 3 and 4 are: $50,000, $40,000, $30,000 and $20,000. Will it
accept the project if it's payback period is 31 months?
A) Yes, because it pays back in 25 months.
B) Yes, because it pays back in 28 months.
C) No, because it pays back in over 31 months.
D) No, because it pays back in over 35 months.
Answer: B
Explanation: B) We can see that after two years, we will have paid back $90,000. Thus, we only need
$10,000 in after-tax cash flows in the third year. Since we get $30,000 in the third year, the rule of thumb is
to divide what is needed by the cash inflows we will get next period and add the result to the number of
previous periods of cash inflows, e.g., ($10,000 divided by $30,000) + 2. Doing this gives 2-1/3 years. The
payback period in months is 2-1/3 * 12 = 28 months. Thus, Acme can accept the project as it pays back
within 31 months.
Diff: 3
4
7) Which of the statements below is TRUE of the payback period method?
A) It ignores the cash flow after the initial outflow has been recovered.
B) It is biased against projects with early-term payouts.
C) It incorporates time-value-of-money principles.
D) It focuses on cash flows after the initial outflow has been recovered.
Answer: A
Explanation: A) By ignoring the cash flow after the initial outflow has been recovered, the payback
period is biased toward those projects that have higher early-year cash inflow and against those with
higher late-year inflow.
Diff: 2
8) Which of the statements below is FALSE?

A) Firms rarely use the payback period for small-dollar decisions.
B) Many companies use the payback period for small-dollar decisions because the time spent gathering
the accurate cash flow may be lowered substantially if it is necessary to estimate only through the first
few years.
C) Many companies use the payback period for small-dollar decisions because the future cash flows on
these smaller projects may be quite difficult to accurately estimate far into the future.
D) Many companies use the payback period for small-dollar decisions because it does prevent a serious
error when the future cash flow is insufficient to recover the initial cash outlay.
Answer: A
Explanation: A) Many companies use the payback period for small-dollar decisions. This is because for
small-dollar decisions, the time spent gathering the accurate cash flows may be lowered substantially if it
is necessary to estimate only through the first few years. The future cash flows on these smaller projects
may be quite difficult to accurately estimate far into the future. Therefore, the company establishes a short
arbitrary cut-off date for handling the initial screening of many small-dollar opportunities. And finally, it
does prevent a serious error when the future cash flow is insufficient to recover the initial cash outlay.
Diff: 2
5
9) The initial outlay or cost for a four-year project is $1,000,000. The respective cash inflows for years 1, 2,
3 and 4 are: $500,000, $300,000, $300,000 and $300,000. What is the discounted payback period if the
discount rate is 10%?
A) About 2.67 years
B) About 3.35 years
C) About 3.67 years
D) About 4.50 years
Answer: B
Explanation: B) We first discount all after-tax cash inflows, which gives us after-tax cash inflows of
$454,545.45, $247,933.88, $225,394.44 and $204,904.04. After three years, we will have paid back
$927,873.77 leaving $72,126.23 to pay back in after-tax cash flows in the fourth year. Since we get
$204,904.04 in the fourth year, the rule of thumb is to divide what is needed by the cash inflows we will
get next period and add it to the number of previous periods of cash inflows, e.g., ($72,126.23 divided by
$204,904.04) + 3. Doing this gives 3.352. Thus, the payback period is about 3.35 years.
Diff: 3
10) Acme, Inc. is considering a four-year project that has initial outlay or cost of $100,000. The respective
cash inflows for years 1, 2, 3 and 4 are: $50,000, $40,000, $30,000 and $20,000. Acme uses the discounted
payback period method, and has a discount rate of 11.50%. Will Acme accept the project if it's payback
period is 37 months?
A) Yes, because it pays back in less than 37 months.
B) No, because it pays back in over 37 months.
C) No, because it pays back in over 38 months.
D) No, because it pays back in over 40 months.
Answer: B
Explanation: B) We first discount all after-tax cash inflows, which gives us after-tax cash inflows of
$44,843.05, $32,174.39, $21,641.96, and $12,939.89. After three years or 36 months, we will have paid back
$98,659.40, leaving $1,340.60 to pay back in after-tax cash flows in the fourth year. Since we get $12,939.89
in the fourth year, the rule of thumb is to divide what is needed by the cash inflows we will get next
period and add it to the number of previous periods of cash inflows, e.g., ($1,340.60 divided by
$12,939.89) + 3. Doing this gives 3.104. Thus, the payback period in months is 3.104 × 12 = 37.243 months.
Because this is over 37 months, Acme does not accept the project.
Diff: 3
6
A) In order to account for the time value of money with the Payback Period Model, the future cash flow
needs to be restated in current dollars.
B) The Discounted Payback Period method is the time it takes to recover the initial investment in current
dollars.
C) When we discount a future cash flow with our standard time-value-of-money concepts, we inherently
assume that the entire cash flow was received at the end of the year.
D) The Payback Period method (with no discounting) is the dollar amount that it takes to recover the
initial investment in current dollars.
Answer: D
Explanation: D) The Discounted Payback Period method is the TIME it takes to recover the initial
investment in current dollars.
Diff: 2

A) To account for the time value of money with the Payback Period Model, the future cash flow needs to
be restated in current dollars.
B) The Discounted Payback Period method is the time it takes to recover the initial investment in future
dollars.
C) When we discount a future cash flow with our standard time-value-of-money concepts, we inherently
assume that the entire cash flow was received at the end of the year.
D) The Discounted Payback Period method does not correct for the cash flow after the recovery of the
initial outflow.
Answer: B
Explanation: B) The Discounted Payback Period method is the time it takes to recover the initial
investment in CURRENT dollars.
Diff: 2
7
13) Consider the following four-year project. The initial outlay or cost is $180,000. The respective cash
inflows for years 1, 2, 3 and 4 are: $100,000, $80,000, $80,000 and $20,000. What is the discounted payback
period if the discount rate is 11%?
A) About 1.667 years
B) About 2.000 years
C) About 2.135 years
D) About 2.427 years
Answer: D
Explanation: D) We first discount all after-tax cash inflows, which gives us after-tax cash inflows of
$90,090.09, $64,929.79, $58,495.31, and $13,174.62. After two years, we will have paid back $155,019.88,
leaving $24,980.12 to pay back in after-tax cash flows in the third year. Since we get $58,495.31 in the third
year, the rule of thumb is to divide what is needed by the cash inflows we will get next period and add it
to the number of previous periods of cash inflows, e.g., ($24,980.12 divided by $58,495.31) + 2. Doing this
gives 2.427 years as the discounted payback period.
Diff: 3
14) A company usually establishes a short, arbitrary cutoff date for handling the initial screening of many
small-dollar opportunities.
Answer: TRUE
Diff: 1
15) By switching to monthly cash flows, we cannot get a more accurate estimate of the discounted
payback period.
Answer: FALSE
Explanation: By switching to monthly cash flows, we CAN GET a more accurate estimate of the
discounted payback period.
Diff: 2
16) The Discounted Payback Period method is a modified payback period model that considers how long
it takes to recover the initial investment in current dollars.
Answer: TRUE
Diff: 1
8
17) Identify and describe the shortcomings of the payback period model or method (without
discounting).
Answer: The payback period method ignores cash inflows after the initial outflow has been recovered.
Thus, this method is biased toward those projects that have higher cash inflows in earlier years and
against those with higher inflows in later years. The payback period has a fundamental flaw from a
finance perspective: it fails to account for the time value of money. This problem can be easily corrected
by adjusting to a payback period model with discounting.
Diff: 2
18) Acme, Inc. is considering a four-year project that has an initial outlay or cost of $80,000. The respective
future cash inflows for years 1, 2, 3 and 4 are: $40,000, $40,000, $30,000 and $30,000. Acme uses the
discounted payback period method and has a discount rate of 12%. Will Acme accept the project if it's
payback period is two and one-half years?
Answer: We first discount all after-tax cash inflows, which gives us after-tax cash inflows of $35,714.29,
$31,887.76, $21,353.41, and $19,065.54. After two years or 24 months, we will have paid back $67,602.04
leaving $12,397.95 to pay back in after-tax cash flows in the third year. Since we get $21,353.41 in the third
year, the rule of thumb is to divide what is needed by the cash inflows we will get next period and add it
to the number of previous periods of cash inflows, e.g., (12,397.95 divided by $21,353.41) + 2. Doing this
gives 2.581. Thus, the payback period is about 2.58 years (or in months it is 2.581 × 12 = 30.967 months).
Acme does not accept the project because the payback period is over two and one-half years (or over 30
months).
Diff: 3
9.3 Net Present Value
1) The capital budgeting decision model that utilizes all the discounted cash flow of a project is the
________ model, which is one of the single most important models in finance.
A) net present value (NPV)
B) internal rate of return (IRR)
C) profitability index (PI)
D) discounted payback period
Answer: A
Diff: 1
Topic: 9.3 Net Present Value
LO: 9.3 Understand the net present value (NPV) decision model and appreciate why it is the preferred criterion for
evaluating proposed investments.
9
2) The net present value of an investment is ________.
A) the present value of all benefits (cash inflows)
B) the present value of all benefits (cash inflows) minus the present value of all costs (cash outflows) of
the project
C) the present value of all costs (cash outflows) of the project
D) the present value of all costs (cash outflow) minus the present value of all benefits (cash inflow) of the
project
Answer: B
Diff: 1
3) In the NPV model, all cash flows are stated ________.

A) in future value dollars, and the total inflow is "netted" against the outflow to see if the net amount is
positive or negative
B) in present value or current dollars, and the outflow is "netted" against the total inflow to see if the
gross amount is positive or negative
C) in present value or current dollars, and the total inflow is "netted" against the initial outflow to see if
the net amount is positive or negative
D) in future dollars, and the initial outflow is "netted" against the total inflow to see if the net amount is
positive
Answer: C
Diff: 2
4) In regard to the NPV method, which of the statements below is TRUE?

A) In the NPV model, if two projects are being compared, the one with the highest IRR is selected.
B) In the NPV model, the present cash flows are discounted at the rate r, the cost of capital.
C) In the NPV model, most future cash flows are stated in present value or current dollars and the inflow
is "netted" against the outflow to see if the net amount is positive or negative.
D) In the NPV model, the net present value of an investment is the present value of all benefits (cash
inflow) minus the present value of all costs (cash outflow) of the project.
Answer: D
Explanation: D) In the NPV model, if two projects are being compared, the one with the highest
POSITIVE NET PRESENT VALUE is selected. In the NPV model, the FUTURE cash flows are discounted
at the rate r, the cost of capital. In the NPV model, ALL cash flows (including the initial costs and future
cash inflows) are stated in present value or current dollars and the total inflow is "netted" against the
outflow to see if the net amount is positive or negative.
Diff: 2
10
A) The NPV decision criterion is true when all projects are independent and the company has a sufficient
source of funds to accept all positive NPV projects.
B) Two projects are mutually exclusive if the acceptance of one project has no bearing on the acceptance
or rejection of the other project.
C) Projects are mutually exclusive if picking one project eliminates the ability to pick the other project.
D) If a company has constrained capital, then it can only take on a limited number of projects.
Answer: B
Explanation: B) Two projects are INDEPENDENT if the acceptance of one project has no bearing on the
acceptance or rejection of the other project.
Diff: 2
6) Projects are mutually exclusive if picking one project eliminates the ability to pick the other project.
This mutually exclusive situation can arise for different reasons. Which of the statements below is NOT
one of these reasons?
A) One project will always have a negative NPV.
B) There is a scarce resource that both projects would need.
C) There is need for only one project, and both projects can fulfill that current need.
D) By using funds for one project, there are not enough funds available for the other project.
Answer: A
Explanation: A) Projects are mutually exclusive if picking one project eliminates the ability to pick the
other project even if BOTH PROJECTS HAVE POSITIVE net present values. This mutually exclusive
situation can arise for one of two reasons: there is need for only one project, and both projects can fulfill
that current need; there is a scarce resource that both projects need, and by using it in one project, it is not
available for the second project.
Diff: 2
7) Which of the following may be TRUE regarding mutually exclusive capital budgeting projects?
A) There is need for only one project, and both projects can fulfill that current need.
B) By using funds for one project, there are not enough funds available for the other project.
C) There is a scarce resource that both projects would need.
D) All of the above
Answer: D
Diff: 2
11
A) The net present value decision model is an economically sound model when comparing different
projects across a wide variety of products, services, and activities under capital constraint.
B) The greater the NPV of a project, the greater the "bag of money" for doing the project, and more money
is better. If a company is short of capital, it would choose those projects that provide the largest "bag of
money."
C) Despite all of the advantages of using the NPV model, it is inconsistent with the concept of the time-
value-of-money.
D) By discounting all future cash flows to the present, adding up all inflows, and subtracting all outflows,
we are determining the net present value of the project.
Answer: C
Explanation: C) One of the important aspects of the NPV model is that it IS CONSISTENT with the
concept of the time-value-of-money.
Diff: 2
9) There are two ways to correct for projects with unequal lives when using the NPV approach. Which of
the answers below is one of these ways?
A) One way is to find a common life, without the need to extend the projects to the least common
multiple of their lives.
B) One way is to find the present value factors and then compare them.
C) One way is to compare the lengths of the projects and take the project with the shortest life.
D) One way is to find a common life by extending the projects to the least common multiple of their lives.
Answer: D
Explanation: D) One way is to find a common life by extending the projects to the least common multiple
of the lives. The other way is to deal with unequal lives is by finding the equivalent annual annuity
(EAA) for the NPV of each project over the life of the project.
Diff: 2
12
A) We calculate the equivalent annual annuity by taking the NPV of the project and find the annuity
stream that equates to the NPV, using the appropriate discount rate for the project and life of the project.
B) In dealing with mutually exclusive projects of unequal lives, we can compute the EAA for the NPV of
the project over the life of the project.
C) One of the advantages of NPV over other decision models is that we can select the appropriate
discount rate for each individual project and still compare the resulting NPVs across different projects.
D) By using the EAA approach for mutually exclusive projects, we overcome all potential problems.
Answer: D
Explanation: D) There are some potential problems with the EAA approach to selecting projects with
unequal lives when dealing with mutually exclusive projects. For example, it is not always proper to
assume that cash flows will be extended into the future. Also, projects that are currently mutually
exclusive due to needs or capital constraints may not be mutually exclusive in the future.
Diff: 2
11) Dweller, Inc. is considering a four-year project that has an initial after-tax outlay or after-tax cost of
$80,000. The future cash inflows from its project are $40,000, $40,000, $30,000 and $30,000 for years 1, 2, 3
and 4, respectively. Dweller uses the net present value method and has a discount rate of 12%. Will
Dweller accept the project?
A) Dweller accepts the project because the NPV is greater than $30,000.
B) Dweller rejects the project because the NPV is less than -$4,000.
C) Dweller rejects the project because the NPV is -$3,021.
D) Dweller accepts the project because it has a positive NPV of over $28,000.
Answer: D
Explanation: D) NPV = -CF0 + + + +
= -$80,000 + + + +
= -$80,000 + $35,714.29 + $31,887.76 + $21,353.41 + $19,065.54

= -$80,000 + $108,020.99 = $28,020.99.
Thus, Dweller accepts the project because it has a positive NPV.
Diff: 3
13
12) Washington Industries Inc. is considering a project that has an initial after-tax outlay or after-tax cost
of $350,000. The respective future cash inflows from its five-year project for years 1 through 5 are $75,000
each year. Washington expects an additional cash flow of $50,000 in the fifth year. The firm uses the net
present value method and has a discount rate of 10%. Will Washington accept the project?
A) Washington accepts the project because it has an NPV greater than $5,000.
B) Washington rejects the project because it has an NPV less than $0.
C) Washington accepts the project because it has an NPV greater than $18,000.
D) There is not enough information to make a decision.
Answer: B
Explanation: B) Using the NPV function in Excel the NPV = -$34,644.93. Because the NPV is less than $0
we reject the project.
Diff: 3
13) Rogue River, Inc. is considering a project that has an initial after-tax outlay or after-tax cost of
$220,000. The respective future cash inflows from its four-year project for years 1 through 4 are: $50,000,
$60,000, $70,000 and $80,000. Rogue River uses the net present value method and has a discount rate of
11%. Will Rogue River accept the project?
A) Rogue River accepts the project because the NPV is greater than $10,000.00.
B) Rogue River rejects the project because the NPV is about -$22,375.73.
C) Rogue River rejects the project because the NPV is about -$12,375.60.
D) Rogue River rejects the project because the NPV is about -$2,375.60.
Answer: B
Explanation: B) NPV = -CF0 + + + +
= -$220,000 + + + +
= -$220,000 + $45,045.05 + $48,697.35 + $51,183.40 + $52,698.48

= -$220,000 + $197,624.27 = -$22,375.73.
Thus, Rogue River rejects the project since it has a negative NPV.
Using the NPV function in Excel yields the same answer.
Diff: 3
14
14) Simpson, Inc. is considering a five-year project that has an initial after-tax outlay or after-tax cost of
$80,000. The respective future cash inflows from its project for years 1, 2, 3, 4 and 5 are: $15,000, $25,000,
$35,000, $45,000 and $55,000. Simpson uses the net present value method and has a discount rate of 9%.
Will Simpson accept the project?
A) Simpson accepts the project because the NPV is $129,455.25.
B) Simpson accepts the project because the NPV is 79,455.25.
C) Simpson accepts the project because the NPV is $49,455.25.
D) Simpson accepts the project because the NPV is less than zero.
Answer: C
Explanation: C) NPV = -CF0 + + + + +
= -$80,000 + + + + +
= -$80,000 + $13,761.47 + $21,042.00 + $27,026.42 + $31,879.13 + $35,746.23

= -$80,000 + $129,455.25 = $49,455.25.
Thus, Simpson accepts the project since it has a positive NPV.
Diff: 3
15) Meyer, Inc. is considering a five-year project that has an initial after-tax outlay or after-tax cost of
$70,000. The future after-tax cash inflows from its project for years 1, 2, 3, 4 and 5 are all the same at
$35,000. Meyer uses the net present value method and has a discount rate of 10%. Will Meyer accept the
project?
A) Meyer accepts the project because the NPV is about $69,455.
B) Meyer accepts the project because the NPV is about $62,678.
C) Meyer rejects the project because the NPV is about -$13,382.
D) Meyer rejects the project because the NPV is less than -$33,021.
Answer: B
Explanation: B) The future after-tax cash inflows are an annuity. Thus, we can use:
NPV = -CF0 + (PMT × . Inserting the given values gives:
NPV = -$70,000 + = -$70,000 + ($35,000 × 3.790787)
= -$70,000 + $132,677.54 = $62,677.54. Thus, Meyer accepts the project since it has a positive NPV.
Diff: 3
15
16) Aviary, Inc. is considering a five-year project that has initial after-tax outlay or after-tax cost of
$170,000. The future after-tax cash inflows from its project for years 1 through 5 are $45,000 for each year.
Aviary uses the net present value method and has a discount rate of 11.25%. Will Aviary accept the
project?
A) Aviary accepts the project because the NPV is about $5,455.
B) Aviary accepts the project because the NPV is about $165,275.
C) Aviary rejects the project because the NPV is about -$4,725.
D) Aviary rejects the project because the NPV is about -$154,725.
Answer: C
Explanation: C) The future after-tax cash inflows are an annuity. Thus, we can use:
NPV = -CF0 + . Inserting in the given values gives:
NPV = -$170,000 + = -$170,000 + ($45,000 × 3.672771)
= -$170,000 + $165,274.71 = -$4,725.29. Thus, Aviary rejects the project since it has a negative NPV.
Diff: 3
17) Chase, Inc. is considering an eight-year project that has an initial after-tax outlay or after-tax cost of
$180,000. The future after-tax cash inflows from its project for years 1 through 8 are the same at $35,000.
Chase uses the net present value method and has a discount rate of 12%. Will Chase accept the project?
A) Chase accepts the project because the NPV is over $10,000.
B) Chase accepts the project because the NPV is about $6,141.
C) Chase rejects the project because the NPV is about -$6,133.
D) Chase rejects the project because the NPV is below -$7,000.
Answer: C
Explanation: C) The future after-tax cash inflows are an annuity. Thus, we can use:
NPV = -$180,000 + = -$180,000 + ($35,000 × 4.967640)
= -$180,000 + $173,867.39 = -$6,132.61. Thus, Chase rejects the project since it has a negative NPV.
Diff: 3
16
18) Manhattan, Inc. is considering an eight-year project that has an initial after-tax outlay or after-tax cost
of $180,000. The future after-tax cash inflows from its project for years 1 through 8 are the same at $38,000.
Manhattan uses the net present value method and has a discount rate of 11.50%. Will Manhattan accept
the project?
A) Manhattan accepts the project because the NPV is about $12,114.
B) Manhattan accepts the project because the NPV is about $11,114.
C) Manhattan rejects the project because the NPV is about -$11,114.
D) Manhattan rejects the project because the NPV is less than -$12,000.
Answer: A
Explanation: A) The future after-tax cash inflows are an annuity. Thus, we can use:
NPV = -$180,000 + = -$180,000 + ($38,000 × 5.055637)
= -$180,000 + $192,114.20 = $12,114.20. Thus, Manhattan accepts the project since it has a positive NPV.
Diff: 3
17
19) Allied, Inc. is considering Project A and Project B, which are two mutually exclusive projects with
unequal lives. Project A is an eight-year project that has an initial outlay or cost of $180,000. Its future
cash inflows for years 1 through 8 are $38,000. Project B is a six-year project that has an initial outlay or
cost of $160,000. Its future cash inflows for years 1 through 6 are the same at $36,000. Allied uses the
equivalent annual annuity (EAA) method and has a discount rate of 11.50%. Will Allied accept the
project?
A) Allied accepts Project B because it has a more positive EAA.
B) Allied rejects both projects because both have a negative NPV (and thus negative EAA).
C) Allied accepts Project A because its EAA is about $2,396 and Project B's EAA is only about $1,097.
D) Allied accepts Project A because its NPV (and thus EAA) is positive and Project B's NPV (and thus
EAA) is negative.
Answer: D
Explanation: D) We will compute the EAA for both projects and choose the one with the greater positive
EAA. If both EAAs are negative, then we will reject both projects. If one Project has a negative NPV (and
thus negative EAA), then we will choose the project with the positive NPV (and thus positive EAA).
For Project A, the NPV = -CF0 + . Inserting the given values, we have: NPV = -
$180,000 + = -$180,000 + ($38,000 × 5.055637)
= -$180,000 + $192,114.20 = $12,114.20. The EAA is the NPV divided by the PVIFA.
We have: EAA (Project A) = = $2,396.18.
For Project B, the NPV = -CF0 +
= -$160,000 + = -$160,000 + ($36,000 × 4.170294)
= -$160,000 + $150,130.59 = -$9,869.41. The EAA is the NPV divided by the PVIFA. We have: EAA (Project
B) = = -$2,366.60. Allied will take Project A, not only because its EAA is positive and superior
to Project B's, but because the NPV for Project B is negative. Thus, we can really only consider one project,
and that is Project A.
Diff: 3
18
20) Apple, Inc. is considering Project A and Project B, which are two mutually exclusive projects with
unequal lives. Project A is an eight-year project that has an initial outlay or cost of $140,000. Its future
cash inflows for years 1 through 8 are the same at $36,500. Project B is a six-year project that has an initial
outlay or cost of $160,000. Its future cash inflows for years 1 through 6 are the same at $48,000. Apple uses
the equivalent annual annuity (EAA) method and has a discount rate of 13%. Which project(s), if any, will
Apple accept?
A) Apple will take Project B because it has a positive NPV and its EAA is greater than that for Project A.
B) Apple rejects both projects because both have a negative NPV (and thus negative EAA).
C) Apple accepts both projects because both have a positive NPV (and thus positive EAA).
D) Apple accepts Project A because its EAA of about $7,975 is greater than Project B's EAA of about
$6,440.
Answer: A
Explanation: A) We will compute the EAA for both projects and choose the one with the greater positive
EAA since the projects are mutually exclusive and only one can be taken. If both EAAs are negative then
we will reject both projects. If one Project has a negative NPV (and thus negative EAA), then we will
choose the project with the positive NPV (and thus positive EAA). For Project A, the NPV = -CF 0 +
Inserting the given values, we have:
NPV = -$140,000 + = -$140,000 + ($36,500 × 4.79877)
We have: EAA (Project A) = = $7,325.86.
For Project B, the NPV = -CF0 +
= -$160,000 + = -$160,000 + ($48,000 × 3.997550)
= -$160,000 + $191,882.39 = $31,882.39. The EAA is the NPV divided by the PVIFA. We have: EAA (Project
A) = = $7,975.48. Apple will take Project B because it has a positive NPV and its EAA is greater
than that for Project A.

Diff: 3
19
21) The assignment of a discount rate to each project is an integral part of the NPV process.
Answer: TRUE
Diff: 1
22) To determine the current value of a project, discount all future cash flows to the present and add up
all cash inflow and outflow.
Answer: FALSE
Explanation: To determine the current value of a project, discount all future cash flows to the present,
add up all cash inflow, and SUBTRACT all cash outflow.
Diff: 2
23) Finding the equivalent annual annuity (EAA) is a good way to deal with projects with unequal lives
and should only be used with mutually exclusive projects.
Answer: TRUE
Diff: 2
24) To be considered acceptable, a project must have an NPV greater than 1.0.
Answer: FALSE
Explanation: To be considered acceptable, a project must have an NPV greater than $0.0
Diff: 2
20
25) Stanton, Inc. wants to analyze the NPV profile for a five-year project that is considered to be very
risky. The project's initial outlay or cost is $80,000 and it has respective cash inflows for years 1, 2, 3, 4 and
5 of $15,000, $25,000, $35,000, $45,000 and $55,000. Stanton wants to know how the NPV will change for
the following required rates of returns: 9%, 14%, 19%, 24%, and 29%. From the NPV profile, at about what
rate will the NPV be equal to zero?
Answer: Let us first compute the NPV for 9%. We have:
NPV = -CF0 + + + + +
= -$80,000 + + + + +
= -$80,000 + $13,761.47 + $21,042.00 + $27,026.42 + $31,879.13 + $35,746.23

= -$80,000 + $129,455.25 = $49,455.25.
In a similar fashion, for 14%, 19%, 24% and 29%, we get respective NPVs of $31,227.48, $16,516.53,
$4,507.67, and -$5,398.55. Thus, we can see the rate of return where the NPV is zero will be between 24%
and 29%. Using an Excel spreadsheet, one can compute a break-even rate of return (called IRR in the next
section) of about 26.16% (26.159675%, which will give a zero negative present value to two decimal
points). Beginning with a rate of 24%, the rule of thumb when trying various rates is to increase the rate
of return until the NPV becomes zero. If it becomes negative, then one decreases the rate.
Diff: 3
21
26) Ace, Inc. is considering Project A and Project B, which are two mutually exclusive projects with
unequal lives. Project A is an eight-year project that has an initial outlay or cost of $18,000. Its future cash
inflows for years 1 through 8 are the same at $3,800. Project B is a six-year project that has an initial outlay
or cost of $16,000. Its future cash inflows for years 1 through 6 are the same at $3,600. Ace uses the
equivalent annual annuity (EAA) method and has a discount rate of 11.50%. Which, if any, project will
Ace accept?
Answer: We will compute the EAA for both projects and choose the one with the greater positive EAA. If
both EAAs are negative, we will then reject both projects. If one Project has a negative NPV (and thus
negative EAA), we will then choose the project with the positive NPV (and thus positive EAA). For
Project A, the NPV = -CF0 + . Inserting the given values, we have: NPV = -$18,000 +
= -$18,000 + ($3,800 × 5.055637)
We have: EAA (Project A) = = $239.62.
For Project B, the NPV = -CF0 + = -$16,000 +
= -$16,000 + ($3,600 × 4.170294) = -$16,000 + $15,013.06 = -$986.94. The EAA is the NPV divided by the
PVIFA. We have: EAA (Project A) = = -$236.66. Ace will take Project A not only because its EAA
is positive and superior to Project B's, but because the NPV for Project B is negative. Thus, we can really
only consider one project and that is Project A.
Diff: 3
9.4 Internal Rate of Return
1) The most popular alternative to NPV for capital budgeting decisions is the ________ method.
A) internal rate of return (IRR)
B) payback period
C) discounted payback period
Answer: A
Diff: 1
Topic: 9.4 Internal Rate of Return
LO: 9.4 Calculate the most popular capital budgeting alternative to the NPV, the internal rate of return (IRR); explain
how the modified internal rate of return (MIRR) model attempts to address the IRR's problems.
22
2) The IRR is the discount rate that produces a zero NPV or the specific discount rate at which the present
value of the cost equals ________.
A) the future value of the present cash outflows
B) the present value of the future benefits or cash inflows
C) the present value of the cash outflow
D) the investment
Answer: B
Explanation: B) The IRR is defined as the discount rate that produces a zero NPV or the specific discount
rate at which the present value of the cost (the investment or cash outflows) equals the present value of
the future benefits.
Diff: 1
3) Without a computer and special calculator, ________.

A) computing the payback period is much more difficult than computing the IRR
B) finding the IRR will typically be a very easy process
C) finding the IRR may be a very tedious process only if the NPV is negative
D) finding the IRR may be a very tedious process since it is an iterative process
Answer: D
Explanation: D) Computing an IRR without a computer or special calculator is typically much more
difficult than computing the payback period or the NPV.
Diff: 1
4) Which of the statements below describes the IRR decision criterion?

A) The decision criterion is to accept a project if the IRR falls below the desired or required return rate.
B) The decision criterion is to reject a project if the IRR exceeds the desired or required return rate.
C) The decision criterion is to accept a project if the IRR exceeds the desired or required return rate.
D) The decision criterion is to accept a project if the NPV is positive.
Answer: C
Diff: 2
23
5) The hurdle rate should be set so that it reflects the proper risk level for the project. If we have to choose
between two projects with similar risk and therefore similar hurdle rates, we would select the project that
________.
A) has a higher internal rate of return
B) has a lower internal rate of return
C) has a hurdle rate that is consistent with the payback period method
D) has a hurdle rate that is consistent with the discounted payback period model
Answer: A
Diff: 1
6) Which of the statements below is TRUE?

A) The hurdle rate is the cost of debt needed to fund a project.
B) If the IRR exceeds a project's hurdle rate, the project should be rejected.
C) If the IRR clears the hurdle rate, the project is rejected.
D) The hurdle rate should be set so that it reflects the proper risk level for the project.
Answer: D
Explanation: D) The hurdle rate is the COST OF CAPITAL needed to fund a project. If the IRR exceeds a
project's hurdle rate, the project CAN BE ACCEPTED (assuming the NPV method renders the same
decision). If the IRR CANNOT CLEAR the hurdle rate, the project is rejected.
Diff: 2
7) Flynn, Inc. is considering a four-year project that has an initial outlay or cost of $80,000. The future cash
inflows from its project are $40,000, $40,000, $30,000, and $30,000 for years 1, 2, 3 and 4, respectively.
Flynn uses the internal rate of return method to evaluate projects. What is the approximate IRR for this
project?
A) The IRR is less than 12%.
B) The IRR is between 12% and 20%.
C) The IRR is about 24.55%.
D) The IRR is about 28.89%.
Answer: D
Explanation: D) Using a financial calculator or software program like Excel or trial and error, we get IRR
= 28.89% if we round our answer to two decimal places.
Diff: 3
24
8) Washington Industries Inc. is considering a project that has an initial after-tax outlay or after-tax cost of
$350,000. The respective future cash inflows from its five-year project for years 1 through 5 are $75,000
each year. Washington expects an additional cash flow of $50,000 in the fifth year. The firm uses the IRR
method and has a hurdle rate of 10%. Will Washington accept the project?
A) Washington accepts the project because it has an IRR greater than 10%.
B) Washington rejects the project because it has an IRR less than 10%.
C) Washington accepts the project because it has an IRR greater than 5%.
D) There is not enough information to answer this question.
Answer: B
Explanation: B) Using a financial calculator or software program like Excel or trial and error (and
rounding our answer to two decimal places), we get IRR = 6.32%. Thus, Washington will reject the project
as its IRR is less than its hurdle rate.
Diff: 3
9) Rogue River, Inc. is considering a project that has an initial outlay or cost of $220,000. The respective
future cash inflows from its four-year project for years 1 through 4 are: $50,000, $60,000, $70,000, and
$80,000, respectively. Rogue River uses the internal rate of return method to evaluate projects. Will Rogue
River accept the project if its hurdle rate is 10%?
A) Rogue River will not accept this project because its IRR is about 9.70%.
B) Rogue River will not accept this project because its IRR is about 8.70%.
C) Rogue River will not accept this project because its IRR is about 6.50%.
D) Rogue River will not accept this project because its IRR is about 4.60%.
Answer: C
Explanation: C) Using a financial calculator or software program like Excel or trial and error (and
rounding our answer to two decimal places), we get IRR = 6.50%. Thus, Rogue River will reject the project
as its IRR is less than its hurdle rate.
Diff: 3
25
10) Simpson, Inc. is considering a five-year project that has an initial outlay or cost of $80,000. The
respective future cash inflows from its project for years 1, 2, 3, 4 and 5 are: $15,000, $25,000, $35,000,
$45,000, and $55,000. Simpson uses the internal rate of return method to evaluate projects. What is the
project's IRR?
A) The IRR is less than 22.50%.
B) The IRR is about 24.16%.
C) The IRR is about 26.16%.
D) The IRR is over 26.50%.
Answer: C
Explanation: C) Using a financial calculator or software program like Excel or trial and error (and
rounding off to two digits), we get IRR = 26.16%.
Diff: 3
11) Meyer, Inc. is considering a very risky five-year project that has an initial outlay or cost of $70,000.
The future cash inflows from its project for years 1, 2, 3, 4, and 5 are all the same at $35,000. Meyer uses
the internal rate of return method to evaluate projects. Will Meyer accept the project if its hurdle rate is
41.00%?
A) Meyer will probably reject this project because its IRR is about 39.74%, which is slightly below its
hurdle rate.
B) Meyer will probably accept this project because its IRR is about 41.04%, which is slightly above its
hurdle rate.
C) Meyer will accept this project because its IRR is about 41.50%.
D) Meyer will accept this project because its IRR is over 45.50%.
Answer: B
Explanation: B) Using a financial calculator or software program like Excel or trial and error (and
rounding our answer to two decimal places), we get IRR = 41.04%. Thus, it appears that Meyer will accept
this project since Meyer's hurdle rate of 41.00% is slightly less than the project's IRR of 41.04%.
Diff: 3
12) The Internal Rate of Return (IRR) Model suffers from three problems. Which of the below is NOT one
of these problems?
A) Comparing mutually exclusive projects
B) Cumbersome computations not resolvable by the latest technology
C) Incorporates the IRR as the reinvestment rate for the future cash flows
D) Multiple IRRs
Answer: B
Diff: 2
26
13) Which of the following in NOT a potential problem suffered by the IRR method of capital budgeting?
A) Multiple IRRs
B) Disagreement with the NPV as to whether a project with ordinary cash flows is profitable or not
C) Incorporates the IRR as the reinvestment rate for the future cash flows
D) Comparing mutually exclusive projects
Answer: B
Diff: 2
14) Two projects intersect, in terms of NPV, at a discount rate labeled the ________.
A) crossover rate
B) internal rate of return
C) discount rate
D) yield to maturity
Answer: A
Diff: 1
15) The crossover rate is the discount rate where both projects have the same ________.
A) IRR
B) PI
C) NPV
D) length to completion
Answer: C
Diff: 1
27
A) Project A has a higher y-axis intercept for its NPV profile than mutually exclusive Project B. As long as
the profile of Project A is above the profile of Project B, Project A will have a higher NPV value for that
particular discount rate.
B) Project A and Project B are mutually exclusive. The two projects intersect in terms of NPV at a discount
rate labeled the crossover rate.
C) Project A has a higher y-axis intercept for its NPV profile than mutually exclusive Project B. As we
proceed past the crossover rate to the right on the x-axis, Project B's profile will be above Project A's
profile.
D) Project A has a higher y-axis intercept for its NPV profile than mutually exclusive Project B. This
means that Project A has a lower NPV than Project B when the discount rate is zero.
Answer: D
Explanation: D) Project A has a higher y-axis intercept for its NPV profile than mutually exclusive Project
B. This means that Project A has a HIGHER NPV than Project B when the discount rate is zero.
Diff: 2

A) One problem with IRR as a decision rule is that if the cash flow is not standard, there is a possibility of
multiple IRRs for a single project.
B) When we talk about standard cash flow for a project, we assume an initial cash outflow at the
beginning of the project and negative cash flows in the future.
C) When we apply IRR to standard cash flow, we have the potential for more than one IRR solution.
D) For every period that the cash flow has a change of sign (negative to positive or positive to negative),
the NPV profile could cross the y-axis, generating a MIRR.
Answer: A
Explanation: A) When we talk about standard cash flow for a project, we assume an initial cash outflow
at the beginning of the project and POSITIVE cash flows in the future. When we apply IRR to
NONSTANDARD cash flow we have the potential for more than one IRR solution. For every period that
the cash flow has a change of sign (negative to positive or positive to negative), the NPV profile could
cross the X-AXIS GENERATING AN IRR.
Diff: 2
28
18) Suppose you have an investment that costs $80,000 at the beginning of the project, and it generates
$30,000 a year for four years in positive cash flows. The cost of capital is 12%. The IRR of the project is
18.45% and the NPV is about $11,120. The IRR model assumes that at the end of the first year you can
invest the $30,000 at ________.
A) 18.45%
B) 12.00%
C) a rate less than the cost of capital
D) a rate greater than the IRR
Answer: A
Diff: 2
19) Find the Modified Internal Rate of Return (MIRR) for the following series of future cash flows, given a
discount rate of 11%: Year 0: -$22,000; Year 1: $5,000; Year 2: $6,000; Year 3: $7,000; Year 4: $7,500; and,
Year 5: $8,000.
A) About 12.13%
B) About 12.88%
C) About 13.04%
D) About 13.12%
Answer: D
Explanation: D) Step One. Find the future values of all the cash inflows by reinvesting the cash inflows
at the appropriate cost of capital. FV = $5,000 × (1.11)4 + $6,000 × (1.11)3 + $7,000 × (1.11)2 + $7,500 × (1.11)1
+ $8,000 × (1.11)0 = $7,590.35 + $8,205.79 + $8,624.70 + $8,325.00 + $8,000.00. Summing these we get: FV =
$40,745.84.
Step Two. Find the present value of the cash outflow by discounting at the appropriate cost of capital.
This is the initial cash outflow of $22,000 because all investment is made at the start of the project.
Expressing the cash outflow in absolute terms: PV = $22,000.
Step Three. Find the interest rate that equates the present value of the cash outflow with the future value
of the cash inflow given as: MIRR = (FV/PV)1/n - 1 = ($40,745.84/$22,000)1/5 - 1 = (1.852084)1/5 - 1 =
1.131181 - 1 = 0.131181, or about 13.12%.
Diff: 3
29
20) Find the Modified Internal Rate of Return (MIRR) for the following annual series of cash flows, given
a discount rate of 10.50%: Year 0: -$75,000; Year 1: $15,000; Year 2: $16,000; Year 3: $17,000; Year 4: $17,500;
and, Year 5: $18,000.
A) About 6.35%
B) About 6.88%
C) About 7.35%
D) About 7.88%
Answer: A
Explanation: A) Step One. Find the future values of all the cash inflow by reinvesting the cash inflow at
the appropriate cost of capital. FV = $15,000 × (1.1050)4 + $16,000 × (1.1050)3 + $17,000 × (1.1050)2 + $17,500
× (1.1050)1 + $18,000 × (1.1050)0 = $22,363.53 + $21,587.72 + $20,757.43 + $19,337.50 + $18,000.00. Summing
these we get: FV = $102,046.18.
This is the initial cash outflow of $75,000 because all investment is made at the start of the project.
Expressing the cash outflow in absolute terms: PV= $75,000.
of the cash inflow given as: MIRR = (FV / PV)n - 1 = ($102,046.18 / $75,000)1/5 - 1 = (1.360616)1/5 - 1 =
1.063524 - 1 = 0.063524 or about 6.35%.
Diff: 3
30
21) Corbett and Sullivan Enterprises (CSE) use the Modified Internal Rate of Return (MIRR) when
evaluating projects. CSE's cost of capital is 9.5%. What is the MIRR of a project if the initial costs are
$10,200,000 and the project lasts seven years, with each year producing the same after-tax cash inflows of
$1,900,000?
A) About 7.95%
B) About 8.01%
C) About 8.24%
D) About 8.88%
Answer: C
Explanation: C) Step One. Find the future values of all the cash inflow by reinvesting the cash inflow at
the appropriate cost of capital. We can use the future value annuity formula, given that the cash inflow
stream is identical. We have: FV = $1,900,000 × = $1,900,000 × = $1,900,000 ×
9.342648. Thus, FV = $17,751,032.

This is the initial cash outflow of $10,200,000 because all investment is made at the start of the project.
Expressing the cash outflow in absolute terms: PV= $10,200,000.
of the cash inflow given as: MIRR = (FV / PV)n - 1 = ($17,751,032 / $10,200,000)1/ 7 - 1 = (1.740297)1/ 7 - 1 =
1.082368 - 1 = 0.082368, or about 8.24%.
Diff: 3
22) The IRR decision criterion is to accept a project if the IRR exceeds the desired or required return rate
and to reject the project if the IRR is less than the desired or required rate of return.
Answer: TRUE
Diff: 1
23) The IRR is an unpopular capital budgeting decision model because even with the advent of
calculators and spreadsheets, the cumbersome calculation remains.
Answer: FALSE
Explanation: The IRR is very popular because with the advent of calculators and spreadsheets the
cumbersome calculation is a thing of the past. [NOTE: It can also be argued that the IRR is popular
because lenders understand the IRR and know that a firm with an IRR greater than the cost of borrowing
is a good investment.]
Diff: 2
31
24) One problem with the decision criterion of IRR is that if cash flow is not standard, there is a possibility
of multiple IRRs for a single project.
Answer: TRUE
Diff: 1
25) One of the underlying assumptions of the IRR model is that all cash inflow can be reinvested at the
individual project's internal rate of return (IRR) over the remaining life of the project.
Answer: TRUE
Diff: 2
26) Pandora, Inc. is considering a five-year project that has an initial outlay or cost of $70,000. The cash
inflows from its project for years 1, 2, 3, 4 and 5 are all the same at $14,000. The borrowing costs are 10%.
What is the IRR? Should Pandora use the IRR method to evaluate this project? Explain.
Answer: Using a financial calculator or software program like Excel or trial and error, we get an IRR that
is exactly equal to zero percent (this is because the undiscounted sum of all future inflows equals the
initial outlay, e.g., $14,000 × 5 = $70,000). It does not appear that Pandora will accept this project since its
borrowing costs of 10% will be greater than 0%. Thus, Pandora can use the IRR method if it likes because
it does indicate the project should not be accepted. Pandora can verify its rejection decision of the project
by computing its NPV, which is about -$16,929.
Diff: 3
27) Spotify, Inc. is considering a five-year project that has an initial outlay or cost of $22,000. The future
cash inflows from its project for years 1, 2, 3, 4 and 5 are $15,000, $15,000, $15,000, $15,000 and -$41,000,
respectively. Compute both IRRs. Given these IRRs, compute the two NPVs. If Spotify's true cost of
borrowing for this project is 10%, would Spotify choose the project?
Answer: Using a financial calculator or software program like Excel or trial and error (and rounding off
to two digits), we can get two IRRs: 24.88% and 9.34%. If using Excel, you can get 24.88% by typing in a
percentage near 24.88% (like 20%) and you can get 9.34% by typing in a percentage near 9.34% (like 10%).
If we use these two values to compute the Net Present Value, you would get $0 for each IRR used. If the
true cost of capital for this project is 10%, then the NPV would be $90.21 and Spotify would accept the
project.
Diff: 3
32
28) Wyatt and Zachary Enterprises (WZE) uses the Modified Internal Rate of Return (MIRR) when
evaluating projects. WZE's cost of capital is 9.75%. What is the MIRR of a project if the initial cost is
$1,200,000 and the project will last seven years, with each year producing cash inflows of $290,000?
Should WZE accept this project according to the MIRR method? Explain.
Answer:
Step One. Find the future values of all the cash inflow by reinvesting the cash inflow at the appropriate
cost of capital. We can use the future value annuity formula, given that the cash inflow stream is
identical. We have: FV = $290,000 × = $290,000 × = $290,000 × 9.414619. Thus, FV
= $2,730,240.
This is the initial cash outflow of -$1,200,000 because all investment is made at the start of the project.
Expressing the cash outflow in absolute terms: PV= $1,200,000.
of the cash inflow given as: MIRR = (FV / PV)n - 1 = ($2,730,240 / $1,200,000)7 - 1 = (2.2751996)7 - 1 =
1.124612 - 1 = 0.124612 or about 12.46%. Since the MIRR is greater than the cost of capital (e.g., 12.46% >
9.75%), WZE should accept the project. To verify this, WZE can compute the NPV; in doing this, they
would find out that it is positive, e.g., NPV = $223,537.95.
Diff: 3
9.5 Profitability Index
1) Which method is designed to give the dollar amount of return for every $1.00 invested in the project in
terms of current dollars?
A) Profitability Index Method
B) Internal Rate of Return Method
C) Net Present Value Method
D) Discounted Payback Period Method
Answer: A
Diff: 1
Topic: 9.5 Profitability Index
LO: 9.5 Understand the profitability index (PI) as a modification of the NPV model.
33
2) ________ is a modification of NPV to produce the ratio of the present value of the benefits (future cash
inflow) to the present value of the costs (initial investment).
A) Modified Internal Rate of Return Method
B) Profitability Index (PI)
C) Payback Period Method
D) Discounted Cash Flow Method
Answer: B
Diff: 1
3) The ________ method of capital budgeting is a ratio of the present value of cash inflows divided by the
initial investment.
A) payback period
B) net present value
C) internal rate of return
Answer: D
Diff: 1

A) The profitability index (PI) decision criterion states: if PI > 1.0, accept the project.
B) The profitability index (PI) decision criterion states: if PI < 1.0, reject the project.
C) The profitability index (PI) method multiplies the Present Value of Benefits by Present Value of Costs.
D) If the PI is greater than one, the benefits exceed the costs.
Answer: C
Explanation: C) The profitability index method DIVIDES the Present Value of Benefits by Present Value
of Costs.
Diff: 1
34
A) According to the profitability index (PI) decision criterion when the PI is greater than 1, the costs
exceed the benefits.
B) If we realize that NPV is the present value of the benefits minus the present value of the costs, then we
simply need to subtract the costs from the NPV to get the present value of the benefits.
C) There are two acceptable projects, but we can only take one due to a shortage of funds. The PI for these
two projects are: Project A: 2.25; Project B: 1.89. We would take Project B.
D) A PI of 1.50 can be interpreted as meaning that for every $1.00 invested today the firm gets back $1.50
in current dollars.
Answer: D
Explanation: D) According to the profitability index (PI) decision criterion, when the PI is greater than 1,
the BENEFITS exceed the COSTS. If we realize that NPV is the present value of the benefits minus the
present value of the costs, then we simply need to ADD BACK the costs to the NPV to get the present
value of the benefits. There are two acceptable projects, but we can only take one due to a shortage of
funds. The PI for these two projects are: Project A: 2.25; Project B: 1.89. We would take Project A because
it gives back $2.25 for every dollar invested, while Project B only gives back $1.89 for every dollar
invested.
Diff: 2
6) Dakota, Inc. is currently considering an eight-year project that has an initial outlay or cost of $140,000.
The cash inflows from its project for years 1 through 8 are the same at $35,000. Dakota has a discount rate
of 12%. Because there is a shortage of funds to finance all good projects, Dakota wants to compute the
profitability index (PI) for each project. That way Dakota can get an idea as to which project might be a
better choice. What is the PI for Dakota's current project?
A) About 1.24
B) About 1.21
C) About 1.19
D) About 1.09
Answer: A
Explanation: A) The PI is (NPV plus the absolute value of the costs) divided by the absolute value of the
costs. The future after-tax cash inflows are an annuity. Thus, we can use:
NPV = -CF0 + . Inserting the given values gives:
NPV = -$140,000 + = -$140,000 + ($35,000 × 4.967640)
= -$140,000 + $173,867.39 = $33,867.39. We can now compute the PI.
We have: PI = = = 1.2419, or about 1.24.

Diff: 3
35
7) Project A has an NPV of $20,000 and a PI of 1.2. Project B has an NPV of $10,000 and a PI of 1.3. Both
projects have equal lives. Which project should be preferred if we are NOT concerned with capital
rationing (that is, we are NOT concerned with being short of funds)?
A) We should prefer Project B since it has a higher PI.
B) We should compute the EAA before we make any decision.
C) We should prefer Project A since it has a higher NPV.
D) We should prefer Project B if it has a higher IRR.
Answer: C
Explanation: C) We should NOT prefer Project B even though it has a higher PI; this is because it has a
lower NPV and we are not facing capital constraints. Computing the EAA is typically used if we have
mutually exclusive projects with unequal lives; we do not know if such is the case for this situation since
we are not told if the projects are mutually exclusive (we are only asked which one we would prefer, i.e.,
which one adds more value to the company). Even if Project B has a higher IRR, this would not tell us to
prefer it because it has a lower NPV.
Diff: 2
8) Hollister, Inc. is currently considering an eight-year project that has an initial outlay or cost of $120,000.
The future cash inflows from its project for years 1 through 8 are the same at $30,000. Hollister has a
discount rate of 11%. Because of capital rationing (shortage of funds for financing), Hollister wants to
compute the profitability index (PI) for each project. What is the PI for Hollister's current project?
A) About 1.29
B) About 1.31
C) About 1.33
D) About 1.39
Answer: A
Explanation: A) The PI is (NPV plus the absolute value of the costs) divided by the absolute value of the
costs (or the present value of all future cash flows divided by the cost). The future after-tax cash inflows
are an annuity. Thus, we can use:
NPV = -CF0 + . Inserting the given values gives:
NPV = -$120,000 + = -$120,000 + ($30,000 × 5.146123)
We have: PI = = = 1.2865 or about 1.29.

Diff: 3
36
9) Birdman, Inc. is currently considering an eight-year project that has an initial outlay or cost of $80,000.
The future cash inflows from its project for years 1 through 8 are the same at $30,000. Birdman has a
discount rate of 13%. Because of concerns about funds being short to finance all good projects, Birdman
wants to compute the profitability index (PI) for each project. What is the PI for Birdman's current
project?
A) About 1.50
B) About 1.60
C) About 1.70
D) About 1.80
Answer: D
Explanation: D) The PI is (NPV plus the absolute value of the costs) divided by the absolute value of the
costs (or the present value of all future cash flows divided by the cost). The future after-tax cash inflows
are an annuity. Thus, we can use:
NPV = -$80,000 + = -$80,000 + ($30,000 × 4.798770)
We have: PI = = = 1.7995, or about 1.80.

Diff: 3
10) The present value of the benefits and costs needed to calculate Profitability Index (PI) is the same
information one finds when computing the NPV.
Answer: TRUE
Diff: 1
11) When the Profitability Index (PI) is greater than 1, the benefits exceed the costs.
Answer: TRUE
Explanation: Ranking projects by PI with different costs levels CAN STILL LEAD to selection problems.
Diff: 2
37
12) A firm is considering four projects with the following PIs, NPVs, and Costs. Project A: PI of 1.3, NPV
of $3,600, and cost of $12,000; Project B: PI of 1.4, NPV of $5,600, and cost of $14,000; Project C: PI of 1.5,
NPV of $5,000, and cost of $10,000; Project D: PI of 2.1, NPV of $8,800, and cost of $8,000. Rank the
projects from best to worst in terms of their NPVs. Now rank the projects from best to worst in terms of
their PIs.
Answer: Ranking by NPV, we get D: $8,000; B: $5,600; C: $5,000; and A: $3,600.
Ranking by PI, we get D: 2.1; C: 1.5; B: 1.4; and A: 1.3.
Explanation: If we could only spend, say, $20,000, then Project D looks great since it has the highest PI
(the biggest bang for our limited bucks), and yet costs only $8,000. Our next pick would then be Project C,
based on the PI. Although it would add another $10,000 to our costs to boost the total to $18,000, we
would still be within our limit. Then, we would use the PI to look at Project B, but we would reject it since
its cost of $14,000 would push us over our limit. We would then look at Project A, and we would also
reject it since its cost of $12,000 would also push us over the limit. The PI is simply a guide that tells us
which projects to look at in what order when you have a capital budgeting cost limit.
Diff: 3
9.6 Overview of Six Decision Models
1) The ________ method is simple and fast but economically unsound as it ignores all cash flow after the
cutoff date and ignores the time-value of money.
A) Payback Period
B) MIRR
C) Net Present Value
D) IRR
Answer: A
Diff: 1
Topic: 9.6 Overview of the Six Decision Models
LO: 9.6 Compare and contrast the strengths and weaknesses of each decision model in a holistic way.
2) The ________ model incorporates the time-value of money but still ignores cash flows after the cutoff
date.
A) Payback Period
B) Discounted Payback Period
C) IRR
D) Modified Internal Rate of Return
Answer: B
Diff: 1
38
3) The ________ method is economically sound and properly ranks projects across various sizes, time
horizons, and levels of risk, without exception for all independent projects.
A) NPV
C) Profitability Index
D) Modified IRR
Answer: A
Diff: 1
4) The ________ model provides a single measure (return) but must apply risk outside the model, thus
allowing for errors in rankings of projects.
A) Payback Period
B) IRR
D) Profitability Index
Answer: B
Diff: 1
5) ________ corrects for most, but not all, of the problems of IRR and gives the solution in terms of a
return.
A) Profitability Index
D) MIRR
Answer: D
Diff: 1
6) The discounted payback method, net present value method (NPV), internal rate of return (IRR),
modified internal rate of return (MIRR), and profitability index (PI) are all consistent with the time value
of money.
Answer: TRUE
Explanation: The IRR method is used by 75.61% of the respondents while the NPV method is used by
74.93% of the respondents. The payback method came in third at 56.74%. From these results one may
conclude that some corporations use more than one method to evaluate their projects.
Diff: 2
39
7) Calculating IRR, NPV, or MIRR is easy and efficient using a spreadsheet once you know the relevant
cash flow, the timing of the cash flow, the cost of capital, and the reinvestment rate.
Answer: TRUE
Diff: 1
8) According to an academic survey of large and small U.S. businesses, the IRR method of capital
budgeting is slightly preferred over NPV by the survey respondents.
Answer: TRUE
Diff: 1
AACSB: 1 Written and Oral Communication
9) Describe three of the six decision models used in capital budgeting decision-making and briefly
evaluate their effectiveness.
Answer:
Payback Period is simple and fast but economically unsound. It ignores all cash flow after the cutoff date
and it ignores the time value of money.
Discounted Payback Period incorporates the time value of money but still ignores cash flow after the
cutoff date.
Net Present Value is economically sound and properly ranks projects across various sizes, time horizons,
and levels of risk, without exception for all independent projects.
IRR provides a single measure (return) but has the potential for errors in ranking projects. It also can lead
to incorrect selection of two mutually exclusive projects or incorrect acceptance or rejection of a project
with more than a single IRR.
Modified Internal Rate of Return, in general, corrects for most of, but not all, the problems of IRR and
gives the solution in terms of a return.
Profitability Index incorporates risk and return, but the benefits-to-cost ratio is actually just another way
of expressing the NPV.
Diff: 2
40

Chapter 09

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 09

Uploaded by

Copyright:

Available Formats

Financial Management: Core Concepts, 3e, GE (Brooks)

Chapter 9 Capital Budgeting Decision Models

9.1 Short-Term and Long-Term Decisions

5) Capital budgeting decisions are typically long-term decisions.

9.2 Payback Period

8) Which of the statements below is FALSE?

12) Which of the statements below is FALSE?

9.3 Net Present Value

3) In the NPV model, all cash flows are stated ________.

4) In regard to the NPV method, which of the statements below is TRUE?

Explanation: D) NPV = -CF0 + + + +

= -$80,000 + $35,714.29 + $31,887.76 + $21,353.41 + $19,065.54

Explanation: B) NPV = -CF0 + + + +

= -$220,000 + $45,045.05 + $48,697.35 + $51,183.40 + $52,698.48

Explanation: C) NPV = -CF0 + + + + +

= -$80,000 + $13,761.47 + $21,042.00 + $27,026.42 + $31,879.13 + $35,746.23

NPV = -CF0 + (PMT × . Inserting the given values gives:

NPV = -$70,000 + = -$70,000 + ($35,000 × 3.790787)

NPV = -CF0 + . Inserting in the given values gives:

NPV = -$170,000 + = -$170,000 + ($45,000 × 3.672771)

NPV = -CF0 + . Inserting in the given values gives:

NPV = -$180,000 + = -$180,000 + ($35,000 × 4.967640)

NPV = -CF0 + . Inserting in the given values gives:

NPV = -$180,000 + = -$180,000 + ($38,000 × 5.055637)

$180,000 + = -$180,000 + ($38,000 × 5.055637)

We have: EAA (Project A) = = $2,396.18.

For Project B, the NPV = -CF0 +

= -$160,000 + = -$160,000 + ($36,000 × 4.170294)

Inserting the given values, we have:

NPV = -$140,000 + = -$140,000 + ($36,500 × 4.79877)

We have: EAA (Project A) = = $7,325.86.

For Project B, the NPV = -CF0 +

= -$160,000 + = -$160,000 + ($48,000 × 3.997550)

than that for Project A.

= -$80,000 + $13,761.47 + $21,042.00 + $27,026.42 + $31,879.13 + $35,746.23

= -$18,000 + ($3,800 × 5.055637)

We have: EAA (Project A) = = $239.62.

For Project B, the NPV = -CF0 + = -$16,000 +

9.4 Internal Rate of Return

3) Without a computer and special calculator, ________.

4) Which of the statements below describes the IRR decision criterion?

6) Which of the statements below is TRUE?

17) Which of the statements below is TRUE?

stream is identical. We have: FV = $1,900,000 × = $1,900,000 × = $1,900,000 ×

9.342648. Thus, FV = $17,751,032.

identical. We have: FV = $290,000 × = $290,000 × = $290,000 × 9.414619. Thus, FV

9.5 Profitability Index

4) Which of the statements below is FALSE?

NPV = -CF0 + . Inserting the given values gives:

NPV = -$140,000 + = -$140,000 + ($35,000 × 4.967640)

= -$140,000 + $173,867.39 = $33,867.39. We can now compute the PI.

We have: PI = = = 1.2419, or about 1.24.

NPV = -CF0 + . Inserting the given values gives:

NPV = -$120,000 + = -$120,000 + ($30,000 × 5.146123)

= -$120,000 + $154,383.68 = $34,383.68. We can now compute the PI.

We have: PI = = = 1.2865 or about 1.29.

NPV = -CF0 + . Inserting in the given values gives:

NPV = -$80,000 + = -$80,000 + ($30,000 × 4.798770)

= -$80,000 + $143,963.11 = $63,963.11. We can now compute the PI.

We have: PI = = = 1.7995, or about 1.80.

9.6 Overview of Six Decision Models

You might also like