Principles of Corporate Finance 11th Edition Brealey Test Bank 1

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11th Edition Brealey Myers Allen 0078034760

9780078034763
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Chapter 05
Net Present Value and Other Investment Criteria
Multiple Choice Questions
1. Which of the following investment rules does NOT use the time value of money concept?
A. Net present value

B. Internal rate of return
C. The payback period
D. Profitability index
2. Suppose a firm has $100 million in excess cash. It could:
A. invest the funds in projects with positive NPVs.

B. pay high dividends to the shareholders.
C. buy another firm.
D. all of the options
3. The following are measures used by firms when making capital budgeting decisions EXCEPT:
A. payback period.
B. internal rate of return.
C. P/E ratio.
D. net present value.
5-1
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in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
4. The survey of CFOs indicates that the NPV method is always, or almost always, used for
evaluating investment projects by approximately:
A. 12% of firms.
B. 20% of firms.
C. 57% of firms.
D. 75% of firms.
5. The survey of CFOs indicates that the IRR method is used for evaluating investment projects by
approximately:
A. 12% of firms.
B. 20% of firms.
C. 75% of firms.
D. 57% of firms.
6. Which of the following investment rules has the value additivity property?
A. the payback period method

B. the net present value method
C. the book rate of return method
D. the internal rate of return method
7. If the net present value (NPV) of project A is +$100, and that of project B is +$60, then the net
present value of the combined projects is:
A. +$100
B. +$60
C. +$160
D. +$6,000
8. If the NPV of project A is + $30 and that of project B is -$60, then the NPV of the combined
projects is:
A. +$30
B. -$60
C. -$30
D. -$1,800
5-2
9. You are given a job to make a decision on project X, which is composed of three independent
projects A, B, and C that have NPVs of + $70, -$40 and + $100, respectively. How would you go
about making the decision about whether to accept or reject the project?
A. Accept project X as it has a positive NPV.

B. Reject project X.
C. Break up the project into its components: accept A and C, but reject B.
D. Break up the project into its components: accept C.
10. If the NPV of project A is + $120, that of project B is -$40, and that of project C is + $40, what is
the NPV of the combined project?
A. +$100
B. -$40
C. +$70
D. +$120
11. The net present value of a project depends upon the:
A. company's choice of accounting method.

B. manager's tastes and preferences.
C. project's cash flows and opportunity cost of capital.
D. company's profitability index.
12. Which of the following investment rules may not use all possible cash flows in its calculations?
A. NPV
B. payback period
C. IRR
D. profitability index
13. The payback period rule:
A. varies the cut-off point with the interest rate.

B. determines a cut-off point so that all projects accepted by the NPV rule will be accepted by the
payback period rule.
C. requires an arbitrary choice of a cut-off point.
D. both A and C.
5-3
14. The payback period rule accepts all projects for which the payback period is:
A. greater than the cut-off value.

B. less than the cut-off value.
C. positive.
D. an integer.
15. The main advantage of the payback rule is:
A. adjusts for uncertainty of early cash flows.

B. simple to use.
C. does not discount cash flows.
D. better accounts for salvage costs at the end of a project.
16. The following are disadvantages of using the payback rule EXCEPT the rule:
A. ignores all cash flow after the cutoff date.

B. does not use the time value of money.
C. is easy to calculate and use.
D. does not have the value additivity property.
17. Which of the following statements regarding the discounted payback period rule is true?
A. The discounted payback rule uses the time value of money concept.
B. The discounted payback rule is better than the NPV rule.
C. The discounted payback rule considers all cash flows.
D. The discounted payback rule exhibits the value additivity property.
18. Given the following cash flows for project A: C0 = -1,000, C1 = +600, C2 = +400, and C3 = +1,500,
calculate the payback period.
A. one year
B. two years
C. three years
D. cannot be determined
5-4
19. The cost of a new machine is $250,000. The machine has a five-year life and no salvage value. If
the cash flow each year is equal to 25% of the cost of the machine, calculate the payback period
for the project:
A. 2.0 years
B. 2.5 years
C. 3.0 years
D. 4.0 years
20. Given the following cash flows for project Z: C0 = -1,000, C1 = 600, C2 = 720, and C3 = 2,000,
calculate the discounted payback period for the project at a discount rate of 20%.
A. 1 year
B. 2 years
C. 3 years
D. >3 years
21. Internal rate of return (IRR) method is also called the:
A. discounted payback period method.

B. discounted cash-flow (DCF) rate of return method.
C. modified internal rate of return (MIRR) method.
D. book rate of return method.
22. The quickest way to calculate the internal rate of return (IRR) of a project is by:
A. trial and error method.

B. using the graphical method.
C. using a financial calculator.
D. doubling the opportunity cost of capital.
23. If an investment project (normal project) has an IRR equal to the cost of capital, the NPV for that
project is:
A. positive.
B. negative.
C. zero.
D. unable to determine.
5-5
24. Given the following cash flows for Project M: C0 = -1,000, C1 = +200, C2 = +700, C3 = +698,
calculate the IRR for the project.
A. 23%
B. 21%
C. 19%
D. 17%
25. The IRR is defined as:
A. the discount rate that makes a project's NPV equal to zero.

B. the difference between the cost of capital and the present value of the cash flows.
C. the discount rate used in the NPV method.
D. the discount rate used in the discounted payback period method.
26. Which of the following methods of evaluating capital investment projects incorporates the time
value of money concept?
I) payback period; II) discounted payback period; III) net present value (NPV); IV) internal rate of
return
A. I, II, and III only

B. II, III, and IV only
C. III and IV only
D. I, II, III, and IV
27. Driscoll Company is considering investing in a new project. The project will need an initial
investment of $2,400,000 and will generate $1,200,000 (after-tax) cash flows for three years.
Calculate the IRR for the project.
A. 14.5%
B. 18.6%
C. 20.2%
D. 23.4%
28. The following are some of the shortcomings of the IRR method except:
A. IRR is conceptually easy to communicate.

B. Projects can have multiple IRRs.
C. IRR cannot distinguish between a borrowing project and a lending project.
D. It is very cumbersome to evaluate mutually exclusive projects using the IRR method.
5-6
29. Project X has the following cash flows: C0 = +2,000, C1 = -1,300,and C2 = -1,500. If the IRR of the
project is 25% and if the cost of capital is 18%, you would:
A. accept the project.

B. reject the project.
30. Project X has the following cash flows: C0 = +2,000, C1 = -1,150, and C2 = -1,150. If the IRR of
the project is 9.85% and if the cost of capital is 12%, you would:

31. If the sign of the cash flows for a project changes two times, then the project likely has:
A. one IRR.
B. two IRRs.
C. three IRRs.
D. four IRRs.
32. Project Y has following cash flows: C0 = -800, C1 = +5,000, and C2 = -5,000.
Calculate the IRRs for the project:
A. 25% and 400%.

B. 125% and 500%.
C. -44% and 11.6%.
D. no IRRs exist for this project.
33. Music Company is considering investing in a new project. The project will need an initial
Calculate the NPV for the project if the cost of capital is 15%.
A. $169, 935
B. $1,200,000
C. $339,870
D. $125,846
5-7
34. Muscle Company is investing in a giant crane. It is expected to cost $6.5 million in initial
investment, and it is expected to generate an end-of-year cash flow of $3.0 million each year for
three years. Calculate the IRR.
A. 14.6 %
B. 16.4 %
C. 18.2 %
D. 22.1%
35. A project will have only one internal rate of return if:
A. the net present value is positive

B. the net present value is negative
C. the cash flows decline over the life of the project
D. there is a one-sign change in the cash flows
36. Story Company is investing in a giant crane. It is expected to cost $6.0 million in initial
investment, and it is expected to generate an end-of-year after-tax cash flow of $3.0 million each
year for three years. Calculate the NPV at 12%.
A. $2.4 million
B. $1.2 million
C. $0.80 million
D. $0.20 million
37. Dry-Sand Company is considering investing in a new project. The project will need an initial
investment of $1,200,000 and will generate $600,000 (after-tax) cash flows for three years.
However, at the end of the fourth year, the project will generate -$500,000 of after-tax cash flow
due to dismantling costs. Calculate the MIRR (modified internal rate of return) for the project if the
cost of capital is 15%.
A. 8.1%
B. 12.6%
C. 28.2%
D. 20.4%
5-8
38. Mass Company is investing in a giant crane. It is expected to cost $6.0 million in initial
investment, and it is expected to generate an end-of-year cash flow of $3.0 million each year for
three years. At the end of the fourth year, there will be a $1.0 million disposal cost. Calculate the
MIRR for the project if the cost of capital is 12%.
A. 17.8%
B. 15.3%
C. 23.8%
D. 22.1%
39. Given the following cash flows for project A: C0 = -3,000, C1 = +500, C2 = +1,500, and C3 =
+5,000, calculate the NPV of the project using a 15% discount rate.
A. $5,000
B. $2,352
C. $3,201
D. $1,857
40. One can use the profitability index most usefully for which situation?
A. when capital rationing exists

B. evaluation of exceptionally long-term projects
C. evaluation of non-normal projects
D. when a project has unusually high cash-flow uncertainty
41. The profitability index is the ratio of the:
A. future value of cash flows to investment

B. net present value of cash flows to investment
C. net present value of cash flows to IRR
D. present value of cash flows to IRR
5-9
42. The following table gives the available projects (in $millions) for a firm.
If the firm has a limit of 210 million to invest, what is the maximum NPV the company can obtain?
A. 200
B. 283
C. 307
D. 347
The firm has only 20 million to invest. What is the maximum NPV that the company can obtain?
A. 3.5
B. 4.0
C. 4.5
D. 5.0
44. The benefit-cost ratio is defined as the ratio of:
A. net present value cash flows to initial investment.

B. present value of cash flows to initial investment.
C. net present value of cash flows to IRR.
D. present value of cash flows to IRR.
45. What is the profitability index of an investment with cash flows in years 0 thru 4 of -340, 120, 130,
153, and 166, respectively, and a discount rate of 16%?
A. .15
B. .22
C. .35
D. .42
5-10
46. Which investment analysis technique is used the least by CFOs?
A. net present value

B. internal rate of return
C. payback
D. book rate of return
47. How does modified internal rate of return (MIRR) differ from IRR?
A. MIRR does not consider cash flows occurring after the cutoff date.
B. MIRR uses NPV. IRR does not.
C. MIRR calculates the PV of cash inflows and then divides by the PV of the investment.
D. MIRR reduces the number of sign changes in a cash-flow sequence.
True / False Questions
48. The profitability index is always less than 1.0.
True False
49. The profitability index of a positive NPV project is always positive.
True False
50. Present values have the value additivity property.
True False
51. The payback rule ignores all cash flows after the cutoff date.
True False
52. The discounted payback rule calculates the payback period and then discounts the payback
period at the opportunity cost of capital.
True False
53. The internal rate of return is the discount rate that makes the PV of a project's cash inflows equal
to zero.
True False
5-11
54. The IRR rule states that firms should accept any project offering an internal rate of return in
excess of the cost of capital.
True False
55. In the case of a loan project (borrowing), one should accept the project if the IRR is more than the
cost of capital.
True False
56. There can never be more than one value of the IRR for any sequence of cash flows.
True False
57. Decommissioning and clean-up costs for any project is always insignificant and should typically
be ignored.
True False
58. The benefit-cost ratio is equal to the profitability index plus one.
True False
59. Soft rationing may be used to control managerial behavior.
True False
60. The internal rate of return is the discount rate that makes the NPV of a project's cash flows equal
to zero.
True False
61. A project's internal rate of return depends on its level of risk.
True False
62. A project's "book value" represents, essentially, the market valuation of the project.
True False
63. Accounting earnings from a firm's income statement, prepared according to generally accepted
accounting principles (GAAP), are typically the best data source for calculating a project's NPV.
True False
64. The discounted payback technique discounts cash flows at the opportunity cost of capital and
then calculates the payback period.
True False
5-12
65. The discounted payback technique will never accept a negative-NPV project.
True False
66. The denominator of the profitability index is the present value of the investment.
True False
Essay Questions
67. Briefly explain the value additivity property.
68. Discuss some of the advantages of using the payback method.
5-13
69. Discuss some of the disadvantages of the payback rule.
70. What are some of the disadvantages of using the IRR method?
71. What are some of the advantages of using the IRR method?
72. Briefly discuss capital rationing.
5-14
73. Briefly explain the term soft rationing.
74. Briefly explain the term hard rationing.
75. When calculating a weighted average profitability index, should you apply an index of zero to
leftover money?
5-15
Chapter 05 Net Present Value and Other Investment Criteria Answer
Key
Multiple Choice Questions
1. Which of the following investment rules does NOT use the time value of money concept?
A. Net present value

B. Internal rate of return
C. The payback period
D. Profitability index
Type: Easy
2. Suppose a firm has $100 million in excess cash. It could:
A. invest the funds in projects with positive NPVs.

B. pay high dividends to the shareholders.
C. buy another firm.
D. all of the options
Type: Easy
3. The following are measures used by firms when making capital budgeting decisions EXCEPT:
A. payback period.
B. internal rate of return.
C. P/E ratio.
D. net present value.
Type: Easy
5-16
4. The survey of CFOs indicates that the NPV method is always, or almost always, used for
evaluating investment projects by approximately:
A. 12% of firms.
B. 20% of firms.
C. 57% of firms.
D. 75% of firms.
Type: Medium
5. The survey of CFOs indicates that the IRR method is used for evaluating investment projects
by approximately:
A. 12% of firms.
B. 20% of firms.
C. 75% of firms.
D. 57% of firms.
Type: Medium
6. Which of the following investment rules has the value additivity property?
A. the payback period method

B. the net present value method
C. the book rate of return method
D. the internal rate of return method
Type: Difficult
7. If the net present value (NPV) of project A is +$100, and that of project B is +$60, then the net
present value of the combined projects is:
A. +$100
B. +$60
C. +$160
D. +$6,000
NPV(A + B) = NPV(A) + NPV(B) = 100 + 60 = 160.
Type: Easy
5-17
8. If the NPV of project A is + $30 and that of project B is -$60, then the NPV of the combined
projects is:
A. +$30
B. -$60
C. -$30
D. -$1,800
NPV(A + B) = 30 - 60 = -30.
Type: Easy
9. You are given a job to make a decision on project X, which is composed of three independent
projects A, B, and C that have NPVs of + $70, -$40 and + $100, respectively. How would you
go about making the decision about whether to accept or reject the project?
A. Accept project X as it has a positive NPV.

B. Reject project X.
C. Break up the project into its components: accept A and C, but reject B.
D. Break up the project into its components: accept C.
Type: Difficult
10. If the NPV of project A is + $120, that of project B is -$40, and that of project C is + $40, what
is the NPV of the combined project?
A. +$100
B. -$40
C. +$70
D. +$120
NPV(A + B + C) = 120 + 40 - 40 = 120.
Type: Easy
5-18
11. The net present value of a project depends upon the:
A. company's choice of accounting method.

B. manager's tastes and preferences.
C. project's cash flows and opportunity cost of capital.
D. company's profitability index.
Type: Medium
12. Which of the following investment rules may not use all possible cash flows in its
calculations?
A. NPV
B. payback period
C. IRR
D. profitability index
Type: Medium
13. The payback period rule:
A. varies the cut-off point with the interest rate.

B. determines a cut-off point so that all projects accepted by the NPV rule will be accepted by
the payback period rule.
C. requires an arbitrary choice of a cut-off point.
D. both A and C.
Type: Medium
14. The payback period rule accepts all projects for which the payback period is:
A. greater than the cut-off value.

B. less than the cut-off value.
C. positive.
D. an integer.
Type: Easy
5-19
15. The main advantage of the payback rule is:
A. adjusts for uncertainty of early cash flows.

B. simple to use.
C. does not discount cash flows.
D. better accounts for salvage costs at the end of a project.
Type: Medium
16. The following are disadvantages of using the payback rule EXCEPT the rule:
A. ignores all cash flow after the cutoff date.

B. does not use the time value of money.
C. is easy to calculate and use.
D. does not have the value additivity property.
Type: Medium
17. Which of the following statements regarding the discounted payback period rule is true?
A. The discounted payback rule uses the time value of money concept.
B. The discounted payback rule is better than the NPV rule.
C. The discounted payback rule considers all cash flows.
D. The discounted payback rule exhibits the value additivity property.
Type: Easy
18. Given the following cash flows for project A: C0 = -1,000, C1 = +600, C2 = +400, and C3 =
+1,500, calculate the payback period.
A. one year
B. two years
C. three years
D. cannot be determined
Initial investment: 1,000 = CF1 + CF2 = 600 + 400; payback period = two years.
Type: Medium
5-20
19. The cost of a new machine is $250,000. The machine has a five-year life and no salvage
value. If the cash flow each year is equal to 25% of the cost of the machine, calculate the
payback period for the project:
A. 2.0 years
B. 2.5 years
C. 3.0 years
D. 4.0 years
Cash flow each year = (0.25)(250,000) = 62,500; Payback period = 4.0 years.
Type: Medium
20. Given the following cash flows for project Z: C0 = -1,000, C1 = 600, C2 = 720, and C3 = 2,000,
calculate the discounted payback period for the project at a discount rate of 20%.
A. 1 year
B. 2 years
C. 3 years
D. >3 years
1,000 = (600/1.2) + (720/1.2^2); Discounted payback = 2 years.
Type: Difficult
21. Internal rate of return (IRR) method is also called the:
A. discounted payback period method.

B. discounted cash-flow (DCF) rate of return method.
C. modified internal rate of return (MIRR) method.
D. book rate of return method.
Type: Medium
5-21
22. The quickest way to calculate the internal rate of return (IRR) of a project is by:
A. trial and error method.

B. using the graphical method.
C. using a financial calculator.
D. doubling the opportunity cost of capital.
Type: Easy
23. If an investment project (normal project) has an IRR equal to the cost of capital, the NPV for
that project is:
A. positive.
B. negative.
C. zero.
D. unable to determine.
Type: Easy
24. Given the following cash flows for Project M: C0 = -1,000, C1 = +200, C2 = +700, C3 = +698,
calculate the IRR for the project.
A. 23%
B. 21%
C. 19%
D. 17%
-1,000 + [200/(1 + IRR)] + [700/(1 + IRR)^2] + [698/(1 + IRR)^3] = 0; IRR = 23%. In Excel:
Arrange cash flows in order starting with -1,000 in cell A1 and ending with +698 in cell A4,
then "= IRR(A1:A4)".
Type: Difficult
25. The IRR is defined as:
A. the discount rate that makes a project's NPV equal to zero.

B. the difference between the cost of capital and the present value of the cash flows.
C. the discount rate used in the NPV method.
D. the discount rate used in the discounted payback period method.
Type: Easy
5-22
26. Which of the following methods of evaluating capital investment projects incorporates the time
value of money concept?
I) payback period; II) discounted payback period; III) net present value (NPV); IV) internal rate
of return
A. I, II, and III only

B. II, III, and IV only
C. III and IV only
D. I, II, III, and IV
Type: Medium
27. Driscoll Company is considering investing in a new project. The project will need an initial
Calculate the IRR for the project.
A. 14.5%
B. 18.6%
C. 20.2%
D. 23.4%
-2,400,000 + [1,200,000/(1 + IRR)] + [1,200,000/(1 + IRR)^2] + [1,200,000/(1 + IRR)^3] = 0;

IRR = 23.4%. In Excel: Arrange cash flows in order starting with -2,400,000 in cell A1 and
1,200,000 in cells A2 through A4, then "= IRR(A1:A4)".
Type: Difficult
28. The following are some of the shortcomings of the IRR method except:
A. IRR is conceptually easy to communicate.

B. Projects can have multiple IRRs.
C. IRR cannot distinguish between a borrowing project and a lending project.
D. It is very cumbersome to evaluate mutually exclusive projects using the IRR method.
Type: Difficult
5-23
29. Project X has the following cash flows: C0 = +2,000, C1 = -1,300,and C2 = -1,500. If the IRR of
the project is 25% and if the cost of capital is 18%, you would:

This is a loan project (i.e., borrowing) with IRR greater than the cost of capital. Therefore reject
it.
Type: Difficult
30. Project X has the following cash flows: C0 = +2,000, C1 = -1,150, and C2 = -1,150. If the IRR of
the project is 9.85% and if the cost of capital is 12%, you would:

This is a loan project (i.e., borrowing) with IRR less than the cost of capital. Therefore accept
it.
Type: Difficult
31. If the sign of the cash flows for a project changes two times, then the project likely has:
A. one IRR.
B. two IRRs.
C. three IRRs.
D. four IRRs.
Type: Difficult
5-24
32. Project Y has following cash flows: C0 = -800, C1 = +5,000, and C2 = -5,000.
Calculate the IRRs for the project:
A. 25% and 400%.

B. 125% and 500%.
C. -44% and 11.6%.
D. no IRRs exist for this project.
-800 + [5,000/(1 + IRR)] - [5,000/(1 + IRR)^2] = 0,

or 800[(1 + IRR)^2] - 5000(1 + IRR) + 5,000 = 0.
This is a quadratic equation and has two roots.
1 + IRR = [5000 + SQRT{5000^2 - (4) × (800) × (5000)}]/(2 × 800) = 5; IRR = 4 = 400%.
1 + IRR = [5000 + SQRT{5000^2 - (4) × (800) × (5000)}]/(2 × 800) = 1.25; IRR = 0.25 = 25%.
Type: Difficult
33. Music Company is considering investing in a new project. The project will need an initial
Calculate the NPV for the project if the cost of capital is 15%.
A. $169, 935
B. $1,200,000
C. $339,870
D. $125,846
NPV = -2,400,000 + [(1,200,000)/(1.15)] + [(1,200,000/(1.15)^2] + [1,200,000/(1.15)^3] =

339,870.
Type: Medium
5-25
34. Muscle Company is investing in a giant crane. It is expected to cost $6.5 million in initial
investment, and it is expected to generate an end-of-year cash flow of $3.0 million each year
for three years. Calculate the IRR.
A. 14.6 %
B. 16.4 %
C. 18.2 %
D. 22.1%
0 = -6.5 + ((3/(1 + IRR) + (3/((1 + IRR)^2)) + (3/((1 + IRR)^3)));

IRR = 18.2% (by trial & error). In Excel: Arrange cash flows in order starting with -6.5 in cell A1
and 3 in cells A2 through A4, then "= IRR(A1:A4)".
Type: Medium
35. A project will have only one internal rate of return if:
A. the net present value is positive

B. the net present value is negative
C. the cash flows decline over the life of the project
D. there is a one-sign change in the cash flows
Type: Medium
36. Story Company is investing in a giant crane. It is expected to cost $6.0 million in initial
investment, and it is expected to generate an end-of-year after-tax cash flow of $3.0 million
each year for three years. Calculate the NPV at 12%.
A. $2.4 million
B. $1.2 million
C. $0.80 million
D. $0.20 million
NPV(millions) = -6.0 + 3/1.12 + 3/(1.12^2) + 3/(1.12^3) = 1.2.
Type: Medium
5-26
37. Dry-Sand Company is considering investing in a new project. The project will need an initial
investment of $1,200,000 and will generate $600,000 (after-tax) cash flows for three years.
However, at the end of the fourth year, the project will generate -$500,000 of after-tax cash
flow due to dismantling costs. Calculate the MIRR (modified internal rate of return) for the
project if the cost of capital is 15%.
A. 8.1%
B. 12.6%
C. 28.2%
D. 20.4%
To eliminate the second sign change, combine year 3 and year 4 cash flows: PV 3 = + 600 -
500/1.15 = 165.22;
-1,200 + 600/(1 + MIRR) + 600/(1 + MIRR)^2 + 165.22/(1 + MIRR)^3 = 0;
MIRR = 8.1%.
In Excel: Arrange cash flows in order starting with -1,200 in cell A1; 600 in cells A2 through
A3; and 165.22 in cell A4; then "= IRR(A1:A4)".
Type: Difficult
38. Mass Company is investing in a giant crane. It is expected to cost $6.0 million in initial
investment, and it is expected to generate an end-of-year cash flow of $3.0 million each year
for three years. At the end of the fourth year, there will be a $1.0 million disposal cost.
Calculate the MIRR for the project if the cost of capital is 12%.
A. 17.8%
B. 15.3%
C. 23.8%
D. 22.1%
To eliminate the second sign change, combine year 3 and year 4 cash flows: PV 3 = +3 - 1/1.12
= 2.11.
-6 + 3/(1 + MIRR) + 3/(1+MIRR)^2 + 2.11/(1+MIRR)^3 = 0;
MIRR = 17.8%.
In Excel: Arrange cash flows in order starting with -6 in cell A1; 3 in cells A2 through A3; and
2.11 in cell A4; then "= IRR(A1:A4)".
Type: Difficult
5-27
39. Given the following cash flows for project A: C0 = -3,000, C1 = +500, C2 = +1,500, and C3 =
+5,000, calculate the NPV of the project using a 15% discount rate.
A. $5,000
B. $2,352
C. $3,201
D. $1,857
NPV = -3000 + (500/1.15) + (1500/1.15^2) + (5000/1.15^3) = 1857.
Type: Medium
40. One can use the profitability index most usefully for which situation?
A. when capital rationing exists

B. evaluation of exceptionally long-term projects
C. evaluation of non-normal projects
D. when a project has unusually high cash-flow uncertainty
Type: Medium
41. The profitability index is the ratio of the:
A. future value of cash flows to investment

B. net present value of cash flows to investment
C. net present value of cash flows to IRR
D. present value of cash flows to IRR
Type: Medium
5-28
If the firm has a limit of 210 million to invest, what is the maximum NPV the company can
obtain?
A. 200
B. 283
C. 307
D. 347
A + B + C + F = 140 + 70 + 65 + 32 = 307; Total investment = 90 + 20 + 60 + 40 = 210.
Type: Difficult
The firm has only 20 million to invest. What is the maximum NPV that the company can
obtain?
A. 3.5
B. 4.0
C. 4.5
D. 5.0
A + C + D + E + F = 4.5; Total investment = 5 + 5 + 1 + 2 + 7 = $20 million.
Type: Difficult
5-29
44. The benefit-cost ratio is defined as the ratio of:
(p. 136)
A. net present value cash flows to initial investment.

B. present value of cash flows to initial investment.
C. net present value of cash flows to IRR.
D. present value of cash flows to IRR.
Type: Medium
45. What is the profitability index of an investment with cash flows in years 0 thru 4 of -340, 120,
130, 153, and 166, respectively, and a discount rate of 16%?
A. .15
B. .22
C. .35
D. .42
NPV = 49.7 PI = 49.7/340 = .15.
Type: Difficult
46. Which investment analysis technique is used the least by CFOs?
A. net present value

B. internal rate of return
C. payback
D. book rate of return
Type: Easy
47. How does modified internal rate of return (MIRR) differ from IRR?
A. MIRR does not consider cash flows occurring after the cutoff date.
B. MIRR uses NPV. IRR does not.
C. MIRR calculates the PV of cash inflows and then divides by the PV of the investment.
D. MIRR reduces the number of sign changes in a cash-flow sequence.
Type: Difficult
5-30
True / False Questions
48. The profitability index is always less than 1.0.
FALSE
Type: Medium
49. The profitability index of a positive NPV project is always positive.
TRUE
Type: Medium
50. Present values have the value additivity property.
TRUE
Type: Difficult
51. The payback rule ignores all cash flows after the cutoff date.
TRUE
Type: Medium
52. The discounted payback rule calculates the payback period and then discounts the payback
period at the opportunity cost of capital.
FALSE
Type: Medium
53. The internal rate of return is the discount rate that makes the PV of a project's cash inflows
equal to zero.
FALSE
Type: Difficult
54. The IRR rule states that firms should accept any project offering an internal rate of return in
excess of the cost of capital.
TRUE
Type: Medium
5-31
55. In the case of a loan project (borrowing), one should accept the project if the IRR is more than
the cost of capital.
FALSE
Type: Difficult
56. There can never be more than one value of the IRR for any sequence of cash flows.
FALSE
Type: Difficult
57. Decommissioning and clean-up costs for any project is always insignificant and should
typically be ignored.
FALSE
Type: Medium
58. The benefit-cost ratio is equal to the profitability index plus one.
TRUE
Type: Difficult
59. Soft rationing may be used to control managerial behavior.

(p. 138)
TRUE
Type: Easy
60. The internal rate of return is the discount rate that makes the NPV of a project's cash flows
equal to zero.
TRUE
Type: Medium
61. A project's internal rate of return depends on its level of risk.
FALSE
Type: Medium
62. A project's "book value" represents, essentially, the market valuation of the project.
FALSE
Type: Medium
5-32
63. Accounting earnings from a firm's income statement, prepared according to generally
accepted accounting principles (GAAP), are typically the best data source for calculating a
project's NPV.
FALSE
Type: Difficult
64. The discounted payback technique discounts cash flows at the opportunity cost of capital and
then calculates the payback period.
TRUE
Type: Easy
65. The discounted payback technique will never accept a negative-NPV project.
TRUE
Type: Easy
66. The denominator of the profitability index is the present value of the investment.
TRUE
Type: Easy
Essay Questions
67. Briefly explain the value additivity property.
For example, the net present value (NPV) of a combined project—say A and B—-is equal to
the NPV(A) plus the NPV(B). Naturally, this property holds for present values also. This
property is not shared by IRR. The IRR of a combined project does not equal the sum of the
individual IRRs. The value additivity property is very useful when making comparative
decisions among numerous projects.
Type: Medium
5-33
68. Discuss some of the advantages of using the payback method.
It tells you how quickly you can recover your investment. The main advantage is that it is easy
to calculate and use.
Type: Easy
69. Discuss some of the disadvantages of the payback rule.
The disadvantages are that it does not take the time value of money into account and also
does not consider any cash flows beyond the cutoff point.
Type: Easy
70. What are some of the disadvantages of using the IRR method?
There are several disadvantages to the IRR method. It is not useful in evaluating mutually
exclusive projects and dependent projects. You can also get multiple IRRS for projects having
cash flows with more than one change in sign. Also, IRR cannot distinguish between
borrowing and lending projects. In most cases it may be easier to use the NPV method.
Type: Difficult
71. What are some of the advantages of using the IRR method?
The main advantage of IRR is that it is easy to communicate. Financial managers tend to think
in terms of percentages and find rates of return intuitively easy to grasp.
Type: Medium
5-34
72. Briefly discuss capital rationing.
There are two types of capital rationing; soft rationing imposed by the company and hard
rationing imposed by the capital markets. Capital rationing may result in the firm forgoing
some positive NPV projects, thereby reducing a firm's value.
Type: Medium
73. Briefly explain the term soft rationing.
Management uses soft rationing to get better financial control over investment decisions. Soft
rationing is imposed by management and not by capital markets. Soft rationing is an upper-
management technique often used to restrain overoptimistic capital spending requests by
midlevel managers.
Type: Medium
74. Briefly explain the term hard rationing.
A firm faces hard rationing when it cannot raise more funding from capital markets. Hard
rationing also indicates the existence of market imperfections. Market imperfections do not
invalidate the NPV rule as long as the shareholders of the firm have access to well-functioning
capital markets so that their portfolio choices are not restricted. The NPV rule is undermined
when imperfections restrict shareholders' portfolio choices. Generally, hard rationing is rare for
large corporations in the U.S.
Type: Medium
75. When calculating a weighted average profitability index, should you apply an index of zero to
leftover money?
The NPV of money that is not invested is zero. If the NPV is zero the profitability index is zero.
Thus, the math leads to a PI of zero for leftover money. Additionally, one cannot assume that
money not invested will create value.
Type: Difficult
5-35
5-36

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Solution Manual for Principles of Corporate Finance

11th Edition Brealey Myers Allen 0078034760

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Net Present Value and Other Investment Criteria

Multiple Choice Questions

A. Net present value

2. Suppose a firm has $100 million in excess cash. It could:

A. invest the funds in projects with positive NPVs.

A. the payback period method

A. Accept project X as it has a positive NPV.

11. The net present value of a project depends upon the:

A. company's choice of accounting method.

13. The payback period rule:

A. varies the cut-off point with the interest rate.

A. greater than the cut-off value.

15. The main advantage of the payback rule is:

A. adjusts for uncertainty of early cash flows.

A. ignores all cash flow after the cutoff date.

21. Internal rate of return (IRR) method is also called the:

A. discounted payback period method.

A. trial and error method.

25. The IRR is defined as:

A. the discount rate that makes a project's NPV equal to zero.

A. I, II, and III only

A. IRR is conceptually easy to communicate.

A. accept the project.

A. accept the project.

A. 25% and 400%.

A. the net present value is positive

A. when capital rationing exists

41. The profitability index is the ratio of the:

A. future value of cash flows to investment

44. The benefit-cost ratio is defined as the ratio of:

A. net present value cash flows to initial investment.

A. net present value

True / False Questions

48. The profitability index is always less than 1.0.

49. The profitability index of a positive NPV project is always positive.

50. Present values have the value additivity property.

59. Soft rationing may be used to control managerial behavior.

61. A project's internal rate of return depends on its level of risk.

67. Briefly explain the value additivity property.

68. Discuss some of the advantages of using the payback method.

72. Briefly discuss capital rationing.

74. Briefly explain the term hard rationing.

Multiple Choice Questions

A. Net present value

2. Suppose a firm has $100 million in excess cash. It could:

A. invest the funds in projects with positive NPVs.

A. the payback period method

NPV(A + B) = NPV(A) + NPV(B) = 100 + 60 = 160.

A. Accept project X as it has a positive NPV.

NPV(A + B + C) = 120 + 40 - 40 = 120.

A. company's choice of accounting method.

13. The payback period rule:

A. varies the cut-off point with the interest rate.

A. greater than the cut-off value.

A. adjusts for uncertainty of early cash flows.

A. ignores all cash flow after the cutoff date.

1,000 = (600/1.2) + (720/1.2^2); Discounted payback = 2 years.

21. Internal rate of return (IRR) method is also called the:

A. discounted payback period method.

A. trial and error method.