Final exam - Chapter 9

Question 1

What are the 4 Decision Models for Evaluating Alternatives

Answer 1

Net Present Value (NPV)
Profitability Index (PI)
Internal Rate of Return (IRR)
Payback Period (PB)

Question 2

Capital Budgeting: Decision Criteria and real option consideration
What is the main goal

Answer 2

To figure out to accept or reject the project

Question 3

Capital rationing

Answer 3

is the act of placing restrictions on the amount of new investments or projects undertaken by a company. This is accomplished by imposing a higher cost of capital for investment consideration or by setting a ceiling on specific portions of a budget.

Question 4

Formula for Net Present Value

Answer 4

NPV = PV (All NCF’s) - NINV

It should be positive

Question 5

Net Present Value

Answer 5

The present value of the stream of future
cash flows from a project minus the
project’s net investment

Question 6

NPV
Independent Projects
Which one to accept?

Answer 6

Accept if its net present value is greater than or
equal to zero and reject if its net present value
is less than zero

Question 7

NPV
Mutually Exclusive Projects
Which one to accept?

Answer 7

Accept the project with the largest net present value

Question 8

When product and factor markets are not
perfectly competitive, it is possible for a
firm to

Answer 8

earn above-normal profits that

result in positive net present value projects

Question 9

(3) NPV advantages

Answer 9

Advantages

Theoretically the best criteria among 4 decision
models
Realistic assumption that cash flows are
reinvested at the cost of capital
Considers the time value of money

Question 10

(2) NPV disadvantages

Answer 10

Disadvantages

NPV result not easily understood
Does not consider the value of real options

Question 11

Profitability Index

Answer 11

The ratio of the present value of expected
net cash flows over the life of a project to
the net investment

Question 12

The ratio of the present value of expected
net cash flows over the life of a project to
the net investment

Answer 12

Profitability Index

Question 13

Profitability Index

Formula

Answer 13

Profitability Index=
Present Value (All NCF’s)
/
Net investment

Question 14

Should the Net Present Value be positive or negative

Answer 14

positive

Question 15

Which project would you use choose
PI= 0.97
PI= 1.15

Answer 15

PI= 1.15

Question 16

PI

 Independent Projects

Answer 16

Accept if the profitability index is greater than or

equal 1

Question 17

PI

 Mutually Exclusive Projects

Answer 17

Accept the project with the largest profitability
index
Conflicts may occur between NPV and PI for
mutually exclusive projects

Question 18

Internal Rate of Return

Answer 18

Discount rate that makes NPV = 0

Question 19

Internal Rate of Return Formula

Answer 19

NPV = 
Sum 
NCF
/
(1+IRR)^t

• NINV

= 0

Question 20

IRR

 Independent Projects

Answer 20

Accept if the IRR is greater than the cost of

capital

Question 21

IRR

 Mutually Exclusive Projects

Answer 21

Accept the project with the higher IRR
Conflicts may occur between NPV and IRR for
mutually exclusive projects

Question 22

IRR advantages

Answer 22

Advantages

Considers the time value of money
Interpretation easier than NPV

Question 23

IRR

Disadvantages

Answer 23

Disadvantages

Non-normal cash flow pattern (can result in
multiple IRRs)
Assumption that cash flows are reinvested at
IRR sometimes unrealistic
Does not consider the value of real options

Question 24

How do NPV and IRR differ in how each

handles the reinvestment of cash flows?

Answer 24

NPV - cost of capital

IRR - IRR

Question 25

NPV: Assumes cash flows are reinvested at the

Answer 25

cost of capital

Question 26

IRR: Assumes cash flows are reinvested at the

Answer 26

IRR

Question 27

Which one is more realistic? | Between IRR and NPV

Answer 27

NPV

Question 28

Payback Period =

Answer 28

Net Investment / Annual Net Cash Inflows (loosely speaking)

Question 29

Discounted Payback Period

Answer 29

uses the net cash inflows, discounted at the firm’s cost of capital, in determining the number of years required to recover the net investment in a project

Question 30

uses the net cash inflows, discounted at the firm’s cost of capital, in determining the number of years required to recover the net investment in a project

Answer 30

Discounted Payback Period

Question 31

Decision Rule for Payback Period

Answer 31

Accept if the payback period is less than or | equal to a specified maximum period

Question 32

PB advantages |  Advantages

Answer 32

PB advantages Simple Provides a measure of liquidity A measure of risk For this reason, both of NPV and PB criteria are often used together in the industry where fast technological changes are common. 21 

Question 33

PB Disadvantages

Answer 33

Disadvantages Ignores the time value of money No objective decision criterion Ignores cash flows after the payback period May not maximize shareholder wealth

Question 34

Read the summary slide on page 11 for every model

Answer 34

-

Question 35

What should a firm do if it does not have enough money to invest in all of its positive NPV projects?

Answer 35

Pick the highest PI one

Question 36

Capital Rationing and the Capital | Budgeting Decision

Answer 36

Many firms do not have unlimited funds available for investment, so there is a constraint on the amount of funds allocated to capital investments

Question 37

Capital Rationing and the Capital Budgeting Decision  When there is a capital budgeting constraint, an approach employing the profitability index can be used

Answer 37

Step 1  Calculate the profitability index for each of a series of investment projects Step 2  Rank the projects according to their profitability indexes from highest to lowest Step 3  Beginning with the project with the highest profitability index, proceed through the list, and accept projects having profitability indexes greater than or equal to 1 until the entire capital budget has been utilized

Question 38

(3) Reviewing and Post-Auditing an | Accepted Project

Answer 38

``` Compare actual cash flows to projected cash flows Find systematic biases or errors in uncertain projected cash flows Decide whether to abandon or continue projects that have done poorly ```

Question 39

Does the Cost of Cpaital already include the effects of expected inflation

Answer 39

Yes

Question 40

The cost of capital already includes the | effects of _____ ______

Answer 40

expected inflation

Question 41

All cash flow estimates should also be | adjusted to reflect _____ ______ _____

Answer 41

anticipated inflationary | increases

Question 42

Real Options in Capital Budgeting Classification of Real Options in Capital Budgeting

Answer 42

``` Investment Timing Options Abandonment Option Shutdown Options Growth Options Designed-In Options ```

Question 43

Designed-In Options

Answer 43

Input Flexibility Output Flexibility Expansion Options