Chapter 9 Capital Budgeting Decision Models

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%

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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.

23) The IRR is an unpopular capital budgeting decision model because even with the advent of calculators and spreadsheets, the cumbersome calculation remains.

Comment: 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.]

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.

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.

26) Robinson, 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 Robinson use the IRR method to evaluation this project? Explain.

27) Carter, 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 Carter's true cost of borrowing for this project is 10%, would Carter choose the project?

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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.

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

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

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 D) profitability index

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4) Which of the statements below is FALSE?

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.

5) Which of the statements below is TRUE?

A) According to the profitability index (PI) decision criterion when the PI is greater than 1, the cost 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 to 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.

6) 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.