6.3 The Payback Rule
Use the
following information to answer the question(s) below.
Rearden Metals
is considering opening a strip mining operation to provide some of the raw
materials needed in producing Rearden metal. The initial purchase of the land
and the associated costs of opening up mining operations will cost $100 million
today. The mine is expected to generate $16 million worth of ore per year for
the next 12 years. At the end of the 12th year Rearden will need to spend $20
million to restore the land to its original pristine nature appearance.
1) The payback
period for Rearden's mining operation is closest to:
A) 5.00 years
B) 6.00 years
C) 6.25 years
D) 6.50 years
2) Which of the
following statements is false?
A) It is
possible that an IRR does not exist for an investment opportunity.
B) If the
payback period is less than a prespecified length of time you accept the
project.
C) The internal
rate of return (IRR) investment rule is based upon the notion that if the
return on other alternatives is greater
than the return on the investment opportunity you should undertake the
investment opportunity.
D) It is
possible that there is no discount rate that will set the NPV equal to zero.
3) Which of the
following statements is false?
A) The payback
investment rule is based on the notion that an opportunity that pays back its
initial investments quickly is a good idea.
B) An IRR will
always exist for an investment opportunity.
C) A NPV will
always exist for an investment opportunity.
D) In general,
there can be as many IRRs as the number of times the project's cash flows
change sign over time.
4) Which of the
following statements is false?
A) In general,
the IRR rule works for a standalone project if all of the project's positive
cash flows precede its negative cash flows.
B) There is no
easy fix for the IRR rule when there are multiple IRRs.
C) The payback
rule is primarily used because of its simplicity.
D) No investment
rule that ignores the set of alternative investment alternatives can be
optimal.
5) Which of the
following statements is false?
A) The payback
rule is useful in cases where the cost of making an incorrect decision might
not be large enough to justify the time required for calculating the NPV.
B) The payback
rule is reliable because it considers the time value of money and depends on
the cost of capital.
C) For most
investment opportunities expenses occur initially and cash is received later.
D) Fifty percent
of firms surveyed reported using the payback rule for making decisions.
Consider a
project with the following cash flows:
Year

Cash
Flow

0

10,000

1

4,000

2

4,000

3

4,000

4

4,000

6) Assume the
appropriate discount rate for this project is 15%. The payback period for this project is
closest to:
A) 3
B) 2.5
C) 2
D) 4
Use the table
for the question(s) below.
Consider the
following two projects:
Project

Year
0
Cash
Flow

Year
1
Cash
Flow

Year
2
Cash
Flow

Year
3
Cash
Flow

Year
4
Cash
Flow

Discount
Rate

A

100

40

50

60

N/A

.15

B

73

30

30

30

30

.15

7) The payback
period for project A is closest to:
A) 2.0 years
B) 2.4 years
C) 2.5 years
D) 2.2 years
8) The payback
period for project B is closest to:
A) 2.5 years
B) 2.0 years
C) 2.2 years
D) 2.4 years
Use the table
for the question(s) below.
Consider the
following two projects:
Project

Year
0
C/F

Year
1
C/F

Year
2
C/F

Year
3
C/F

Year
4
C/F

Year
5
C/F

Year
6
C/F

Year
7
C/F

Discount
Rate

Alpha

79

20

25

30

35

40

N/A

N/A

15%

Beta

80

25

25

25

25

25

25

25

16%

9) The payback
period for project Alpha is closest to:
A) 3.2 years
B) 2.9 years
C) 3.1 years
D) 2.6 years
10) The payback
period for project beta is closest to:
A) 2.9 years
B) 3.1 years
C) 2.6 years
D) 3.2 years
Use the
information for the question(s) below.
The Sisyphean
Company is planning on investing in a new project. This will involve the purchase of some new
machinery costing $450,000. The
Sisyphean Company expects cash inflows from this project as detailed below:
Year
One

Year
Two

Year
Three

Year
Four

$200,000

$225,000

$275,000

$200,000

The appropriate
discount rate for this project is 16%.
11) The payback
period for this project is closest to:
A) 2.1 years
B) 3.0 years
C) 2 years
D) 2.2 years
6.4 Choosing Between Projects
1) Which of the
following statements is false?
A) Problems can
arise using the IRR method when the mutually exclusive investments have
different cash flow patterns.
B) The IRR is
affected by the scale of the investment opportunity.
C) Multiple
incremental IRRs might exist.
D) The
incremental IRR rule assumes that the riskiness of the two projects is the
same.
2) Which of the
following statements is false?
A) The
incremental IRR investment rule applies the IRR rule to the difference between
the cash flows of the two mutually exclusive alternatives.
B) When a
manager must choose among mutually exclusive investments, the NPV rule provides
a straightforward answer.
C) The
likelihood of multiple IRRs is greater with the regular IRR rule than with the
incremental IRR rule.
D) Problems can
arise using the IRR method when the mutually exclusive investments have
differences in scale.
:
3) Which of the
following statements is false?
A) When using
the incremental IRR rule, you must keep track of which project is the
incremental project and ensure that the incremental cash flows are initially
positive and then become negative.
B) Picking one
project over another simply because it has a larger IRR can lead to mistakes.
C) Problems
arise using the IRR method when the mutually exclusive investments have
differences in scale.
D) When the
risks of two projects are different, only the NPV rule will give a reliable
answer.
4) Which of the
following statements is false?
A) The
incremental IRR need not exist.
B) If a change
in the timing of the cash flows does not affect the NPV, then the change in
timing will not impact the IRR.
C) Although the
incremental IRR rule can provide a reliable method for choosing among projects,
it can be difficult to apply correctly.
D) When projects
are mutually exclusive, it is not enough to determine which projects have
positive NPVs.
5) Consider two
mutually exclusive projects A & B.
If you subtract the cash flows of opportunity B from the cash flows of
opportunity A, then you should
A) take
opportunity A if the regular IRR exceeds the cost of capital.
B) take
opportunity A if the incremental IRR exceeds the cost of capital.
C) take
opportunity B if the regular IRR exceeds the cost of capital.
D) take
opportunity B if the incremental IRR exceeds the cost of capital.
6) You are
trying to decide between three mutually exclusive investment
opportunities. The most appropriate tool
for identifying the correct decision is
A) NPV.
B) Profitability
index.
C) IRR.
D) Incremental
IRR.
:
Use the table
for the question(s) below.
Consider the
following two projects:
Project

Year
0
Cash
Flow

Year
1
Cash
Flow

Year
2
Cash
Flow

Year
3
Cash
Flow

Year
4
Cash
Flow

Discount
Rate

A

100

40

50

60

N/A

.15

B

73

30

30

30

30

.15

7) Assume that
projects A and B are mutually exclusive.
The correct investment decision and the best rational for that decision
is to
A) invest in
project A since NPVB < NPVA.
B) invest in
project B since IRRB > IRRA.
C) invest in
project B since NPVB > NPVA.
D) invest in
project A since NPVA > 0.
8) The
incremental IRR of Project B over Project A is closest to:
A) 12.6%
B) 23.3%
C) 1.7%
D) 17.3%
Answer: A
9) The maximum
number of incremental IRRs that could
exist for project B over project A is:
A) 1
B) 2
C) 0
D) 3
Use the table
for the question(s) below.
Consider the
following two projects:
Project

Year
0
C/F

Year
1
C/F

Year
2
C/F

Year
3
C/F

Year
4
C/F

Year
5
C/F

Year
6
C/F

Year
7
C/F

Discount
Rate

Alpha

79

20

25

30

35

40

N/A

N/A

15%

Beta

80

25

25

25

25

25

25

25

16%

10) Assume that
projects Alpha and Beta are mutually exclusive.
The correct investment decision and the best rational for that decision
is to
A) invest in
project Beta since NPVBeta > 0.
B) invest in
project Alpha since NPVBeta < NPVAlpha.
C) invest in project
Beta since IRRB > IRRA.
D) invest in
project Beta since NPVBeta > NPVAlpha> 0.
ects Alpha and
Beta are mutually exclusive. Which of
the following statements is true regarding the investment decision tools'
suitability for deciding between projects Alpha & Beta.
A) The
incremental IRR should not be used since the projects have different lives.
B) The
incremental IRR should not be used since the projects have different discount
rates
C) The
incremental IRR should not be used since the projects have different cash flow
patterns.
D) Both the NPV
and incremental IRR approaches are appropriate to solve this problem.
12) When
choosing between projects, an alternative to comparing their IRRs is
A) to compute
the incremental IRR, which tells us the discount rate at which it becomes
profitable to switch from one project to the other.
B) to compute
the incremental payback period, which tells us the number of years during which
it becomes profitable to switch from one project to the other.
C) to compute
the incremental NPV, which tells us the discount rate at which it becomes
profitable to switch from one project to the other.
D) There is no
alternative selection criterion to comparing IRRs.
Use the table
for the question(s) below.
Consider two
mutually exclusive projects with the following cash flows:
Project

C/F0

C/F1

C/F2

C/F3

C/F4

C/F5

C/F6

A

$(41,215)

$12,500

$14,000

$16,500

$18,000

20,000

N/A

B

$(46,775)

$15,000

$15,000

$15,000

$15,000

$15,000

$15,000

13) You are
considering using the incremental IRR approach to decide between the two
mutually exclusive projects A & B.
How many potential incremental IRRs could there be?
A) 3
B) 0
C) 2
D) 1
14) If the
discount rate for project A is 16%, then what is the NPV for project A?
15) If the
discount rate for project B is 15%, then what is the NPV for project B?
16) What is the
incremental IRR for project B over project A?
Would you feel comfortable basing your decision on the incremental IRR?
17) Assuming
that the discount rate for project A is 16% and the discount rate for B is 15%,
then given that these are mutually exclusive projects, which project would you
take and why?