andytrader

Which of the following is NOT a problem with the internal rate of return (IRR)?

A) Sometimes the IRR exceeds the cost of capital.

B) Non-normal cash flow patterns may result in multiple IRRs.

C) A higher IRR does not necessarily indicate a more-profitable project.

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If the IRR exceeds the cost of capital, that merely indicates that the project is acceptable—this is not a problem associated with IRR. Non-normal cash flow patterns such as cash outflows during the project's life can result in multiple IRRs, leaving open the question as to which one is valid. A higher IRR will only be realized if the project’s cash flows can be reinvested at the IRR, and the true profitability of a project also depends on project size, not just IRR.

andytrader

Jack Smith, CFA, is analyzing independent investment projects X and Y. Smith has calculated the net present value (NPV) and internal rate of return (IRR) for each project:

Project X: NPV = $250; IRR = 15%
Project Y: NPV = $5,000; IRR = 8%

Smith should make which of the following recommendations concerning the two projects?

A) Accept Project X only.

B) Accept Project Y only.

C) Accept both projects.

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The projects are independent, meaning that either one or both projects may be chosen. Both projects have positive NPVs, therefore both projects add to shareholder wealth and both projects should be accepted.

andytrader

Which of the following statements regarding making investment decisions using net present value (NPV) and internal rate of return (IRR) is least accurate?

A) If two projects are mutually exclusive, one should always choose the project with the highest IRR.

B) Projects with a positive NPVs increase shareholder wealth.

C) If a firm undertakes a zero-NPV project, the firm will get larger, but shareholder wealth will not change.

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If two projects are mutually exclusive, the firm should always choose the project with the highest NPV rather than the highest IRR. If two projects are mutually exclusive, the firm may only choose one. It is possible for NPV and IRR to give conflicting decisions for projects of different sizes. Because NPV is a direct measure of the change in shareholder wealth, NPV criteria should be used when NPV and IRR decisions conflict.
When a project has a positive NPV, it will add to shareholder wealth because the project is earning more than the opportunity cost of capital needed to undertake the project. If a firm takes on a zero-NPV project, the firm will earn exactly enough to cover the opportunity cost of capital. The firm will increase in size by taking the project, but shareholder wealth will not change.

andytrader

Williams Warehousing currently has a warehouse lease that calls for five annual payments of $120,000. The warehouse owner, who needs cash, is offering Williams a deal wherein Williams will pay $200,000 this year and then pay only $80,000 each of the remaining 4 years. (Assume that all lease payments are made at the beginning of the year.) Should Williams Warehousing accept the offer if its required rate of return is 9%, and why?

A) Yes, there is a savings of $45,494 in present value terms.

B) Yes, there is a savings of $49,589 in present value terms.

C) No, there is an additional $80,000 payment in this year.

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The present value of the current lease is $508,766.38, while the present value of the lease being offered is $459,177.59; a savings of 49,589. Alternatively, the present value of the extra $40,000 at the beginning of each of the next 4 years is $129,589 which is $49,589 more than the extra $80,000 added to the payment today.

clearlycanadian

The financial manager at IBFM, a farm implement distributor, is contemplating the following three mutually exclusive projects. IBFM’s required rate of return is 9.5%. Based on the information provided, which should the financial manager select and why?

Project	Investment at t = 0	Cash Flow at t = 1	IRR	NPV @ 9.5%
A	$10,000	$11,300	13.00	$320
B	$25,000	$29,000	16.00	$1,484
C	$35,000	$40,250	15.00	$1,758

A) Project C with the highest net present value.

B) Project A with the lowest initial investment.

C) All of the projects, because they all earn more than 9.5%.

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When projects are mutually exclusive, only one can be chosen. Project selection should be done on the basis of which project will enhance firm value the most. That project, Project C in this case, is the one with the highest NPV.

clearlycanadian

Financial managers should always select the project that provides the highest net present value (NPV) whenever NPV and IRR methods conflict, because maximizing:

A) the shareholders' rate of return is the goal of financial management.

B) shareholder wealth is the goal of financial management.

C) revenues is the goal of financial management.

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Focusing on the maximization of earnings does not consider the differences in risk across projects, while focusing on revenues precludes concern for the expenses incurred. Earning a higher return on a small project provides less of a benefit than earning a slightly lower rate of return on a much larger project.

clearlycanadian

The financial manager at Johnson & Smith estimates that its required rate of return is 11%. Which of the following independent projects should Johnson & Smith accept?

A) Project A requires an up-front expenditure of $1,000,000 and generates an NPV of -$4,600.

B) Project C requires an up-front expenditure of $600,000 and generates a positive internal rate of return of 12.0%.

C) Project B requires an up-front expenditure of $800,000 and generates a positive IRR of 10.5%.

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When projects are independent, you can use either the NPV method or IRR method to make the accept or reject decision. Only Project C has an IRR in excess of 11%. Acceptance of Project A reduces the firm’s value by $4,600.

clearlycanadian

An investor expects a stock currently selling for $20 per share to increase to $25 by year-end. The dividend last year was $1 but he expects this year's dividend to be $1.25. What is the expected holding period return on this stock?

A) 24.00%.

B) 28.50%.

C) 31.25%.

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Return = [dividend + (end − begin)] / beginning price
R = [1.25 + (25 − 20)] / 20 = 6.25 / 20 = 0.3125

clearlycanadian

An investor is considering investing in Tawari Company for one year. He expects to receive $2 in dividends over the year and feels he can sell the stock for $30 at the end of the year. To realize a return on the investment over the year of 14%, the price the investor would pay for the stock today is closest to:

A) $28.

B) $29.

C) $32.

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HPR = [Dividend + (Ending price − Beginning price)] / Beginning price 0.14 = [2 + (30 − P)] / P
1.14P = 32 so P = $28.07

clearlycanadian

Banca Hakala purchases two front row concert tickets over the Internet for $90 per seat. One month later, the rock group announces that it is dissolving due to personality conflicts and the concert that Hakala has tickets for will be the “farewell” concert. Hakala sees a chance to raise some quick cash, so she puts the tickets up for sale on the same internet site. The auction closes at $250 per ticket. After paying a 10% commission to the site on the amount of the sale and paying $10 in shipping costs, Hakala’s one-month holding period return is approximately:

A) 44%.

B) 144%.

C) 139%.

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The holding period return is calculated as: (ending price – beginning price +/- any cash flows) / beginning price. Here, the beginning and ending prices are given. The other cash flows consist of the commission of 0.10 × $250 × 2 tickets = $50 and the shipping cost of $10 (total for both tickets).
Thus, her one-month holding period return is: [(2 × $250) – (2 × $90) – $50 − $10] / (2 × $90) = 1.44, or approximately 144%.