hinsafdar

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

A) For mutually exclusive projects, you must accept the project with the highest NPV regardless of the sign of the NPV calculation.

B) For independent projects, the internal rate of return IRR and the NPV methods always yield the same accept/reject decisions.

C) The NPV tells how much the value of the firm will increase if you accept the project.

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If the NPV for two mutually exclusive projects is negative, both should be rejected.

hinsafdar

Which of the following statements about the internal rate of return (IRR) and net present value (NPV) is least accurate?

A) The discount rate that causes the project's NPV to be equal to zero is the project's IRR.

B) The IRR is the discount rate that equates the present value of the cash inflows with the present value of the outflows.

C) For mutually exclusive projects, if the NPV rankings and the IRR rankings give conflicting signals, you should select the project with the higher IRR.

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The NPV method is always preferred over the IRR, because the NPV method assumes cash flows are reinvested at the cost of capital. Conversely, the IRR assumes cash flows can be reinvested at the IRR. The IRR is not an actual market rate.

hinsafdar

Two projects being considered by a firm are mutually exclusive and have the following projected cash flows:

Year	Project 1 Cash Flow	Project 2 Cash Flow
0	−$4.0	?
1	$3.0	$1.7
2	$5.0	$3.2
3	$2.0	$5.8

[/table]
The crossover rate of the two projects’ NPV profiles is 9%. What is the initial cash flow for Project 2? [table]
A)
−$4.51.

B)

−$5.70.

C)

−$4.22.

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The crossover rate is the rate at which the NPV for two projects is the same. That is, it is the rate at which the two NPV profiles cross. At a discount rate of 9%, the NPV of Project 1 is: CF0 = –4; CF1 = 3; CF2 = 5; CF3 = 2; I = 9%; CPT → NPV = $4.51. Now perform the same calculations except that we need to set the unknown CF0 = 0. The remaining entries are: CF1 = 1.7; CF2 = 3.2; CF3 = 5.8; I = 9%; CPT → NPV = $8.73. Since by definition the crossover rate produces the same NPV for both projects, we know that both projects should have an NPV = $4.51. Since the NPV of Project 2 (with CF0 = 0) is $8.73, the unknown cash flow must be a large enough negative amount to reduce the NPV for Project 2 from $8.73 to $4.51. Thus the unknown initial cash flow for Project 2 is determined as $4.51 = $8.73 + CF0, or CF0 = −$4.22.

hinsafdar

For a project with cash outflows during its life, the least preferred capital budgeting tool would be:

A) internal rate of return.

B) net present value.

C) profitability index.

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The IRR encounters difficulties when cash outflows occur throughout the life of the project. These projects may have multiple IRRs, or no IRR at all. Neither the NPV nor the PI suffer from these limitations.

hinsafdar

When a company is evaluating two mutually exclusive projects that are both profitable but have conflicting NPV and IRR project rankings, the company should:

A) accept the project with the higher internal rate of return.

B) accept the project with the higher net present value.

C) use a third method of evaluation such as discounted payback period.

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Net present value is the preferred criterion when ranking projects because it measures the firm’s expected increase in wealth from undertaking a project.

hinsafdar

If the calculated net present value (NPV) is negative, which of the following must be CORRECT. The discount rate used is:

A) less than the internal rate of return (IRR).

B) equal to the internal rate of return (IRR).

C) greater than the internal rate of return (IRR).

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When the NPV = 0, this means the discount rate used is equal to the IRR.  If a discount rate is used that is higher than the IRR, the NPV will be negative.  Conversely, if a discount rate is used that is lower than the IRR, the NPV will be positive.

hinsafdar

Which of the following statements regarding the internal rate of return (IRR) is most accurate? The IRR:

A) can lead to multiple IRR rates if the cash flows extend past the payback period.

B) assumes that the reinvestment rate of the cash flows is the cost of capital.

C) and the net present value (NPV) method lead to the same accept/reject decision for independent projects.

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NPV and IRR lead to the same decision for independent projects, not necessarily for mutually exclusive projects. IRR assumes that cash flows are reinvested at the IRR rate. IRR does not ignore time value of money (the payback period does), and the investor may find multiple IRRs if there are sign changes after time zero (i.e., negative cash flows after time zero).

hinsafdar

If a project has a negative cash flow during its life or at the end of its life, the project most likely has:

A) a negative internal rate of return.

B) more than one internal rate of return.

C) multiple net present values.

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Projects with unconventional cash flows (where the sign of the cash flow changes from minus to plus to back to minus) will have multiple internal rates of return. However, one will still be able to calculate a single net present value for the cash flow pattern.

hinsafdar

Which of the following statements about the internal rate of return (IRR) for a project with the following cash flow pattern is CORRECT?

• Year 0: -$ 2,000
• Year 1: $10,000
• Year 2: -$ 10,000

A) No IRRs can be calculated.

B) It has a single IRR of approximately 38%.

C) It has two IRRs of approximately 38% and 260%.

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The number of IRRs equals the number of changes in the sign of the cash flow. In this case, from negative to positive and then back to negative. Although 38% seems appropriate, one should not automatically discount the value of 260%.
Check answers by calculation:
10,000 ÷ 1.38 - 10,000 ÷ 1.382 = 1995.38
And:
10,000 ÷ 3.6 - 10,000 ÷ 3.62 = 2006.17
Both discount rates give NPVs of approximately zero and thus, are IRRs.

hinsafdar

The NPV profile is a graphical representation of the change in net present value relative to a change in the:

A) discount rate.

B) prime rate.

C) internal rate of return.

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As discount rates change the net present values change. The NPV profile is a graphic illustration of how sensitive net present values are to different discount rates. By comparison, every project has a single internal rate of return and payback period because the values are determined solely by the investment’s expected cash flows.