Question

In: Finance

1.  Which of the following statements is correct? a. All the answers are correct. b. The NPV...

1.  Which of the following statements is correct?

a. All the answers are correct.

b. The NPV cannot be used effectively for projects with unconventional cash flows.

c. The decision criterion for the accounting rate of return is consistent with the goal of shareholder wealth maximization.

d. The NPV provides a direct (dollar) measure of how much a capital project will increase the value of the firm.

e. The process of limiting, or rationing, capital expenditures among possible projects is called capital budgeting.

2. Which of the following statements is correct?

a. With independent projects, accepting or rejecting one project does not eliminate other projects from consideration (assuming the firm has unlimited funds to invest).

b. There is a strong economic rationale that links the payback method to stockholder value maximization.

c. All the answers are correct.

d. If a capital project has a negative Payback Period, the value of the cash flows the project is expected to generate exceeds the project's cost.

e. Projects are classified as independent when their cash flows are related.

3. Which of the following statements is incorrect?

a. The greatest shortcoming of the payback method is its failure to consider cash flows after the payback period.

b. Most of the answers are correct except one.

c. The IRR is the discount rate that equates the present value of a project's cost to the present value of its expected cash inflows.

d. One of the weaknesses of the ordinary payback period criteria is that it does not take into account the time value of money.

e. A project's payback period provides an objective measure of its incremental value to the firm's investors, and thus makes it simple to choose between two or more mutually exclusive projects.

Solutions

Expert Solution

1. Which of the following statements is correct

Answer: a. All the statements are correct.

  • Unconventional cash flows are more difficult to handle in an NPV analysis than a conventional cash flow since it will produce multiple internal rates of return (IRR), depending on the number of changes in the cash flow direction.
  • Wealth maximization is the concept of increasing the value of a business in order to increase the value of the shares held by its stockholders. The concept requires a company's management team to continually search for the highest possible returns on funds invested in the business while mitigating any associated risk of loss.
  • A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. Since the goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.
  • Capital budgeting is the process a business undertakes to evaluate potential major projects or investments. Construction of a new plant or a big investment in an outside venture are examples of projects that would require capital budgeting before they are approved or rejected.

2. Which of the following statements is correct?

Answer: a. With independent projects, accepting or rejecting one project does not eliminate other projects from consideration (assuming the firm has unlimited funds to invest).

If a firm has unlimited funds to invest in capital assets, all independent projects that meet its minimum investment criteria should be implemented. In capital budgeting, the preferred approaches in assessing whether a project is acceptable are those that integrate time value procedures, risk and return considerations, and valuation concepts.

3. Which of the following statements is incorrect?

Answer: c. The IRR is the discount rate that equates the present value of a project's cost to the present value of its expected cash inflows.

The internal rate of return of a project is the discount rate that would yield a net present value of zero, i.e., the rate of interest which makes the present value of the estimated cash inflow equal to the present value of the cash outflow required by the investment.


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