Pena Company is considering a project that calls for an initial cash outlay of $50,000. The expected net cash inflows from the project are $7,791 for each of 10 years. What is the IRR of
Answer (D) is correct. The IRR can be calculated by equating the initial cash outlay with the present value of the net cash inflows: $50,000 = $7,791 (PV at i for 10 periods) $50,000 ÷ $7,791 = 6.418 Using a PV table, 6.418 is PV at 9% for 10 periods.
Assume that the probability distribution of NPVs is normal. The firm considers true risk occurring if the project results in a NPV that is zero or less. If the expected NPV is $1,000 and the standard deviation of NPV is $500, what is the probability that the project has an NPV of 0 or less?
Answer (A) is correct. Since three standard deviations incorporate over 99% of all observations, and two standard deviations incorporate over 95% of observations, less than 5% will not be included within two standard deviations, and this is divided between both ends of the normal curve. Therefore, less than 2.5% of the observations will be in the negative portion of the curve.
Project 1 has an expected NPV of $120,000 and a standard deviation of $200,000. Project 2 has an expected NPV of $100,000 and a standard deviation of $150,000. The correlation between these two projects is 0.80. What is the coefficient of variation for the portfolio of projects?
Answer (C) is correct. The coefficient of variation is useful when the rates of return and standard deviations of two investments differ. It measures the risk per unit of return by dividing the standard deviation by the expected return. Thus, for Project 1, dividing $200,000 by $120,000 produces a coefficient of 1.67. For Project 2, the calculation is to divide $150,000 by $100,000, or 1.50. If the two projects had perfect correlation (=1.0), then you could combine the calculations ($350,000 ÷ $220,000 = 1.59). However, with a correlation of less than one, the risk will be something less than 1.59.
When using the net present value method for capital budgeting analysis, the required rate of return is called all of the following except the
Answer (A) is correct. The rate used to discount future cash flows is sometimes called the cost of capital, the discount rate, the cutoff rate, or the hurdle rate. A risk-free rate is the rate available on risk-free investments such as government bonds. The risk-free rate is not equivalent to the cost of capital because the latter must incorporate a risk premium.
The internal rate of return for a project can be determined
Answer (C) is correct. The IRR is a capital budgeting technique that calculates the interest rate that yields a net present value equal to $0. It is the interest rate that will discount the future cash flows to an amount equal to the initial cost of the project. Thus, the higher the IRR, the more favorable the ranking of the project.
Carco, Inc., wants to use discounted cash flow techniques when analyzing its capital investment projects. The company is aware of the uncertainty involved in estimating future cash flows. A simple method some companies employ to adjust for the uncertainty inherent in their estimates is to
Answer (C) is correct. Uncertainty can be compensated for by adjusting the desired rate of return. If projects have relatively uncertain returns, a higher rate should be required. A lower rate of return may be acceptable given greater certainty. The concept is that with increased risk should come increased rewards, i.e., a higher rate of return.
The accountant of Ronier, Inc., has prepared an analysis of a proposed capital project using discounted cash flow techniques. One manager has questioned the accuracy of the results because the discount factors employed in the analysis have assumed the cash flows occurred at the end of the year when the cash flows actually occurred uniformly throughout each year. The net present value calculated by the accountant will
Answer (D) is correct. The effect of assuming cash flows occur at the end of the year simply understates the present values of the future cash flows; in reality, they probably occur on the average at mid-year.
The internal rate of return on an investment
Answer (C) is correct. Investment projects may be mutually exclusive under conditions of capital rationing (limited capital). In other words, scarcity of resources will prevent an
entity from undertaking all available profitable activities. Under the IRR method, an interest rate is computed such that the present value of the expected future cash flows equals the cost of the investment (NPV = 0). The IRR method assumes that the cash flows will be reinvested at the IRR. The NPV is the excess of the present value of the estimated net cash inflows over the net cost of the investment. The cost of capital must be specified in the NPV method. An assumption of the NPV method is that cash flows from the investment will be reinvested at the particular project’s cost of capital. Because of the difference in the assumptions regarding the reinvestment of cash flows, the two methods will occasionally give different answers regarding the ranking of mutually exclusive projects. Moreover, the IRR method may rank several small, short-lived projects ahead of a large project with a lower rate of return but with a longer life span. However, the large project might return more dollars to the company because of the larger amount invested and the longer time span over which earnings will accrue. When faced with capital rationing, an investor will want to invest in projects that generate the most dollars in relation to the limited resources available and the size and returns from the possible investments. Thus, the NPV method should be used because it determines the aggregate present value for each feasible combination of projects.
The internal rate of return is
Answer (D) is correct. The internal rate of return (IRR) is the discount rate at which the present value of the cash flows equals the original investment. Thus, the NPV of the project is zero at the IRR. The IRR is also the maximum borrowing cost the firm could afford to pay for a specific project. The IRR is similar to the yield rate/effective rate quoted in the business media.
All of the following are the rates used in net present value analysis except for the
Answer (D) is correct. The NPV is the excess of the present values of the estimated cash inflows over the net cost of the investment. The discount rate used is sometimes the cost of capital or other hurdle rate designated by management. This rate is also called the required rate of return. The accounting rate of return is never used in NPV analysis because it ignores the time value of money; it is computed by dividing the accounting net income by the investment.