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Practice Questions for Capital Budgeting

1. Thomson Electric Systems is considering a project that has the following


cash flow and WACC data. What is the project's NPV?
WACC = 10%
Year:
Cash flows:

0
-$1,000

1
$500

2
$500

3
$500

2. Edison Electric Systems is considering a project that has the following


cash flow and WACC data. What is the project's NPV?
WACC = 10%
Year:
Cash flows:
3.

0
-$1,000

1
$450

2
$460

3
$470

Genuine Products Inc. requires a new machine.


Two companies have
submitted bids, and you have been assigned the task of choosing one of
the machines. Cash flow analysis indicates the following:
Machine A
Cash Flow
-$2,000
0
0
0
3,877

Year
0
1
2
3
4

Machine B
Cash Flow
-$2,000
832
832
832
832

What is the IRR for each machine?


4. Brown Grocery is
The project will
each of the next
12%. What is the

considering a project that has an up-front cost of $X.


generate a positive cash flow of $75,000 at the end of
20 years. The project has a WACC of 10% and an IRR of
projects NPV?

5. Edison Electric Systems is considering a project that has the following


cash flow and WACC data. What is the project's MIRR?
WACC = 10%
Year:
Cash flows:

0
-$1,000

1
$350

2
$370

3
$390

6. Arrington Motors is considering a project with the following cash flows:


Time period
0
1
2
3
The project has a WACC of 12%.

Cash Flows
-$200
+120
-50
+700
What is the projects MIRR?

7. Blanchford Enterprises is considering a project that has the following


cash flow data. What is the project's payback period?
Year:
Cash flows:

0
-$1,000

1
$500

2
$500

3
$500

8. The Seattle Corporation has an investment opportunity that will yield cash
flows of $30,000 per year in Years 1 through 4, $35,000 per year in Years
5 through 9, and $40,000 in Year 10. This investment will cost $150,000
today, and the firms WACC is 10%. What is the payback period for this
investment?
9. Shannon Industries is considering a project that has the following cash
flows:
Project
Cash Flow
?
$2,000
3,000
3,000
1,500

Year
0
1
2
3
4

The project has a payback of 2.5 years, and its WACC 12%.
projects NPV?
10.

Belanger Construction
subsequent cash flows:
Project

is

considering

Year
0
1
2
3

project

with

What is the

the

following

Cash Flow
?
$400
500
200

The projects payback is 1.5 years, and it has a WACC of 10%.


the projects MIRR?

What is

11. Project C has the following net cash flows:


Year
0
1
2
3
4

Project C
Cash Flow
-$500
200
X
300
500

Note, that the cash flow, X, at t = 2 is an outflow (that is, X < 0).
Project C has a WACC of 10% and an MIRR of 12%. What is the projects
cash outflow at t = 2?

12. Blanchford Enterprises is considering a project that has the following


cash flow and WACC data. The discount rate is 10%. What is the project's
discounted payback?
Year:
Cash flows:

0
-$1,000

1
$500

2
$500

3
$500

13. Last month, Wong Systems Inc. decided to accept the project whose cash
flows are shown below. However, before actually starting the project, the
Federal Reserve took actions that changed interest rates and Wong's WACC.
By how much did the change in the WACC affect the project's forecasted
NPV? Assume that the Fed action will not affect the cash flows.
Old WACC = 10%
New WACC = 5%
Year:
0
1
2
Cash flows:
-$1,000 $500
$500

3
$500

14. Davis Corporation has an investment policy that requires acceptable


projects to recover all costs within 3 years. The corporation uses the
discounted payback method to assess potential projects and uses a WACC of
10%. The cash flows for two independent projects are shown below:
Project A
Cash Flow
-$100,000
40,000
40,000
40,000
30,000

Year
0
1
2
3
4

Project B
Cash Flow
-$80,000
50,000
20,000
30,000
0

According to the companys investment policy, which investment project(s)


should the company invest in?
a.
b.
c.
d.

Project
Neither
Project
Project

A only.
Project A nor Project B.
A and Project B.
B only.

15. You must find the payback for a project, and you have misplaced some of
the information that you were given.
You know that the project will
generate positive cash flows of $60,000 per year at the end of each of the
next 5 years, that its NPV is $75,000, and that the companys WACC is 10%.
What is the projects regular payback?
Hint: You must first find the
project's cost, then use it to find the payback.
16. Taylor Technologies has a target capital structure that consists of 40%
debt and 60% equity. The equity will be financed with retained earnings.
The companys bonds have a yield to maturity of 10%. The companys stock
has a beta = 1.1. The risk-free rate is 6%, the market risk premium is 5%,
and the tax rate is 30%. The company is considering a project with the
following cash flows:
Year
0
1

Project A
Cash Flow
-$50,000
35,000

2
3
4

43,000
60,000
-40,000

What is the projects MIRR?


17. Assume a project has normal cash flows.
following statements is CORRECT?
a.
b.
c.
d.
e.

The
The
The
The
The

projects
projects
projects
projects
projects

All else equal, which of the

IRR increases as the WACC declines.


NPV increases as the WACC declines.
MIRR is unaffected by changes in the WACC.
regular payback increases as the WACC declines.
discounted payback increases as the WACC declines.

18. Which of the following statements is CORRECT?


a. c. If a project has normal cash flows, then it will have exactly
two real IRRs.
b. The definition of normal cash flows is that the cash flow stream
has one or more negative cash flows followed by a stream of positive
cash flows and then one negative cash flow at the end of the
projects life.
c. If a project has normal cash flows, then it can have only one real
IRR, whereas a project with nonnormal cash flows might have more
than one real IRR.
19. Which of the following statements is CORRECT? Assume that the project
being considered has normal cash flows, with one outflow followed by a
series of inflows.
a. A projects NPV is found by compounding the cash inflows at the IRR
to find the terminal value (TV), then discounting the TV at the
WACC.
b. The lower the WACC used to calculate it, the lower the calculated
NPV will be.
c. If a projects NPV is less than zero, then its IRR must be less than
the WACC.
d. If a projects NPV is greater than zero, then its IRR must be less
than zero.
e. The NPV of a relatively low risk project should be found using a
relatively high WACC.
20. Which of the following statements is CORRECT? Assume that the project
being considered has normal cash flows, with one outflow followed by a
series of inflows.
a. The shorter a projects payback period, the less desirable the
project is normally considered to be by this criterion.
b. One drawback of the payback criterion for evaluating projects is
that this method does not take account of cash flows beyond the
payback period.
c. If a projects payback is positive, then the project should be
accepted because it must have a positive NPV.
d. The regular payback ignores cash flows beyond the payback period,
but the discounted payback method overcomes this problem.
e. One drawback of the discounted payback is that this method does not
consider the time value of money, while the regular payback

overcomes this drawback.

21. Which of the following statements is CORRECT?


a. The IRR method appeals to some managers because it gives an estimate
of the rate of return on projects rather than a dollar amount like
the NPV method provides.
b. The discounted payback method eliminates all of the problems
associated with the payback method.
c. When evaluating independent projects, the NPV and IRR methods often
yield conflicting results.
d. To find the MIRR, we discount the TV at the IRR.
e. A projects NPV profile must intersect the x-axis at the projects
WACC.
22. Projects S and L are equally risky, mutually exclusive projects with
normal cash flows. Project S has an IRR of 15%, while Project Ls IRR is
12%. The two projects have the same NPV when the WACC is 7%. Which of the
following statements is CORRECT?
a.
b.
c.
d.
e.

If the WACC
If the WACC
If the WACC
If the WACC
Project Ss

is 10%, both projects will have positive NPVs.


is 6%, Project S will have the higher NPV.
is 13%, Project S will have the lower NPV.
is 10%, both projects will have a negative NPV.
NPV is more sensitive to changes in WACC than Project L.

ANSWERS
1. $243.43
2. $142.37
3. IRRA = 18%; IRRB = 24%
4. $78,309
5. 6.87%
6. 52.49%
7. 2 years
8. 4.86 years
9. $765.91
10. 23.82%
11. -$237.95
12. 2.36 years
13. $118.20
14. d
15.2.54 years
16. 20.52%
17. b
18. c
19. c
20. b
21. a
22. a