Dr. Sudhakar Raju
FN 6100
PRACTICE EXAM QUESTIONS ON NPV AND OTHER INVESTMENT CRITERIA
1.
The net present value (NPV) rule can be best stated as:
a.
b.
c.
d.
An investment should be accepted if, and only if, the NPV is exactly equal to zero.
An investment should be rejected if the NPV is positive and accepted if it is negative.
An investment should be accepted if the NPV is positive and rejected if it is negative.
An investment with greater cash inflows than cash outflows, regardless of when the cash flows
occur, will always have a positive NPV and therefore should always be accepted.
2.
The discount rate that makes the net present value of investment exactly equal to zero is the:
a.
b.
c.
d.
e.
Payback period.
Internal rate of return.
Average accounting return.
Profitability index.
Discounted payback period.
3.
Which of the following statements is true?
a.
b.
c.
d.
e.
NPV should never be used if the project under consideration has unconventional cash flows.
NPV is similar to a cost/benefit ratio.
If the financial manager relies on NPV in making capital budgeting decisions, she acts in the
shareholders’ best interests.
NPV can normally be directly observed in the marketplace.
IRR is generally preferred to NPV in making correct capital budgeting acceptance decisions.
4.
Net present value
a.
b.
c.
d.
e.
is equal to the initial investment in a project
is equal to the present value of the project returns
is equal to zero when the interest rate used to discount cash flows equals the IRR
is simplified by the fact that future cash flows are easy to estimate
requires the firm set an arbitrary cutoff point for determining whether an investment is
acceptable
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5.
The
decision rule is considered the “best” in principle:
a.
b.
c.
d.
e.
internal rate of return
payback period
average accounting return
net present value
profitability index
6.
An NPV of zero implies that an investment ______
a.
b.
c.
d.
e.
has no initial cost
has the sum of the total cash flows equal to zero
creates shareholder wealth
destroys shareholder wealth
is immaterial to the shareholder
7.
You own some manufacturing equipment that must be replaced. Two different suppliers
present a purchase and installation plan for your consideration. This is an example of a
business decision involving
projects.
a.
b.
c.
d.
e.
mutually exclusive
independent
working capital
positive NPV
crossover
8.
Consider a project with an initial investment and positive future cash flows. As the discount
.
rate is decreased the
a.
b.
c.
d.
e.
IRR remains constant while the NPV increases
IRR decreases while the NPV remains constant
IRR remains constant while the NPV decreases
IRR increases while the NPV remains constant
IRR decreases while the NPV decreases
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9.
A project costs $300 and has cash flows of $75 for the first three years and $50 in each of the
project’s last three years. If the discount rate is 15%, what is the discounted payback period?
a.
b.
c.
d.
e.
The project never pays back on a discounted basis
3 years
4 years
5 years
6 years
10. You are evaluating two mutually exclusive projects, A and B. Project A costs $600 and has
cash flows of $400 in each of the next 2 years. Project B also costs $600, and generates cash
flows of $500 and $275 for the next 2 years, respectively. What is the crossover rate? What is
the NPV at the cross-over rate?
a.
b.
c.
d.
e.
10%, $200
15%, -$200
25%, -$24
25%, $24
25%, $25
11. You are considering an investment with the following cash flows. Your required return is 8%,
you generally require a payback of 3 years and a discounted payback of 4 years. If your
objective is to maximize your wealth, should you take this investment?
Year
0
Cash Flow –$50,000
a.
b.
c.
d.
e.
1
$20,000
2
$20,000
3
$20,000
4
$20,000
5
–$50,000
Yes, because the payback is 2.5 years.
Yes, because the discounted payback is less than 4 years.
Yes, because both the payback and the discounted payback are less than 2 years.
No, because the NPV is negative.
No, because the project cash flows are not conventional.
12. You are going to choose between two investments. Both cost $50,000, but investment A pays
$25,000 a year for 3 years while investment B pays $20,000 a year for 4 years. If your required
return is 12%, which should you choose?
a.
b.
c.
d.
e.
A because it pays back sooner.
A because its IRR exceeds 12%.
A because it has a higher IRR.
B because its IRR exceeds 12%.
B because it has a higher NPV.
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13. You have a choice between 2 mutually exclusive investments. If you require a 15% return,
which investment should you choose?
A
B
Year
Cash Flow
Cash Flow
0
–$100,000
–$125,000
1
20,000
75,000
2
40,000
45,000
3
80,000
40,000
a.
b.
c.
d.
e.
Project A, because it has a smaller initial investment.
Project B, because it has a higher NPV.
Either one, because they have the same profitability indexes.
Project A, because it has the higher internal rate of return.
Project B, because it pays back faster.
Use the following information to answer questions 14 through 16.
You need to borrow $5,000 quickly, and the local pawn shop will give it to you if you promise to repay
them $500 every month over the next year.
14. From the pawn shop’s point of view, what is the IRR of this transaction?
a.
b.
c.
d.
e.
1.33% per month
1.76% per month
2.04% per month
2.51% per month
2.92% per month
15. What is the EAR (Effective Annual Rate) of this transaction?
a.
b.
c.
d.
e.
120%
35.07%
24.48%
30.12%
41.29%
16. Suppose that the pawn shop’s cost of funds is 18% p.a., compounded monthly. From their
point of view, what is the NPV of this deal?
a.
b.
c.
d.
e.
$ 84.82
$211.06
$326.17
$453.75
$692.01
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Use the following information to answer questions 17 through 20.
Bill plans to open a service center. The equipment will cost $50,000. Bill expects the after-tax cash
inflows to be $15,000 annually for 8 years, after which he plans to scrap the equipment and retire.
17. What is the project’s regular payback period?
a.
b.
c.
d.
e.
2.67 years
3.33 years
3.67 years
4.33 years
5.67 years
18. Assume the required return is 10%. What is the project’s discounted payback period?
a.
b.
c.
d.
e.
4.25 years
5.25 years
6 years
7 years
The project does not payback on a discounted basis.
19. Assume the required return is 10%. What is the project’s NPV?
a.
b.
c.
d.
e.
$887
$13,322
$22,759
$30,024
$45,001
20. Assume the required return is 20%. What is the project’s IRR? Should it be accepted?
a.
b.
c.
d.
e.
15%;
15%;
25%;
25%;
20%;
yes
no
yes
no
indifferent
(ANSWER KEY ON NEXT PAGE)
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ANSWER KEY
1. C
2. B
3. C
4. C
5. D
6. E
7. A
8. A
9. A
10.C
11.D
12.E
13.B
14.E
15.E
16.D
17.B
18.A
19.D
20.C
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