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Basic concepts of NPV, IRR and Payback period

1. If an investment project has an internal rate of return equal to the interest rate, the NPV for that project:
(A) Is negative
(B) Is positive
(C) Is Zero
(D) May be either positive or negative

2. The Balistan Rug Company is considering investing in a new loom that will cost $12,000. The new loom will create positive end of year cash flow of $5,000 for the next 3 years. The internal rate of return for this project is:
(A) Between 10% and 15%.
(B) Between 15% and 20%.
(C) Between 20% and 25%.
(D) Between 25% and 30%.

3. The profitability index is a useful way of adjusting the net present value rule in case of:
(A) Capital rationing
(B) Collectively exhaustive projects
(C) Mutually exclusive projects.
(D) Required budgeted problems when modified by accounting data rather than cash flow data.

4. The average accounting rate of return is determined by:
(A) Dividing the yearly cash flows by the investment.
(B) Dividing the average cash flows by the investment.
(C) Dividing the average net income by the average investment.
(D) Dividing the average net income by the initial investment.

5. The payback period rule:
(A) Determines a cutoff point so that all projects accepted by the NPV rule will be accepted by the payback period rule
(B) Determines a cutoff point so that depreciation is just equal to positive cash flows in the payback year.
(C) Requires an arbitrary choice of a cutoff point.
(D) Varies the cutoff point with the interest rate.

6. The profitability index is the ratio of:
(A) Average net income to average investment.
(B) Internal rate of return to current market interest rate.
(C) Net present value of cash flows to internal rate of returns
(D) Present value of cash flows to initial investment cost.

7. An investment that requires initial cash outlay of $100,000 has a useful life
of 4 years. In each of these years the before-tax cash flow is $35,000. If the
tax rate is 40% and straight-line depreciation is used, the average
accounting return is:
(A) 5%
(B) 12%
(C) 35%
(D) 48%

8. An investment project is most likely to be accepted by the payback period rule and not accepted by the NPV rule if the project has
(A) A large initial investment with moderate positive cash flows over a very long period of time.
(B) A very large negative cash flow at the termination of the project.
(C) Most of the cash flow at the beginning of the project.
(D) All projects approved by the payback period rule will be accepted by the NPV rule

9. An investment project has the cash flow stream of -250, 75, 125, 100, and
The cost of capital is 12%. What is the discount payback period?
(A) 2.5 years
(B) 2.7 years
(C) 3.38 years
(D) 1.40 years

10. The elements that cause problems with the use of the IRR in projects that are mutually exclusive are:
(A) The discount rate and scale problems.
(B) Timing and scale problems.
(C) The discount rate and timing problems.
(D) Scale and reversing flow problems.

Solution Preview

Solution is attached as word document also.

Solution:

1.If an investment project has an internal rate of return equal to the interest rate, the NPV for that project:
(A) Is negative
(B) Is positive
(C) Is Zero
(D) May be either positive or negative

If IRR is equal to discount rate NPV=0
Answer (C) is zero

2. The Balistan Rug Company is considering investing in a new loom that will cost $12,000. The new loom will create positive end of year cash flow of $5,000 for the next 3 years. The internal rate of return for this project is:
(A) Between 10% and 15%.
(B) Between 15% and 20%.
(C) Between 20% and 25%.
(D) Between 25% and 30%.

NPV at 10%=-12000+5000/(1.1)^1+5000/(1.1)^2+5000/(1.1)^3=$434.26
NPV at 15%=-12000+5000/(1.15)^1+5000/(1.15)^2+5000/(1.15)^3=-$583.874
We can say
Answer (A) Between 10% and 15%.

3. The profitability index is a useful way of adjusting the net present value rule in case of:
(A) Capital rationing
(B) Collectively exhaustive projects
(C) Mutually exclusive projects.
(D) Required budgeted ...

Solution Summary

There are 10 MCQ/short answer type problems. Solutions explains the basic concepts of NPV, IRR and payback period.

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