# Cash Flow Problems

1. The payback period is the length of time it takes an investment to generate sufficient cash flows to enable the project to:

A. produce a positive annual cash flow.

B. produce a positive cash flow from assets.

C. offset its fixed expenses.

D. offset its total expenses.

E. recoup its initial cost.

2. The average net income of a project divided by the project's average book value is referred to as the project's:

A. required return.

B. market rate of return.

C. internal rate of return.

D. average accounting return.

E. discounted rate of return.

3. Which one of the following defines the internal rate of return for a project?

A. Discount rate that creates a zero cash flow from assets

B. Discount rate which results in a zero net present value for the project

C. Discount rate which results in a net present value equal to the project's initial cost

D. Rate of return required by the project's investors

E. The project's current market rate of return

4. Which one of the following can be defined as a benefit-cost ratio?

A. Net present value

B. Internal rate of return

C. Profitability index

D. Accounting rate of return

E. Modified internal rate of return

5. Which one of the following indicates that a project is expected to create value for its owners?

A. Profitability index less than 1.0

B. Payback period greater than the requirement

C. Positive net present value

D. Positive average accounting rate of return

E. Internal rate of return that is less than the requirement

6. The net present value:

A. decreases as the required rate of return increases.

B. is equal to the initial investment when the internal rate of return is equal to the required return.

C. method of analysis cannot be applied to mutually exclusive projects.

D. is directly related to the discount rate.

E. is unaffected by the timing of an investment's cash flows.

7. Which one of the following is generally considered to be the best form of analysis if you have to select a single method to analyze a variety of investment opportunities?

A. Payback

B. Profitability index

C. Accounting rate of return

D. Internal rate of return

E. Net present value

8. Which one of the following indicates that a project should be rejected?

A. Average accounting return that exceeds the requirement

B. Payback period that is shorter than the requirement period

C. Positive net present value

D. Profitability index less than 1.0

E. Internal rate of return that exceeds the required return

9. Which one of the following indicators offers the best assurance that a project will produce value for its owners?

A. PI equal to zero

B. Negative rate of return

C. Positive AAR

D. Positive IRR

E. Positive NPV

10. Which one of the following statements is correct?

A. A longer payback period is preferred over a shorter payback period.

B. The payback rule states that you should accept a project if the payback period is less than one year.

C. The payback period ignores the time value of money.

D. The payback rule is biased in favor of long-term projects.

E. The payback period considers the timing and amount of all of a project's cash flows.

11. You were recently hired by a firm as a project analyst. The owner of the firm is unfamiliar with financial analysis and only wants to know what the expected dollar return is per dollar spent on a given project. Which financial method of analysis will provide the information that the owner requests?

A. Internal rate of return

B. Modified internal rate of return

C. Net present value

D. Profitability index

E. Payback

12. Mary has just been asked to analyze an investment to determine if it is acceptable. Unfortunately, she is not being given sufficient time to analyze the project using various methods. She must select one method of analysis and provide an answer based solely on that method. Which method do you suggest she use in this situation?

A. Internal rate of return

B. Payback

C. Average accounting rate of return

D. Net present value

E. Profitability index

13. Which one of the following is specifically designed to compute the rate of return on a project that has unconventional cash flows?

A. Average accounting return

B. Profitability index

C. Internal rate of return

D. Indexed rate of return

E. Modified internal rate of return

14. The average accounting return:

A. measures profitability rather than cash flow.

B. discounts all values to today's dollars.

C. is expressed as a percentage of an investment's current market value.

D. will equal the required return when the net present value equals zero.

E. is used more often by CFOs than the internal rate of return.

15. The reinvestment approach to the modified internal rate of return:

A. individually discounts each separate cash flow back to the present.

B. reinvests all the cash flows, including the initial cash flow, to the end of the project.

C. discounts all negative cash flows to the present and compounds all positive cash flows to the end of the project.

D. discounts all negative cash flows back to the present and combines them with the initial cost.

E. compounds all of the cash flows, except for the initial cash flow, to the end of the project.

16. Which one of the following is true if the managers of a firm only accept projects that have a profitability index greater than 1.5?

A. The firm should increase in value each time the firm accepts a new project.

B. The firm is most likely steadily losing value.

C. The price of the firm's stock should remain constant.

D. The net present value of each new project is zero.

E. The internal rate of return on each new project is zero.

17. What is the net present value of a project with the following cash flows if the discount rate is 14 percent?

A. $742.50

B. $801.68

C. $823.92

D. $899.46

E. $901.15

18. A project has the following cash flows. What is the payback period?

A. 2.48 years

B. 2.59 years

C. 2.96 years

D. 3.21 years

E. 3.43 years

19. An investment has an initial cost of $410,000 and will generate the net income amounts shown below. This investment will be depreciated straight line to zero over the 4-year life of the project. Should this project be accepted based on the average accounting rate of return if the required rate is 16 percent? Why or why not?

A. Yes; because the AAR is equal to 16 percent

B. Yes; because the AAR is greater than 16 percent

C. Yes; because the AAR is less than 16 percent

D. No; because the AAR is greater than 16 percent

E. No; because the AAR is less than 16 percent

20. Which one of the following methods of analysis is most appropriate to use when two investments are mutually exclusive?

A. Internal rate of return

B. Profitability index

C. Net present value

D. Modified internal rate of return

E. Average accounting return

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#### Solution Preview

1. E 2. D 3. B 4. C 5. C 6. A ...

#### Solution Summary

The positive annual cash flows which are produced are determined. The length of time it takes for an investment to generate sufficient cash flows to enable a project are given.

Business Finance-Week 4

1. (Payback and discounted payback period calculations) The Bar-None Manufacturing Co. manufactures fence panels used in cattle feed lots throughout the Midwest. Bar-None's management is considering three investment projects for next year but doesn't want to make any investment that requires more than three years to recover the firm's initial investment. The cash flows for the three projects (Project A, Project B, and Project C) are as follows:

Year Project A Project B Project C

0 $(1000) $(10,000) $(5,000)

1 600 5,000 1,000

2 300 3,000 1,000

3 200 3,000 2,000

4 100 3,000 2,000

5 500 3,000 2,000

a. Given Bar-None's three-year payback period, which of the projects will qualify for acceptance?

b. Rank the three projects using their payback periods. Which project looks the best using this criterion? Do you agree with this ranking? Why or why not?

c. If Bar-None uses a 10 percent discount rate to analyze projects, what is the discounted payback period for each of the three projects? If the firm still maintains its three-year payback policy for the discounted payback, which projects should the firm undertake?

2. (Net present value calculation) Big Steve's makers of swizzle sticks, is considering the purchase of a new plastic stamping machine. This investment requires an initial outlay of $100,000 and will generate net cash inflows of $18,000 per year for 10 years.

a. What is the project's NPV using a discount rate of 10 percent? Should the project be accepted? Why or Why not?

b. What is the project's NPV using a discount rate of 15 percent? Should the project be accepted? Why or why not?

c. What is this project's internal rate of return? Should the project be accepted? Why or why not?

3. (Incremental earnings from advertising synergies) Bangers, Inc. is a start-up manufacturer of Australian-style frozen veggie pies located in San Antonio, Texas. The company is five years old and recently installed the manufacturing capacity to quadruple its unit sales. To jump start the demand for its products, the company founders have hired a local advertising firm to create a series of ads for its new line of meat pies. The ads will cost the firm $400,000 to run for one year. Boomerang's management hopes that the advertising will produce annual sales of $2 million for its meat pies. Moreover, the firm's management expects that sales of its veggie pies will increase by $200,000 next year as a result of the company name recognition derived from the meat pie ad campaign. If Boomerang's operating profits per dollar of new sales revenue are 40 percent and the firm faces a 30 percent tax bracket, what is the incremental operating profit the firm can expect to earn from the ad campaign? Does the decision to place the ad look good from the perspective of the anticipated profits?

4. (Calculating project cash flows and NPV) You are considering expanding your product line that currently consists of skateboards to include gas powered skateboards, and you feel you can sell 10,000 of these per year for 10 years (after which time this project is expected to shut down, with solar-powered skateboards taking over). The gas skateboards would sell for $100 each with variable costs of $40 for each one produced, and annual fixed costs associated with production would be $160,000. In addition, there would be a $1,000,000 initial expenditure associated with the purchase of new production equipment. It is assumed that this initial expenditure will be depreciated using the simplified straight-line method down to zero over 10 years. The project will also require a one-time initial investment of $50,000 in net working capital associated with inventory, and this working capital investment will be recovered when the project is shut down. Finally, assume that the firm's marginal tax rate is 34 percent.

a. What is the initial cash outlay associated with this project?

b. What are the annual net cash flows associated with this project for Year 1 through 9?

c. What is the terminal cash flow in Year 10 (that is, what is the free cash flow in Year 10 plus any additional cash flows associated with termination of the project)?

d. What is the project's NPV given a 10 percent required rate of return?

5. (Calculating cash flows-comprehensive problem) The C Corporation, a firm in the 34 percent marginal tax bracket with a 15 percent required rate of return or discount rate, is considering a new project. This project involves the introduction of a new product. This project is expected to last five years and then, because this is somewhat of a fad product, it will be terminated. Given the following information, determine the net cash flows associated with the project, the project's net present value, the profitability index, and the internal rate of return. Apply the appropriate decision criteria.

Cost of new plant and equipment: $198,000,000

Shipping and installation cost: $ 2,000,000

Unit Sales:

Year Units Sold

1 1,000,000

2 1,800,000

3 1,800,000

4 1,200,000

5 700,000

Sales price per unit: $800/unit in Years 1-4, $600/unit in Year 5

Variable cost per unit: $400/unit

Annual fixed costs: $10,000,000

Working capital requirements: There will be an initial working capital requirement of $2,000,000 just to get production started. For each year, the total investment in net working capital will equal 10 percent of the dollar value of sales for that year. Thus, the investment in working capital will increase during Years 1 through 3, then decrease in Years 4, Finally, all working capital is liquidated at the termination of the project at the end of Year 5.

The depreciation method: Use the simplified straight-line method over five years. It is assumed that the plant and equipment will have no salvage value after five years.