# 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.

Ratio Analysis to solve Reed's Clothiers Cash Flow Problem

Calculate a few ratios and compare Reed's results with industry averages. (Some industry averages are shown in Exhibit 16.4.) What do these ratios indicate?

Exhibit 16.4.

Reed's Clothiers Selected Ratios*

Liquidity Ratios Industry

Current ratio 2.7

Quick ratio 1.6

Receivables turnover 7.7

Average collection period 47.4

Efficiency Ratios

Total asset turnover 1.9

Inventory turnover 7.0

Payable turnover 15.1

Profitability Ratios

Gross profit margin 33.0

Net profit margin 7.8

Return on common equity 25.9

*Since many ratios may have different meanings the following definitions were used in the above calculations: Receivable turnover = sales/accounts receivable Average collection period = 365/receivable turnover Total asset tumover = cost of sales/total assets Inventory turnover = cost of sales/inventories Payable turnover = cost of sales/accounts payable.

B.) Why does Holmes want Reed's to have an inventory reduction sale, and what does he think will be accomplished by it?

C.) Jim Reed had adopted a very loose working capital policy with higher current assets than industry averages. If he merely tightens his working capital policy to the averages, should this affect his sales?

D.) Assuming that Reed's can improve its operations to be in line with the industry averages, construct a 1995 pro forma income statement. Assume that net sales will be reduced 5 percent to $1,938,000 but that depreciation and amortization will not change but remain at $32,000.

E.) What type of inventory control system would you suggest to Jim Reed?

F.) What type of accounts receivable control would you suggest to Jim Reed?

G.) Is the increase in sales related to the increase in inventory? (See Exhibit 16.5.)

Exhibit 16.5.

Reed's Clothiers

Year Inventories Net Sales

1991 $378 1,812

1992 411 1,886

1993 452 1,954

1994 491 2,035

H.) What is Reed's cost of not taking the suppliers' discounts?

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