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Quiz-2 Finance Answers

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Q 1: Calculate the NPV of a 20-year project with a cost of $400,000 and annual cash flows of $50,000

in years 1-10 and $25,000 in years 11-20. The company's required rate of return is 10%.

a)     ($33,547)

b)     ($18,547)

c)     $0

d)     $18,547

e)     $33,547

Q2: It will cost $14,900 to acquire a hot dog cart. Cart sales are expected to be $16,200 a year for
three years. After the three years, the cart is expected to be worthless as that is the expected life of
the heating system. What is the payback period of the hot dog cart?

a)     .87 year

b)     .92 year

c)     1.03 year

d)     1.09 year

e)     1.14 year

Q3:  A 30 year project is estimated to cost $35 million dollars and provide annual cash flows of $5 per
year in years 1-5; $4 million per year in years 6-20 and $2 million per year in years 21-30. If the
company's required rate of return is 10%, determine the discounted payback for the project.

a)     15.90 years

b)     13.90 years

c)     11.90 years

d)     9.90 years

e)     7.90 years

Q4: Bodner Corporation purchased an asset costing $475,000. The asset has a 4 year life, no
salvage value, and is depreciated on a straight line method. During the past four years, Bodner
posted net income of $30,000, $25,000, $20,000 and $15,000. Given the following information,
calculate the company's average accounting return over the past four years.

a)     20.15%

b)     18.32%

c)     16.45%

d)     14.51%

e)     12.63%
Q5:  A 30 year project is estimated to cost $35 million and provide annual cash flows of $5 million per
year in years 1-5; $4 million per year in years 6-20 and $2 million per year in years 21-30. If the
company's required rate of return is 10%, determine the payback of the project.

a)     6.50 years

b)     7.00 years

c)     7.50 years

d)     8.00 years

e)     8.50 years

Q6: Without using formulas, provide a definition of internal rate of return (IRR).

a)     The rate of return provided by a project. The value is compared with a company's rate of
return to determine viability of a project.

b)     A situation whereby a choice has to be made between two or more projects, and choosing
multiple projects is not an option.

c)     A graphical representation of the relationship between varying rates of return and the
corresponding NPV value.

d)     A project analysis tool that measures the acceptability of a project through the difference
between a project's initial investment and whether the present value of its cash flow will repay the
investment.

e)     A project analysis tool that measures the acceptability of a project by determining the amount of
profit that can be expected based on an investment made.

Q7:  Sal is considering a project that costs $15,000. The project produces cash inflows of $3,000,
$5,000, $7,000, and $3,000 respectively for the next four years. Sal wants to recoup his money within
3 years after applying a 6% discount rate. Sal should:

a)     Accept the project because it produces $15,534 on a discounted payback basis.

b)     Accept this project because the discounted payback period is 2.78 years.

c)     Accept this project because the payback period is exactly 3 years.

d)     Reject this project because the payback period is 2.78 years.

e)     Reject this project because the discounted payback period is 3.78 years.

 
Q8:  Use the following mutually exclusive investment cash flows for the question(s) below:

Based on the payback criterion, which of the following is NOT true?

a)     With a payback cutoff of 2.5 years, both projects are acceptable.

b)     With a payback cutoff of three years, both projects are acceptable.

c)     With a payback cutoff of 1.5 years, neither project is acceptable.

d)     With a payback cutoff of 1.75 years, only Project A is acceptable.

e)     If you choose the project that pays back the fastest, Project A is preferred.

Q9:  The internal rate of return (IRR) is often preferred by managers over the net present value (NPV)
because the IRR:

a)     Is more reliable given unconventional cash flows.

b)     Is the discount rate that maximizes net profits.

c)     Is contingent upon the current market rates of return.

d)     Reveals the discount rate that maximizes the net present value.

e)     Is expressed as a rate while the NPV is expressed in dollar terms.

Q10: An independent project has conventional cash flows and a positive net present value. It can be
stated with certainty that the project is acceptable according to the capital budgeting technique known
as:

a)     Payback.

b)     Discounted payback.

c)     The accounting rate of return.

d)     The crossover method.

e)     The internal rate of return.

 
S1: How does the net present value method of analysis help managers adhere to the primary

objective of creating shareholder wealth?

The net present value rule states that projects with positive net present values should be
accepted and projects with negative net present values should be rejected. This directly
corresponds to shareholder wealth considerations as positive net present value projects
increase shareholder wealth whereas negative net present value projects reduce shareholder
wealth.

S2: List and identify the discounted cash flow (DCF) and the non-discounted cash flow

capital budgeting techniques. If you were asked to evaluate a project using one of each, which

techniques would you use? Why?

Discounted cash flow DCF techniques

Net Present Value, Internal Rate of Return, Discounted Payback, and Profitability Index

Non-DCF

Payback period and Accounting rate of return

The Discounted Cash Flow method is superior to the Non-discounted Cash flow
method for analysing capital investment decisions since it incorporates the time value of
money. The Discounted Cash Flow method estimates the value of an investment's projected
future cash flows as if the cash flows were available today.

S3: Given our goals of firm value and shareholder wealth maximization, we have stressed the
importance of NPV. And yet, many of the financial decision-makers at some of the most prominent
firms in the world continue to use less desirable measures such as the payback period and AAR, in
addition to the NPV and IRR. Why do you think this is the case?

1. The Net Present value takes into account present value of all the cash flows, and then
calculates the Net present worth of the investment, based on a discounting factor. This
indeed gives an accurate measurement of the firm value but in the process it involves
Complex calculations and assumptions which are required in determining the Cost of
Capital.
Many prominent firms try to avoid the complication involved in the process of such
complex calculations and uses Pay Back Rule and AAR due to simplicity in calculations.
2. The payback period is one of the simplest tools used to make a decision about whether to
accept the project or to reject.

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