PrinciplesofFinance-WEB-104

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profitability index (PI) the present value of cash inflows divided by the present value of cash outflows
replacement chain approach a method of comparing projects of differing lives by repeating shorter
projects multiple times until they reach the lifetime of the longest project
CFA Institute
This chapter supports some of the Learning Outcome Statements (LOS) in this CFA® Level I Study Session
(https://openstax.org/r/cfa-level-i-study-session). Reference with permission of CFA Institute.
Multiple Choice
1. Which of the following is a disadvantage of using the payback method?
a. It only considers cash flows that occur after the project breaks even.
b. It ignores the time value of money.
c. It is difficult to calculate.
d. You must know the company’s cost of raising funds to be able to use it.
2. A company should accept a project if ________.
a. the NPV of the project is positive
b. the NPV of the project is negative
c. the IRR of the project is positive
d. the IRR of the project is negative
3. The net present value of a project equals ________.
a. the future value of the cash inflows minus the future value of the cash outflows
b. the present value of the cash inflows minus the future value of the cash outflows
c. the present value of the cash inflows minus the present value of the cash outflows
d. the future value of the cash inflows minus the present value of the cash outflows
4. The IRR of a project is the discount rate that ________.
a. makes the NPV equal to zero
b. equates the present value of the cash inflows to the future value of the cash outflows
c. makes the NPV positive
d. equates the present value of cash outflows to the future value of the cash inflows
5. The IRR method assumes that ________.
a. cash flows are reinvested at the firm’s cost of attracting funds when they are received
b. cash flows of a project are never reinvested
c. cash flows are reinvested at the internal rate of return when they are received
d. the NPV of a project is negative
6. When cash outflows occur during more than one time period, ________.
a. the project’s NPV will definitely be negative
b. the project can have multiple IRRs
c. the project should not be done
d. the time value of money is not important
7. The discounted payback period method ________.
a. is used to compare two projects that have different lives
b. fails to consider the time value of money
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c. provides an objective criterion for an accept-or-reject decision grounded in financial theory
d. discounts cash flows using the company’s cost of funds to overcome a flaw of the payback period
method
8. Which of the following is a method of adjustment for comparing projects of different lives?
a. IRR
b. Modified IRR
c. Payback period
d. Equal annuity
9. When a company can only fund some of its good projects, it should rank the projects by ________.
a. PI
b. IRR
c. NPV
d. payback period
10. If a company is considering two mutually exclusive projects, which of the following statements is true?
a. The company must do both projects if it chooses to do one of the projects.
b. The IRR method should be used to compare the projects.
c. Doing one of the projects means the other project cannot be done.
d. The company does not need to compare the projects because it can choose to do both.
Review Questions
1. Describe the disadvantages of using the payback period to evaluate a project.
2. Explain why a company would want to accept a project with a positive NPV and reject a project with a
negative NPV.
3. Westland Manufacturing could spend $5,000 to update its existing fluorescent lighting fixtures to newer
fluorescent fixtures that would be more energy efficient. Explain why updating the light fixtures with
newer fluorescent fixtures and replacing the existing fixtures with LED fixtures would be considered
mutually exclusive projects.
4. When faced with a decision between two good but mutually exclusive projects, should a manager base the
decision on NPV or IRR? Why?
Problems
1. Westland Manufacturing spends $20,000 to update the lighting in its factory to more energy-efficient LED
fixtures. This will save the company $4,000 per year in electricity costs. What is the payback period of this
project?
2. Westland Manufacturing spends $20,000 to update the lighting in its factory to more energy-efficient LED
fixtures. This will save the company $4,000 per year in electricity costs. The company estimates that these
fixtures will last for 10 years. If the company’s cost of funds is 8%, what is the NPV of this project?
3. If Westland Manufacturing finds that its cost of funds is 11%, what will happen to the NPV of the project in
problem 2?
4. Westland Manufacturing spends $20,000 to update the lighting in its factory to more energy-efficient LED
fixtures. This will save the company $4,000 per year in electricity costs. The company estimates that these
fixtures will last for 10 years. What is the IRR of this project?
16 • Review Questions 503
5. Westland Manufacturing spends $20,000 to update the lighting in its factory to more energy-efficient LED
fixtures. This will save the company $4,000 per year in electricity costs. The company estimates that these
fixtures will last for 10 years. If the company’s cost of funds is 8%, what is the PI of this project?
6. Westland Manufacturing spends $20,000 to update the lighting in its factory to more energy-efficient LED
fixtures. This will save the company $4,000 per year in electricity costs. The company estimates that these
fixtures will last for 10 years. If the company’s cost of funds is 8%, what is the modified IRR of this project?
7. Westland Manufacturing spends $20,000 to update the lighting in its factory to more energy-efficient LED
fixtures. This will save the company $4,000 per year in electricity costs. The company estimates that these
fixtures will last for 10 years. If the company’s cost of funds is 8%, what is the discounted payback period
of this project?
8. Holiday Hotels is considering two different floorings to use in its buildings. The less expensive tile will need
to be replaced every five years. The more durable, more expensive tile will need to be replaced every eight
years. To use the replacement chain approach to compare these two projects, how many times would you
have to assume each type of tile would be replaced?
9. You will be living in your college town for two more years. You are considering purchasing a townhouse
that will cost you $250,000 today. You estimate that if you do, your expenses for each of the next two years
will be $6,000 less than if you rented an apartment. You think that you would be able to lease the
townhouse to another college student afterward for $12,000 per year and that your taxes, maintenance,
and other expenses for the townhouse would be $5,000 per year. You expect to lease the townhouse for
five years before you sell it, and you expect to be able to sell the townhouse for $275,000. Use Excel to
create an NPV profile for this undertaking. If it will cost you 3% to borrow money, should you buy the
townhouse? What if it will cost you 8% to borrow money?
Video Activity
Calculating NPV and IRR
Click to view content (https://openstax.org/r/CFA-Level-I)
Businesses use NPV and IRR to determine whether or not a project will add value for shareholders. Watch this
CFA® Level I Corporate Finance video to learn more. Working along with the video, you will gain practice in
using your financial calculator to calculate IRR.
1. According to the video, how should a company use NPV and IRR to decide whether a project should be
undertaken?
2. In the video, Trim Corp. is considering a project that is expected to have cash inflows of $350, $250, and
$150 in years 1, 2, and 3, respectively. What do you think would happen to the NPV of the project if the
company expected the same cash flows, but in reverseorder? In other words, what do you think would
happen to the NPV if the $150 were the cash inflow of year 1, $250 were the cash inflow for year 2, and
$350 were the cash inflow for year 3? Using the same discount rate as in the video, 25%, calculate the NPV
for the project with this string of cash outflows. Was the outcome what you thought it would be?
The Tokyo Olympics
Click to view content (https://openstax.org/r/tokyo-olympics)
The capital investment a city must undertake to host the Olympic Games is massive. Learn more about the
capital investments and expenses Tokyo faced as host of the 2020 Summer Olympics and how it was impacted
by a global pandemic by watching this video, How the Tokyo Olympics Became the Most Expensive Summer
Games Ever.
3. Given the costs discussed in the video, create an Excel spreadsheet to estimate the NPV and IRR of hosting
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https://openstax.org/r/tokyo-olympics
the Olympic Games for a city.
4. How would the numbers in your Excel spreadsheet change because of the COVID-19 pandemic? Create an
NPV profile for Tokyo’s Olympic Games given the changes that were caused by the pandemic.
16 • Video Activity 505
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	Chapter 16 How Companies Think about Investing
	CFA Institute
	Multiple Choice
	Review Questions
	Problems
	Video Activity