THE BASICS OF CAPITAL BUDGETING
(Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard)
We point out to our students that some of the questions can best be analyzed by sketching out a NPV profile graph and then thinking about the question in relation to the graph. Please see the preface for information on the AACSB letter indicators (F, M, etc.) on the subject lines.
Multiple Choice: True/False
(11-1) Capital budget F I Answer: b EASY
[i]. A firm should never accept a project if its acceptance would lead to an increase in the firm's cost of capital (its WACC).
(11-2) PV of cash flows F I Answer: b EASY
[ii]. Because "present value" refers to the value of cash flows that occur at different points in time, a series of present values of cash flows should not be summed to determine the value of a capital budgeting project.
(11-2) NPV F I Answer: b EASY
[iii]. Assuming that their NPVs based on the firm's cost of capital are equal, the NPV of a project whose cash flows accrue relatively rapidly will be more sensitive to changes in the discount rate than the NPV of a project whose cash flows come in later in its life.
(11-2) NPV and IRR F I Answer: b EASY
[iv]. A basic rule in capital budgeting is that If a project's NPV exceeds its IRR, then the project should be accepted.
(11-2) Mutually exclusive projects F I Answer: a EASY
[v]. Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the higher NPV.
(11-2) Mutually exclusive projects F I Answer: b EASY
[vi]. Conflicts between two mutually exclusive projects occasionally occur, where the NPV method...