9 Lecture

1. What is net present value (NPV)? a. The sum of expected cash inflows b. The difference between expected cash inflows and outflows c. The present value of expected cash inflows minus the present value of expected cash outflows d. The future value of expected cash inflows

Answer: c

2. What is internal rate of return (IRR)? a. The rate at which the present value of expected cash inflows equals the present value of expected cash outflows b. The rate at which the future value of expected cash inflows equals the future value of expected cash outflows c. The rate at which the expected cash inflows are greater than the expected cash outflows d. The rate at which the expected cash outflows are greater than the expected cash inflows

Answer: a

3. Which of the following is true about NPV? a. A project is acceptable if its NPV is negative b. NPV considers the time value of money c. NPV is not affected by the discount rate d. NPV only considers cash inflows

Answer: b

4. Which of the following is true about IRR? a. A project is acceptable if its IRR is less than the required rate of return b. IRR does not consider the time value of money c. IRR is the same as the cost of capital d. IRR is a measure of profitability

Answer: d

5. If the NPV of a project is zero, what does this mean? a. The project is not profitable b. The project is only profitable if the discount rate is increased c. The project is only profitable if the discount rate is decreased d. The project is just breaking even

Answer: d

6. Which of the following is a disadvantage of using IRR as a capital budgeting technique? a. It is difficult to calculate b. It does not consider the time value of money c. It can have multiple solutions d. It is not affected by the discount rate

Answer: c

7. Which of the following is a limitation of using NPV as a capital budgeting technique? a. It does not consider the time value of money b. It can be difficult to interpret for projects with multiple cash flows c. It does not consider the risk associated with the project d. It is affected by the discount rate

Answer: b

8. When evaluating two investment projects using NPV, which project is more desirable? a. The project with a lower NPV b. The project with a higher NPV c. The project with a zero NPV d. It depends on the discount rate

Answer: b

9. What is the required rate of return? a. The minimum rate of return an investor expects to earn b. The maximum rate of return an investor expects to earn c. The rate at which the expected cash inflows are equal to the expected cash outflows d. The rate at which the future value of expected cash inflows equals the future value of expected cash outflows

Answer: a

10. Which capital budgeting technique is more sensitive to changes in the discount rate? a. NPV b. IRR c. Both NPV and IRR d. Neither NPV nor IRR

Answer: b

1. What is net present value (NPV) and how is it calculated?

Answer: Net present value is the difference between the present value of expected cash inflows and the present value of expected cash outflows. It is calculated by discounting all future cash flows to their present values and subtracting the initial investment.

2. What is internal rate of return (IRR) and how is it calculated?

Answer: Internal rate of return is the discount rate at which the present value of expected cash inflows equals the present value of expected cash outflows. It is calculated by trial and error or by using a financial calculator or spreadsheet function.

3. How is the required rate of return determined and why is it important in capital budgeting?

Answer: The required rate of return is the minimum rate of return an investor expects to earn on an investment. It is determined based on the investor's risk tolerance and opportunity cost of capital. It is important in capital budgeting because it is used as the discount rate to calculate the present value of future cash flows.

4. What are the advantages and disadvantages of using NPV as a capital budgeting technique?

Answer: The advantages of using NPV are that it considers the time value of money and provides an absolute dollar value for the project's profitability. The disadvantages are that it can be difficult to interpret for projects with multiple cash flows and it does not consider the risk associated with the project.

5. What are the advantages and disadvantages of using IRR as a capital budgeting technique?

Answer: The advantages of using IRR are that it is easy to understand and provides a percentage rate of return for the project. The disadvantages are that it can have multiple solutions and is more sensitive to changes in the discount rate.

6. How does the size and timing of cash flows affect NPV and IRR?

Answer: The size and timing of cash flows can affect the NPV and IRR calculations. A larger cash flow will have a greater impact on the NPV and IRR calculations than a smaller cash flow. Cash flows received earlier have a greater impact on NPV and IRR than cash flows received later.

7. What is the relationship between NPV and IRR?

Answer: NPV and IRR are both methods used to evaluate the profitability of investment projects. A project is considered acceptable if its NPV is positive or if its IRR is greater than the required rate of return. However, there can be situations where the two methods lead to different decisions.

8. How does the cost of capital affect NPV and IRR?

Answer: The cost of capital is used as the discount rate in the NPV and IRR calculations. A higher cost of capital will result in a lower NPV and a higher required rate of return for the project to be acceptable using the IRR method.

9. What are the limitations of using NPV and IRR in capital budgeting?

Answer: The limitations of using NPV and IRR include their sensitivity to changes in the discount rate, their assumptions about cash flows, and their inability to consider non-financial factors such as environmental impact or social responsibility.

10. How can sensitivity analysis be used to evaluate the risk associated with a capital investment project?

Answer: Sensitivity analysis involves examining how changes in assumptions, such as cash flows or discount rates, affect the NPV or IRR of a project. It can be used to evaluate the risk associated with a project by identifying which assumptions have the greatest impact on the project's profitability.

Net present value (NPV) and internal rate of return (IRR) are two common capital budgeting techniques used to evaluate investment opportunities. NPV calculates the present value of future cash flows and compares it to the initial investment. If the NPV is positive, the investment is expected to generate a return that exceeds the required rate of return, making it an attractive opportunity. On the other hand, a negative NPV indicates that the investment is not expected to generate sufficient returns. IRR calculates the discount rate that makes the present value of expected cash inflows equal to the present value of expected cash outflows. If the IRR is greater than the required rate of return, the investment is expected to be profitable. If the IRR is less than the required rate of return, the investment is not expected to generate sufficient returns. Both techniques consider the time value of money and the cost of capital. However, there are some differences between the two methods. NPV provides an absolute dollar value for the project's profitability, while IRR provides a percentage rate of return. NPV can handle projects with multiple cash flows, while IRR can have multiple solutions for complex projects. The size and timing of cash flows can also affect the NPV and IRR calculations. A larger cash flow will have a greater impact on the NPV and IRR calculations than a smaller cash flow. Cash flows received earlier have a greater impact on NPV and IRR than cash flows received later. The cost of capital is a crucial factor in both NPV and IRR calculations. A higher cost of capital will result in a lower NPV and a higher required rate of return for the project to be acceptable using the IRR method. While NPV and IRR are commonly used in capital budgeting, they do have limitations. They rely on assumptions about cash flows and discount rates that may not hold true in the future. They also do not consider non-financial factors such as environmental impact or social responsibility. Sensitivity analysis can be used to evaluate the risk associated with a capital investment project by examining how changes in assumptions affect the NPV or IRR. This allows for a more robust evaluation of the investment opportunity and a better understanding of the project's risks and potential returns.