A major disadvantage of the payback period is that it a. Is useless as a risk in

Question

A major disadvantage of the payback period is that it a. Is useless as a risk indicator. b. Ignores cash flows beyond the payback period. c. Does not directly account for the time value of money. d. Statements b and c are correct. e. All of the statements above are correct. 2. Project A has an internal rate of return (IRR) of 15 percent. Project B has an IRR of 14 percent. Both projects have a cost of capital of 12 percent. Which of the following statements is most correct? a. Both projects have a positive net present value (NPV). b. Project A must have a higher NPV than Project B. c. If the cost of capital were less than 12 percent, Project B would have a higher IRR than Project A. d. Statements a and c arc correct. c. All of the statements above are correct. 3. Project X and Project Y each have normal cash flows (an up-front cost followed by a series of positive cash flows) and the same level of risk. Project X has an IRR equal to 12 percent, and Project Y has an IRR equal to 14 percent. If the WACC for both projects equals 9 percent Project X has a higher net present value than Project Y. Which of the following statements is most correct? a. If the WACC equals 13 percent Project X will have a negative NPV, while Project Y will have a positive NPV. b. Project X probably has a quicker payback than Project Y. c. The crossover rate in which the two projects have the same NPV is greater than 9 percent and less than 12 percent. d. Statements a and b are correct. e. Statements a and c are correct. 4. A company estimates that its weighted average cost of capital (WACC) is 10 percent. Which of the following independent projects should the company accept? a. Project A requires an up-front expenditure of $1,000,000 and generates a net present value of $3,200. b. Project B has a modified internal rate of return of 9.5 percent. c. Project C requires an up-front expenditure of $1,000,000 and generates a positive internal rate of return of 9.7 percent. d. Project D has an internal rate of return of 9.5 percent. e. None of the projects above should be accepted. 5. The capital budgeting director of Sparrow Corporation is evaluating a project that costs $200,000, is expected to last for 10 years, and produces after-tax cash flows, including depreciation, of $44,503 per year. If the firm's cost of capital is 14 percent, what is the project's IRR? a. 8% b. 14% c.l8% d. -5% e. 12%

Explanation / Answer

1. The correct answer is Option d

Statement B and C are correct as Payback period is a useful risk indicator. This is because payback period considers when the initial project cost would be recovered. However it ignores cashflow after payback period and do not account for time value of money.

2. The correct answer is Option a.

IRR has nothing to with cost of capital of capital. IRR assumes that cashflows generated each year are reivested as IRR, hence it is difficult to comment that a project with higher IRR will have higher NPV.

3. The correct answer is Option a.

Payback period has nothing to do with cost of capital. A project might have higher NPV but its cashflows maybe at the latter stages of project thus making its payback period longer.

4. The correct answer is Option a

Any project with postive NPV should be accepted as the returns are above the hurdle rate set by management. In all the other options, the IRR rate is less than 10% hurdle rate.

5. The correct answer is Option c - 18%

Since the WACC is 14% and at this rate the NPV = $44503 * 5.2161 - $200000 = $32,133

This means that the IRR is greater than 14%, the only option left is 18%.

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