3.Iapital budgeting analysis, do you always accept projects with the highest pos

Question

3.Iapital budgeting analysis, do you always accept projects with the highest positive NFV and IRR? a. Yes, because it is the most scientific and objective way to determine the attractiveness of the project. b. No, other qualitative factors like timing of cash flow, size of the investment outlay and strategic importance of the project play a role too even if the positive NPV or IRR are the highest It depends on whether the projects are independent or mutually excltusive. d. Two of the above are correct. e. None of the answers above are correct. 39. In determining which mutually exclusive projects to accept, we may encounter conflicting decision points: one project may have a high IRR but low NPV, and another a high NPV but low IRR at cross-over point. Which factors contribute to this situation? a. Differences in timing of cash flow and size of project. b. Non-normal vs. normal cash flow stream. c. Both answers (a) and (b) are correct. d. Neither answers (a) nor (b) is correct. e. I don't really know the answer. 40. Which of the following statement is false? a. The optimal distribution policy strikes the balance between current dividends and capital b. Other things held constant, the higher a firm's target payout ratio, the higher its expected c. If investors prefer firms that retain most of their earnings, then a firm that wants to maximize d. A 100% stock dividend and a 2:1 stock split should, at least conceptually, have the same effect e. A "reverse split" reduces the number of shares outstanding. gains that maximizes the firm's stock price. growth rate should be. f its stock price should set a low payout ratio. on the firm's stock price.

Explanation / Answer

38. Option B. The qualitative factors should be also taken into account or the firm will end up being too mechanical in its choice of projects and may end up choosing projects that will cost the company its core resources.

39. Option A. The timing of cash flows and size of project result in such conflict.

The following illustration catches this point:

The above example assumes a discount rate of 10%. As you can see, Project A has higher IRR, while Project B has higher NPV.

If these two projects were independent, it wouldn’t matter much because the firm can accept both the projects. However, in case of mutually exclusive projects, the firm needs to decide one of the two projects to invest in.

In such situation, the project with a higher NPV should be chosen because there is an irrelevant reinvestment assumption. In our calculation, we assume that the cash flows will be reinvested at the same discount rate at which they are discounted. In the NPV calculation, the implicit assumption for reinvestment rate is 10%. In IRR, the implicit reinvestment rate assumption is of 41% or 28% which are quite unrealistic compared to NPV. This makes the NPV results superior to the IRR results. In this example, project B should be chosen.

The conflicting results can also occur because of the size and investment of the projects. A small project may have low NPV but higher IRR.

Project A 5164

Project B 7744.72

IRR:

A: 29%

B: 22%

In this case, Project A has lower NPV compared to Project B but has higher IRR. Again, if these were mutually exclusive projects, we should choose the one with higher NPV, that is, project B.

40. Option D. All other statements are true. Stock split and dividend policy are conceptually independent of each other and shall not have the same effect on stock price.

Project A Project B Year 0 -10000 -10000 Year 1 5000 0 Year 2 5000 0 Year 3 5000 0 Year 4 5000 0 Year 5 5000 35000 NPV $8,953.93 $11,735 IRR 41% 28%

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