Freight is evaluating a proposed capital budgeting project (project Lima) that will require an initial investment of $800,000.
Freight has been basing capital budgeting decisions on a project’s NPV; however, its new CEO wants to start using the IRR method for capital budgeting decisions. The CFO says that the IRR is a better method because returns in percentage form are easier to understand and compare to required returns. Fright WACC is 8%, and project Lima has the same risk as the firm’s average project.
The project is expected to generate the following net cash flows:
1. Which of the following is the correct calculation of project Lima IRR?
2. If this is an independent project, the IRR method states that the firm should
a. Accept Project Lima
b. Reject Project Lima
3. If mutually exclusive projects are proposed that both have an IRR greater than the necessary WACC, the IRR method states that the firm should accept:
a. The project with the greatest IRR, assuming that both projects have the same risk as the firm’s average project
b. The project with the greater future cash inflows, assuming that both projects have the same risk as the firm’s average project
c. The project that requires the lowest initial investment, assuming that both projects have the same risk as the firm’s average project.
d. Crane Co is analyzing the project that requires an initial investment of $3,225,000.
The projects’s expected cash flows are:
4. Crane WACC is 8%, and the project has the same risk as the firm’s average project. Calculate this project’s modified internal rate of return (MIRR).
5. If Crane managers select projects based on the MIRR criterion, they should _____ this independent project.
Suppose you are evaluating a project with the cash inflows shown in the following table. Your boss has asked you to calculate the project’s NPV. You don’t know the project’s initial cost, but you do know th project’s regular payback period is 2.5 years.
Year Cash Flow
6. If the project’s WACC is 7%, the project’s NPV is which of the following
7. Which of the following statements indicate a disadvantage of using the regular payback period (not the discounted payback period) for capital budgeting decisions? Check all that apply
a. The payback period does not take the project’s entire life into account
b. The payback period does not take the time value of money into account
c. The payback period is calculated using net income instead of cash flows.
8. Companies often use several methods to evaluate the project’s cash flows and each of them has its benefits and disadvantages. Based on your understanding of the capital budgeting evaluation methods, which of the following conclusions about capital budgeting are valid? Check all that apply.
a. Managers have been slow to adapt the IRR, because percentage returns are a harder concept for them to grasp.
b. The NPV shows how much value the company is creating for its shareholders.
c. For most firms, the reinvestment rate assumption in the MIRR is more realistic than the assumption in the IRR.