Q: A project requires an initial investment of $$120,000 and generates annual cash flows of 30$$,000 for 5 years. What is the payback period for this project?

$$120,000 / 30$$,000 = 4.0 \text{ years}$

Q: Which formula correctly calculates the Net Present Value (NPV) of a project with an initial investment of $$250 million and perpetual annual cash flows of 35 $$million, discounted at rate $$r$$?

$$\text{NPV} = -250 + \frac{35}{r}$$

Q: A CEO is offered $$1,000,000 upfront to write a book, but must give up 500$$,000 per year in speaking fees for 3 years. If the opportunity cost of capital is 10%, what is the NPV of this deal?

$$\text{NPV} = 1,000,000 - \frac{500,000}{1.1} - \frac{500,000}{1.1^2$} - \frac{500,000}{1.1^3$} = -243,426$$

Q: Which of the following is a correct formula for the Equivalent Annual Cost (EAC)?

$$\text{EAC} = \frac{\text{NPV}}{A_{r,N}}$$

Question 1

Which of the following best describes the main limitation of the payback period rule when evaluating capital investments?

Accepted Answer

It ignores the time value of money and cash flows after the payback period.

Question 2

A project requires an initial investment of $$120,000 and generates annual cash flows of 30$$,000 for 5 years. What is the payback period for this project?

Accepted Answer

$$120,000 / 30$$,000 = 4.0 	ext{ years}$

Question 3

Which formula correctly calculates the Net Present Value (NPV) of a project with an initial investment of $$250 million and perpetual annual cash flows of 35 $$million, discounted at rate $$r$$?

Accepted Answer

$$	ext{NPV} = -250 + \frac{35}{r}$$

Question 4

If a project has an NPV of $100 million at a discount rate of 10%, what should the firm do according to the NPV rule?

Accepted Answer

Accept the project because the NPV is positive.

Question 5

A CEO is offered $$1,000,000 upfront to write a book, but must give up 500$$,000 per year in speaking fees for 3 years. If the opportunity cost of capital is 10%, what is the NPV of this deal?

Accepted Answer

$$	ext{NPV} = 1,000,000 - \frac{500,000}{1.1} - \frac{500,000}{1.1^2$} - \frac{500,000}{1.1^3$} = -243,426$$

Question 6

What is the Internal Rate of Return (IRR) for the CEO’s book deal with $$1,000,000 upfront and three annual outflows of 500$$,000?

Accepted Answer

23.38\%

Question 7

Why can the IRR rule fail when cash flows alternate between positive and negative more than once?

Accepted Answer

There may be multiple IRRs, making the decision ambiguous.

Question 8

When comparing mutually exclusive projects, which rule should always be used if the NPV and IRR rules disagree?

Accepted Answer

The NPV rule

Question 9

A company must choose between two air cleaners: Cheapo ($$1,000 initial, 500/$$year for 5 years) and Cadillac ($$4,000 initial, 100/$$year for 10 years), both at $$r = 10\%. $$What method should be used to compare these projects with unequal lives?

Accepted Answer

Equivalent Annual Cost (EAC) method

Question 10

Given the following, which project should be chosen based on the NPV rule?
Book Store: Initial $$250,000$$, First-Year Cash Flow $$55,000$$, Growth Rate $$4\%$$, Cost of Capital $$7\%$$
Sandwich Shop: Initial $$350,000$$, First-Year Cash Flow $$75,000$$, Growth Rate $$4\%$$, Cost of Capital $$8\%$$
Hair Salon: Initial $$400,000$$, First-Year Cash Flow $$120,000$$, Growth Rate $$4\%$$, Cost of Capital $$8\%$$
Clothing Store: Initial $$500,000$$, First-Year Cash Flow $$125,000$$, Growth Rate $$8\%$$, Cost of Capital $$12\%$$

Accepted Answer

Clothing Store

Question 11

Which of the following is a correct formula for the Equivalent Annual Cost (EAC)?

Accepted Answer

$$	ext{EAC} = \frac{	ext{NPV}}{A_{r,N}}$$

Question 12

If a project’s size is doubled, what happens to its IRR and NPV?

Accepted Answer

NPV doubles, IRR remains the same.

Question 13

Which of the following scenarios can result in a project having no IRR?

Accepted Answer

When the NPV is positive for all discount rates.

Question 14

Why is the NPV rule considered superior to the IRR rule for mutually exclusive projects?

Accepted Answer

NPV measures the dollar value added, while IRR can be misleading due to scale and timing differences.

Question 15

A project has the following cash flows: $$550,000$$ today, $$-500,000 in $$years 1-3, and $$1,000,000 in $$year 4. What is a potential issue with using the IRR rule for this project?

Accepted Answer

There are multiple IRRs, making the decision ambiguous.

Question 16

Which of the following statements about the payback period is correct?

Accepted Answer

It is most often used for small projects or in entities with capital constraints.

Question 17

If a project’s cash flows alternate between positive and negative more than once, what should you do?

Accepted Answer

Use the NPV rule instead of the IRR rule.

Question 18

Which of the following is NOT a pitfall of the payback period method?

Accepted Answer

It considers all cash flows over the project’s life.

Question 19

What is the main reason the IRR rule can lead to incorrect decisions for mutually exclusive projects?

Accepted Answer

It does not account for differences in project scale or timing of cash flows.

Investment Decision Rules: NPV, IRR, and Payback Methods

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