BNKF5001 Project Evaluation

The net present value decision criterion for whether to accept or reject a project can be stated as:

• If net present value > the cost of capital, accept the project. Otherwise reject.

• If net present value > internal rate of return, accept the project. Otherwise reject.

• If net present value > 0, accept the project. Otherwise reject.

• If net present value > or equal to 0, accept the project. Otherwise reject.

To accept a project with an NPV equal to zero would be:

• neutral, as the project would satisfy shareholders’ required returns without adding further value to the firm.

• unwise, as the project essentially earns a zero profit.

• unwise, as the project fails to earn a return equal to that required by the firm's owners.

• wise, as the project increases the wealth of the firm’s owners.

Doggy Kennels Ltd is evaluating the purchase of new facilities that cost $100,000. The acquisition is expected to generate net operating cash flows of $60,000 in year one and $25,000 in each of years two, three and four. Assuming a cost of capital of 15%, the net present value of the proposed investment (rounded to the nearest dollar) is:

• -$12,485.

• $1,809.

• $9,255.

• $35,000.

The __________ is the percentage return that discounts all cash flows from a project, including the initial investment, to zero.

• net present value

• weighted average cost of capital

• accounting return on investment

• internal rate of return

All of the following statements about the IRR are true, except:

• the IRR is the discount rate that makes the NPV of an investment equal to zero.

• to correctly use the IRR technique, it is necessary to estimate the firm’s cost of capital.

• the IRR can result in sub-optimal decisions when alternative projects must be ranked.

• it can give misleading signals for accept/reject decisions when projects are independent.

Girlzone Clothing Ltd is considering the purchase of new equipment that will cost $330,000, and is expected to generate net operating cash flows of $100,000 per year for five years. If the firm’s cost of capital is 18%, then the correct decision is:

• to accept the investment as the internal rate of return > 18%.

• to reject the investment as the internal rate of return < 18%.

• to accept the investment as the internal rate of return = 18%.

• to reject the investment as the internal rate of return = 18%.

From a theoretical point of view, net present value is a superior technique of investment appraisal because:

• it is consistent with the goal of owner wealth maximisation.

• the internal rate of return may not give the best decision when projects are mutually exclusive.

• the internal rate of return may not give the best decision when capital is rationed.

• all of the above.

Little Guy Limited is evaluating the purchase of new equipment that will cost $50,000. The purchase is expected to reduce net operating costs by $30,000 in year 1, $25,000 in year 2, and $5,000 in year 3.

The payback period of this investment is:

• between 1 and 2 years.

• exactly 2 years.

• between 2 and 3 years.

• exactly 3 years.

The net present value measures:

• the present value of future cash flows divided by the investment outlay.

• the length of time required for an investment’s discounted cash flows to equal its initial cost.

• the percentage return to be earned from a project, taking the time value of money into account.

• the present dollar value added to the firm as a result of undertaking a project.