Quantitative Methods - Quantitative Methods Section 1

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11. As a project manager, Alan Smith has to choose between three mutually exclusive projects: A, B and C. He uses the information given below to evaluate the three projects:

 NPV   IRRPayback Period
A $22,000  7.5%4 years
B $30,000  8%4.5 years
C$25,000  12%6 years

  • Option : B
  • Explanation : Whenever there is a conflict in ranking between the IRR rule and the NPV rule, the NPV rule should be used to decide between mutually exclusive projects. This is because the NPV represents the expected addition to shareholder wealth from an investment. The maximization of shareholder wealth is a basic financial objective of a company and hence, the NPV rule must be given preference. Project B has the highest NPV among the three projects and thus results in the greatest addition to shareholder wealth. While there is a conflict among the NPV and IRR rules for projects B and C, NPV rule is to be given preference for its superiority over IRR and hence B would be the most appropriate choice. Payback period should be given the least consideration as it does not affect the decision due to its various drawbacks.
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12. Ms. Silvio, a corporate finance analyst is considering two mutually exclusive capital budgeting projects with conflicting rankings (one has the higher positive NPV, while the other has a higher IRR). The most appropriate project she can choose is the one with the:

  • Option : B
  • Explanation : When the IRR and NPV rules conflict in ranking projects, consider the NPV rule. The NPV of an investment represents the expected addition to shareholder wealth from an investment, and we take the maximization of shareholder wealth to be a basic financial objective of a company.
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13. Emad Gohar plans to invest in a project that requires an initial investment of $3 million. The project is expected to generate the following cash flows.

Time Cash flow
120 million
21.05 million
30.90 million
40.75 million

  • Option : C
  • Explanation : Using a financial calculator, enter the cash flows to compute NPV and IRR. CF0 = - 3 million, CF1 = 1.2 million, CF2 = 1.05 million, CF3 = 0.9 million, CF4 = 0.75 million, I= 10%, CPT NPV = 0.147 million, CPT IRR = 12.44%. Since the NPV is positive and the IRR is greater than the cost of capital, both rules indicate that the project should be accepted.
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14. Which of the following reasons will least likely lead to a conflicting decision between the IRR rule and the NPV rule for mutually exclusive projects?

  • Option : C
  • Explanation : IRR and NPV can rank projects differently when: The size or scale of the projects differs. Timing of the projects’ cash flows differs.
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15. Information about a common stock investment is given below:

 Date Amount €
Stock purchase 15 January 201362.00
Cash dividend received 14 July 20135.00
Stock sale15 July 201378.00

  • Option : B
  • Explanation : Holding period return is calculated as follows: HPR = P1– P0+ D1 / P0 = ending value – beginning value + cash flow beginning value where: P0 = initial investment P1 = price received at the end of the holding period D1 = cash paid by the investment at the end of the holding period HPR = (78 –62 + 5) / 62 = 33.87%. The HPR is not annualized for holding periods shorter than a year.
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