Finance 701 Exam Study Guide Questions
and Answers
Net Present Value (NPV) - Answer-the difference between the present value of a
project's future cash flows and its cost. Estimating cost is usually straight forward;
however, estimating future cash flows can be tricky.
discounted cash flow (DCF) valuation - Answer-finding the market value of assets or
their benefits by taking the present value of future cash flows EX: estimating what the
future cash flows would trade in for in today's dollars
What is the Benefit of NPV? - Answer-It measures the magnitude, timing, and risk of
Cash flows, which further illustrates its link to the firm's stock price
What happens if NPV>0? - Answer-Then accepting the project creates value. So to
maximize value, choose projects with the HIGHEST NPV.
Payback Period - Answer-length of time until the accumulated cash flows equal or
exceed the original investment
Payback Period Rule - Answer-Investment is acceptable if the calculated payback is
less than some prespecified number of years
Advantages of Payback Period - Answer-Easy to Understand, Adjusts for the
Uncertainty of later cash flows, Biased towards liquidity
Disadvantages of Payback Period - Answer-Ignores the time value of money, Requires
an arbitrary cutoff point, Ignores cash flows beyond the cutoff date, Biased against long-
term projects
The Discounted Payback Period Advantages - Answer-All of the simple payback rule
plus time value of money (at least for cash flows prior to the cutoff), If a project pays
back on a discounted basis, and has all positive cash flows after the initial investment,
then it must have a positive NPV
Disadvantages Discounted Payback Period - Answer-The arbitrary cut-off period may
eliminate projects that would increase firm value, If there are negative cash flows after
the cut-off period, the rule may indicate acceptance of a project that has a negative NPV
Internal Rate of Return (IRR) - Answer-The rate that makes the present value of the
future cash flows equal to the initial cost or investment. In other words, the discount rate
that gives a project $0 NPV
, IRR Decision Rule - Answer-The investment is acceptable if its IRR exceeds the
required return
Mutually Exclusive Investment Decisions - Answer-Taking one project means another
cannot be taken
Independent Decision - Answer-A given project can be taken in conjunction with other
projects. Accept all that meet the minimum criteria.
Problem 1: Investing or Financing? - Answer-If the cash flows are of loan type, meaning
money is received at the beginning and paid out over the life of the project, then the IRR
is really a borrowing rate, and lower is better
Problem 2: Multiple IRRS
Non-Conventional Cash Flows - Answer-The sign of the cash flows changes more than
once (or, as above, the cash inflow comes first and outflows come later)
What is one method to eliminate multiple IRRs? - Answer-Modified Internal Rate of
Return (MIRR)
Modified IRR - Answer-Discount all cash outflows to the present, and compound all
cash inflows to the last period of the project. Then, the find the rate that equates the
values. The discounting and compounding can be done at different borrowing and
investment rates, respectively.
Problems Specific to Mutually Exclusive Projects - Answer-Problem 1: Scale
IRR does not account for the amount of total value created, only a percentage return.
Problem 2: Timing
NPV and IRR Comparison: - Answer-If a projects cash flows are conventional (costs are
paid early and benefits are received over the life), and if the project is independent, the
NPV and IRR will give the same accept or reject signal.
Profitability Index (PI) - Answer-Present value of future cash flows divided the initial
investment
What happens to the PI if there is a positive NPV? - Answer-The PI will be greater than
1
Relevant Cash Flows - Answer-Cash flows that occur (or do not occur) because a
project is undertaken. Cash flows that will occur whether or not we accept a project are
not relevant.
Incremental Cash Flows - Answer-Any and all changes in the firm's future cash flows
that are a direct consequence of taking the project.
and Answers
Net Present Value (NPV) - Answer-the difference between the present value of a
project's future cash flows and its cost. Estimating cost is usually straight forward;
however, estimating future cash flows can be tricky.
discounted cash flow (DCF) valuation - Answer-finding the market value of assets or
their benefits by taking the present value of future cash flows EX: estimating what the
future cash flows would trade in for in today's dollars
What is the Benefit of NPV? - Answer-It measures the magnitude, timing, and risk of
Cash flows, which further illustrates its link to the firm's stock price
What happens if NPV>0? - Answer-Then accepting the project creates value. So to
maximize value, choose projects with the HIGHEST NPV.
Payback Period - Answer-length of time until the accumulated cash flows equal or
exceed the original investment
Payback Period Rule - Answer-Investment is acceptable if the calculated payback is
less than some prespecified number of years
Advantages of Payback Period - Answer-Easy to Understand, Adjusts for the
Uncertainty of later cash flows, Biased towards liquidity
Disadvantages of Payback Period - Answer-Ignores the time value of money, Requires
an arbitrary cutoff point, Ignores cash flows beyond the cutoff date, Biased against long-
term projects
The Discounted Payback Period Advantages - Answer-All of the simple payback rule
plus time value of money (at least for cash flows prior to the cutoff), If a project pays
back on a discounted basis, and has all positive cash flows after the initial investment,
then it must have a positive NPV
Disadvantages Discounted Payback Period - Answer-The arbitrary cut-off period may
eliminate projects that would increase firm value, If there are negative cash flows after
the cut-off period, the rule may indicate acceptance of a project that has a negative NPV
Internal Rate of Return (IRR) - Answer-The rate that makes the present value of the
future cash flows equal to the initial cost or investment. In other words, the discount rate
that gives a project $0 NPV
, IRR Decision Rule - Answer-The investment is acceptable if its IRR exceeds the
required return
Mutually Exclusive Investment Decisions - Answer-Taking one project means another
cannot be taken
Independent Decision - Answer-A given project can be taken in conjunction with other
projects. Accept all that meet the minimum criteria.
Problem 1: Investing or Financing? - Answer-If the cash flows are of loan type, meaning
money is received at the beginning and paid out over the life of the project, then the IRR
is really a borrowing rate, and lower is better
Problem 2: Multiple IRRS
Non-Conventional Cash Flows - Answer-The sign of the cash flows changes more than
once (or, as above, the cash inflow comes first and outflows come later)
What is one method to eliminate multiple IRRs? - Answer-Modified Internal Rate of
Return (MIRR)
Modified IRR - Answer-Discount all cash outflows to the present, and compound all
cash inflows to the last period of the project. Then, the find the rate that equates the
values. The discounting and compounding can be done at different borrowing and
investment rates, respectively.
Problems Specific to Mutually Exclusive Projects - Answer-Problem 1: Scale
IRR does not account for the amount of total value created, only a percentage return.
Problem 2: Timing
NPV and IRR Comparison: - Answer-If a projects cash flows are conventional (costs are
paid early and benefits are received over the life), and if the project is independent, the
NPV and IRR will give the same accept or reject signal.
Profitability Index (PI) - Answer-Present value of future cash flows divided the initial
investment
What happens to the PI if there is a positive NPV? - Answer-The PI will be greater than
1
Relevant Cash Flows - Answer-Cash flows that occur (or do not occur) because a
project is undertaken. Cash flows that will occur whether or not we accept a project are
not relevant.
Incremental Cash Flows - Answer-Any and all changes in the firm's future cash flows
that are a direct consequence of taking the project.
