Advantages of IRR as a capital budget method: A.) It generates more accurate cash flow estimates. B.) It is relatively simple and easily comprehensible. C.) It tells a company how long it will take to recover their investment. D.) It is useful for comparing projects with different lifespans. What is one disadvantage of NPV as a capital budget method? A.) It is not very good at accounting for opportunity cost. B.) There is disagreement about whether a project with a negative NPV should be approved or not. C.) It can only be used to assess a single investment and is not a comparative tool. D.) It can be inaccurate because a company cannot adjust the discount rate when calculating NPV. When considering a replacement project, __ must be included in the cash flow analysis. A.) unrecoverables B.) depreciation C.) salvage value D.) sunk costs Which of the following is an example of a market risk for a company that manufactures automobiles? A.) Difficulty attracting workers with the requisite skills to meet production demands B.) Increasing costs in the supply chain of material, due to rising fuel costs C.) A union strike that halts production D.) Rising tariffs that increase the price of automobiles sold overseas, thereby reducing demand
The Correct Answer and Explanation is:
. Advantages of IRR as a capital budget method:
Correct Answer: B.) It is relatively simple and easily comprehensible.
Explanation:
The Internal Rate of Return (IRR) is one of the most widely used capital budgeting methods due to its straightforwardness. It is simple for both financial professionals and non-financial managers to understand. IRR represents the rate at which the net present value (NPV) of future cash flows equals zero, essentially showing the expected return of a project. This makes it easier for stakeholders to quickly compare different projects and decide which is most likely to generate the best returns.
However, while IRR is easy to grasp, its primary drawback is that it can sometimes give misleading results for non-standard cash flows or multiple IRRs, which occurs in projects where cash inflows and outflows alternate.
2. Disadvantage of NPV as a capital budget method:
Correct Answer: B.) There is disagreement about whether a project with a negative NPV should be approved or not.
Explanation:
The Net Present Value (NPV) method is widely regarded as an effective capital budgeting tool because it accounts for the time value of money. A project with a positive NPV typically indicates it will create value for the company, while a negative NPV suggests the project will destroy value. However, one of its disadvantages is that disagreement may arise when deciding whether to approve projects with negative NPVs, particularly in the case of projects with strategic or non-financial benefits that may not be captured by traditional financial analysis. For instance, a company may approve a project with a negative NPV if it aligns with long-term strategic goals, such as expanding market share or meeting regulatory requirements.
3. Cash Flow Analysis in Replacement Projects:
Correct Answer: C.) Salvage Value
Explanation:
In the context of replacement projects, the salvage value (the residual value from selling or disposing of an asset) must be included in the cash flow analysis. This value is considered part of the net cash inflows and will affect the overall financial decision regarding whether replacing an asset is beneficial. The salvage value typically represents the amount of money that can be recovered from selling the old asset and should be subtracted from the costs associated with the new replacement.
Sunk costs (D) are not included in replacement decisions since they represent past investments that cannot be recovered.
4. Example of Market Risk for an Automobile Manufacturer:
Correct Answer: D.) Rising tariffs that increase the price of automobiles sold overseas, thereby reducing demand
Explanation:
Market risks pertain to external factors that can affect a company’s operations and financial performance. For an automobile manufacturer, rising tariffs represent a market risk because they could increase the price of automobiles when exported overseas, which in turn could reduce demand for the company’s vehicles in international markets.
While difficulty in attracting workers (A) or union strikes (C) are operational risks, and increasing costs in the supply chain (B) are examples of cost-related risks, tariffs directly impact the market demand and pricing structure, which is why they are a critical market risk for international operations.
