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Free CMA Exam Braindumps (page: 23)

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The internal rate of return is

  1. The breakeven borrowing rate for the project in question.
  2. The yield rate/effective rate of interest quoted on long-term debt and other instruments.
  3. Favorable when it exceeds the hurdle rate.
  4. All of the answers are correct.

Answer(s): D

Explanation:

The internal rate of return (IRR) is the discount rate at which the present value of the cash flows equals the original investment. Thus, the NPV of the project is zero at the IRR. The IRR is also the maximum borrowing cost the firm could afford to pay for a

specific project. The IRR is similar to the yield rate/effective rate quoted in the business media.



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All of the following are the rates used in net present value analysis except for the

  1. Cost of capital.
  2. Hurdle rate.
  3. Discount rate.
  4. Accounting rate of return.

Answer(s): D

Explanation:

The NPV is the excess of the present values of the estimated cash inflows over the net cost of the investment. The discount rate used is sometimes the cost of capital or other hurdle rate designated by management. This rate is also called the required rate of return. The accounting rate of return is never used in NPV analysis because it ignores the time value of money; it is computed by dividing the accounting net income by the investment.



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In evaluating a capital budget project, the use of the net present value (NPV) model is generally not affected by the

  1. Method of funding the project.
  2. Initial cost of the project.
  3. Amount of added working capital needed for operations during the term of the project.
  4. Project's salvage value.

Answer(s): A

Explanation:

The NPV method computes the present value of future cash inflows to determine whether they are greater than the initial cash outflow. Future cash inflows include any salvage value on facilities. Included in the initial investment are the cost of new equipment and other facilities, and additional working capital needed for operations during the term of the project. The discount rate (cost of capital or hurdle rate) must be known to discount the future cash inflows. If the NPV is positive, the project should be accepted. The method of funding a project is a decision separate from that of whether to invest.



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An advantage of the net present value method over the internal rate of return model in discounted cash flow analysis is that the net present value method

  1. Computes a desired rate of return for capital projects.
  2. Can be used when there is no constant rate of return required for each year of the project.
  3. Uses a discount rate that equates the discounted cash inflows with the outflows.
  4. Uses discounted cash flows whereas the internal rate of return model does not.

Answer(s): B

Explanation:

The NPV method calculates the present values of estimated future net cash inflows and compares the total with the net cost of the investment. The cost of capital must be specified. If the NPV is positive, the project should be accepted. The IRR method computes the interest rate at which the NPV is zero. The IRR method is relatively easy to use when cash inflows are the same from one year to the next. However, when cash inflows differ from year to year, the IRR can be found only through the use of trial and error. In such cases, the NPV method is usually easier to apply. Also, the NPV method can be used when the rate of return required for each year varies. For example, a company might want to achieve a higher rate of return in later years when risk might be greater. Only the NPV method can incorporate varyinq levels of rates of return.






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