Investment Analysis Flashcards

A project with conventional cash flows has a positive NPV when discounted at the firm's 10% cost of capital. What must be true of its IRR?

Answer: IRR is greater than 10%

For conventional cash flows, a positive NPV at a given rate means the IRR exceeds that rate.

A project requires a $1,000,000 investment and its future cash flows have a present value of $1,200,000. What is its profitability index?

Answer: 1.20

PI = PV of future cash flows ÷ initial investment = $1.2M ÷ $1.0M = 1.20.

Two mutually exclusive projects rank differently under NPV and IRR. Which project should a value-maximizing CFO choose?

Answer: The project with the higher NPV

NPV measures the absolute dollar increase in shareholder wealth, so it governs when rankings conflict.

What is the most significant weakness of the simple payback period method?

Answer: It ignores cash flows occurring after the payback point

Payback ignores all cash flows beyond the cutoff and also ignores the time value of money.

What reinvestment rate assumption does the Modified Internal Rate of Return (MIRR) typically use?

Answer: The firm's cost of capital

MIRR assumes interim cash flows are reinvested at the cost of capital, which is more realistic than IRR's assumption.

A company spent $250,000 on a market study last year before deciding whether to launch a product. How should this cost be treated in the launch NPV analysis?

Answer: Exclude it as a sunk cost

Sunk costs are already incurred regardless of the decision and are irrelevant to incremental cash flow analysis.

Which technique is most appropriate for comparing mutually exclusive projects with unequal useful lives that will be replaced repeatedly?

Answer: Equivalent annual annuity (EAA)

EAA converts each project's NPV into an annual equivalent, allowing fair comparison across different lives.

Using CAPM, what is the required return on a stock with a beta of 1.5 if the risk-free rate is 4% and the expected market return is 10%?

Answer: 13.0%

Required return = 4% + 1.5 × (10% − 4%) = 13%.

The Sharpe ratio measures a portfolio's excess return per unit of which risk measure?

Answer: Standard deviation

Sharpe ratio = (portfolio return − risk-free rate) ÷ standard deviation of portfolio returns.

Which type of risk can be substantially eliminated through diversification?

Answer: Unsystematic (firm-specific) risk

Firm-specific risk cancels out across a well-diversified portfolio, leaving only systematic risk.

If market interest rates rise after a fixed-rate bond is issued, what happens to the bond's market price?

Answer: It falls

Bond prices move inversely to market yields because existing fixed coupons become less attractive.

A bond has a modified duration of 6. If its yield increases by 1 percentage point, what is the approximate change in its price?

Answer: −6%

Percentage price change ≈ −modified duration × change in yield = −6 × 1% = −6%.

A stock is expected to pay a $2.00 dividend next year, dividends grow at 4% annually, and the required return is 10%. What is its value using the Gordon Growth Model?

Answer: $33.33

Value = D1 ÷ (r − g) = $2.00 ÷ (0.10 − 0.04) = $33.33.

Which performance measure divides a portfolio's excess return by its beta?

Answer: Treynor ratio

The Treynor ratio measures excess return per unit of systematic risk (beta).