Module 4

Question 1

Payback period =

Answer 1

Time taken to recover initial outlay (recorded as X years, Y months)

Question 2

Payback period advantages (2)

Answer 2

• Good initial screening tool

- Easy to calculate and understand

Question 3

Payback period disadvantages (2)

Answer 3

• Ignores cashflows after the payback period

- Ignores the time value of money (no discounting of cash flows)

Question 4

Accounting rate of return =

Answer 4

Expressing the average annual cashflows compared to the average capital investment as a %

Question 5

ARR formula

Answer 5

Average annual profits / Average capital investment

Question 6

Average annual profits =

Answer 6

Average pre tax cash flows less annual depreciation

Question 7

Average capital investment =

Answer 7

1/2 x (cost + residual value)

Question 8

Accounting rate of return advantage

Answer 8

Simple to understand

Question 9

Accounting rate of return disadvantages (3)

Answer 9

• Can’t meaningfully compare to cost of capital
• Ignores the time value of money
• Ignores the life of the project

Question 10

Net Present Value (NPV) =

Answer 10

Discounting cashflows to their present value using WACC

Question 11

If NPV > 0

Answer 11

Accept

Question 12

If NPV < 0

Answer 12

Reject

Question 13

NPV advantages (3)

Answer 13

• Easy to calculate
• Includes the time value of money
• Considers all relevant cash flows

Question 14

Internal rate of return (IRR)

Answer 14

Discount rate that gives us NPV = 0 as a percentage

Question 15

If IRR > Cost of capital

Answer 15

Accept

Question 16

If IRR < Cost of capital

Answer 16

Reject

Question 17

IRR disadvantages (3)

Answer 17

• Can be possible to get more than one IRR
• Doesn’t provide the magnitude of the increase in wealth from the project (ignores the scale of any project)
• Can prove misleading where projects are mutually exclusive or if capital is rationed

Question 18

Cost of preference shares =

Answer 18

% preference share / market value

Question 19

Disadvantages with WACC (2)

Answer 19

• Difficult to estimate for unlisted companies

- Not possible to calculate for government organisations

Question 20

Only correct to use the WACC as the discount rate in NPV analysis if (3)

Answer 20

• Project being assessed is small relative to the business
• Existing capital structure will be maintained
• Project has same risk profile as rest of business

Question 21

NPV is superior method of investment appraisal because

Answer 21

It measures the addition the shareholder’s wealth of accepting a new project

Question 22

Relevant cash flows

Answer 22

Those cash flows affected by the decision to invest

Question 23

Relevant cash flows > sunk costs

Answer 23

Ignore

Question 24

Relevant cash flows > opportunity costs

Answer 24

Include the lost contribution

Question 25

Relevant cash flows > overhead costs

Answer 25

Additional overheads > include | Central/ arbitrarily apportioned > exclude

Question 26

Relevant cash flows > Materials

Answer 26

If replaced > replacement cost Not replaced > cost = 0 If could have been sold > lost revenue = cost`

Question 27

Relevant cash flows > Labour

Answer 27

Idle > cost = 0 Full capacity > cost = contribution lost on work they had to stop doing Hired specifically for project > cost = salary paid

Question 28

Relevant cash flows > Machinery

Answer 28

Purchased outright > cost included | Acquired through loan/ lease > ignore interest payments

Question 29

Relevant cash flows > Working capital (stock)

Answer 29

Cash tied up (outflow) -> Cash release (inflow) -> Net effect (for NPV)

Question 30

Assumption > timing of cash flows

Answer 30

Unless told otherwise, assume all cash flows received at end of the year

Question 31

Two impacts of inflation on NPV

Answer 31

- Cash flows rise > project more attractive | - Cost of capital (discount rate) rises > project less attractive

Question 32

Inflate from...

Answer 32

Following period eg if provided with Year 0/ current year prices, inflate from year 1

Question 33

Real terms/ current prices

Answer 33

Ignore inflation

Question 34

Nominal market

Answer 34

Include inflation

Question 35

If one rate of inflation

Answer 35

Ignore inflation > use real cash flows + real discount rate

Question 36

If multiple rates of inflation

Answer 36

Cash flows and cost of capital must be inflated > use nominal cash flows and nominal discount rate

Question 37

Complications arising when foreign projects are assessed (3)

Answer 37

- Discount rates - Exchange rates - Inflation rates

Question 38

Approach to international investment appraisal > Approach 1

Answer 38

1) Forecast projected cash flows 2) Calculate expected forecast exchange rate 3) Convert foreign cash flows to sterling 4) Discount at sterling cost of capital

Question 39

Approach to international investment appraisal > Approach 2

Answer 39

1) Forecast projected cash flows 2) Estimate foreign adjusted discount rate 3) Discount foreign cash flows at foreign discount rate 4) Convert NPV into sterling at spot rate

Question 40

Sensitivity analysis variables (5)

Answer 40

- Selling price - Sales volume - Cost of capital - Initial cost - Operating costs

Question 41

Weakness of sensitivity analysis

Answer 41

- Can only have one variable > unrealistic

Question 42

Simulation

Answer 42

Generates the distributions of the NPVs for each project > the wider the distributions, the higher the risk