05. Relevant Cash Flows

Question 1

What are three characteristics of relevant costs?

Answer 1

1. Future
2. Incremental
3. Cash flows

Question 2

List five examples of costs that are not relevant costs.

Answer 2

1. Sunk costs (I.e. money already spent).
2. Non-cash costs (eg depreciation)
3. Book values (eg FIFO inventory values)
4. Unavoidable costs (ie money already committed and apportioned fixed costs)
5. Finance costs such as interest.

Question 3

Taxation has a negative effect and a positive effect in investment appraisal. Outline these two effects.

Answer 3

Negative effect - taxation is charged in operating results.

Positive effect - tax relief is given in non-current assets via tax-allowable depreciation.

Question 4

What are 7 reasons why inflation is a problem for project appraisal?

Answer 4

1. It is hard to estimate, especially when rates are high.
2. It causes governments to take actions which may affect businesses (eg raising interest rates, cutting state spending).
3. Different costs and revenues will inflate at different rates.
4. It alters the cost of capital (in nominal terms).
5. It makes historic costs irrelevant and therefore causes ROCE to be overstated.
6. It creates uncertainty for customers, which may lead to lower demand.
7. It encourages managers to become short term in outlook.

Question 5

Differentiate between real and nominal interest rates.

Answer 5

The real rate of interests reflects the rate of interest which would be required in the absence of inflation. The market rate quotes a real rate of interest.

The nominal rate of interest reflects the real rate of interest adjusted for the effect of general inflation as measured, for example, by the CPI or the Eurozone Harmonised Index of Consumer Prices (HICP).

Question 6

Outline the Fisher Formula which links nominal rates, real rates and general inflation.

Answer 6

(1+i) = (1+r)(1+h)

Where:
i = nominal interest rate
r = real interest rate
h = general inflation rate

Question 7

Differentiate between specific and general inflation.

Answer 7

A specific inflation rate is the rate of inflation on an individual item (eg wage inflation, materials price inflation).

In comparison, the general inflation rate is a weighted average of many specific inflation rates.

Question 8

For project appraisal, how is “net current assets” defined?

Answer 8

For project appraisal working capital is defined as inventory + accounts receivable - accounts payable. This definition excludes cash. Cashflow is calculated as the change in the level of inventory + accounts receivable - accounts payable.