Chapter 4

Question 1

Simple interest

Answer 1

Interest only accrues on the initial amount invested

Question 2

Compound interest

Answer 2

Interest is reinvested alongside principal

Question 3

EAIR

Answer 3

when interest is charged on a non annual basis it is useful to know the EAIR in order to compare the EAIR with the cost of finance of other sources

Question 4

Formula for EAIR

Answer 4

1 + R = (1 + r)^n
Where R = annual rate (EAIR)
r = interest rate per period
n = number of period in a year

Question 5

Why is EAIR important

Answer 5

Gives the true interest rate associated with an investment or loan

Question 6

Discounting

Answer 6

How much should be invested now in order to receive a given sum in the future

Question 7

Reasons for the time value of money assumption

Answer 7

$1 received today can be invested to grow more money in the future (Liquidity)
$1 received today is certain whereas $1 received tomorrow is not (Risk)
$1 value may be lower tomorrow (Inflation)

Question 8

Two methods of investment appraisal

Answer 8

NPV and IRR

Question 9

Why is NPV considered to be the superior technique in business making

Answer 9

Because shareholder wealth is increased if positive NPV projects are accepted

Question 10

Annuity

Answer 10

A stream of identical dash flows arising each year but not to infinity

Question 11

Perpetuity

Answer 11

A stream of identical cash flows arising each year to infinity

Question 12

Note well

Answer 12

Assume Cash flows at the end of the year to which they relate

Question 13

Not well for perpetuity

Answer 13

Present value of a perpetuity is based on the assumption that the cash flow starts after one year

Question 14

Not well for perpetuity

Answer 14

Present value of a perpetuity is based on the assumption that the cash flow starts after one year

Question 15

IRR

Answer 15

a discount rate which when used to discount cash flows results in an NPV of 0. It represents the average annual percentage return from a project and so shows the highest cost of finance that can be accepted for a project

Question 16

IRR of a perpetuity

Answer 16

Annual cash flows/investment x 100

Question 17

IRR of an annuity

Answer 17

Annuity factor = cash outflow/annual cash inflow

Question 18

Advantages of DCF Techniques

Answer 18

Take into account:
the time value of money;
all of a project’s cash flows over its entire duration; and
the timing of cash flows.
Provide a more objective basis for evaluating and selecting investment projects as they are not affected by financial accounting policies

Question 19

Disadvantages of DCF Techniques

Answer 19

he potentially complex and time-consuming process of calculating NPV and/or IRR (see later in this chapter).
Difficulty in explaining DCF techniques to non-financial managers.
Complexity of estimating an appropriate discount rate (i.e. the applicable interest rate), particularly for unquoted companies.
Managers may feel little connection between DCF techniques and their own reported performance and bonus systems.