Chapter 4: Cash management and working capital finance

Question 1

Cash flow forecast

Answer 1

A detailed forecast of cash inflows and outflows incorporating both revenue and capital items

Question 2

Working capital finance

Answer 2

The approach taken to financing the level, and fluctuations in the level, of net working capital

Question 3

A disadvantage of using payback period as a tool for investment appraisal is:

Answer 3

It ignores cash flows arising after the payback period

Payback period uses cash flows for appraisal (not profits) and it does ignore time value of money. It also ignores cash flows arising after the payback period when analysing an investment

Question 4

A potential project involves an initial investment in machinery of $1,000,000 and has the following cash inflows: Year 1 - $250,000; Year 2 - $350,000; Year 3 - $200,000; Year 4 - $400,000; At the end of year 4, the machinery will be sold for $400,000. Calculate the accounting rate of return based on initial investment. Answer: ARR is

Answer 4

15

Total cash profits over four years = $250,000 + $350,000 + $200,000 + $400,000 = $1,200,000. Total depreciation = $1,000,000 - $400,000 = $600,000. Total profit after depreciation = 1,200,000 - $600,000 depreciation = $600,000. Annual profit = $600,000 / 4 = $150,000. Initial investment = $1,000,000. ARR = 150,000 / 1,000,000 = 0.15 or 15%

Question 5

Which of the following investment appraisal techniques does not involve discounting?

Answer 5

Accounting rate of return

Question 6

Which of the following investment appraisal techniques does involve discounting?

Answer 6

Net present value
Discounted payback
Internal rate of return

Question 7

Which of the following is an advantage of ARR as compared to payback method?

Answer 7

Considers entire project life
As compared to payback method, ARR considers the entire project life. The other three statements are basically disadvantages of ARR.

Question 8

A potential project involves an initial investment in machinery of $1,000,000 and has the following cash inflows: Year 1 - $250,000; Year 2 - $350,000; Year 3 - $200,000; Year 4 - $400,000. At the end of year 4, the machinery will be sold for $400,000. Calculate the accounting rate of return based on average investment.

Answer 8

21.43%

Total cash profits over four years = $250,000 + $350,000 + $200,000 + $400,000 = $1,200,000. Total depreciation = $1,000,000 - $400,000 = $600,000. Total profit after depreciation = 1,200,000 - $600,000 depreciation = $600,000. Annual profit = $600,000 / 4 = $150,000. Average investment = ($1,000,000 + $400,000) / 2 = $700,000. ARR = 150,000 / 700,000 = 0.2143 or 21.43%

Question 9

A potential project involves an initial investment in machinery of $1,500,000 and has these operating annual cash inflows:

Year $
1 100,000
2 500,000
3 430,000
4 210,000
5 420,000
6 320,000
7 150,000
The machinery will be sold for scrap at the end of year 7 for $100,000. What is the payback period of this project?

Answer 9

4 years 7 months

Question 10

A company is considering to use a warehouse for its production purposes. The company has also been approached to give that warehouse on rent to another company for $10,000 per month rent for one year. Currently, the warehouse is not being used at all. The warehouse was purchased two years ago for $100,000 and currently the market value of the warehouse is $150,000. The company has no intention of selling the warehouse. If the warehouse is used for the production process, what is the total relevant cost of this warehouse?

Answer 10

120,000

The warehouse can be rented for $10,000 per month for 1 year, which means a rent of (12 x 10,000 =) $120,000 will be foregone. As opportunity cost is the cost of second best alternative, and the company has no plan on selling the warehouse, the second best alternate is to give the warehouse on rent. Thus, $120,000 is the opportunity cost of the warehouse

Question 11

A company is deciding whether to launch a new product or not. The research and development cost incurred by the company for this new product is $10,000. The research suggests that the revenue of the company will increase by $10,000 per year for next 5 years. However, the new product will have additional operating expenses of $5,000 per year as well. If the corporation tax rate is 30%, what will the net relevant cash flows for the first year of operations, if the product is launched?

Answer 11

3,500

As research and development is a sunk cost, it is not relevant to this decision. The relevant new cash flows for the first year will be; (incremental sales – incremental costs) x (1 – 30%) = (10,000 – 5,000) x (70%) = $3,500. The company will need to pay tax on the incremental net cash earned on extra sales, the tax expense arising on the extra revenue will also be relevant (hence, 30% out flow is adjusted

Question 12

Mr. B will receive $25,000 in 22 years. Assuming that the discount rate is 20%, calculate the present value.

Answer 12

452.84

Present value = Future value x 1 / (1+r)^n = $25,000 x 1 / (1.20)^22 = $452.84

Question 13

A business has invested $120,000 in machinery. The machinery is eligible for capital allowances at the rate of 30%. The tax rate is 25%. Calculate the tax savings due to capital allowances in year 2.

Answer 13

6,300

Year 1 capital allowance = $120,000 x 30% = $36,000. Year 2 capital allowance = ($120,000 - $36,000) x 30% = $25,200. Tax savings = $25,200 x 25% = $6,300

Question 14

Glen Co is considering an investment that will generate $3,000 for the next 14 years. Assuming that the discount rate is 1%, calculate the present value of the annuity

Answer 14

39,012

Question 15

A business wants to evaluate a project using the nominal cost of capital. The real cost of capital is 10%, whereas the general inflation rate is 5%. Calculate the nominal cost of capital.

Answer 15

15.5

(1+i) = (1+r) x (1+h) = (1.10) x (1.05) Therefore: i = 1.155 - 1 = 0.155, or 15.5%”

Question 16

The cost of capital compensates the investors for three key factors.

Answer 16

Risk
Inflation
Interest

Question 17

The following revenues have been forecasted by a business: Year 1 – $1,000; Year 2 – $2,000; Year 3 – $4,000; Year 4 – $4,000; Year 5 – $6,000. Working capital equal to 10% of the sales revenue is required at the start of the year. Calculate the amount of working capital cash outflow at the end of year 3 (or beginning of year 4).

Answer 17

0

There will be no working capital outflow at the end of year 3 (or beginning of year 4). This is because the required amount would be already available from previous year. Remember, working capital is always included on incremental basis. Year 0 = $1,000 x 10% = $100. Year 1 = $2,000 x 10% - $100 = $100. Year 2 = $4,000 x 10% - $200 = $200. Year 3 = $4,000 x 10% - $400 = $0.”

Question 18

Mr. Harry has been promised by a bank to receive 7% interest on the deposited amount forever. If Mr. Harry decides to deposit $70,000 in the bank and his required rate of return is 10%, calculate the present value of interest payments.

Answer 18

49,000

The question is asking only for the present value of interest payments. Perpetuity = Cash flows / r = ($70,000 x 0.07) / 0.1 = $49,000

Question 19

NPV is usually considered superior to IRR because:

Answer 19

IRR assumes cash flows are reinvested at internal rate of return

IRR is a relative measure not an absolute measure (i.e. expressed as a percentage). IRR can be used for traditional projects, but projects showing non-traditional cash flows give multiple IRRs. IRR takes account of the time value of money by discounting the cash flows to the present values, just like NPV. The IRR assumes that the cash flows are reinvested at internal rate of return (reinvestment assumption), which is a weak assumption, as compared to NPV, which assumes that the cash flows are reinvested at the cost of capital or discount rate.

Question 20

Mr. A puts $2,000 into a bank account that will earn him 10% a year. By the end of 25 years, the balance in his bank account will be: $

Answer 20

21,669

Future value = Present value x (1+r)^n = $2,000 x (1.1)^25= $21,669