Chapter 4 - Investment appraisal - Further aspects of discounted cash flows

Question 1

What is inflation?

Answer 1

a general increase in prices leading to a general decline in the real value of money

Question 2

In times of inflation, the funding providers will require a return made up of what two elements?

Answer 2

• a real return for use of their funds
• an additional return to compensate for inflation

Question 3

What is the overall return?

Answer 3

the overall return required from these two elements is called the money or nominal rate of return.

Question 4

What is the formula that links real and money (nominal) returns?

Answer 4

(1 + i) = (1 + r)(1 + h)
r= real rate of return
h=inflation rate
i= money cost of capital (the company’s normal cost of capital)

Question 5

Cash flows that have not been increased for expected inflation are described as what?

Answer 5

being in current prices or today’s prices

Question 6

Cash flows that have been increase to take account of inflation are known as what?

Answer 6

as money cash flows or nominal cash flows

Question 7

Money or nominal cash flows represent what?

Answer 7

the expected cash outflow or inflow to hit the bank account

Question 8

Assume in the exam that cash flows are what kind unless stated otherwise?

Answer 8

money cash flows

Question 9

What is the method with dealing with the real method?

Answer 9

Do NOT inflate the cash flows - leave them in current terms i.e., current prices, current cash flows
Discount using the real rate

Question 10

What is the method with dealing with the money/nominal method?

Answer 10

inflate each cash flow by its specific inflation rate i.e., convert it to a money cash flow
Discount using the money rate

Question 11

What would we use general inflation rates for?

Answer 11

to calculate discount factors, when calculating the real or money rate of return.HO

Question 12

How do we convert current cash flows to money cash flows?

Answer 12

Inflate using specific rate

Question 13

How do we convert money cash flows to real cash flows?

Answer 13

deflate using general rate

Question 14

What are the 2 tax effects in investment appraisal?

Answer 14

• Tax on operating cash flows
• Tax relief on investment spending

Question 15

What is tax on operating cash flows?

Answer 15

additional income = additional tax paid
additional costs = less tax paid

Question 16

what is tax relief on investment spending?

Answer 16

Tax-allowable depreciation allowed as an expense against profits instead of depreciation

Question 17

When is tax paid?

Answer 17

one year after the related operating cash flow is earned

Question 18

What is the assumption with when an asset is bought?

Answer 18

Bought at time period t0

Question 19

What is the assumption for the first tax-allowable depreciation is claimed?

Answer 19

time period t1

Question 20

What is the assumption of when the first tax saving would be?

Answer 20

time period 2 t2

Question 21

Initial investment is treated as what of working capital?

Answer 21

is a cash flow at the start of the project (t0)

Question 22

If the investment is increased what is the treatment of the working capital?

Answer 22

The increase is a relevant cash outflow

Question 23

If the investment is decreased what is the treatment of working capital?

Answer 23

the decrease is a relevant cash inflow

Question 24

When is working capital ‘released’?

Answer 24

the end of the project, leading to a cash inflow

Question 25

Working capital investment cash flows should add across to what?

Answer 25

0

Question 26

If a question has both tax and inflation what method should be used?

Answer 26

money method