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FM (Test) > D Rote > Flashcards

D Rote Flashcards

1
Q

Rule for relevant cash flows?

A

Future and incremental cash flows

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2
Q

What is meant by incremental cash flows?

A

Those that change because a project is undertaken

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3
Q

What are example of incremental cash flows?

A

Cash from sales
Operating costs (materials and labour)

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4
Q

Are financing cash flows relevant?

A

No, because cost of finance measured in discount rate

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5
Q

Are sunk costs (money already spent) included or not included in relevant cash flows?

A

Not included

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6
Q

Are non-cash costs (depreciation) included or not included in relevant cash flows?

A

Not included

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7
Q

Are book values (FIFO inventory values) included or not included in relevant cash flows?

A

Not included

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8
Q

Are unavoidable fixed costs included or not included in relevant cash flows?

A

Not included

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9
Q

Are finance costs such as interest included or not included in relevant cash flows?

A

Not included

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10
Q

Example of unavoidable costs?

A

Money already committed and apportioned fixed costs

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11
Q

Are opportunity and revenues included or not included in relevant cash flows?

A

Included

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12
Q

Is lost contribution included or not included in relevant cash flows?

A

Included

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13
Q

What years does ROCE take account of?

A

All years of operation of an investment project

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14
Q

Main issue with payback period?

A

Doesn’t measure the potential impact on shareholder wealth

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15
Q

Why should salary not be included in the project appraisal?

A

It is not incremental

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16
Q

What are the advantages of IRR (TVM)

A

Time value of money

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17
Q

What are the advantages of IRR (whole)

A

Considers the whole project

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18
Q

What happens to IRR when there’s an increase in the cost of capital?

A

No change

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19
Q

What happens to NPV when there’s an increase in the cost of capital?

A

Decrease

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20
Q

What does the decision rule depend on in IRR?

A

The shape of the IRR curve

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21
Q

What is meant by the reinvestment assumption in IRR?

A

No reason to suppose that funds generated early on in a project are reinvested at IRR after that point. Funds may be distributed elsewhere

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22
Q

How many NPV calculations are needed to estimate IRR using linear interpolation?

A

Two NPVs

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23
Q

What slope would an unusual project with an initial large inflow followed by years of outflows have?

A

A positive slope

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24
Q

What is the inflation figure included in the money cost of capital?

A

It is expected general inflation suffered by the investors

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25
Q

What is meant by the expected NPV?

A

Value expected to occur if an investment project with several possible outcomes is undertaken once

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26
Q

What is meant by the discounted payback period?

A

Time taken for the cumulative NPV to change from negative to positive

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27
Q

How is soft capital rationing brought about?

A

By internal factors and decisions by management

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28
Q

When can ranking using the profitability index be used?

A

If projects are divisible

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29
Q

When is a lease is better than buy?

A

Saved outlay is a benefit of the lease so if it outweighs the present value of the costs relevant to the lease then lease is financially worthwhile

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30
Q

Why should interest not be included as a cash flow?

A

As it is part of the discount rate

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31
Q

When is the profitability index be suitable for?

A

Handling single-period capital rationing problems if projects are divisible

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32
Q

Is investing in a machine likely to be divisible for a project?

A

No

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33
Q

Is buying a chain of shops likely to be divisible for a project?

A

Yes, as it might be possible to buy half the chain for half the cost and expect half the NPV

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34
Q

What is tax exhaustion?

A

When a business has negative taxable income so it cannot benefit from tax relief such as tax-allowable depreciation

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35
Q

Is avoiding tax exhaustion a benefit to the lessee?

A

Yes

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36
Q

Is attracting lease customers that may not have been otherwsie possible a benefit to the lessee?

A

No, the lessor

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37
Q

Is exploiting a low cost of capital a benefit to the lessee?

A

No, the purchaser

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38
Q

Is potential future scrap proceeds a benefit to the lessee?

A

No, the purchaser as the lessee is not entitled to scrap proceeds

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39
Q

When is depreciation higher?

A

In earlier years

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40
Q

Benefits of a shorter replacement cycle (scrap)

A

Higher scrap value

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41
Q

Benefits of a shorter replacement cycle (company)

A

Better company image and efficiency

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42
Q

What decision is the cost of capital used for?

A

Asset replacement decisions

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43
Q

When would the after tax cost of debt be used in?

A

A lease vs buy decision

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44
Q

When will the profitability index be used to?

A

Rank divisible projects

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45
Q

What is the relevant cash flow in tax allowable depreciation?

A

Tax saving

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46
Q

What do government restrictions on bank lending?

A

Represent hard capital rationing

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47
Q

Where does hard capital rationing stem from?

A

Sources external to the business that needs the capital

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48
Q

A company is considering a project that has an initial outflow followed by several years ofcash inflows, with a cash outflow in the final year

How many IRR could there be for this project

A

Up to two IRRs as project’s cash flows have two sign changes

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49
Q

The lower risk of a project can be recognised by increasing …

A

The estimates of future cash inflows from the project

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50
Q

What is independent of the risk of the project?

A

IRR and cost of the initial investment

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51
Q

The lower risk of a project can be recognised by decreasing …

A

The required rate of return of the project

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52
Q

What principles is IRR based on?

A

Discounted cash flow principles

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53
Q

Does IRR include depreciation?

A

No

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54
Q

Does IRR consider TVM?

A

Yes

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55
Q

Why is IRR not useful if liquidity is poor?

A

As timings of cash flows are hidden within the calculation

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56
Q

Can a project have a high IRR even if cash flows are weighted towards the end of the project?

A

YES

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57
Q

How is IRR calculated?

A

Using linear interpolation

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58
Q

What is the payback period?

A

The number of years that it takes a business to recover its originalinvestment from net returns

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59
Q

How is the payback period calculated?

A

Before depreciation and after cash flow

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60
Q

Are sale proceeds affected by inflation

A

No as they represent a flow of money

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61
Q

Are revenue flows subject to inflation?

A

Yes

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62
Q

What is the payback method based on?

A

Project’s cash flows

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63
Q

Benefit of a requirement for an early payback?

A

Can increase a company’s liquidity

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64
Q

What is payback method based on?

A

Cash flows

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65
Q

What is ROCE method based on?

A

Accounting profit

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66
Q

Does ROCE and payback period relate to cost of capital?

A

NO

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67
Q

What period of life does ROCE look at for a project?

A

The entire life

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68
Q

What sort of analysis/simulation is affected by changing one variable at a time?

A

Sensitivity analysis

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69
Q

What does simulation give?

A

More information about investment decision but does not point to correct result or assess likelihood of a variable changing

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70
Q

What is meant by standard deviation?

A

A measure of the variability of a distribution around its mean

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71
Q

When there’s a tighter distribution (standard deviation)?

A

The lower the standard deviation

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72
Q

When tehre;s a wider dispersion in standard deviation?

A

The riskier the situation

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73
Q

What value is the weighted average of all possible outcomes in standard deviation?

A

The expected value

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74
Q

Risks and rewards in a long-term lease?

A

All risk and rewards of ownership transfer to the lessee

75
Q

Where are asset and lease obligation in a long-term lease recorded?

A

In the SFP

76
Q

What period does the lease period cover (long-term lease)

A

Cover almost all of the leased asset’s sueful economic life

77
Q

What is lessee responsible for in a long-term lease?

A

For repairs and maintenance of the leased asset

78
Q

What years does ROCE take into account?

A

All years of operation of an investment project

79
Q

Discounted or profit based for cash flow decisions?

A

Discounted are better

80
Q

Where is the ROCE calculation compared to?

A

A ROCE-based percentage target that is unrelated ot the cost of capital

81
Q

Where is a decision under ROCE compared to?

A

A target set by management rather than to existing ROCE levels

82
Q

WHy does capital budgeting require management’s evaluation of an uncertain future?

A

When it involves acquisition of long-term assets which will produce uncertain revenues and operating costs

83
Q

When does accepting investment projects with a ROCE greater than the WACC only apply?

A

If the mix of finance for the investment project is the same as the WACC

84
Q

Years taken into account and ROCE?

A

Project’s ROCE sh ould exceed the project-specific cost of capital

85
Q

What is the minimum required rate of return for capital budgeting decisions?

A

WACC

86
Q

Does decreased tax-allowable depreciation available on the investment (increase or decrease IRR)

A

Decrease IRR

87
Q

Does decreased working capital requirements (increase or decrease IRR)

A

Increase IRR

88
Q

Does decreased cost of capital (increase or decrease IRR)

A

No effect on IRR

89
Q

Does using reducing balance, instead of straight-line depreciation for financial reporting purposes (increase or decrease IRR)

A

No effect on IRR

90
Q

Does increased contribution per unit (increase or decrease IRR)

A

Increase in IRR

91
Q

Does increased initial investment (increase or decrease IRR)

A

Decrease in IRR

92
Q

Does NPV take into account TVM?

A

Yes

93
Q

Why does NPV consider compounding?

A

Assumes that surplus cash flows are reinvested at the minimum required rate of return

94
Q

What normally affects a project’s NPV?

A

Estimated scrap value of the asset

95
Q

Net present value in investment decision-making is based on which cash flows?

A

Investing and operating. Not finance costs as they are implied in the discount rate

96
Q

What is the IRR on a project?

A

The discount rate at which the net present value of the project equals zero

97
Q

Why is wrong to assume funds can be reinvested at the computed IRR?

A

It may not be realistic if the IRR is particularly high compared to the company’s normal rate of return

98
Q

Limitations with capital rationing (divisible)

A

It cannot deal with non-divisible projects

99
Q

Limitations with capital rationing (period)

A

It cannot deal with multi-period capital rationing

100
Q

Which of the following decision-making models equates the initial investment with the present value of the future cash inflows?

A

IRR

101
Q

A possible formula for calculating the profitability index of a project?

A

PV of net cash infows / the initial investment in the project

102
Q

Does the discounted payback method takes into account cash flows for all periods?

A

No

103
Q

Does the payback method ignores all cash flows after the investment cost has been recovered?

A

Yes

104
Q

If weighted average cost of capital is greater than the internal rate of return in IRR. Is project accepted or rejected?

A

Rejected

105
Q

Is the IRR indepedent of the cost of capital?

A

No

106
Q

What happens if the cost of capital is reduced in IRR?

A

The PV of future inflows would rise; therefore, the DPP will decrease

107
Q

“A company wants to know how many years it will take before the accumulated cash flows from an investment equal the initial investment cost, without taking the time value of money into account”

Which method should company use?

A

Payback period as it ignores TVM

108
Q

How must the sensitivity of NPV to a change in sales volume be calculated?

A

Based on contribution

109
Q

How are the riskless equivalent amounts under certainty equivalent approach are discounted?

A

At the risk-free rate of return

110
Q

What is a simulation model?

A

Using random numbers to generate possible values of project variables

111
Q

What does the payback period determine?

A

Number of years that it will take for an investment’s operating cash flows to recover the cost of investment

112
Q

Does payback method consider TVM?

A

No

113
Q

What does NPV estimate?

A

The absolute change in the value of equity due to an investment

114
Q

Which investment appraisal method is most likely to result in the maximisation of shareholder wealth?

A

NPV

115
Q

Are profits and cash flows affected by accounting policies?

A

Profits are, cash flows are not

116
Q

What is a balancing allowance?

A

A tax loss on disposal

117
Q

When does a balancing allowance occur?

A

When the disposal proceeds are below the tax written down value of the asset

118
Q

The profitability index is a variation of which of the following capital budgeting models

A

Net present value

119
Q

A company should accept all positive NPV projects when?

A

It has unlimited resources for capital investment

120
Q

What is the common disadvantage of all capital budgeting models?

A

Their reliance on forecast data. Since long-term capital investment decisions are subject to greater levels of uncertainty

121
Q

What is the certainty equivalent approach?

A

Requires that riskless equivalent amounts are discounted by a riskless discount rate, that is risk-free rate of return

122
Q

What is a CAPM derived project-specific cost of capital?

A

A rate of return that reflects the systematic risk of a particular investment project

123
Q

What does IRR ignore?

A

The relative sizes of investments

124
Q

Weakness of PI (size)

A

Does not take into account size of individual projects

125
Q

Weakness of PI (returns)

A

Does not highlight the projects which are slowest in generating returns

126
Q

Weakness of PI (certainty)

A

Assumes there is complete certainty about each outcome

127
Q

When is equivalent annual cost method most conveniant to use?

A

In a period of no inflation

128
Q

Weakness of EAC method?

A

Assumes that machine can be replaced by exactly the same machine in perpetuity

129
Q

ROCE and purchasing a machine?

A

ROCE needs to be higher than target ROCE

130
Q

Can mutually exclusive projects be compared using ROCE?

A

Yes

131
Q

Does IRR ignore relative sizes of investments?

A

Yes

132
Q

Do IRR and NPV sometimes conflict?

A

Yes

133
Q

When discount rates are expected to differ over the life of the project (NPV)

A

Incorporated easily for NPV

134
Q

When discount rates are expected to differ over the life of the project (IRR)

A

Can’t be incorporated with IRR

135
Q

What happens top NPV and IRR when there are unconventional cash flow patterns?

A

There may be multiple IRRs and so NPV and IRR decisions may not be the same

136
Q

When is a project financially viable under IRR?

A

If it exceeds the cost of capital

137
Q

Main advantage of using simulations to assist the appraisal?

A

More than one variable can change at a time

138
Q

Is it possible to have a negative real discount rate to apply to the cash flow estimatesmade in current terms when making investment decisions?

A

Yes, it will happen if the rate of inflation exceedsthe money cost of capital

139
Q

Input variables and distributions are what in simulations?

A

Estimates

140
Q

What is deflation likely to increase for cash flow estimates?

A

To increase thechance of having a positive real discount rate

141
Q

What does EAC assume?

A

The same type of machine is going to be used into the foreseeable future and two machines’s capabilities are identical

142
Q

What does simulation require for probabilities?

A

Probabilities of estimates subject to risk to be known

143
Q

How do simulations deal with risk?

A

Help quantify the effects by producing a range of possible NPV and an idea of the probability distribution of those NPVs

144
Q

What does a replacement analysis model assume?

A

Replaces like with like each time it needs to replace an existing asset

145
Q

What is meant by hard rationing?

A

The limit on the amount of finance imposed by the lending institutions, so from external factors

146
Q

Does soft rationing relate to external or internal factors?

A

Internal factors

147
Q

Example of soft rationing?

A

The decision to save some cash for a later project or the unwillingness to tieup all available cash for many years

148
Q

What does linear interpolation provide for IRR?

A

An estimate and IRR is not a measure of absolute profitability

149
Q

Are reported profits affected by tax-allowable depreciation?

A

No

150
Q

Does payback period provide clear advice?

A

No

151
Q

Does payback period ignore TVM?

A

Yes

152
Q

Does payback period have a risk-focused approach in decision-making?

A

Yes

153
Q

Does ROCE incorporate TVM?

A

No and it can’t be directly compared to cost of equity

154
Q

How should riskier projects be evaluated?

A

With shorter payback periods

155
Q

What does payback period ignore?

A

Timing of cash flows within payback period

156
Q

What should amangerial reward schemes of listed companies encourage?

A

Achievement of stakeholder objectives

157
Q

Is ROCE more for profitability or shareholder wealth?

A

Profitability

158
Q

What does linking financial rewards to a target return on capital employed encourage?

A

Short-term profitability and discourage capital investment

159
Q

Benefits of a share option scheme for directors’?

A

Directors’ objectives in line with shareholders’ objectives

160
Q

Weakness of sensitivity analysis? (interdependence)

A

Ignores interdependence between project variables

161
Q

What does probability analysis assess?

A

The risk of a project

162
Q

Where does a new issue of loan notes take place?

A

In the primary market

163
Q

How is the interest rate paid on new issue of debt influenced by?

A

Market rates and risk level the investors perceive that the company has

164
Q

What are scale economies an advantage of?

A

A monopoly and oligopoly

165
Q

What are social cost or externalities an example of?

A

Economic inefficiency arising from market failure

166
Q

Why is a monopoly discouraged?

A

Because it can lead to inefficiency and excessive profits

167
Q

Why managers may reduce theamount that they are willing to invest as part of soft capital rationing? (projects)

A

Managers believe that better quality projects will shortly be available

168
Q

Why managers may reduce theamount that they are willing to invest as part of soft capital rationing? (motive)

A

The precautionary motive

169
Q

The managers have decided that they will hold on to $600,000 of the available investment cash for 3 months, as they know that another very good project will become available at that time.

Which of the following investments would be suitable to make use of this cashover this period? (Certificates)

A

Certificates of deposit

170
Q

The managers have decided that they will hold on to $600,000 of the available investment cash for 3 months, as they know that another very good project will become available at that time.

Which of the following investments would be suitable to make use of this cashover this period? (Instant)

A

Instant access bank deposit account

171
Q

Are unlisted company shares easy or difficult to sell?

A

Difficult to sell

172
Q

What is an example of imperfect information?

A

Where consumers are not well informed of their rights.

173
Q

Decreasing interest rates in order to stimulate consumer spending (fiscal or monetary policy)

A

Monetary policy

174
Q

Reducing taxation while maintaining public spending (fiscal or monetary policy)

A

Fiscal policy

175
Q

Using official foreign currency reserves to buy the domestic currency (fiscal or monetary policy)

A

Monetary policy

176
Q

Borrowing money from the capital markets and spending it on public works (fiscal or monetary policy)

A

Fiscal policy

177
Q

When should nominal after-tax WACC be used to estimate the project’s NPV?

A

When the project is affected by both tax and (different rates of) inflation

178
Q

Is a rights issue possible for an unlisted company?

A

No

179
Q

Is commercial paper short-term or long-term finance?

A

Short-term

180
Q

Are treasury bills short-term or long-term finance?

A

Short-term

181
Q

What does a balancing charge refer to?

A

Taxable gain on disposal

182
Q

When does a balancing charge refer to?

A

If the trade-in value exceeded the tax written down value

183
Q

Issue with replacing laptops too often?

A

Environmental damage

184
Q

What do tangible assets provide? (debt)

A

Good potential security for providers of debt finance

FM (Test) (8 decks)

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