Fiance Management 9

Question 1

four methods to evaluate business opportunities

Answer 1

accounting rate of return (ARR)
payback period
net present value
internal rate of return

Question 2

what is accounting rate of return

Answer 2

method takes the average accounting operating profit that an investment will generate and expresses it as a percentage of the average investment made over the life of the project

Question 3

ARR equation

Answer 3

average expected return (accounting profit)/ average capital employed (investment) *100%

Question 4

average capital employed =

Answer 4

(initial capital outlay + proceed/disposal value at the end)/2

Question 5

pros of ARR

Answer 5

simple and easy to calculate easy to understand
very similar to return on capital employed seen as key ratio by investors
projects judged by ARR are assessed internally in the same way as assessed internally

Question 6

cons of ARR

Answer 6

attaches same value to cash flows whether received in year 1 or year 5
(should ARR be calculated before or after depreciation)
doesnt consider size of investment, investment of £400 with 10% generates £4, investment of £4000, £40

Question 7

what is the payback period

Answer 7

length of time it takes for an initial investment to be repaid out of the net cash inflows from a project

Question 8

why would a business choose a project with quick payback

Answer 8

further in the future, harder to estimate cash flows, therefore reduces the risk involved in estimate and so funds are available for a new project

Question 9

pros of payback

Answer 9

minimises impact of long term risk
quick and simple to calculate and managers easily understand
avoids obvious difficulties in projecting cash flow several years from hence

Question 10

negatives of payback

Answer 10

ignores time value of money
favours short term project over long term projects
difficulties in predicting when expenditure has to be paid, especially when large negative cash flow at the end of the project is present

Question 11

how do you compound money

Answer 11

you have money value of x * (1+r)^n where r is your interest rate and n the number of years

Question 12

how do you discount money

Answer 12

you have money value of x * (1+r)^-n where r is your discount rate and n the number of periods

Question 13

what is discounting

Answer 13

when doing invesment appraisal use to take into account inflation but also the firms required rate of return

Question 14

how will a higher risk companies rate of return and discount rate be affected

Answer 14

high risk - higher rate of return required - higher discount rate

Question 15

discount rate for a business uses for investment appraisal is known as

Answer 15

its cost of capital

Question 16

how is the rate of return calculated

Answer 16

opportunity cost of other projects, risk and inflation

Question 17

how is net present value calculated

Answer 17

(investment) + discounted total cash flow

Question 18

if an investment has a positive net present value

Answer 18

it should be accepted

Question 19

benefits of NPV

Answer 19

recognises the time value of money,
recognises the difference in size of investmet
it allows for additivity - can combine NPVs of multiple dependent projects to calculate overall

Question 20

weakness of NPV

Answer 20

difficult to explain to people not formally trained in finance
provides answer in monetary terms so does not allow comparison for profitability of the project

Question 21

What is internal rate of return (IRR)

Answer 21

is the discount rate that when applied to its future cash flows will produce an NPV of zero, represents return from an investment opportunity

Question 22

which is preferred NPV or IRR

Answer 22

NPV where net cash flows are both positives and negative there can be more than one IRR
business might be concerned with value of cash

Question 23

why does all appraisal techniques consider cash flow not profit

Answer 23

as cash does not suffer from accounting allocations is a better predictor of future wealth