Finance (Question 3)

Question 1

Cash Flow Forecast

Answer 1

Question 2

Define ‘Payback Period’

Answer 2

A simple and unsophisticated investment appraisal technique that involves estimating the length of time it will take for cash inflows to cover the initial investment outflow.

Question 3

Define ‘Net Present Value’

Answer 3

The aggregate of a set of cash inflows and outflows forecast to take place at future dates, discounted to present value. Present value is the discounted value at the present time of cash flow expected to arise in the future.

Question 4

Define ‘Break-Even Point’

Answer 4

Where neither a profit or loss is made - where Total Costs = Total Revenue

Question 5

Define ‘Margin of Safety’

Answer 5

The excess number of units sold over the break-even point

Question 6

Define ‘Contribution’

Answer 6

The amount that remains after deducting variable costs from sales revenue

Question 7

Calculate ‘Payback Period’

Answer 7

Question 8

Calculate ‘Net Present Value’

Answer 8

Question 9

Calculate ‘Break-Even Point’

Answer 9

Question 10

Calculate ‘Margin of Safety’

Answer 10

Question 11

Calculate ‘Contribution’

Answer 11

Contribution (per unit) = Sales Price Per Unit - Variable Cost Per Unit

Contribution = Sales Revenue - Variable Cost

Question 12

Explain the importance of ‘Break-Even Point’

Answer 12

Break-even point is important for a business- need to know how many units you need to sell to be profitable.

If just starting or expanding to a new product line particularly important.

If a business expect to be able to produce or sell the required number of units then should not proceed.

Question 13

Explain the importance of ‘Margin of Safety’

Answer 13

Margin of safety give the directors confidence that even if sales or production falls slightly a profit can still be maintained.

This gives the owners of the business an indication of how sensitive to a change in sales the profit is. How likely it is to slip below break-even point. Comfort as to continued profitability.

Question 14

Explain the importance of ‘Contribution’ in Short-Term Decision Making

Answer 14

When making a decision in the short-term and a company has surplus capacity, if a project makes a positive contribution it will help pay the fixed costs of the business and help generate profits. A project looked at in isolation with fixed costs allocated to it may be unprofitable but as those fixed costs are to be paid in full by the business regardless of whether a project is accepted. It is better to consider each project /division in terms of contribution and then deduct fixed costs in total. This takes the arbitrary allocation of fixed costs out of decision making.

Question 15

Consider advantages and limitation to the Payback Period and Net Present Value

Answer 15

Both Payback & NPV rely on estimates of future cash flows which may not be reliable especially the further into the future estimates are made. Payback is quick and simple, it does give weight to earlier cash flows but ignores the time value of money. The payback period does not take into account time value of money but effectively does give more weight to earlier cash flows. NPV uses all cash flows and takes into account time value of money. But it is only as reliable as estimates. Does not state what actual return on capital is. NPV is more complicated.

Question 16

Explain why Investment Appraisal Techniques apply Discount Factors

Answer 16

Discounting at the cost of capital to a particular company or project to bring cash flows to their net present value allows factors such as risk, opportunity cost and the time value of money to be taken into consideration. Recognises £1 today is worth more than £1 tomorrow in terms of spending power. Compensates for the fact that a project carries a risk and so must ensure the future cash flows not only compensates for deferred consumption but that its return is put at risk. Opportunity cost. If a company has an amount of money to invest there will be alternative options’ The project chosen should generate a return equal to or greater than the next best alternative project. The discount factor takes this into account

Question 17

Define ‘Accounting Rate of Return’

Answer 17

The Accounting Rate of Return method uses projections of accounting profit to calculate the expected rate of return on capital invested into an asset or project.

Question 18

Calculate ‘Accounting Rate of Return’

Answer 18