Financial Modeling & Analysis Flashcards
Which of the following is a strength of the payback method?
a. It considers cash flows from all years of the project.
b. It distinguishes the sources of cash inflows.
c. It is easy to understand.
d. It considers the time value of money.
Choice “c” is correct. One of the major strengths of the payback method is that it is easy to understand. The payback method takes the total investment in a project and divides it by its annual cash flows to determine the number of years it will take to gain a return of the initial investment. The technique does not consider time value of money concepts.
If the net present value of a capital budgeting project is positive, it would indicate that the:
a. Present value index would be less than 100 percent.
b. Present value of cash outflows exceeds the present value of cash inflows.
c. Rate of return for this project is greater than the discount percentage rate used in the net present value computation.
d. Internal rate of return is equal to the discount percentage rate used in the net present value computation.
Choice “c” is correct. If the net present value of a project is positive, it would indicate that the rate of return for the project is greater than the discount percentage rate (hurdle rate) used in the net present value computation.
Under which one of the following conditions is the internal rate of return method less reliable than the net present value technique?
a. When the net present value of the project is equal to zero.
b. When both benefits and costs are included, but each is separately discounted to the present.
c. When there are several alternating periods of net cash inflows and net cash outflows.
d. When income taxes are considered in the analysis.
Choice “c” is correct. The internal rate of return (IRR) method is less reliable than the net present value (NPV) technique when there are several alternating periods of net cash inflows and net cash outflows or the amounts of cash flows differ significantly. The IRR is strictly a percentage measure of return, while the NPV is an absolute measure. Due to this difference, the timing or amount of cash flows under IRR can be misleading when compared to the NPV method.
Example:
If an investment of $50 earns $100. Then, 100/50 = 200% return
If an investment of $50,000 earns $25,000 then, 25,000/50,000 = 50% return
IRR suggests it is best to invest $50 to earn $100 and a 200% return while the NPV method will favor a larger NPV for the $50,000 investment.
When the risks of the individual components of a project’s cash flows are different, an acceptable procedure to evaluate these cash flows is to:
a. Compare the internal rate of return from each cash flow to its risk.
b. Discount each cash flow using a discount rate that reflects the degree of risk.
c. Utilize the accounting rate of return.
d. Compute the net present value of each cash flow using the firm’s cost of capital.
Choice “b” is correct. Discount rates may be adjusted to factor differences in risk into cash flow analysis. For example, a 12% discount rate may be used for the first three years of a project and a 15% discount rate for subsequent years to reflect the greater risk associated with the cash flows in the later time periods. Discount rates may also be adapted to compensate for expected inflation.
An advantage of the net present value method over the internal rate of return model in discounted cash flow analysis is that the net present value method:
a. Computes a desired rate of return for capital projects.
b. Can be used when there is no constant rate of return required for each year of the project.
c. Uses a discount rate that equates the discounted cash inflows with the outflows.
d. Uses discounted cash flows whereas the internal rate of return model does not.
Choice “b” is correct. When using the net present value method of capital budgeting, different hurdle rates can be used for each year of the project.
In evaluating a capital budget project, the use of the net present value model is generally not affected by the:
a. Initial cost of the project.
b. Method of funding the project.
c. Amount of added working capital needed for operations during the term of the project.
d. Amount of the project’s associated depreciation tax allowance.
Choice “b” is correct. The method of funding the project has no effect on the net present value model. NPV uses a hurdle rate to discount cash flows. If the NPV is positive, the project is acceptable. The method of financing the project, and the cost, are independent of the process of screening the project for acceptability.
The capital budgeting model that is generally considered the best model for long-range decision making is the:
a. Unadjusted rate of return model.
b. Payback model.
c. Accounting rate of return model.
d. Discounted cash flow model.
Choice “d” is correct. The discounted cash flow model is the best for long-term decisions. Discounted cash flow methods include NPV, IRR, and profitability index.
A project’s net present value, ignoring income tax considerations, is normally affected by the:
a. Proceeds from the sale of the asset to be replaced.
b. Amount of annual depreciation on the asset to be replaced.
c. Carrying amount of the asset to be replaced by the project.
d. Amount of annual depreciation on fixed assets used directly on the project.
Choice “a” is correct. A project’s net present value is a function of current and future cash flows, including proceeds from the sale of the old asset.
Which one of the following statements concerning cash flow determination for capital budgeting purposes is not correct?
a. Book depreciation is relevant since it affects net income.
b. Net working capital changes should be included in cash flow forecasts.
c. Tax depreciation must be considered since it affects cash payments for taxes.
d. Relevant opportunity costs should be included in cash flow forecasts.
Choice “a” is correct. Book depreciation is not relevant to cash flow determination for capital budgeting purposes because depreciation is a “non-cash” expenditure. Further, the only cash flow effect of depreciation is the tax shield, and there is no “tax shield” for book depreciation − only for tax depreciation.
The profitability index is a variation of which of the following capital budgeting models?
a. Net present value.
b. Economic value-added.
c. Internal rate of return.
d. Discounted payback.
Choice “a” is correct. The profitability index is a variation of the net present value capital budgeting model.
RULE: The profitability index is the ratio of the present value of net future cash inflows to the present value of the net initial investment. The profitability index is also referred to as the “excess present value index” or simply the “present value index.” Companies hope that this ratio will be over 1.0, which means that the present value of the inflows is greater than the present value of the outflows.
Present value of net future cash inflows/
Present value of net initial investment
=
Profitability index
A multiperiod project has a positive net present value. Which of the following statements is correct regarding its required rate of return?
a. Greater than the project’s internal rate of return.
b. Less than the project’s internal rate of return.
c. Less than the company’s weighted average cost of capital.
d. Greater than the company’s weighted average cost of capital.
Choice “b” is correct. The required rate of return must be less than the project’s internal rate of return (IRR). The IRR is the rate earned by an investment that equates to a net present value (NPV) of zero. By definition, a project with a positive NPV will have an IRR greater than the required rate of return used to compute that NPV.
Which of the following statements is true regarding the payback method?
a. It does not consider the time value of money.
b. The salvage value of old equipment is ignored in the event of equipment replacement.
c. It is the time required to recover the investment and earn a profit.
d. It is a measure of how profitable one investment project is compared to another.
Choice “a” is correct. The payback method determines the number of years that it will take for a company to recoup or be paid back for its investment. The payback method does not consider the time value of money.
A depreciation tax shield is:
a. Caused by the fact that depreciation does not affect cash flow.
b. The expense caused by depreciation.
c. An after-tax cash outflow.
d. A reduction in income taxes.
Choice “d” is correct. Whenever depreciation protects income from taxation, it is known as a depreciation tax shield.
Net present value as used in investment decision-making is stated in terms of which of the following options?
a. Cash flow.
b. Net income.
c. Earnings before interest and taxes.
d. Earnings before interest, taxes, and depreciation.
Choice “a” is correct. Net present value, like most capital budgeting techniques, focuses on cash flow. Cash flow is a pure measure of financial performance that isolates relevant information for decision making. The amount of cash the firm takes in and pays out for an investment affects the amount of cash the firm has available for operations and other activities.
Which of the following statements about investment decision models is true?
a. The payback rule ignores all cash flows after the end of the payback period.
b. The net present value model says to accept investment opportunities when their rates of return exceed the company’s incremental borrowing rate.
c. The internal rate of return rule is to accept the investment if the opportunity cost of capital is greater than the internal rate of return.
d. The discounted payback rate takes into account cash flows for all periods.
Choice “a” is correct. The payback period computation ignores cash flows after the initial investment has been recovered. The payback method focuses on liquidity and the time it takes to recover the initial investment.
Which of the following limitations is common to the calculations of payback period, discounted cash flow, internal rate of return, and net present value?
a. They require knowledge of a company’s cost of capital.
b. They require multiple trial and error calculations.
c. They rely on the forecasting of future data.
d. They do not consider the time value of money.
Choice “c” is correct. The common disadvantage of all capital budgeting models is their reliance on future data. Capital financing relates to longer periods of time that are subject to greater levels of uncertainty than other short-term budgeting and financing decisions.
Which of the following decision-making models equates the initial investment with the present value of the future cash inflows?
a. Cost-benefit ratio.
b. Payback period.
c. Internal rate of return.
d. Accounting rate of return.
Choice “c” is correct. The internal rate of return method computes the rate of return where net present value equals zero. The method equates the initial investment with the present value of the future cash inflows.
Which of the following statements is correct regarding financial decision making?
a. Opportunity cost is recorded as a normal business expense.
b. Capital budgeting is based on predictions of an uncertain future.
c. A strength of the payback method is that it is based on profitability.
d. The accounting rate of return considers the time value of money.
Choice “b” is correct. Capital budgeting involves the management’s evaluation of an uncertain future since it involves long term commitments for asset acquisition and, often involves long term financing decisions as well. Management’s decisions on the increased requirement for capital investment and the required return and the cost of capital require evaluation of an uncertain future.
What is an internal rate of return?
a. A payback period expected from an investment.
b. A time-adjusted rate of return from an investment.
c. An accounting rate of return.
d. A net present value.
Choice “b” is correct. The internal rate of return is one of many capital budgeting techniques that utilize present value concepts to value both the investment and the related cash flows. These methods are generally referred to as using a time-adjusted rate of return.
Which of the following events would decrease the internal rate of return of a proposed asset purchase?
a. Use accelerated, instead of straight-line depreciation.
b. Shorten the payback period.
c. Decrease related working capital requirements.
d. Decrease tax credits on the asset.
Rule: The internal rate of return is computed as follows:
Investment / Cash Flows = Present Value Factor
The higher the present value factor, the lower the computed rate (internal rate of return). Increases to the investment or decreases to the cash flows serve to increase the present value factor.
Choice “d” is correct. A decrease in tax credits associated with an asset would increase the initial investment. That increase would cause the present value factor to increase and would result in a decline in internal rate of return.
Which of the following changes would result in the highest present value for a series of cash flows?
a. A $100 decrease in taxes each year for four years.
b. A $100 decrease in the cash outflow each year for three years.
c. A $100 increase in disposal value at the end of four years.
d. A $100 increase in cash inflow each year for three years.
Choice “a” is correct. A decrease in taxes for each year for four years causes increases in cash flow over a greater period of time than other alternatives and, therefore, a greater present value than any of the alternatives.
Which of the following is an advantage of net present value modeling?
a. It uses accrual basis, not cash basis accounting for a project.
b. It is measured in time, not dollars.
c. It uses the accounting rate of return.
d. It accounts for compounding of returns.
Choice “d” is correct. The net present value method assumes that positive cash flows are reinvested at the hurdle rate thereby considering compounding.
A client wants to know how many years it will take before the accumulated cash flows from an investment exceed the initial investment, without taking the time value of money into account. Which of the following financial models should be used?
a. Internal rate of return.
b. Payback period.
c. Discounted payback period.
d. Net present value.
Choice “b” is correct. The payback method typically ignores the time value of money and computes the number of years it will take for cash flows to equal (pay back) the initial investment.
The calculation of depreciation is used in the determination of the net present value of an investment for which of the following reasons?
a. Depreciation increases cash flow by reducing income taxes.
b. The decline in the value of the investment should be reflected in the determination of net present value.
c. Depreciation adjusts the book value of the investment.
d. Depreciation represents a cash outflow that must be added back to net income.
Choice “a” is correct. Although depreciation is not directly relevant to net present value computations, the depreciation tax shield (reduced income taxes) results in increased cash flows from an investment and is used in the determination of net present value.
A characteristic of the payback method (before taxes) is that it:
a. Incorporates the time value of money.
b. Uses accrual accounting inflows in the numerator of the calculation.
c. Neglects total project profitability.
d. Uses the estimated expected life of the asset in the denominator of the calculation.
Choice “c” is correct. The payback method neglects total project profitability. It simply looks at the time required to recover the initial investment; subsequent cash flows are ignored.
Which of the following inputs would be most beneficial to consider when management is developing the capital budget?
a. Current product sales prices and costs.
b. Wage trends.
c. Supply/demand for the company’s products.
d. Profit center equipment requests.
Choice “d” is correct. In developing its capital budget, management would find the employee input associated with equipment requests from various profit centers most helpful. Departmental requests, appropriately justified, would provide key insights into the capital requirements of the business that are not otherwise known.
Candidate Note:
Some candidates may question why the correct answer is not choice “c.” However, the answer to the question is very clear.
The question really is what are the best (most beneficial to consider) inputs to a capital budget. The “supply and demand for the company’s products” is very indirect. The demand for the company’s products may or may not result in the company spending any capital money because the demand may be able to be satisfied with the current capital equipment. But, equipment requests, if approved, will most likely result in spending money (assuming that the money in the budget is actually spent) and thus should go into the capital budget. The supply and demand might affect future capital budgets if the demand is not able to be satisfied with the current capital equipment. But the question asks for the best inputs for presumably the current capital budget.
Various methodologies can be used to develop the fair value of common shares. The most objective methodologies are considered to be:
a. Price Sales Ratio.
b. Price Earnings (P/E) methods.
c. Discounted Cash Flow (DCF) methods.
d. Price Earnings Growth (PEG) methods.
Choice “c” is correct. Discounted Cash Flow (DCF) methods are considered the most rigorous and objective of the valuation methods.
In equipment-replacement decisions, which one of the following does not affect the decision-making process?
a. Current disposal price of the old equipment.
b. Operating costs of the new equipment.
c. Original fair market value of the old equipment.
d. Cost of the new equipment.
Choice “c” is correct. The original FMV of the old equipment is a sunk cost that does not affect equipment-replacement decisions.
What is the formula for calculating the profitability index of a project?
a. Divide the present value of the annual after-tax cash flows by the original cash invested in the project.
b. Multiply net profit margin by asset turnover.
c. Subtract actual after-tax net income from the minimum required return in dollars.
d. Divide the initial investment for the project by the net annual cash inflow.
Choice “a” is correct.
The formula for the profitability index is:
Present value of net future cash inflows/
Present value of net initial investment
=
Profitability index
The profitability index is used to rank qualifying investments.
Note: The denominator maybe the “present value of the cash outflows” as opposed to “original cash invested” if the investment is not all made at the time of the initial investment.
Which of the following statements is correct regarding the payback method as a capital budgeting technique?
a. Payback is calculated by dividing the annual cash inflows by the net investment.
b. The payback method provides the years needed to recoup the investment in a project.
c. The payback method considers the time value of money.
d. An advantage of the payback method is that it indicates if an investment will be profitable.
Choice “b” is correct.
The formula for calculating the payback period is:
Net Initial Investment / Increase in annual net after-tax cash flow
The payback method computes the years needed to recoup an investment. The net cash inflows are generally assumed to be constant for each period during the life of the project. It is often used for risky investments, since it shows how quickly the initial investment will be recouped.
Which of the following is a limitation of the profitability index?
a. It ignores the time value of money.
b. It uses free cash flows.
c. It requires detailed long-term forecasts of the project’s cash flows.
d. It is inconsistent with the goal of shareholder wealth maximization.
Choice “c” is correct. The profitability index is the ratio of the present value of net future cash inflows to the present value of the net initial investment. The profitability ratio requires detailed long-term forecasts of project’s cash flows. For longer term projects, cash flow projections might be either unavailable or unreliable.
Which of the following metrics equates the present value of a project’s expected cash inflows to the present value of the project’s expected cash outflows?
a. Internal rate of return.
b. Net present value.
c. Economic value-added.
d. Return on assets.
Choice “a” is correct. The internal rate of return (IRR) focuses the decision maker on the discount rate at which the present value of a project’s cash inflows equals the present value of the cash outflows. The IRR is the rate used to arrive at a net present value of zero.
Egan Co. owns land that could be developed in the future. Egan estimates it can sell the land for $1,200,000, net of all selling costs. If it is not sold, Egan will continue with its plans to develop the land. As Egan evaluates its options for development or sale of the property, what type of cost would the potential selling price represent in Egan’s decision?
a. Sunk.
b. Future.
c. Variable.
d. Opportunity.
Choice “d” is correct. Opportunity cost is the potential benefit lost by selecting a particular course of action. If the land is developed rather than sold, the potential selling price foregone is an opportunity cost.
The ABC Company is trying to decide between keeping an existing machine and replacing it with a new machine. The old machine was purchased just two years ago for $50,000 and had an expected life of 10 years. It now costs $1,000 a month for maintenance and repairs due to a mechanical problem. A new machine is being considered to replace it at a cost of $60,000. The new machine is more efficient and it will only cost $200 a month for maintenance and repairs. The new machine has an expected life of 10 years. In deciding to replace the old machine, which of the following factors, ignoring income taxes, should ABC not consider?
a. The estimated useful life of the new machine.
b. The original cost of the old machine.
c. The lower maintenance cost on the new machine.
d. Any estimated salvage value on the old machine.
Choice “b” is correct. The original cost of the old machine is a sunk cost that will not change regardless of the decision that is made. Sunk costs are not relevant and would not be considered by ABC as part of their decision to keep or replace the current machine.
In making capital budgeting decisions, management considers factors that are far broader than costs alone. Which one of the following factors is least likely to be considered a non-financial or qualitative factor?
a. Reduction in new product development time.
b. Improved product delivery and service.
c. Less scrap and rework.
d. Increase in manufacturing flexibility.
Choice “c” is correct. Less scrap and rework is least likely to be considered a non-financial or qualitative factor because it is the most easily quantifiable of the selections and therefore most likely to be included as a relevant avoidable cost in the capital budgeting analysis.
In evaluating costs for decision-making, a company would always consider each of the following as relevant, except:
a. Incremental costs.
b. Variable costs.
c. Avoidable costs.
d. Differential costs.
Choice “b” is correct. Variable costs change with the level of output but may not change purely in response to different selected alternatives. Although variable costs are frequently relevant, they are not always relevant. Relevant costs are those costs that will change in response to the selection of different courses of action.
The discount rate is determined in advance for which of the following capital budgeting techniques?
a. Accounting rate of return.
b. Payback.
c. Net present value.
d. Internal rate of return.
Choice “c” is correct. The discount or hurdle rate is determined in advance for computations of net present value. Project cash flows are discounted based upon a predetermined rate and compared to the investment in the project to arrive at a positive or negative net present value. Advance determination of management’s required return is integral to the development and evaluation of net present value.
Which of the following phrases defines the internal rate of return on a project?
a. The weighted-average cost of capital used to finance the project.
b. The number of years it takes to recover the investment.
c. The discount rate at which the net present value of the project equals zero.
d. The discount rate at which the net present value of the project equals one.
Choice “c” is correct. Internal rate of return is defined as the discount rate at which the net present value of the project equals zero.
Management at MDK Corp. is deciding whether to replace a delivery van. A new delivery van costing $40,000 can be purchased to replace the existing delivery van, which cost the company $30,000 and has accumulated depreciation of $20,000. An employee of MDK has offered $12,000 for the old delivery van. Ignoring income taxes, which of the following correctly states relevant costs when making the decision whether to replace the delivery vehicle?
a. Purchase price of new van, disposal price of old van, and gain on sale of old van.
b. Purchase price of new van, disposal price of old van.
c. Purchase price of new van, purchase price of old van, and gain on sale of old van.
d. Purchase price of new van, purchase price of old van, accumulated depreciation of old van, gain on sale of old van, disposal price of old van.
Choice “b” is correct. Costs are deemed to be relevant if they change as a result of selecting different alternatives. The decision to replace the old van will result in the company paying the purchase price of the new van and receiving the disposal price of the old van. Neither the purchase price of the new van nor the disposal price of the old van will be incurred if the van is not replaced. Ignoring income taxes, the book value of the old van and any potential gain is not relevant.
When estimating cash flow for use in capital budgeting, depreciation is:
a. Excluded for all purposes in the computation.
b. Utilized to estimate the salvage value of an investment.
c. Included as a cash or other cost.
d. Utilized in determining the tax costs or benefit.
Choice “d” is correct. Depreciation is used in capital budgeting for determining tax costs or benefits of a decision. Asset value is determined based on the present value of its future after-tax cash flows. After-tax cash flows are the most relevant to cash flow decisions and consider the tax impact of depreciation deductions.
Which of the following methods should be used if capital rationing needs to be considered when comparing capital projects?
a. Net present value.
b. Profitability index.
c. Internal rate of return.
d. Return on investment.
Choice “b” is correct. The profitability index is used for capital rationing. The profitability index is the ratio of the present value of net future cash inflows to the present value of the net initial investment. Ranking and selection of investments is made by listing projects in descending order. Limited capital resources are applied in the order of the index until resources are either exhausted or the investment required by the next project exceeds remaining resources.
