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.