Investment Appraisal

Question 1

Money discount rate?

Answer 1

(1 + money rate) = (1 + real rate) × (1 + general inflation rate)

Question 2

When considering risk in project appraisal, what is the main advantage of using simulations to assist the appraisal?

Answer 2

More than one variable can change at a time.

Question 3

ROCE (Accounting rate of return)

Answer 3

Average annual profit before interest and tax/Initial capital costs x 100%

Question 4

Payback period?

Answer 4

Initial payment/Annual cash flow

Question 5

Strengths of payback period?

Answer 5

1. Simple to calculate and understand
2. It favours quick return
3. Helps company grow and minimizes risk

Question 6

Limitations of payback period?

Answer 6

1. Does not ensure that shareholder wealth is maximised.
2. Ignore timings of cash flows
3. Ignores returns after the payback period
4. It is subjective - no definitive investment decision.

Question 7

Which of the following statements is/are true regarding sensitivity?

Answer 7

The sensitivity of NPV to a change in sales volume can be calculated as NPV divided by the present value of future sales contribution after tax.

Question 8

Using the average investment method and assuming operating cash flows of $729,000 per year, what is the return on capital employed of the investment project?

Answer 8

Annual operating cash flow = $729,000

Annual depreciation = 1,800,000/4 = $450,000

Annual profit = 729,000 - 450,000 = $279,000

Average investment = 1,800,000/2 = $900,000

ROCE = 279,000/900,000 x 100 = 31%

Question 9

Which of the following statements relating to debt finance is correct?

Answer 9

A new issue of loan notes by Link Co will take place in the primary market

Question 10

Which of the following statements relating to competition policy is/are correct?

Answer 10

Scale economies are an advantage of monopoly and oligopoly

Social costs or externalities are an example of economic inefficiency arising from market failure

Monopoly is discouraged because it can lead to inefficiency and excessive profits

Question 11

Limitations of expected values

Answer 11

Average unlikely to be achieved

Averages not useful for one off decisions

EVs hide risk levels

If price falls by more than 19.9%, project is not viable

Cause for concern if lower price becomes most likely

Question 12

ROCE Strengths

Answer 12

Expressed in term familiar to managers - profit and capital employed.

Easy to calculate the likely effect of the project on the reported profit and loss.

Businesses are judged on return on investment measures by financial markets.

Question 13

ROCE Limitations

Answer 13

Does not ensure that shareholder wealth is maximised.

Figures easily manipulated.

Ignores the actual/incremental cash flows associated with the project.

Question 14

Payback period strengths?

Answer 14

Simple to calculate
It favours quick return
Helps company grow
Minimises risk

Question 15

Payback period limitations?

Answer 15

Does not ensure that shareholder wealth is maxmised
Ignores timing of cash flows
Ignores returns after the payback period.

Question 16

Internal rate of return advantages?

Answer 16

Does consider the time value of money
A percentage is easily understood
Uses cash flow
It considers the whole life of the project.
It does not need the cost of capital to be known

Question 17

Internal rate of return limitations?

Answer 17

It is not a measure of absolute profitability

It is fairly complicated to calculate

Interpolation only provides an estimate

Non-conventional cash flows may give rise to multiple IRRs

Question 18

NPV Strengths?

Answer 18

It considers the time value of money
It is an absolute measure of return
It is based on cash flows not profits
It considers the whole life the project
It should lead to the maxmisation of sahreholders wealth

Question 19

NPV limitations

Answer 19

Not easily explained to managers
Requires that the cost of capital is known

Question 20

Hard capital rationing

Answer 20

An absolute limit on the amount of finance available imposed by the lending institutions.
Industry wide factors limiting funds
Company specific factors

Question 21

Soft capital rationing

Answer 21

A company may impose its own rationing on capital e.g. from a desire to control the rate of expansion.

Question 22

Sensitivity analysis?

Answer 22

The maximum possible change is often expressed as a percentage.

Sensitivity margin = NPV/PV of flow under consideration x 100%