Module 3

Question 1

IRR formula (internal rate of return)

Answer 1

IRR = A + ((B-A) x Na/Na-Nb))

A- lower discount rate
B- higher discount rate
Na - NPV at lower rate
Nb - NPV at higher rate

Question 2

ARR calculation?

Answer 2

ARR = average annual profits/ average capital investment. X 100

AAP/ACI x 100

Accounting rate of return

Question 3

AAP calculation

Answer 3

Annual cash flows generate from investment - depreciation / number of years of investment

Average annual profit

Question 4

ACI calculation

Answer 4

1/2 (investment + residual value)

Average capital investment

Question 5

What is market capitalisation?

Answer 5

The value of the business

Question 6

How is market capitalisation calculated?

Answer 6

Share price x number of shares

Question 7

What are examples of positive purpose expenditure?

Answer 7

Expansion
Replacement
New subsidiary, JV
R and D
License or payment for know-how
Costs of tech
Losses in learning to establish reputation 
Major contracts

Question 8

What are examples of negative purpose expenditure?

Answer 8

Redundancy 
Plant closure costs, severance 
Plant mothballing expenses
Compensation payment 
Losses form market withdrawal

Question 9

What does mutually exclusive mean?

Answer 9

One to another (not both)

Choice of one precludes the choice of the other

Question 10

What does Independent mean?

Answer 10

May chose any single project or a combination

Question 11

What does dependent or contingent mean?

Answer 11

A project may depend on the outcome of another project

Question 12

What does the value additivity principle mean?

Answer 12

If the value to the firm of separate projects accepted by management is known, then simple addition will give the overall value

Question 13

Capital investment appraisal criteria

Answer 13

All cash flows considered (remove deprecation as not cash flow)
Appropriate rate
Value additivity
Selection must result in choice which maximises shareholder wealth

Question 14

What is the superior appraisal technique?

Answer 14

Net present value

Question 15

What are the 4 methods of investment appraisal?

Answer 15

Payback
Accounting rate of return
Net present value
Internal rate of return

Question 16

What does payback represent?

Answer 16

Time taken by a project to recover the initial capital outlay

Best used as an initial screening tool

Question 17

What are the advantages of payback?

Answer 17

Simplicity involved

Length of time that the capital is at risk is known

Question 18

What are the disadvantages of payback?

Answer 18

The time value of money is not taken into account

Cash flows after the payback period are ignored

Question 19

What does ARR express?

Answer 19

The profits from a project as a percentage of the capital cost

Question 20

If no information is given on depreciation assume what?

Answer 20

Straight line basis p

Question 21

What are he advantages if ARR?

Answer 21

One of the simpler and more easily understood techniques

Question 22

What are the disadvantages of ARR?

Answer 22

Decision to invest or not remains subjective since companies set their target ARR subjectively

Not reliable as:
Ignores life of project
Doesn’t account for time value of money
Doesn’t measure absolute gain in wealth of shareholders

Question 23

What is net present value?

Answer 23

Inflows - outflows

To be acceptable, the project must exhibit a positive net present value (inflows>outflows)

Question 24

What is the impact of tax on NPV calculation?

Answer 24

Only consider on revenue cash flows (not on initial capital investment)

After tax cash flows calculated cash flow x (1-t)

Ignore tax on outflows
Ignore if q doesn’t mention tax

Question 25

What are the advantages of NPV?

Answer 25

Relatively easily to calculate despite complexity of time value

Discount rate ensures exactly measures the increase in shareholders wealth

Question 26

Disadvantages of NPV?

Answer 26

Using firms overall cost of capital (WACC) as d.f is only okay if the potential project has the same risk exposure as the company

Difficulty in predicting future cash flows accurately
Difficulty non-financial accountants may have in understanding

Question 27

What is the internal rate of return? IRR%

Answer 27

The rate of return that brings the net present value of all inflows and outflows to zero

Question 28

If IRR > cost of capital

Answer 28

We will increase shareholder wealth and the project should be accepted

Question 29

If IRR < cost of capital

Answer 29

We will not increase shareholder wealth and the project should be rejected

Question 30

The IRR method is also known as what?

Answer 30

The yield method