Capital Budgeting: Net Present Value Rule and Wealth Maximisation
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Questions and Answers

What is the required initial investment for the property development firm's proposal to build an out-of-town shopping centre?

  • £15m
  • £5m
  • £20m
  • £10m (correct)

What is the required rate of return for investors in this type of venture?

  • 15%
  • 20% (correct)
  • 25%
  • 30%

What is the decision rule for accepting or rejecting a project based on the NPV rule?

  • Reject if NPV > 0, accept if NPV < 0
  • Accept if NPV < 0, reject if NPV > 0
  • Accept if NPV = 0, reject if NPV ≠ 0
  • Accept if NPV > 0, reject if NPV < 0 (correct)

What is one of the conditions of a perfect capital market (PCM)?

<p>There are no transactions costs or other 'frictions' to accessing capital markets (C)</p> Signup and view all the answers

What is the NPV of the property development firm's proposal if the discount rate is 20%?

<p>£3.95m (A)</p> Signup and view all the answers

What is the theorem that states that companies can make their investment decisions independently of individual shareholders' consumption decisions?

<p>Fisher's separation theorem (D)</p> Signup and view all the answers

What is the assumption about taxes in the perfect capital market (PCM) framework?

<p>There are no distorting taxes (A)</p> Signup and view all the answers

What is the main implication of Fisher's separation theorem for firms?

<p>Firms should accept positive NPV projects (A)</p> Signup and view all the answers

What is the advantage of using market interest rates and returns to calculate NPVs in a PCM framework?

<p>It gives the correct trade-offs between current and future consumption (D)</p> Signup and view all the answers

What happens when impatient investors want to borrow and consume more than their income in a PCM framework?

<p>They want the firm to use a higher discount rate (C)</p> Signup and view all the answers

What is the assumption about shareholders in a PCM framework?

<p>Shareholders can sell or buy shares and other securities, or borrow and lend to get their desired consumption-savings pattern (D)</p> Signup and view all the answers

What is the implication of imperfect capital markets for firms' investment decisions?

<p>Firms should use a higher discount rate for impatient investors and a lower discount rate for patient investors (D)</p> Signup and view all the answers

What is the primary goal of a firm according to the concept of wealth maximisation?

<p>Maximise shareholder wealth (C)</p> Signup and view all the answers

What is the key difference between microeconomics and finance in relation to profit maximisation?

<p>Time dimension is implicit in microeconomics and explicit in finance (C)</p> Signup and view all the answers

What is the name of the rule that managers should use when taking decisions according to the concept of wealth maximisation?

<p>The Net Present Value (NPV) rule (A)</p> Signup and view all the answers

Who benefits when firms maximise shareholder wealth?

<p>Society as a whole (D)</p> Signup and view all the answers

What is the relationship between wealth and profit in the context of microeconomics?

<p>Wealth is the same as profit (A)</p> Signup and view all the answers

What is the outcome when firms maximise shareholder wealth?

<p>Firms respond to the needs of other stakeholders (B)</p> Signup and view all the answers

What is the NPV of the project with a required return of 15%?

<p>£533.4 (D)</p> Signup and view all the answers

What happens to the market value of the firm if the market had not previously anticipated the investment?

<p>It increases by £533.4 (C)</p> Signup and view all the answers

Why might a project be delayed?

<p>Because interest rates might fall or expected cash flows might increase (B)</p> Signup and view all the answers

What is a limitation of the conventional DCF-NPV approach?

<p>It ignores the costs of lost future opportunities (D)</p> Signup and view all the answers

Under what condition does the NPV rule maximise shareholder wealth?

<p>Under PCM, using the NPV rule (C)</p> Signup and view all the answers

What type of investment decisions have interdependencies through time?

<p>Strategic investment decisions (D)</p> Signup and view all the answers

What would be the consequence of using a cut-off of 14% if we focus on the NPV curve to the left of 15.47%?

<p>We would accept the project though NPV is negative (D)</p> Signup and view all the answers

What is the relationship between the NPV of Project A and Project B if the market required return is 12%?

<p>NPV (Project A) is less than NPV (Project B) (C)</p> Signup and view all the answers

What is the crossover rate in the NPV profile of Project A and Project B?

<p>12.5% (B)</p> Signup and view all the answers

What is the formula for calculating the Accounting Rate of Return (ARR)?

<p>ARR = (Average accounting profits / Average book value of assets) (B)</p> Signup and view all the answers

What is the decision rule based on the NPV rule if NPV is greater than zero?

<p>Accept the project (C)</p> Signup and view all the answers

What is the formula for calculating the ARR?

<p>Average profit / Average investment (B)</p> Signup and view all the answers

What is the main drawback of the ARR method?

<p>It does not consider the time value of money (B)</p> Signup and view all the answers

What is the primary drawback of the payback period method?

<p>It ignores the time value of money. (D)</p> Signup and view all the answers

What is the advantage of using the ARR method?

<p>It is easy to compute because it uses accounting information (C)</p> Signup and view all the answers

Which of the following is an advantage of the payback period method?

<p>It encourages cash generation. (C)</p> Signup and view all the answers

What is the formula for calculating the Profitability Index (PI)?

<p>PV of future cash flows / Initial investment (D)</p> Signup and view all the answers

What is the key difference between the payback period and discounted payback period methods?

<p>The discounted payback period method considers the time value of money. (D)</p> Signup and view all the answers

What is the consequence of using a short cut-off period in the payback period method?

<p>It leads to the rejection of more projects. (C)</p> Signup and view all the answers

What is the decision rule for accepting or rejecting a project based on the PI?

<p>Accept if PI &gt; 1, reject if PI &lt; 1 (C)</p> Signup and view all the answers

What is the implication of using the payback period method with a 3-year cut-off period?

<p>It is biased towards rejecting short-lived projects. (D)</p> Signup and view all the answers

What is a limitation of the ARR method?

<p>It ignores the time value of money (D)</p> Signup and view all the answers

What is the advantage of using the discounted payback period method over the payback period method?

<p>It considers the time value of money. (D)</p> Signup and view all the answers

What is the reason behind the bias against short-lived projects in the NPV method?

<p>Time value of money (D)</p> Signup and view all the answers

What is the implication of having multiple IRRs for a project?

<p>The project has multiple acceptable solutions (B)</p> Signup and view all the answers

What is the decision rule based on the IRR method?

<p>Accept if IRR &gt; required return (A)</p> Signup and view all the answers

What is the problem with mutually exclusive projects in the DCF-NPV method?

<p>They cannot be compared (A)</p> Signup and view all the answers

What is the assumption behind the DCF-NPV method?

<p>Discount rate is constant (D)</p> Signup and view all the answers

What is a limitation of the conventional DCF-NPV approach?

<p>Ignores non-conventional cash flows (A)</p> Signup and view all the answers

What is the primary reason for calculating the taxable operating profits attributable to a project?

<p>To calculate the corporation taxes associated with the project (A)</p> Signup and view all the answers

Why do we need to convert accounting profits into cash flows when implementing the NPV rule?

<p>Because depreciation is not a cash flow (B)</p> Signup and view all the answers

What is the purpose of calculating the before-tax incremental operating cash flows from a project?

<p>To deduct taxes and include net capital spending (C)</p> Signup and view all the answers

What is the relationship between capital allowances and depreciation?

<p>Capital allowances are governed by tax law, while depreciation is an accounting concept (A)</p> Signup and view all the answers

What is the purpose of including changes in working capital when calculating after-tax cash flows?

<p>To account for changes in investments in stocks or cash (D)</p> Signup and view all the answers

Why do we need to discount cash flows at the project's required rate of return when calculating the NPV?

<p>To reflect the time value of money (C)</p> Signup and view all the answers

What is the purpose of using an after-tax discount rate in capital budgeting decisions?

<p>To reflect the project's weighted average cost of capital (D)</p> Signup and view all the answers

What is the relevance of incremental cash flows in capital budgeting decisions?

<p>They represent the difference between the project's cash flows with and without the project (D)</p> Signup and view all the answers

What is the formula for calculating the project's weighted average cost of capital (WACC)?

<p>reE/V + rd(1 - Tc)D/V (D)</p> Signup and view all the answers

Why are arbitrarily allocated costs irrelevant in capital budgeting decisions?

<p>They are not incremental to the project (B)</p> Signup and view all the answers

What is the purpose of calculating the NPV of a project?

<p>To determine the project's viability and make an accept/reject decision (B)</p> Signup and view all the answers

What is the assumption behind the use of nominal discount rates in capital budgeting decisions?

<p>That the project's cash flows are nominal (D)</p> Signup and view all the answers

What percentage of large UK firms use DCF/NPV method for investment appraisal?

<p>44% (C)</p> Signup and view all the answers

Which of the following methods is used by the highest percentage of small UK firms?

<p>Payback (D)</p> Signup and view all the answers

What is the primary criticism of UK investment performance?

<p>Myopic management (C)</p> Signup and view all the answers

In the capital budgeting process, what is the purpose of the definition stage?

<p>To define the project and its alternatives (A)</p> Signup and view all the answers

What is the primary source of a positive NPV?

<p>Economic rents (B)</p> Signup and view all the answers

What is the effect of using a high discount rate for cash flows after a certain year?

<p>It decreases the present value of the cash flows (B)</p> Signup and view all the answers

What is the primary reason for using a 12-month detailed capital budget and a 2/4-year outline plan?

<p>To ensure that projects are consistent with the strategic plan (D)</p> Signup and view all the answers

What percentage of large UK firms use formal risk analysis for investment appraisal?

<p>26% (A)</p> Signup and view all the answers

What is the main limitation of using a high discount rate for cash flows?

<p>It understates the present value of the cash flows (D)</p> Signup and view all the answers

What is the relationship between a positive NPV and economic rents?

<p>A positive NPV is a necessary condition for economic rents (D)</p> Signup and view all the answers

What is the main implication of using a high discount rate for cash flows after a certain year?

<p>It decreases the NPV of the project (C)</p> Signup and view all the answers

What is the primary source of uncertainty in cash flows?

<p>Forecasting errors (D)</p> Signup and view all the answers

What is the primary objective of post-completion audits in capital budgeting?

<p>To improve the quality of future decisions (B)</p> Signup and view all the answers

Which of the following is a problem in implementing post-audits?

<p>Measuring incremental cash flows (C)</p> Signup and view all the answers

What is the primary reason for using risk-adjusted discount rates in capital budgeting?

<p>To account for project risk (B)</p> Signup and view all the answers

What is the primary implication of using historical cost accounting in capital budgeting?

<p>It overstates the project's profitability (D)</p> Signup and view all the answers

What is the primary objective of capital budgeting in practice?

<p>To evaluate projects using multiple investment appraisal criteria (B)</p> Signup and view all the answers

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