76 Questions
What is the required initial investment for the property development firm's proposal to build an out-of-town shopping centre?
£10m
What is the required rate of return for investors in this type of venture?
20%
What is the decision rule for accepting or rejecting a project based on the NPV rule?
Accept if NPV > 0, reject if NPV < 0
What is one of the conditions of a perfect capital market (PCM)?
There are no transactions costs or other 'frictions' to accessing capital markets
What is the NPV of the property development firm's proposal if the discount rate is 20%?
£3.95m
What is the theorem that states that companies can make their investment decisions independently of individual shareholders' consumption decisions?
Fisher's separation theorem
What is the assumption about taxes in the perfect capital market (PCM) framework?
There are no distorting taxes
What is the main implication of Fisher's separation theorem for firms?
Firms should accept positive NPV projects
What is the advantage of using market interest rates and returns to calculate NPVs in a PCM framework?
It gives the correct trade-offs between current and future consumption
What happens when impatient investors want to borrow and consume more than their income in a PCM framework?
They want the firm to use a higher discount rate
What is the assumption about shareholders in a PCM framework?
Shareholders can sell or buy shares and other securities, or borrow and lend to get their desired consumption-savings pattern
What is the implication of imperfect capital markets for firms' investment decisions?
Firms should use a higher discount rate for impatient investors and a lower discount rate for patient investors
What is the primary goal of a firm according to the concept of wealth maximisation?
Maximise shareholder wealth
What is the key difference between microeconomics and finance in relation to profit maximisation?
Time dimension is implicit in microeconomics and explicit in finance
What is the name of the rule that managers should use when taking decisions according to the concept of wealth maximisation?
The Net Present Value (NPV) rule
Who benefits when firms maximise shareholder wealth?
Society as a whole
What is the relationship between wealth and profit in the context of microeconomics?
Wealth is the same as profit
What is the outcome when firms maximise shareholder wealth?
Firms respond to the needs of other stakeholders
What is the NPV of the project with a required return of 15%?
£533.4
What happens to the market value of the firm if the market had not previously anticipated the investment?
It increases by £533.4
Why might a project be delayed?
Because interest rates might fall or expected cash flows might increase
What is a limitation of the conventional DCF-NPV approach?
It ignores the costs of lost future opportunities
Under what condition does the NPV rule maximise shareholder wealth?
Under PCM, using the NPV rule
What type of investment decisions have interdependencies through time?
Strategic investment decisions
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%?
We would accept the project though NPV is negative
What is the relationship between the NPV of Project A and Project B if the market required return is 12%?
NPV (Project A) is less than NPV (Project B)
What is the crossover rate in the NPV profile of Project A and Project B?
12.5%
What is the formula for calculating the Accounting Rate of Return (ARR)?
ARR = (Average accounting profits / Average book value of assets)
What is the decision rule based on the NPV rule if NPV is greater than zero?
Accept the project
What is the formula for calculating the ARR?
Average profit / Average investment
What is the main drawback of the ARR method?
It does not consider the time value of money
What is the primary drawback of the payback period method?
It ignores the time value of money.
What is the advantage of using the ARR method?
It is easy to compute because it uses accounting information
Which of the following is an advantage of the payback period method?
It encourages cash generation.
What is the formula for calculating the Profitability Index (PI)?
PV of future cash flows / Initial investment
What is the key difference between the payback period and discounted payback period methods?
The discounted payback period method considers the time value of money.
What is the consequence of using a short cut-off period in the payback period method?
It leads to the rejection of more projects.
What is the decision rule for accepting or rejecting a project based on the PI?
Accept if PI > 1, reject if PI < 1
What is the implication of using the payback period method with a 3-year cut-off period?
It is biased towards rejecting short-lived projects.
What is a limitation of the ARR method?
It ignores the time value of money
What is the advantage of using the discounted payback period method over the payback period method?
It considers the time value of money.
What is the reason behind the bias against short-lived projects in the NPV method?
Time value of money
What is the implication of having multiple IRRs for a project?
The project has multiple acceptable solutions
What is the decision rule based on the IRR method?
Accept if IRR > required return
What is the problem with mutually exclusive projects in the DCF-NPV method?
They cannot be compared
What is the assumption behind the DCF-NPV method?
Discount rate is constant
What is a limitation of the conventional DCF-NPV approach?
Ignores non-conventional cash flows
What is the primary reason for calculating the taxable operating profits attributable to a project?
To calculate the corporation taxes associated with the project
Why do we need to convert accounting profits into cash flows when implementing the NPV rule?
Because depreciation is not a cash flow
What is the purpose of calculating the before-tax incremental operating cash flows from a project?
To deduct taxes and include net capital spending
What is the relationship between capital allowances and depreciation?
Capital allowances are governed by tax law, while depreciation is an accounting concept
What is the purpose of including changes in working capital when calculating after-tax cash flows?
To account for changes in investments in stocks or cash
Why do we need to discount cash flows at the project's required rate of return when calculating the NPV?
To reflect the time value of money
What is the purpose of using an after-tax discount rate in capital budgeting decisions?
To reflect the project's weighted average cost of capital
What is the relevance of incremental cash flows in capital budgeting decisions?
They represent the difference between the project's cash flows with and without the project
What is the formula for calculating the project's weighted average cost of capital (WACC)?
reE/V + rd(1 - Tc)D/V
Why are arbitrarily allocated costs irrelevant in capital budgeting decisions?
They are not incremental to the project
What is the purpose of calculating the NPV of a project?
To determine the project's viability and make an accept/reject decision
What is the assumption behind the use of nominal discount rates in capital budgeting decisions?
That the project's cash flows are nominal
What percentage of large UK firms use DCF/NPV method for investment appraisal?
44%
Which of the following methods is used by the highest percentage of small UK firms?
Payback
What is the primary criticism of UK investment performance?
Myopic management
In the capital budgeting process, what is the purpose of the definition stage?
To define the project and its alternatives
What is the primary source of a positive NPV?
Economic rents
What is the effect of using a high discount rate for cash flows after a certain year?
It decreases the present value of the cash flows
What is the primary reason for using a 12-month detailed capital budget and a 2/4-year outline plan?
To ensure that projects are consistent with the strategic plan
What percentage of large UK firms use formal risk analysis for investment appraisal?
26%
What is the main limitation of using a high discount rate for cash flows?
It understates the present value of the cash flows
What is the relationship between a positive NPV and economic rents?
A positive NPV is a necessary condition for economic rents
What is the main implication of using a high discount rate for cash flows after a certain year?
It decreases the NPV of the project
What is the primary source of uncertainty in cash flows?
Forecasting errors
What is the primary objective of post-completion audits in capital budgeting?
To improve the quality of future decisions
Which of the following is a problem in implementing post-audits?
Measuring incremental cash flows
What is the primary reason for using risk-adjusted discount rates in capital budgeting?
To account for project risk
What is the primary implication of using historical cost accounting in capital budgeting?
It overstates the project's profitability
What is the primary objective of capital budgeting in practice?
To evaluate projects using multiple investment appraisal criteria
Test your understanding of the firm's capital budgeting decision, including the net present value rule, separation theorem, and alternative rules such as payback, ARR, IRR, and PI. Implementing the NPV rule and planning and controlling capital expenditure are also covered.
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