Unit 10 Capital Investment Appraisal (End-of-unit assessment)

Transcription

1 Unit 10 Capital Investment Appraisal (End-of-unit assessment) 1. Which of the following investment proposals is most likely to be initiated by non-financial factors? a) to set up health club for the staff b) to start a research project for launching new products c) to acquire a subsidiary for expansion d) to close a non-profitable branch a) Correct. Intend to improve loyalty of staff b) Incorrect. Intend to increase business volume c) Incorrect. Intend to expand business d) Incorrect. Intend to divest and cut losses 2. Which of the following does not employ discounted cash flow approach to rank projects? a) Internal rate of return b) Net present value c) Discounted payback period d) Average rate of return a) Incorrect use discounted cash flow approach b) Incorrect use discounted cash flow approach c) Incorrect use discounted cash flow approach d) Correct use of accounting figures and fail to take into account the time value of money 3. The initial investment cost of a project is $1,000 and the expected cash flows generated from the project are $200 for years 1 and 2, and $150 in each of the years 3 to 8. If the cost of capital is 10%, what is the discounted payback period for the project? a) 6 years b) 6.5 years c) 7 years d) the investment will not pay back on a discount basis over the life of the project 1

2 a) Incorrect. Wrong calculation b) Incorrect. Wrong calculation c) Incorrect. Wrong calculation d) Correct. See calculation below Working Calculate discounted cash flow (DCF) Year Cash inflows / Discount Present value (outflows) factor $ $ Yr 0 Initial investment (1,000) 1 (1,000) Yr /(1+10%) Yr /(1+10%) Yr /(1+10%) Yr /(1+10%) Yr /(1+10%) Yr /(1+10%) Yr /(1+10%) Yr /(1+10%) Total DCF (112.86) 4. When using IRR method to evaluate mutually exclusive projects A and B - A having an internal rate of return of 12%; B having an internal rate of return of 13%. The cost of capital is 11%. Which of the following is true? a) both A and B are accepted b) only A is accepted c) only B is accepted d) both A and B are rejected a) Incorrect. A and B are mutually exclusive. b) Incorrect. A has lower IRR than B. c) Correct. B has higher IRR than A and also the cost of capital d) Incorrect. A and B have higher IRRs than the cost of capital 2

3 Use the following to answer Questions 5 to 7. Robinson BBQ is considering to purchase a chicken wing grilling machine to start a new line of retail business. Two types of grilling machines A and B are available in the market and the following estimates are made: BBQ Machine Cost Useful life Disposal value Grill A $40,000 4 years $4,000 Grill B $50,000 4 years $2,000 Estimated profits before depreciation generated by these two machines are as follows: Year Grill A Grill B Year 1 $12,000 $20,000 Year 2 $20,000 $26,000 Year 3 $23,000 $27,000 Year 4 $25,000 $27,000 Robinson has obtained a bank loan to buy a machine at 10% interest per annum. 5. The Accounting Rate of Return (ARR) of Grill A and Grill B based on average net book value at year-end method are and. a) 67% and 64% b) 63% and 65% c) 50% and 50% d) 55% and 52% a) Incorrect. Failed to consider the disposal value b) Correct. See calculation below c) Incorrect. Wrongly applied profit before depreciation over the average book value d) Incorrect. Wrongly applied the average capital method instead of average net book value Working - Calculate accounting rate of return (ARR) Yr 1 Yr 2 Yr 3 Yr 4 Average Grill A $ $ $ $ $ Profit before depreciation 12,000 20,000 23,000 25,000 20,000 3

4 Depreciation 9,000 9,000 9,000 9,000 9,000 Profit after depreciation 3,000 11,000 14,000 16,000 11,000 Cost 40,000 40,000 40,000 40,000 40,000 Accumulated depreciation 9,000 18,000 27,000 36,000 22,500 Net book value 31,000 22,000 13,000 4,000 17,500 ARR of Grill A = $11,000 / $17,500 x 100% = 62.86% Yr 1 Yr 2 Yr 3 Yr 4 Average Grill B $ $ $ $ $ Profit before depreciation 20,000 26,000 27,000 27,000 25,000 Depreciation 12,000 12,000 12,000 12,000 12,000 Profit after depreciation 8,000 14,000 15,000 15,000 13,000 Cost 50,000 50,000 50,000 50,000 50,000 Accumulated depreciation 12,000 24,000 36,000 48,000 30,000 Net book value 38,000 26,000 14,000 2,000 20,000 ARR of Grill B = $13,000 / $20,000 x 100% = 65% 6. The Net Present Value (NPV) of Grill A and Grill B based on average net book value at year-end method are and. a) $28,194 and $34,324 b) $22,793 and $27,770 c) $21,793 and $28,396 d) $24,558 and $29,779 a) Incorrect. Wrongly discounted the initial investment by 10%. b) Incorrect. Wrongly applied the discounting formula as multipliers of 90%. 4

5 c) Incorrect. Failed to take into account the disposal value. d) Correct. See calculation below Working Net present value (NPV) Cash inflows / Discount Present value (outflows) factor Grill A $ $ Yr 0 Purchase grill (40,000) 1 (40,000) Yr 1 12,000 1/(1+10%) Yr 2 20,000 1/(1+10%) 2 16,529 Yr 3 23,000 1/(1+10%) 3 17,280 Yr 4 25,000 1/(1+10%) 4 17,075 Yr 4 Disposal 4,000 1/(1+10%) 4 2,765 Total NPV 24,558 Cash inflows / Discount Present value (outflows) factor Grill B $ $ Yr 0 Initial investment (50,000) 1 (50,000) Yr 1 20,000 1/(1+10%) 1 18,182 Yr 2 26,000 1/(1+10%) 2 21,488 Yr 3 27,000 1/(1+10%) 3 20,285 Yr 4 27,000 1/(1+10%) Yr 4 Disposal 2,000 1/(1+10%) 4 1,383 Total NPV 29, Base on the results of questions 5 and 6, which grill should be selected under a mutually exclusive decision? a) Grill A b) Grill B c) Both Grill A and Grill B d) None of the answers is correct a) Incorrect. Wrong concept. b) Correct. Both ARR and NPV methods reflect that Grill B (65%, $29,779) is a better purchase than Grill A (63%, $24,558). 5

6 c) Incorrect. Wrong interpretation of mutually exclusive projects. d) Incorrect. Wrong concept 8. An insurance company agrees to pay you $3,310 at the end of 20 years if you pay premiums of $100 per year at the beginning of each year for 20 years. Find the internal rate of return to the nearest whole percentage point. a) 9% b) 7% c) 5% d) 3% a) Incorrect. See calculation below. b) Incorrect. See calculation below. c) Correct. See calculation below. d) Incorrect. See calculation below. Working - Calculate internal rate of return (IRR) Future value (FV) = $3,310 Periodic payment (PMT) = $100 Number of years = 20 years FV = PMT x FVIFA (i, 20) FVIFA (i, 20) = FV / PMT = $3,310 / $100 = 33.1 By looking at the FVIFA (i, n) Table in Appendix 2, FVIFA (5%, 20) = IRR = 5% 9. A company is considering two projects, A and B. The IRR of A is 16% and the IRR of B is 17%. The company requires a minimum return of 18%. Advise whether the project(s) should be taken. a) Project A should be taken. b) Project B should be taken. c) Both projects should be taken. d) Both projects should be rejected. a) Incorrect. IRR of A is lower than minimum required return 18%. 6

7 b) Incorrect. IRR of A is lower than minimum required return18%. c) Incorrect. Both IRR of A and B are lower than minimum required return 18%. d) Correct. Both IRR of A and B are lower than minimum required return 18%. 10. When evaluating mutually exclusive projects, especially those that differ in scale and / or timing, which of the following capital investment appraisal method should be used? a) Net present value b) Payback period c) Discounted payback period d) Internal rate of return a) Correct. The potential ranking conflict situations can be solved. b) Incorrect. Do not take into account of time value of money. c) Incorrect. Do not take into account of cash inflows after payback period. d) Incorrect. Ignore the effect of ranking conflict that may exist by discounting with different cost of capital. 7

8 Appendix 1 TABLE 1 Present Value of $1 Due at the End of n Periods (PVIF i, n ) PERIOD 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% !

9 Appendix 2 TABLE 2 Future Value of an Annuity of $1 per Period for ii Periods (FV1FA i, n ) NO. OF PERIODS 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% ! , , , , , , , , , ! ,