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FM (Test) > D Section C Theory > Flashcards

D Section C Theory Flashcards

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1
Q

When are the additional fixed production overheads relevant?

A

When they are expected to increase

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2
Q

How are direct labour costs treated in relevant costing?

A

Allowable deduction in calculating taxable profit

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3
Q

Examples of a new cash flow arising as the result of an investment decision?

A

Purchase of raw materials for a new production process

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4
Q

Are interest payment relevant or not relevant in costing?

A

Not relevant

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5
Q

Example of a sunk cost (market research)

A

Market research undertaken to determine whether a new product will sell is often undertaken prior to the investment decision on whether to proceed with production of the new product

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6
Q

When should an NPV be accepted?

A

When it is positive

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7
Q

How should evaluation period for investment appraisal be considered?

A

The investment appraisal would be more accurate if the cash flows from further years of operation were considered

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8
Q

How should assumed terminal value for investment appraisal be considered?

A

Calculate a final-year terminal value based on the expected value of future sales

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9
Q

How should discounted payback method for investment appraisal be considered?

A

Should rely on the NPV investment appraisal method instead

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10
Q

How can share option schemes help managers to achieve stakeholder objectives?

A

Removes the agency problem as managers are encouraged to achieve stakeholder objectives by bringing their own objectives more in line with the objectives of stakeholders

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11
Q

How can performance-related pay help managers to achieve stakeholder objectives?

A

Part of the remuneration of managers can be made conditional upon their achieving specified performance targets, so that achieving these performance targets assists in achieving stakeholder objectives.

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12
Q

How can corporate governance codes of best practice help managers to achieve stakeholder objectives?

A

Codes of best practice have developed over time into recognised methods of encouraging managers to achieve stakeholder objectives

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13
Q

How can monitoring help managers to achieve stakeholder objectives?

A

Reduce information asymmetry by monitoring the decisions and performance of managers. One form of monitoring is auditing the financial statements of a company to confirm the quality and validity of the information provided to stakeholders

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14
Q

What is meant by risk?

A

A situation where an investment project has several possible outcomes, all of which are known and to which probabilities can be attached

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15
Q

What is meant by uncertainty?

A

Where an investment project has several possible outcomes but it is not possible to assign probabilities to their occurrence

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16
Q

What does investment project risk increase with?

A

Increasing variability of returns

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17
Q

What does uncertainty risk increase with?

A

Increasing project life

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18
Q

What does sensitivity analysis assess?

A

How the net present value of an investment project is affected by changes in project variables

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19
Q

What does sensitivity analysis not assess?

A

The probability of changes in project variables and so is often dismissed as a way of incorporating risk into the investment appraisal process

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20
Q

What is probability analysis?

A

The assessment of the separate probabilities of a number of specified outcomes of an investment project

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21
Q

What is simulation?

A

More advanced method of modelling project risk and often requires a powerful computer

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22
Q

An example of probability analysis?

A

A range of expected market conditions could be formulated and the probability of each market condition arising in each of several future years could be assessed

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23
Q

What is a monte carlo analysis?

A

estimate the outcome of a project under any combination of the various key factors affecting its success (such as inflation, economic growth, exchange rates, etc)

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24
Q

What happens when capital is rationed?

A

The optimal investment schedule is the one that maximises the return per dollar invested

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25
Assumption of divisible projects when capital is rationed?
A proportion rather than the whole investment can be undertaken, with the net present value (NPV) being proportional to the amount of capital invested
26
Assumption of indivisible projects when capital is rationed?
Ranking by profitability index will not necessarily indicate the optimum investment schedule, since it will not be possible to invest in part of a project.
27
Optimum investment schedule for a divisible project?
Profitability index represents the return per dollar invested and can be used to rank the investment projects
28
Optimum investment schedule for a indivisible project?
NPV of possible combinations of projects must be calculated. The most likely combinations are often indicated by the profitability index ranking
29
Why NPV is better than IRR (absolute measure)
NPV looks at absolute increases in wealth and thus can be used to compare projects of different sizes. IRR looks at relative rates of return
30
Why NPV is better than IRR (non-conventional cash flow)
In situations involving multiple reversals in project cash flows, it is possible that the IRR method may produce multiple IRRs (that is, there can be more than one interest rate which would produce an NPV of zero)
31
Why NPV is better than IRR (shareholder wealth)
NPV links to shareholder wealth whilst IRR only calculates the rate of return on projects
32
Why NPV is better than IRR (cost of capital)
NPV can be used in situations where the cost of capital changes from year to year. In IRR, it's difficult to know what to compare cost of capital with
33
What factors affect hard capital rationing?
External factors
34
What factors affect soft capital rationing?
Internal factors or management decisions
35
What if a company only requires a small amount of finance?
Issue costs may be so high that using external sources of finance is not practical
36
Reason for hard capital rationing (gearing)
Company may have high gearing or low interest cover, or a poor track record
37
Reason for soft capital rationing (aversion)
Managerial aversion to issuing new equity
38
Why might soft capital rationing arise (retained earnings)
Might also arise because managers wish to finance new investment from retained earnings
39
What is the funding gap for SMEs?
A small company and hard capital rationing
40
How may capital rationing issues be overcome (finance)
Obtain information about available sources of finance, since SMEs may lack understanding in this area
41
How may capital rationing issues be overcome (business angel)
Wealthy individuals or groups of investors who invest directly in the company and who are prepared to take higher risks in the hope of higher returns
42
How may capital rationing issues be overcome (crowdfunding)
Whereby many investors provide finance for a business venture
43
What is done once the EAC has been calculated for each cycle?
Lowest figure (i.e. cheapest) will indicate the optimum replacement cycle for the fleet
44
What is a nominal terms approach to inflation?
Both the cash flows and the discount rate incorporate the effects of inflation. Apply the specific rates of inflation to sales, material costs and other cash flows
45
What is a real terms approach to inflation?
Exclude the effects of general inflation. Nominal cash flows incorporating the effects of specific inflation rates would be deflated by the general rate of inflation to give real-terms cash flows
46
When can real-terms inflation be used? (cash flows)
Must be a single rate of inflation affecting all of the project’s cash flows
47
When can real-terms inflation be used? (general rate)
The single rate of inflation affecting the cash flows must also be the same as the general rate of inflation suffered by investors
48
What is sensitivity analysis?
Which project variable is the key or critical variable (i.e. the variable where the smallest relative change makes the NPV zero)
49
What can sensitivity analysis show?
Where management should focus attention in order to make an investment project successful, or where underlying assumptions should be checked for robustness
50
Limitation of sensitivity analysis?
Does not indicate the likelihood of a change in the future value of this variable
51
What does sensitivity analysis ignore?
Risk in the investment appraisal process
52
What does probability analysis do?
Attaches probabilities to the expected future cash flows of an investment project and uses these to calculate the expected net present value (ENPV)
53
What is ENPV?
The mean or expected value of an NPV probability distribution
54
Is probability analysis > sensitivity analysis for considering risk?
Yes
55
Problems with probability analysis?
Difficulty of estimating the probabilities that are to be attached to expected future cash flows
56
What does discounted payback period estimate?
The number of years for the present value of a project returns to recover the initial cost of investment
57
Advantage of discounted payback period?
Takes TVM into account, putting more weight on earlier cash flows
58
Disadvantage of discounted payback period?
Ignores cash flows beyond the payback. A project with a quick discounted payback could potentially have poor (or even negative) cash flows in subsequent periods
59
What does risk increase?
Variability of returns
60
What does uncertainty increase?
Project life
61
Difference between risk and uncertainty?
Risk can be quantified whereas uncertainty cannot be quantified
62
How does sensitivity analysis consider risk in investment appraisal?
Looks at the effect on the NPV of an investment project of changes in project variables, such as selling price per unit, variable cost per unit and sales volume
63
Issue with using sensitivity analysis when considering risk in investment appraisal?
As sensitivity analysis does not consider risk as measured by probabilities, it can be argued that it is not really a way of considering risk in investment appraisal at all
64
What is simulation?
Computer-based method of evaluating an investment project whereby the probability distributions associated with individual project variables and interdependencies between project variables are incorporated
65
How is a simulation ran?
Run randomly selects values of project variables using random numbers and calculates a mean (expected) NPV
66
What if risk and uncertainty are considered to be the same in discounted payback period?
Payback can be used to adjust for risk and uncertainty in investment appraisal
67
What if risk and uncertainty increase in discounted payback period?
Payback period can be shortened to increase the emphasis on cash flows which are nearer to the present time and hence less uncertain
68
What if risk and uncertainty decrease in discounted payback period?
The payback period can be lengthened to decrease the emphasis on cash flows which are nearer to the present time
69
Why is DCF better than non-DCF (TVM)
They allow for TVM and recognise that a $ received today is worth than a $ received in one year's time
70
Why is DCF better than non-DCF (cash flow)
DCF is cash flow based rather than profit based. So won't be affected by accounting policies
71
Issue with ARR (accounting)
Based upon accounting profit and ignores cash flow
72
Issue with ARR (targets)
Arbitrarily set targets based upon internal corporate targets
73
What projects are accepted in NPV?
Positive amounts
74
What projects are accepted in IRR?
IRRs bigger than company's cost of capital
75
What do NPV and IRR consider?
Returns earned throughout a project's life
76
What does payback only consider?
Returns up to the payback point, and as a result ignores later returns
77
When is a real-terms approach more suitable for an organisation?
When the uncertainty surrounding the estimation of inflation is removed
78
Sensitivity vs Probability Analysis (probabilities of outcomes)
Sensitivity: Doesn't take into account probabilities occurring Probability: How likely it is that outcomes will occur which will change the decision
79
Sensitivity vs Probability Analysis (number of variables)
Sensitivity: Involves isolating the impact of each variable on the outcome Probability: Allow for more than one variable changing by combining their probabilities
80
Sensitivity vs Probability Analysis (decision-making)
Sensitivity: Doesn't provide an indication of whether to undertake a project Probability: Calculate the expected NPV of the project, which can provide the decision-maker with a simple decision to go ahead if the expected NPV is positive
81
Payback advantage (cash flows)
Uses cash flows, indicates when the investment will break even and whether this is before projected cash flows become very uncertain
82
Payback disadvantage (period)
Payback period ignores cash flows after the payback period. The payback target is subjective
83
What does ROCE method reflect?
The wishes of shareholders that the company generates sufficient profits and does consider the entire life of the investment
84
ROCE disadvantage (TVM)
Doesn't take into account the TVM
85
ROCE disadvantage (company value)
An investment which increases company value will be rejected if its ROCE is below the target ROCE
86
Why lease instead of buy (flexibility)
Leases offer more flexibility than buying. If technology changes so the asset is out-of-date, the lessee does not have to keep on using it
87
Why lease instead of buy (cash)
Lessee may not have enough cash to pay for the vehicle and might have difficulty in obtaining a bank loan
88
Why choose NPV over IRR (absolute)
NPV looks at absolute increases in wealth and can be used to compare projects of different sizes IRR looks at relative rates of return, thereby ignoring the size of the project
89
Why choose NPV over IRR (reversals)
Due to reversals in cash flows, multiple IRRs may be produced and if management are unaware, may lead to incorrect decision being made. NPV only has one result
90
Why choose NPV over IRR (cost of capital)
NPV can be used in situations where cost of capital changes from year to year IRR is difficult to accept or reject decisions as it's difficult to know what to compare cost of capital with
91
NPV affect if real-term inflation used? (cost of capital)
Real cash flows would need to be discounted using real cost of capital not nominal cost of capital
92
NPV affect if real-term inflation used? (general inflation)
The effects of general inflation are excluded
93
Steps of sensitivity analysis?
Specify variables Specify relationship between the variables Simulate the environment Analyse the results
94
Benefits of simulation (real-world)
More real-world, as it is unlikely a single variable will change in isolation
95
Benefits of simulation (outcomes)
Shows the full range of possible outcomes, enabling further mathematical analysis
96
Limitation of probability analysis (reliability)
Probability estimation requires historic data of the event frequency to give any unreliability to the figures
97
Limitation of probability analysis (risk)
A company's attitude to risk is ignored in its decision
98
Limitation of probability analysis (expected value)
An expected value is essentially a long-run average over a sufficiently high number of repetitions and consequently may not be a possible outcome

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