Revision (ChatGPT)

Question 1

What is Net Present Value (NPV)?

Answer 1

NPV is the sum of all discounted cash flows of a project (inflows minus outflows). It represents the project’s value in today’s money. Formula: NPV = ∑ (Cash Flowₜ ÷ (1+r)ᵗ) – Initial investment. A positive NPV means the project is expected to add value (return exceeds the required rate).

Question 2

What is the decision rule for NPV?

Answer 2

Accept a project if NPV > 0 (it creates shareholder value); reject if NPV < 0. For mutually exclusive projects, choose the highest NPV. If all NPVs are negative, do not invest.

Question 3

What does a positive NPV indicate?

Answer 3

A positive NPV indicates the project’s returns exceed the discount rate (cost of capital), meaning it should increase shareholder wealth. The present value of future inflows is greater than the outflow, so value is created.

Question 4

What is Internal Rate of Return (IRR)?

Answer 4

IRR is the discount rate that makes NPV = 0. It’s the project’s own rate of return. It’s found by solving ∑ (CFₜ/(1+IRR)ᵗ) = 0.

Question 5

What is the decision rule for IRR?

Answer 5

Accept the project if IRR > required return (hurdle rate, typically the cost of capital), and reject if IRR < required return.

Question 6

Why can IRR be misleading for comparing projects?

Answer 6

IRR can be misleading if projects differ in scale or timing. A smaller project might have a higher IRR but contribute less total value than a larger project with a slightly lower IRR. Also, non-conventional cash flows can give multiple IRRs or none.

Question 7

What is the payback period?

Answer 7

The payback period is the time required for cumulative project cash flows to recover the initial investment.

Question 8

What is a major drawback of the payback method?

Answer 8

Payback ignores the time value of money (no discounting) and ignores cash flows after the cutoff.

Question 9

What is the discounted payback period?

Answer 9

The discounted payback is the time for cumulative discounted cash flows to equal the initial investment.

Question 10

How does discounted payback improve on simple payback?

Answer 10

Discounted payback considers the time value of money by discounting cash flows, giving a more realistic breakeven timing.

Question 11

What is the Profitability Index (PI)?

Answer 11

PI is the ratio of present value of future cash inflows to the initial investment. Formula: PI = PV(inflows) / PV(outflows) = 1 + (NPV/Initial Cost). A PI > 1 means the project has positive NPV.

Question 12

When is the Profitability Index especially useful?

Answer 12

PI is useful in capital rationing situations – when funds are limited, it helps rank projects by efficiency (NPV per € invested).

Question 13

Name one advantage of the NPV method.

Answer 13

NPV accounts for time value of money and includes all cash flows over the project’s life.

Question 14

Name one disadvantage of the NPV method.

Answer 14

A drawback of NPV is that it requires an estimate of the discount rate (cost of capital), which can be difficult or uncertain.

Question 15

Name one advantage of the IRR method.

Answer 15

IRR is often appreciated for its intuitive interpretation as a percentage return.

Question 16

Name one disadvantage of the IRR method.

Answer 16

IRR cannot be used reliably for mutually exclusive projects – it may give a different ranking than NPV.

Question 17

Name one advantage of the payback method.

Answer 17

Payback is simple and quick to calculate.

Question 18

Name one disadvantage of the payback method.

Answer 18

It ignores time value and any cash flows after the payback cutoff.

Question 19

What is the cost of capital?

Answer 19

The cost of capital is the required return that a company must earn on its investment projects to maintain its market value.

Question 20

What is the Weighted Average Cost of Capital (WACC)?

Answer 20

WACC is the blended average required return on a firm’s debt and equity.

Question 21

How do you calculate WACC?

Answer 21

WACC = (E / (D + E)) * kₑ + (D / (D + E)) * kₑ(1 - T).

Question 22

Why do we use the after-tax cost of debt in WACC?

Answer 22

Because interest is tax-deductible for companies.

Question 23

How can the cost of debt be estimated?

Answer 23

Typically by the yield to maturity on the company’s existing bonds or the interest rate on new debt of similar risk.

Question 24

What is the cost of equity?

Answer 24

The cost of equity is the required rate of return for equity investors.

Question 25

How do you calculate the cost of equity using the CAPM?

Answer 25

Using the Capital Asset Pricing Model: kₑ = Rₓ + β(Rₘ - Rₓ).

Question 26

What does beta represent in CAPM?

Answer 26

Beta is a measure of an asset’s systematic risk relative to the market.

Question 27

Name one assumption of the CAPM.

Answer 27

CAPM assumes investors hold diversified portfolios, so they only care about systematic risk.

Question 28

How do you calculate the cost of equity using the Dividend Growth Model?

Answer 28

Use the Dividend Valuation Model: kₑ = D₁ / P₀ + g.

Question 29

What is one key assumption of the Dividend Growth Model?

Answer 29

It assumes dividends grow at a constant rate forever.

Question 30

When is the Dividend Valuation Model difficult to use?

Answer 30

When a company does not pay dividends or its dividends are very irregular or unpredictable.

Question 31

What is meant by 'capital structure weights' in WACC?

Answer 31

It refers to the proportion of financing that comes from each source of capital (debt and equity).

Question 32

Why are market values used instead of book values for WACC?

Answer 32

Market values reflect the current worth and required returns of securities as determined by investors.

Question 33

What is working capital?

Answer 33

In finance, working capital = current assets – current liabilities.

Question 34

What is the operating cycle?

Answer 34

The operating cycle is the time duration from the purchase of inventory until the collection of cash from sales.

Question 35

What is the cash conversion cycle (CCC)?

Answer 35

The cash conversion cycle is the operating cycle minus the payables payment period.

Question 36

How do you calculate inventory holding period (days)?

Answer 36

Inventory days = (Inventory / Cost of Goods Sold) × 365.

Question 37

How do you calculate receivables collection period (days)?

Answer 37

Receivables days = (Trade Receivables / Annual Credit Sales) × 365.

Question 38

How do you calculate payables payment period (days)?

Answer 38

Payables days = (Trade Payables / Annual Credit Purchases) × 365.

Question 39

What does a shorter cash conversion cycle imply?

Answer 39

A shorter CCC implies the company is converting its outlay into cash faster.

Question 40

What is Economic Order Quantity (EOQ)?

Answer 40

EOQ is the optimal order quantity of inventory that minimizes total inventory costs.

Question 41

What costs are balanced at the EOQ?

Answer 41

Ordering costs and carrying (holding) costs.

Question 42

What is an example of a working capital policy trade-off?

Answer 42

Granting looser credit terms.

Question 43

What are ordering costs and carrying (holding) costs?

Answer 43

At EOQ, the total cost of placing orders per year equals the total cost of holding inventory. Ordering less than EOQ results in higher order costs but lower holding costs, while ordering more than EOQ results in lower order costs but higher holding costs.

Question 44

What is an example of a working capital policy trade-off?

Answer 44

Granting looser credit terms can increase sales but lengthen receivables days and potentially increase bad debts. Conversely, strict credit terms shorten receivables period and reduce bad debts but might reduce sales.

Question 45

How can a firm improve its receivables collection period?

Answer 45

Offer early payment discounts, tighten credit terms for slow payers, improve the billing and follow-up process, or use factoring or invoice financing.

Question 46

Why might a company offer a cash discount to customers?

Answer 46

To accelerate cash inflows and reduce the average collection period. Early payment discounts encourage customers to pay sooner, which lowers receivables and the need for working capital financing.

Question 47

Name one technique for efficient cash management.

Answer 47

Cash forecasting, short-term investing, maintaining credit lines, centralizing collections and disbursements, or using lockboxes or electronic payments.

Question 48

What is the purpose of working capital management?

Answer 48

To ensure the company can meet its short-term obligations and operate smoothly by managing cash, inventory, and receivables/payables efficiently.