Unit 4

Question 1

Net Present Value (for project)

Answer 1

Difference between MV and Cost (not final answer)

Question 2

Strengths of NPV

Answer 2

1. Uses cash flows, which are better than earnings
2. Other approaches ignore cash flows beyond a certain date
3. fully incorporates the time value of money

Question 3

Payback period

Answer 3

1. Average time a project starts making a profit
2. Must be LESS than target period to ACCEPT
3. Must be MORE than target period to REJECT

Question 4

Shortfalls of payback period

Answer 4

1. TVM is ignored
2. Biased against long term projects
3. Requires arbitrary cutoff point
4. Ignores CF beyond cutoff point

Question 5

Advantages of payback period

Answer 5

1. Easy to understand
2. Adjusts for uncertainty for later
3. Biased towards liquidity

Question 6

Average Accounting Return

Answer 6

1. Investment’s average net income by its average book value
2. Must be MORE than target period to ACCEPT
3. Must be LESS than target period to REJECT

Question 7

Advantages of AAR

Answer 7

1. Easy to calculate
2. Needed information is easily available

Question 8

Disadvantages of AAR

Answer 8

1. Not a true rate of return (TVM ignored)
2. Uses arbitrary benchmark cuttoff rate
3. Based on book values and not CF and MV

Question 9

Depreciation and tax

Answer 9

Relevant cash flow = wear and tear tax shield = (Wear and tear × tax rate)

W&T is a non-cash expense, so only relevant because it affects taxes

Question 10

Recoupment and salvage value

Answer 10

If salvage value is different from tax value of asset, there’s a tax effect

Tax value = initial cost - accumulated W&T

After tax salvage = salvage - T(salvage - tax value)

Question 11

Qualitative factors

Answer 11

1. Reliability of machine purchased
2. Machine life span
3. Suppliers reliability
4. Environmental aspects
5. Social aspects (job losses)