MMM041 Business Finance

Multiple Choice Test (Solution)

1. Depreciation must be added back to the annual profit figures to derive the
annual cash flows.
Annual deprecation = (£46,000 - £4,000)/4 years = £10,500
Adding £10,500 to each year’s profit figure produces the following cash
flows.
Cash flow £ Cumulative cash flow £
Initial investment (46,000) (46,000)
Year 1 27,000 (19,000)
Year 2 34,000 15,000
PP = 1 year + [(19,000/34,000) x 1 year] = 1.56 years

2. ARR
Average profit = £(16,500 + 23,500 +13,500 - £1,500)/4 =£13,000
Average investment = £(46,000 +4,000)/2 = £25,000
ARR = 13,000/25,000 x 100% = 52%

3. IRR =10% + [(3,548/(3,548+ 7,989)) x (15%-10%)]

= 10% + (0.308 x 5%) =11.5%

4.
(i) Incorrect. It uses cash flows or discounted cash flows not profits.
(ii) Correct. It ignores the cash flows after the payback period.
(iii) Incorrect. It does not look at the whole life of the project.
(iv) Correct. It favours projects with shorter payback period.

5. A higher discount rate will produce a lower NPV. There will be no change
to IRR.

6. IRR cannot deal easily with future cash flows that fluctuate between
positive and negative. It will produce more than one IRR.

7. (iii) and (iv) are correct

The disadvantages are (i) it uses accounting profits not cash flows. It might
be subject to manipulation; (ii) the calculation is not universally agreed
(i.e. we can use either initial investment or average investment)

8.
Year Book value Capital Allowance @20% Tax@ DF@ DCF
£ £ 28% 10% £
1 2,000,000 400,000 112,000 0.909 101,808
2 1,100,000 308,000 0.826 254,408
Total Loss in value 1,500,000
2,000,000-500,000
= 1,500,000

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PV= £(101,808+ 254,408) = £356,216

9.
Year 0 Year 1
£ £
40,000+ 20,000 85,000-40,000
(60,000) 45,000

10.
Year Book value Capital Allowance @ 20%
£ £
1 90,000 18,000
2 72,000 14,400
3 57,600 11,520
4 21,080*
Total 90,000-25,000 65,000

11.
PI (NPV ÷ Initial Rank
investment )
Apple 560/450=1.24 3
Orange 370/285 =1.30 2
Banana 330/240 =1.38 1

12.
Project Initial Investment NPV
£‘000 £’000
Banana 240 330
Orange 285 370
Apple 270/450= 0.6 0.6 x 560= 336
Total 795 1,036

13. True False

Soft capital rationing is imposed by managers not by the capital market.
When making replacement decisions with uneven useful lives, we should select
the machine with the lowest equivalent annual annuity.

14. (1+ money rate) = (1+ real rate) x (1+inflation)

1.21 = (1+ real rate) x 1.09
Real rate = 11%

15. NPV= 150 + 20 x 0.909 + 30 x 0.826 + 40 x 0.751 + 20 x 0.683 = £236,660

Equivalent annual cost = £236,660 = £74,656

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 3.170

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