Investment Appraisal Test

1
Investment Appraisal Test

• This test consists of 10 questions designed to
  test your understanding of the methods of
  investment appraisal.
• The links provide you with a choice of answer,
  along with explanations and solutions.
• You will need a calculator to complete this test.

2
Question 1.

• The payback method of IA will always select the
  investment that
• a. gives the highest rate of return
• b. returns the cost of investment first
• c. has the highest total net cash flow.

3
The payback method prioritises those investments
that return the cost of investment in the
shortest time. Your answer is correct.
4
The Payback method focuses on time, not overall
return . Try again.
5
The Payback method focuses on time, not overall
return . Try again.
6
Question 2.

• Annual, or average rate of return method of IA
  will always select?
• A. The project with the lowest cost
• B. The project with the highest total net return
• C. The project with the highest average return

7
Wrong. Think of the name of the method, then try
again
8
Wrong. Think of the name of the method, then try
again
9
Correct.
10
Question 3.

• Which of the following methods of IA allows for
  the effects of inflation on the real value of net
  cash flows?
• A. Payback
• B. Net Present Value
• C. ARR

11
Wrong. Payback takes no account of the effects of
inflation
12
Correct. Discounting cash flows allows
for predicted effects of inflation
13
Wrong. ARR takes no account of the effects of
inflation
14
Question 4.

• Which of the following is an advantage of using
  the Payback method?
• A. Selects the overall most profitable project
• B. Allows easy comparison between alternative
  investments
• C. Focuses on the short term, and cash flows

15
Wrong. Payback ignores total profitability Try
again
16
Payback only focuses on cash flows, and no other
method of comparison. Try again
17
Correct
18
Question 5.

• Which of the following defines IRR?
• A. The discount rate which when applied to a set
  of projected cash flows makes their NPV zero
• B. The reduction in value of money due to the
  effects of inflation.

19
Wrong The discount rate which when applied to a
set of projected cash flows makes their NPV
zero is the IRR
20
Correct
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Question 6.

• A firm has a choice between 2 projects A and B, A
  costs 40,000 and gives a net return over 5 years
  of 170,000. B costs 45,000 and over 5 years
  gives a net return of 185,000. Using the ARR
  method which would be chosen?
• A.
• B.

22
Correct. This project has an ARR of 65
23
Wrong. B has an ARR of 62, whilst As ARR is 65
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Question 7.

• An investment has the following projected cash
  flows. Yr1 5,000 Yr2 6,000
• Yr3 6,000, Yr4 5,000. The cost of the project
  is 15,000 - what is the payback period.
• Need help, click here
• Answer here.

25
Total cash flows. Find year in which payback
occurs. Calculate how much is needed to reach
payback in this year Find monthly cash flow for
year in which payback occurs. Calculate how many
months it will take to reach payback.
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2 years 8 months
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Question 8.

• Given a discount rate of 5, what will be the
  adjusted value of the following flows of cash.
  Yr1 5,000 Yr2 6,000 Yr3 6,500
• Yr4 5,000. ?
• Discount Table
• Help
• Answer

28
Discount Table for 5 Yr1 0.952 Yr2 0.907 Yr3
0.864 Yr4 0.823 Yr5 0.784
29
To find NPV, multiply each years cash flow, by
the discount factor for that year, and then
total your discounted cash flows.
30
The correct answer is 19,110
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Question 9.

• ARR can be criticised as a method of investment
  appraisal because?
• A. It ignores the total profitability of projects
• B. It makes comparison between projects difficult
• C. It ignores that fact that the real value of
  cash flows falls with time.

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ARR takes into account all cash flows
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It calculates return as a proportion of initial
investment. This makes comparison relatively easy
34
Correct. ARR does not allow for the effects
of inflation
35
Question 10.

• Under which of the situations given below is
  Payback an appropriate method of IA to use?
• A. Inflation is high
• B. There are several alternative projects that
  need analysis
• C. The technology being invested in is changing
  rapidly.

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No. Does not account for inflation. Though it
could be argued that payback is important if
future flows of money are likely to lose a
large proportion of their real value
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No. Payback makes analysis difficult. No account
of total profitability is made
38
Correct, well done. This is one of the 2 most
important advantages of payback, the other is
that it focuses on cash flows.
39
You have now completed the test. For further
more detailed revision please use the case
studies on the ALoA web site. www.aloa.co.uk.