ACCA FM · Chapter 6
Investment appraisal techniques MCQs with Answers
10 multiple-choice questions on Investment appraisal techniques for ACCA FM Financial Management. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
A project requires an initial investment of $400k. Net cash inflows are expected to be ($000): year 1 90, year 2 120, year 3 150, year 4 160, year 5 100. Cash flows arise evenly through each year. What is the payback period?
- A) 3.23 years
- B) 3.25 years
- C) 3.40 years
- D) 4.00 years
Show answer & explanation
Answer: B) 3.25 years
Cumulative cash flows ($000): year 1 -310, year 2 -190, year 3 -40, year 4 +120. Payback occurs during year 4: 3 years + 40/160 = 3.25 years (3 years 3 months). Dividing by the year 5 cash flow gives 3.40 years, and using the average annual inflow (124) gives 3.23 years, which ignores the timing of the flows.
Question 2
A machine costs $500k and will be sold for $50k at the end of its 5-year life. Total net cash inflows over the 5 years are expected to be $800k. Depreciation is on a straight-line basis. What is the accounting rate of return (ARR) based on average investment?
- A) 14.0%
- B) 25.5%
- C) 28.0%
- D) 58.2%
Show answer & explanation
Answer: B) 25.5%
Total depreciation = 500 - 50 = 450, so total profit = 800 - 450 = 350 and average annual profit = 350 / 5 = 70. Average investment = (500 + 50) / 2 = 275. ARR = 70 / 275 = 25.5% (1 decimal place). Using the initial investment gives 14.0%, and using cash flows instead of profit gives 58.2%.
Question 3
A project requires an investment of $250,000 now and will generate net cash inflows of $70k, $80k, $90k and $60k at the end of years 1 to 4 respectively. The cost of capital is 10%. Using discount factors rounded to 3 decimal places, what is the net present value?
- A) +$12,120
- B) -$11,720
- C) +$50,000
- D) +$11,720
Show answer & explanation
Answer: B) -$11,720
PV of inflows = 70,000 x 0.909 + 80,000 x 0.826 + 90,000 x 0.751 + 60,000 x 0.683 = 63,630 + 66,080 + 67,590 + 40,980 = $238,280. NPV = $238,280 - 250,000 = -$11,720, so the project should be rejected. Treating the year 1 flow as arising now gives +$12,120, and ignoring discounting gives +$50,000.
Question 4
A project has an NPV of +$18,400 at a discount rate of 10% and an NPV of -$6,200 at 15%. Using linear interpolation, what is the estimated internal rate of return?
- A) 11.26%
- B) 12.50%
- C) 13.74%
- D) 17.54%
Show answer & explanation
Answer: C) 13.74%
IRR = a + [NA / (NA - NB)] x (b - a) = 10% + [18,400 / (18,400 + 6,200)] x (15% - 10%) = 10% + (18,400 / 24,600) x 5% = 13.74% (2 decimal places). Subtracting the NPVs instead of adding their absolute values gives 17.54%, and using the wrong NPV in the numerator gives 11.26%.
Question 5
A project costs $100,000 and generates net cash inflows of $40,000 a year for four years, arising evenly through each year. The cost of capital is 12%, with discount factors of 0.893, 0.797, 0.712 and 0.636 for years 1 to 4. What is the discounted payback period (to 2 decimal places)?
- A) 2.50 years
- B) 2.85 years
- C) 3.15 years
- D) 4.00 years
Show answer & explanation
Answer: C) 3.15 years
PV of inflows: year 1 35,720; year 2 31,880; year 3 28,480; year 4 25,440. Cumulative PV after 3 years = 96,080, leaving 3,920 to recover. Discounted payback = 3 + 3,920 / 25,440 = 3.15 years. The simple (undiscounted) payback would be 100,000 / 40,000 = 2.50 years.
Question 6
A company has spent $45,000 on market research to assess whether to launch a new product. In appraising the launch, how should this cost be treated?
- A) It should be included as an outflow spread over the life of the project
- B) It should be included only if the project is accepted
- C) It should be included as a cash outflow at time 0
- D) It should be excluded because it is a sunk cost
Show answer & explanation
Answer: D) It should be excluded because it is a sunk cost
Only future, incremental cash flows arising as a result of the decision are relevant. The market research has already been incurred and will not change whether or not the product is launched, so it is a sunk cost and is ignored in the appraisal.
Question 7
What is the present value of $25,000 received at the end of each year for 5 years, at a discount rate of 8%? Use an annuity factor rounded to 3 decimal places.
- A) $99,825
- B) $107,800
- C) $125,000
- D) $312,500
Show answer & explanation
Answer: A) $99,825
The 5-year annuity factor at 8% is 3.993. PV = 25,000 x 3.993 = $99,825. $107,800 would be the value if the payments were made at the start of each year, and $312,500 is the value of a perpetuity.
Question 8
An investment will generate $50,000 a year in perpetuity, with the first receipt at the end of year 3. The discount rate is 10%. What is the present value of the receipts (to the nearest $)?
- A) $375,657
- B) $413,223
- C) $454,545
- D) $500,000
Show answer & explanation
Answer: B) $413,223
The perpetuity formula values the stream one year before the first receipt, i.e. at the end of year 2: 50,000 / 0.10 = 500,000. Discounting back two years: 500,000 / 1.10^2 = $413,223 (nearest $). Discounting for three years ($375,657) is a common error, because the formula already places the value at time 2.
Question 9
Which of the following is an advantage of net present value (NPV) over internal rate of return (IRR) as an investment appraisal method?
- A) NPV gives an absolute measure of the increase in shareholder wealth and gives a single unambiguous answer for any cash flow pattern
- B) NPV does not require a cost of capital to be estimated
- C) NPV ignores the time value of money, which makes it simpler to calculate
- D) NPV is expressed as a percentage, which managers find easier to understand
Show answer & explanation
Answer: A) NPV gives an absolute measure of the increase in shareholder wealth and gives a single unambiguous answer for any cash flow pattern
NPV measures in absolute terms the change in shareholder wealth from a project and is unambiguous even for non-conventional cash flows, which can produce multiple IRRs. IRR is a relative percentage measure, which managers often find easier to understand, but it can rank mutually exclusive projects incorrectly. Both methods use discounting, and NPV requires the cost of capital.
Question 10
A project needs 2,000 kg of a material. The company holds 2,000 kg in inventory, bought some time ago for $8 per kg. The current replacement cost is $10 per kg and it could be sold for $5 per kg. The material is in regular use in the business. What is the relevant cost of the material for the project?
- A) $0
- B) $10,000
- C) $16,000
- D) $20,000
Show answer & explanation
Answer: D) $20,000
Because the material is regularly used, any material used on the project must be replaced, so the relevant cost is its current replacement cost: 2,000 kg x $10 = $20,000. The original cost of $8 per kg is a sunk cost. The resale value would only be relevant if the material had no other use in the business.