ACCA FM · Chapter 7
Investment appraisal with inflation and taxation MCQs with Answers
10 multiple-choice questions on Investment appraisal with inflation and taxation for ACCA FM Financial Management. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
Investors require a real return of 6% a year, and general inflation is expected to be 3% a year. What is the money (nominal) cost of capital, to 2 decimal places?
- A) 2.91%
- B) 3.00%
- C) 9.00%
- D) 9.18%
Show answer & explanation
Answer: D) 9.18%
Using the Fisher formula: (1 + money rate) = (1 + real rate) x (1 + inflation rate) = 1.06 x 1.03 = 1.0918. Money rate = 9.18%. Simply adding the two rates (9.00%) is only an approximation.
Question 2
A company's money cost of capital is 12% and general inflation is 4% a year. What is the real cost of capital, to 2 decimal places?
- A) 7.69%
- B) 8.00%
- C) 11.54%
- D) 16.48%
Show answer & explanation
Answer: A) 7.69%
(1 + real rate) = (1 + money rate) / (1 + inflation) = 1.12 / 1.04 = 1.0769. Real rate = 7.69%. Subtracting inflation from the money rate (8.00%) is only an approximation.
Question 3
When using the real method of investment appraisal, which of the following is correct?
- A) Cash flows expressed in current (time 0) prices are discounted at the real cost of capital
- B) Cash flows are inflated at the real rate and discounted at the money rate
- C) Cash flows expressed in current prices are discounted at the money cost of capital
- D) Cash flows inflated to money terms are discounted at the real cost of capital
Show answer & explanation
Answer: A) Cash flows expressed in current (time 0) prices are discounted at the real cost of capital
The real and money methods give the same NPV if applied consistently: real cash flows (in today's prices) are discounted at the real rate, and money cash flows (including expected inflation) are discounted at the money rate. The real method is only practical when all cash flows inflate at the general rate of inflation.
Question 4
A project will sell 10,000 units in year 2. The current selling price is $25 per unit, and selling prices are expected to rise by 4% a year. What is the year 2 sales revenue in money terms (to the nearest $)?
- A) $250,000
- B) $260,000
- C) $270,400
- D) $281,216
Show answer & explanation
Answer: C) $270,400
Year 2 revenue = 10,000 x $25 x 1.04^2 = 10,000 x $27.04 = $270,400. The price must be inflated for two years because the current price is a time 0 price. Inflating for only one year gives $260,000.
Question 5
A company buys a machine for $80,000. Tax-allowable depreciation is available at 25% a year on a reducing balance basis. What is the tax-allowable depreciation for year 3 (to the nearest $)?
- A) $8,438
- B) $11,250
- C) $15,000
- D) $20,000
Show answer & explanation
Answer: B) $11,250
Year 1: 80,000 x 25% = $20,000, leaving 60,000. Year 2: 60,000 x 25% = $15,000, leaving 45,000. Year 3: 45,000 x 25% = $11,250 (exact). A straight-line approach of 25% of cost each year would give $20,000.
Question 6
A machine was bought for $120,000 at the start of year 1 and is sold for $30,000 at the end of year 3. Tax-allowable depreciation is 25% reducing balance, claimed in years 1 and 2, with a balancing adjustment in year 3 (no writing-down allowance is claimed in the year of disposal). What is the balancing allowance in year 3?
- A) $11,250
- B) $16,875
- C) $20,625
- D) $37,500
Show answer & explanation
Answer: D) $37,500
Tax written-down value: start 120,000; year 1 TAD 30,000 leaves $90,000; year 2 TAD $22,500 leaves $67,500. Balancing allowance = written-down value - sale proceeds = $67,500 - $30,000 = $37,500. Claiming a further year 3 TAD of $16,875 first would wrongly give a balancing allowance of $20,625.
Question 7
A company buys an asset for $60,000 at the start of year 1 (time 0) and claims tax-allowable depreciation at 25% reducing balance from year 1. The tax rate is 30% and tax is paid (and tax savings received) one year after the year in which the related cash flow arises. What is the tax saving from the year 1 tax-allowable depreciation, and when does it arise?
- A) $4,500 at the end of year 1
- B) $15,000 at the end of year 2
- C) $4,500 at the end of year 2
- D) $18,000 at the end of year 1
Show answer & explanation
Answer: C) $4,500 at the end of year 2
Year 1 TAD = $60,000 x 25% = $15,000. Tax saving = $15,000 x 30% = $4,500. Because tax is paid one year in arrears, the saving arises at the end of year 2. $15,000 is the allowance itself rather than the tax saved.
Question 8
A project is being appraised using the money method. Which of the following cash flows should NOT be adjusted for future inflation?
- A) Sales revenue
- B) Tax savings from tax-allowable depreciation
- C) Incremental fixed overheads
- D) Labour costs
Show answer & explanation
Answer: B) Tax savings from tax-allowable depreciation
Tax-allowable depreciation is based on the historical cost of the asset, which is fixed when it is bought, so the related tax savings do not increase with inflation. Revenues and operating costs are expected to change with prices and must be inflated (at their specific rates) to money terms.
Question 9
A project costs $200,000 at time 0 and generates pre-tax net cash inflows of $70,000 a year for 4 years, with no scrap value. Tax is 30%, payable in the same year as the cash flows. Tax-allowable depreciation is 25% reducing balance, first claimed in year 1, with a balancing allowance in year 4. The after-tax cost of capital is 10% (factors 0.909, 0.826, 0.751, 0.683). What is the NPV (to the nearest $)?
- A) -$44,719
- B) -$11,133
- C) +$1,834
- D) +$21,830
Show answer & explanation
Answer: C) +$1,834
TAD: year 1 50,000; year 2 37,500; year 3 28,125; year 4 balancing allowance 200,000 - 115,625 = 84,375. Tax savings at 30%: 15,000; 11,250; 8,437.5; 25,312.5. Annual after-tax inflow = 70,000 x 0.7 = 49,000. Net flows: 64,000.0, 60,250.0, 57,437.5, 74,312.5. PVs at 10% total $201,834, so NPV = +$1,834 (nearest $). Tax savings arise in the same year as the TAD because the question states tax is paid without a lag. Claiming only a normal 25% allowance in year 4 (21,094) instead of the balancing allowance gives -$11,133, and ignoring TAD gives -$44,719.
Question 10
A three-year project requires working capital of $50,000 at the start of year 1. The working capital requirement will increase each year in line with inflation of 5% a year, and all working capital is recovered at the end of year 3. What is the working capital cash flow at the end of year 2?
- A) -$55,125
- B) -$2,625
- C) -$2,500
- D) +$55,125
Show answer & explanation
Answer: B) -$2,625
Working capital needed: time 0 $50,000; time 1 $52,500; time 2 $55,125 (to support year 3 activity). The cash flow at each point is the increment: at time 1 an outflow of $2,500, and at time 2 an outflow of $55,125 - $52,500 = $2,625. The full $55,125 is recovered at the end of year 3.