ICAEW BIP · Chapter 13
Investment appraisal MCQs with Answers
9 multiple-choice questions on Investment appraisal for ICAEW BIP Business Insight and Performance. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
A project needs an initial investment of £180,000. Net cash inflows are expected to be: year 1 £45,000, year 2 £55,000, year 3 £70,000, year 4 £80,000. Cash flows arise evenly over each year. What is the payback period?
- A) 3.125 years
- B) 4.000 years
- C) 2.88 years
- D) 3.143 years
Show answer & explanation
Answer: A) 3.125 years
Cumulative cash flows: year 1 £45,000, year 2 £100,000, year 3 £170,000. After 3 years, £10,000 is still to be recovered from year 4's inflow of £80,000. Payback = 3 + 10,000/80,000 = 3.125 years (about 3 years and 1.5 months).
Question 2
A machine costs £240,000 and will be sold for £40,000 at the end of its 5-year life. Total net cash inflows from the machine over the 5 years are expected to be £360,000. Depreciation is charged on a straight-line basis. What is the accounting rate of return based on average investment (to one decimal place)?
- A) 51.4%
- B) 17.1%
- C) 22.9%
- D) 13.3%
Show answer & explanation
Answer: C) 22.9%
Total profit = net cash inflows £360,000 - total depreciation (£240,000 - £40,000) £200,000 = £160,000. Average annual profit = £160,000 / 5 = £32,000. Average investment = (£240,000 + £40,000) / 2 = £140,000. ARR = £32,000 / £140,000 = 22.9%.
Question 3
A project needs an investment of £150,000 now and will generate net cash inflows of £42,000 a year for 5 years, starting in one year's time. The cost of capital is 10%, and the 5-year annuity factor at 10% is 3.791. What is the net present value of the project?
- A) -£16,860
- B) £60,000
- C) £159,222
- D) £9,222
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Answer: D) £9,222
PV of inflows = £42,000 x 3.791 = £159,222. NPV = £159,222 - £150,000 = £9,222. Because the NPV is positive, the project earns more than the 10% cost of capital and should be accepted on financial grounds.
Question 4
A project costs £200,000 now. Net cash inflows are expected at the end of each year as follows: year 1 £60,000, year 2 £80,000, year 3 £90,000, year 4 £50,000. The cost of capital is 12%. Discount factors at 12% are: year 1 0.893, year 2 0.797, year 3 0.712, year 4 0.636. What is the net present value of the project?
- A) £13,220
- B) £38,770
- C) £80,000
- D) £22,360
Show answer & explanation
Answer: A) £13,220
Present values: year 1 £60,000 x 0.893 = £53,580; year 2 £80,000 x 0.797 = £63,760; year 3 £90,000 x 0.712 = £64,080; year 4 £50,000 x 0.636 = £31,800. Total PV of inflows = £213,220. NPV = £213,220 - £200,000 = £13,220.
Question 5
A project has an NPV of £9,222 at a discount rate of 10% and an NPV of -£9,216 at 15%. Using linear interpolation, what is the estimated internal rate of return (to one decimal place)?
- A) 13.5%
- B) 17.5%
- C) 11.0%
- D) 12.5%
Show answer & explanation
Answer: D) 12.5%
IRR = L + [NPV at L / (NPV at L - NPV at H)] x (H - L) = 10% + [9,222 / (9,222 + 9,216)] x 5% = 10% + (9,222 / 18,438) x 5% = 12.5%. The IRR lies between the two rates because the NPV changes from positive to negative. Since it is above the 10% cost of capital, the project is acceptable.
Question 6
Which of the following is a disadvantage of the payback method of investment appraisal?
- A) It is difficult for non-financial managers to understand
- B) It ignores cash flows arising after the payback period and, in its simple form, the time value of money
- C) It is based on accounting profits rather than cash flows
- D) It cannot be used without first estimating the company's cost of capital
Show answer & explanation
Answer: B) It ignores cash flows arising after the payback period and, in its simple form, the time value of money
Payback measures how quickly the initial investment is recovered. It is simple to understand and favours liquidity, but it ignores all cash flows after the payback point and, unless discounted payback is used, the timing of cash flows within the period. Using accounting profit is a weakness of ARR, and needing a cost of capital applies to NPV.
Question 7
A project will generate £10,000 a year at the end of years 3 to 7 inclusive. The cost of capital is 10%. Annuity factors at 10% are: 2 years 1.736, 3 years 2.487, 5 years 3.791, 7 years 4.868. What is the present value of these cash flows?
- A) £48,680
- B) £37,910
- C) £31,320
- D) £23,810
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Answer: C) £31,320
The cash flows are a 5-year annuity covering years 3 to 7. Annuity factor = 7-year factor - 2-year factor = 4.868 - 1.736 = 3.132. PV = £10,000 x 3.132 = £31,320. Subtracting the 3-year factor would wrongly exclude year 3.
Question 8
A company is appraising a new plant costing £300,000. Annual net cash inflows before environmental costs will be £120,000 for 4 years. The plant will incur a carbon emissions levy of £15,000 a year, and site restoration costing £60,000 will be paid at the end of year 4. The cost of capital is 10%. The 4-year annuity factor at 10% is 3.170 and the year 4 discount factor is 0.683. What is the net present value of the project after taking these sustainability-related costs into account?
- A) £80,400
- B) £32,850
- C) £39,420
- D) -£8,130
Show answer & explanation
Answer: D) -£8,130
Net annual inflows = £120,000 - £15,000 = £105,000. PV = £105,000 x 3.170 = £332,850. PV of site restoration = £60,000 x 0.683 = £40,980. NPV = £332,850 - £40,980 - £300,000 = -£8,130. Ignoring the environmental costs gives a misleading NPV of £80,400; including carbon and restoration costs in the cash flows is one way of incorporating sustainability into investment appraisal, alongside non-financial factors.
Question 9
In a net present value calculation for a new production line, which of the following should be included as a relevant cash flow?
- A) Annual depreciation of the production line
- B) Interest payments on a loan used to finance the project
- C) Working capital needed at the start of the project and released at the end
- D) A share of existing head office costs allocated to the project
Show answer & explanation
Answer: C) Working capital needed at the start of the project and released at the end
Relevant cash flows are future, incremental cash flows caused by the project. Working capital tied up and later released is a real cash flow. Depreciation is not a cash flow, allocated head office costs that do not change are not incremental, and financing costs are already allowed for in the discount rate, so including interest would count them twice.