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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.

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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.

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The payback method prioritises those investments that return the cost of investment in the shortest time. Your answer is correct.

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The Payback method focuses on time, not overall return. Try again.

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Question 2. Annual, or average rate of return method of IA will always select? 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

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Wrong. Think of the name of the method, then try again

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Wrong. Think of the name of the method, then try again

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Correct.

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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

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Wrong. Payback takes no account of the effects of inflation

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Correct. Discounting cash flows allows for predicted effects of inflation

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Wrong. ARR takes no account of the effects of inflation

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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

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Wrong. Payback ignores total profitability Try again

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Payback only focuses on cash flows, and no other method of comparison. Try again

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Correct

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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.

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Wrong The discount rate which when applied to a set of projected cash flows makes their NPV = zero is the IRR

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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.

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Correct. This project has an ARR of 65%

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Wrong. B has an ARR of 62%, whilst A’s 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.

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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. ? Yr4 £5,000. ? Discount Table HelpAnswer

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Discount Table for 5% Yr1 0.952 Yr2 0.907 Yr3 0.864 Yr4 0.823 Yr5 0.784

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To find NPV, multiply each years cash flow, by the discount factor for that year, and then total your discounted cash flows.

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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

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Correct. ARR does not allow for the effects of inflation

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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

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Correct, well done. This is one of the 2 most important advantages of payback, the other is that it focuses on cash flows.

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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.

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