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.

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.

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

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

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

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

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

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

Correct.

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

Wrong. Payback takes no account of theeffects of inflation

Correct. Discounting cash flows allows forpredicted effects of inflation

Wrong. ARR takes no account of theeffects of inflation

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

Wrong. Payback ignores total profitabilityTry again

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

Correct

Question 5.

Which of the following is an advantage of ARR?

A. It allows easy comparison between projects of different cost

B. It allows for the reduction in value of money due to the effects of inflation.

Wrong

Correct

Question 6.

A firm has a choice between 2 projects A and B, A costs £400,000 and gives a net return over 5 years of £170,000. B costs £450,000 and over 5 years gives a net return of £185,000. Using the ARR method which would be chosen?

A.

B.

Correct. This project has an ARR of 8.5%

Wrong. B has an ARR of 8.2%, whilst A’s ARR is 8.5%

Question 7.

An investment has the following projected cash flows. Yr1 £5,000 Yr 2 £6,000 Yr 3 £6,000, Yr 4 £5,000. The cost of the project is £15,000 - what is the payback period.

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Answer here.

Total cash flows for the end of each year.Find year in which payback occurs.Calculate how much is needed at the end of previousyear to reach payback in this yearFind monthly cash flow for year in which payback occurs (cash flow for year divided by12).Calculate how many months it will take to reach payback Amount outstanding at beginning of yeardivided by monthly cash flow for year.

2 years 8 months

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

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

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

The correct answer is £19,110

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.

ARR takes into account all cash flows

It calculates return as a proportion of initial investment.This makes comparison relatively easy

Correct. ARR does not allow for the effects ofinflation

Question 10.

Under which of the situations given below is Payback an appropriate method of IA to use?

A. Cash flow is not important

B. There are several alternative projects that need analysis

C. The technology being invested in is changing rapidly.

No.

No. Payback makes analysis difficult.No account of total profitability is made

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

You have now completed the test.