FM: Financial Management

• Topic 01

  Financial Management Function

  255 questions
• Topic 02

  Financial Management Environment

  254 questions
• Topic 03

  Working Capital Management

  234 questions
• Topic 04

  Investment Appraisal

  288 questions
• Topic 05

  Business Finance

  260 questions
• Topic 06

  Business Valuations

  288 questions
• Topic 07

  Risk Management

  265 questions
• Topic 08

  Employability and Technology Skills

  267 questions

A few questions from this unit, with the answer and a full explanation. The complete bank is available when you start practising.

1. What is the replacement cost method of valuation and when is it most appropriate?

   • A
     It values a company at its liquidation value and is used when the company is being wound up
   • B
     It is only appropriate for companies in the insurance sector
   • C
     It values a company at the current cost of replacing all its assets, and is most appropriate when evaluating whether to acquire an existing business versus building an equivalent one from scratch
     Correct answer
   • D
     It values a company based on its future earnings potential
   Explanation

   The replacement cost method answers the question: 'How much would it cost to create an equivalent business from scratch at today's prices?' This provides a ceiling for the asset-based valuation — a rational buyer should not pay more than the cost of replication (unless the business has intangible value that cannot be replicated, such as an established brand, customer relationships, or regulatory licences). It is most useful for: (1) Asset-heavy industries (manufacturing, property, utilities); (2) Make-or-buy decisions (should we acquire or build?); and (3) Insurance valuations (replacement cost for damaged assets).

2. When might NPV and IRR give conflicting results for investment decisions?

   • A
     They only conflict when the cost of capital is negative
   • B
     When ranking mutually exclusive projects that differ in scale or timing of cash flows, or when projects have non-conventional cash flows producing multiple IRRs
     Correct answer
   • C
     NPV and IRR always give the same result for all types of projects
   • D
     They conflict when both projects have the same initial investment
   Explanation

   NPV and IRR can give conflicting rankings when: (1) Mutually exclusive projects with different scales: A smaller project may have a higher IRR but lower NPV than a larger project. NPV correctly identifies the project that creates more absolute wealth. (2) Different timing of cash flows: Projects with different cash flow profiles may have intersecting NPV profiles, leading to different rankings at different discount rates. (3) Non-conventional cash flows: Projects where cash flows alternate between positive and negative can produce multiple IRRs (or no IRR), making the IRR decision rule unreliable. In all cases of conflict, NPV is the theoretically correct criterion because it directly measures shareholder wealth.

3. Why does NPV give a more reliable ranking than IRR for mutually exclusive projects?

   • A
     Because NPV is always larger than IRR for any project
   • B
     Because NPV ignores the cost of capital while IRR does not
   • C
     Because NPV measures the absolute increase in shareholder wealth, while IRR only measures the percentage return and does not account for the scale of investment
     Correct answer
   • D
     Because NPV and IRR always agree on project rankings
   Explanation

   For mutually exclusive projects (where only one can be selected), NPV gives the correct ranking because it measures the absolute increase in shareholder wealth. A project with a higher NPV creates more value, regardless of its percentage return. IRR can mislead because: (1) it does not account for scale (a small project can have a high IRR but low total value creation); (2) it does not account for the timing pattern of cash flows properly; and (3) its implicit reinvestment assumption (that cash flows are reinvested at the IRR rather than the cost of capital) can distort rankings. NPV's assumption that cash flows are reinvested at the cost of capital is more realistic.