BAA6004 Advanced Financial Management

Multiple Choice Question Practice – Week 4

Chapter 11: Asset Replacement

1. A machine is due for replacement on 31 December 20X6 at a cost of £50,000. The
necessary funds are to be provided by investing five equal amounts in a deposit account
paying 10% per annum interest. The first investment will be made on 31 December 20X1.
What is the amount required to be invested each year (to the nearest £10)?
A £6,480
B £6,770
C £7,440
D £8,190

2. Alesme Ltd needs to replace a major item of capital equipment in five years’ time. The
estimated replacement cost will be £750,000. Funds for the replacement will be provided by
setting aside five equal annual sums and investing them at 10%. The first amount will be
invested immediately, the last in four years’ time.
What is the annual amount to set aside (to the nearest £100)?
A £111,700
B £122,800
C £179,900
D £197,800

3. Daisy plc wishes to replace its existing pressing machine with a new model immediately.
The new model would be replaced with the same model in perpetuity. Four new models are
available as follows:
Model I II III IV
Purchase price £50,000 £40,000 £70,000 £85,000
Estimated life 5 years 4 years 6 years 8 years
Annual running costs £4,000 £6,000 £3,500 * see below
(payable at end of each year)

* Model IV is new on the market and the manufacturer boasts that no running costs are
expected for the first five years. After this period, annual running costs will be £5,000 in
years 6 – 8 of the machinery’s life. Daisy plc has a cost of capital of 10% per annum.
Which new model should Daisy plc choose, and what replacement policy should it
follow if it wishes to minimise the present value of its costs?

A Purchase model I and replace every five years

B Purchase model II and replace every four years
C Purchase model III and replace every six years
D Purchase model IV and replace every eight years

1
BAA6004 Advanced Financial Management
Multiple Choice Question Practice – Week 4

4. An investor using a discount factor of 10% is indifferent between replacing a machine every
2 years and replacing it every 4 years. The present value of the first 2 year replacement cycle
is £23,000.
What is the present value of the first 4-year replacement cycle?

A £36,455

B £41,999

C £46,000

D £52,995

5. Moore has estimated the following cash flow pattern for the purchase and maintenance of a
piece of equipment which he expects to use for the foreseeable future:
Time 0 1 2 3 4
£000 £000 £000 £000 £000
Capital cost 150
Maintenance 20 30 40 60
Scrap proceeds (40)

He anticipates purchasing a replacement machine every four years.

Moore has been approached by a leasing company offering to provide a maintenance-free
machine for as long as he wishes for a fixed annual sum payable in advance.
If Moore has a 10% cost of capital, what is the maximum annual sum (to the nearest
£100) he should be prepared to pay to the leasing company?

A £59,200
B £65,000
C £67,900
D £74,700

Chapter 11: Capital Rationing

6. Capital rationing is best described as a situation where

A a company has insufficient cash to undertake all the projects available to it

B a company chooses to use some of its cash to pay a dividend rather than undertaking all the
projects that have a positive NPV at its cost of capital
C a company has insufficient projects available with a positive NPV to use up all its cash
D a company has insufficient cash to accept all projects that have a positive NPV at its cost of
capital

2
BAA6004 Advanced Financial Management
Multiple Choice Question Practice – Week 4

7. A divisible project is:

A One where the initial investment funds have to be divided into very small amounts
B One where it is impossible to undertake a fraction of the project
C One which may be identified with a particular division
D One where it is possible to undertake a fraction of the project

8. Consider the following statements about the profitability index:

1) PI ignores the size of a project
2) PI concentrates on NPV and does not take into account the timing of cash flows.
3) PI can be used to rank any projects to maximise NPV when capital is rationed.
4) PI can only be used when the capital rationing is soft.

Which of the above statements are true?

A 1 and 2 only

B 1, 2 and 3 only

C 2 and 3 only

D 2 and 4 only

9. Spotty Co has appraised three capital investment projects.

The following results were found:

Project £Capital Outlay £PV of cash flows £NPV of project Profitability Index
X 120,000 250,000 130,000 2.08
Y 150,000 300,000 150,000 2.00
Z 200,000 410,000 210,000 2.05

Capital is restricted to £280,000. Calculate the maximum NPV that can be achieved
assuming that all three projects are divisible.

A 210,000

B 242,000

C 280,000

D 298,000

3
 BAA6004 Advanced Financial Management
Multiple Choice Question Practice – Week 4

10. TOTS Co has appraised three capital investment projects.

The following results were found:
Project Capital Outlay£ PV of cash flows£ NPV of project Profitability Index
AA 120,000 250,000 130,000 2.08
BB 150,000 300,000 150,000 2.00
CC 200,000 410,000 210,000 2.05

Capital is restricted to £280,000. Calculate the maximum NPV that can be achieved
assuming that all three projects are indivisible.
A 210,000
B 242,000
C 280,000
D 298,000

11. Four projects, P, Q, R and S are available to a company which is facing shortages of capital
over the next year but expects capital to be freely available thereafter.
Project
P Q R S
£000 £000 £000 £000
Total capital required over life of project 20 30 40 50
Capital required in next year 20 10 30 40
NPV of project at company’s cost of capital 60 40 100 80

In what sequence should the projects be selected if the company wishes to maximise net present value?

A P, R, S, Q

B Q, P, R, S

C Q, R, P, S

D R, S, P, Q

12. Which of the following is not a reason for soft capital rationing?
A Senior managers are aware that to undertake all positive NPV projects may place a strain on
managerial talent or other resources
B Agencies external to the firm will not supply finance for all positive NPV projects
C Managerial unwillingness to borrow leads to the rejection or postponement of positive NPV
projects

4
BAA6004 Advanced Financial Management
Multiple Choice Question Practice – Week 4

D Senior management retains control over divisions by placing limits on the amount any
particular division can spend on a set of projects

5
BAA6004 Advanced Financial Management
Multiple Choice Question Practice – Week 4

13. Capital rationing is:

A When funds are not available to finance all wealth-enhancing projects
B When funds are not available to undertake all the projects put forward by divisional
management teams
C When the financial markets are told by government not to lend beyond imposed limits
D When wealth is destroyed because capital repayments on loans have to be made earlier than
anticipated
14. What is the maximum NPV available from the following projects?

Project NPV (£m) Initial investment (£m)

A 1 0.3 A capital constraint of £16m has been
B 3 3.5 imposed on the total initial investment.
C 5 2.5 The projects are divisible and each may
D 2 0.5 be undertaken only once.
E 10 10

A £20.3m

B £16m

C £17m

D £18m

15. Appt plc has four positive NPV projects to consider. Capital is rationed to £6m at time zero.
Each project can only be undertaken once and none are mutually exclusive.
Cash flow
at time 0 Net Present Value
Project A -£3m £2.2m
Project B -£2m £3.1m
Project C -£2.5m £1.5m
Project D -£4.0m £2.5m

The projects are divisible. Which of the following is the optimal allocation of the capital?

A Undertake projects B and D, and ignore projects A and C

B Undertake projects A, B and one-quarter of D, and ignore project C
C Undertake projects B, C and one-half of A, and ignore project
D Undertake project D and two-thirds of A, and ignore projects B and C
6
BAA6004 Advanced Financial Management
Multiple Choice Question Practice – Week 4

16. Purus plc is considering four possible investment projects for the current year but has only
a limited amount to invest.
As a result it will not be able to undertake in full all of the projects available. All of the projects
are divisible (i.e. it is possible to undertake part of a project and to receive a pro rata return).
Details of each project are as follows:
Project Investment outlay Present value of net cash inflows
£m £m
Japura 40 48
Branco 45 64
Tapajos 60 66
Napo 70 92
In what order should they be ranked if the business wishes to maximise the wealth of
its shareholders?
Project ranking
1 2 3 4
A Japura Branco Tapajos Napo
B Tapajos Branco Japura Napo
C Branco Napo Japura Tapajos
D Napo Tapajos Branco Japura

17. Glarus Co is considering four separate investment opportunities but only has limited funds
to invest during the current year. This means that the company will not be able to invest
fully in all four opportunities. Each investment opportunity is divisible (i.e. it is possible to
undertake part of an investment and to receive a pro rata return). Details of each investment
opportunity are as follows:
Investment opportunity Initial outlay Present value of net cash inflows
£m £m
Kurai 186 211
Barisan 65 84
Carnic 100 120
Flinders 50 71
How should the investment opportunities be ranked if Glarus Co wishes to maximise
the wealth of its shareholders?
Project ranking
1st 2nd 3rd 4th

A Flinders Barisan Carnic Kurai

B Kurai Carnic Barisan Flinders

C Flinders Carnic Barisan Kurai

D Kurai Flinders Carnic Barisan

7
BAA6004 Advanced Financial Management
Multiple Choice Question Practice – Week 4

18. Where there is capital rationing, the profitability index (PI) may be used to rank investment
projects with a positive net present value. It has been claimed that using the PI is
appropriate only when:
1. Capital rationing is for a single period.
2. The investment projects are indivisible.

Which ONE of the following combinations (true/false) concerning the above

statements is correct?
Statement 1 Statement 2
A True True
B True False
C False True
D False False

19. A company has £500,000 available for investment and is considering the following four
divisible, but not repeatable, projects to invest in:
Initial outlay Net present value Profitability Index
Project One £300,000 £60,000 1·20
Project Two £100,000 £40,000 1·40
Project Three £200,000 £50,000 1·25
Project Four £150,000 £45,000 1·30

What is the maximum net present value the company can generate from its
investment?

A £195,000

B £145,000

C £135,000

D £110,000