IFA IFA Financial Analysis & Decision Making 2 — Questions and Answers
Question 1: What is net present value (NPV) used for in financial decision making?
- Calculating the book value of assets
- Determining whether an investment creates value by discounting future cash flows (Correct answer)
- Measuring a company's current profitability
- Calculating tax liabilities on investments
Correct answer: Determining whether an investment creates value by discounting future cash flows
NPV discounts all expected future cash flows of a project to their present value and subtracts the initial investment to determine if the project creates net value.
Question 2: The internal rate of return (IRR) is the discount rate at which:
- Net profit equals zero
- Net present value equals zero (Correct answer)
- The project payback period is maximized
- Return on equity equals cost of debt
Correct answer: Net present value equals zero
The IRR is the discount rate that makes the net present value of all cash flows from a project equal to zero, representing the project's effective yield.
Question 3: What does a high debt-to-equity ratio indicate about a company's capital structure?
- The company is primarily equity-financed and low risk
- The company relies heavily on debt financing, increasing financial risk (Correct answer)
- The company has no outstanding loans
- The company is highly liquid
Correct answer: The company relies heavily on debt financing, increasing financial risk
A high debt-to-equity ratio indicates that a company has financed a large portion of its assets with debt, which increases interest obligations and financial risk.
Question 4: Which financial statement shows changes in a company's cash position over a period?
- Income statement
- Balance sheet
- Statement of cash flows (Correct answer)
- Statement of changes in equity
Correct answer: Statement of cash flows
The statement of cash flows categorizes cash movements into operating, investing, and financing activities to explain changes in the cash balance.
Question 5: What is a payback period and what is its main limitation?
- Time to double profits; ignores taxation
- Time to recover initial investment from cash flows; ignores time value of money and post-payback flows (Correct answer)
- Time until dividends are paid; too simple to calculate
- Time until break-even sales; ignores fixed costs
Correct answer: Time to recover initial investment from cash flows; ignores time value of money and post-payback flows
The payback period measures how long it takes to recoup an investment, but it ignores the time value of money and any cash flows occurring after the payback point.
Question 6: Vertical analysis of an income statement expresses each line item as a percentage of:
- Total assets
- Net income
- Revenue (net sales) (Correct answer)
- Total liabilities
Correct answer: Revenue (net sales)
In vertical analysis of an income statement, each line item is expressed as a percentage of net sales or revenue, showing the relative proportion of each cost and profit component.
IFA IFA Financial Analysis & Decision Making 2
What is net present value (NPV) used for in financial decision making?