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Appendix 3• Suggested answers to review questions

lLong-term finance.The relationship between equity capital and fixed return capi-

tal is the issue. A strong balance sheet would have a fairly modest capital gearing

ratio and, probably, available assets to offer as security for further borrowings.

3.4 The matching convention says that expenses should be matched to the revenues that

they helped to generate, within the same period as that in which those revenues

were realised (recognised).

3.5 This is presumably because Taffler found that it added little or nothing to the reli-

ability of the model. This is not to say that the ratio has no value, or even that it has

little or no value in trying to identify problem businesses. It is probably the case that

other ratios that are included in the model, and which are substantially correlated

with the acid test ratio, perform better in the context of the model.

3.6 A careful reading of the financial statements is certainly extremely valuable in draw-

ing helpful conclusions about a business. It can provide insights that ratio analysis

cannot provide. Ratio analysis can, however, by formally relating one figure to

another, provide insights that a normal reading of the accounts cannot provide.

A major reason for this is that ratios can correct for size differences between the

businesses or time periods that are to be compared. Thus comparing the profit of

Business A with that of Business B will not usually be very helpful, but comparing

the profit per £1 of capital employed by Business A with that of Business B will usu-

ally be informative.

4.1 Discounting is intended to take account of the effective cost of using the funds in the

investment project under consideration. This cost is made up of three elements:

la ‘pure’ rate of interest;

lan allowance for risk; and

lan allowance for inflation.

Inflation is a factor, but it is not the only reason for discounting. Discounting would

need to be undertaken even where no inflation was expected over the lifetime of the

project under consideration.

4.2 The opportunity cost of finance is the rate at which the business (or, more strictly, its

shareholders) could invest the funds if they were not to be used in the investment

project under review. Where relevant, this would take account of the risk involved

in the project.

4.3 It is a fact that NPV is unique among the four methods that are found in practice, in

relating directly to the presumed objective of private sector businesses to maximise the

wealth of shareholders. Reliance on the other three methods will only, by coincidence,

cause decisions to be taken that will work towards a wealth maximisation objective.

4.4 There seem to be two basic possibilities:

lSome users do not realise that it is flawed.

lSome users realise that it is flawed but feel that, nevertheless, it gives helpful

information. Since it is easy to calculate, it is not expensive to produce, certainly

not where the cash flows are to be estimated for use with, say, NPV.

4.5 IRR is flawed because it does not address the generally accepted objective of

shareholder wealth maximisation. Following IRR would promote those projects that

Chapter 4

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