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How is the internal rate of return of a project calculated, and what must one look out for when using the internal rate of return rule? Answer: Instead of asking whether a project has a positive NPV, many businesses prefer to ask whether it offers a higher return than shareholders could expect to get by investing in the capital market. Return is usually defined as the discount rate that would result in a zero NPV. This is known as the INTERNAL RATE OF RETURN, or IRR. The project is attractive if the IRR exceeds the OPPORTUNITY COST OF CAPITAL.

What is the net present value of an investment, and how do you calculate it? Answer: The NET PRESENT VALUE of a project measures the difference between its value and cost. NPV is therefore the amount that the project will add to shareholder wealth. A company maximizes shareholder wealth by accepting all projects that have a positive NPV.

How do changes in working capital affect project cash flows? Answer: Increases in NET WORKING CAPITAL, such as accounts receivable or inventory, are investments and, therefore, use cash. That is, they reduce the net cash flow provided by the project in that period. When working capital is run down, cash is freed up, so cash flow increases.

How is the company's tax bill affected by capital cost allowance (CCA) and how does this affect project value? Answer: CCA is not a cash flow. However, because CCA reduces taxable income, it reduces taxes. This tax reduction is called the CCA TAX SHIELD. For computing tax depreciation in Canada, assets are assigned into different ASSET CLASSES, which have specified CCA rates. Most asset classes follow a declining balance system for computing CCA, and, therefore, most assets continue to generate CCA tax shields over an infinite tie frame. Because of this, we find the present value of operating cash flows separately from the present value of the CCA tax shields to determine the net present value of a project.

How can the cash flows of a project be computed from standard financial statements? Answer: Project cash flow does not equal profit. You must allow for changes in working capital as well as non-cash expenses such as depreciation. Also, if you use a nominal cost of capital, consistency requires that you forecast nominal cash flows - that is, cash flows that recognize the effect of inflation.

What is the difference between unique risk, which can be diversified away, and market risk, which cannot? Answer: Even if you hold a well-diversified portfolio, you will not eliminate all risk. You will still be exposed to macroeconomic changes that affect most stocks and the overall stock market. This means that stock returns are positively correlated. These macro risks combine to create market risk - that is, the risk that the market as a whole will slump. Stocks are not all equally risky. But what do we mean by a "high risk" stock? We don't mean a stock that is risky if held in isolation; we mean a stock that makes an above average contribution to the risk of a diversified portfolio. In other words, investors don't need to worry much about the risk that they can diversify away; they do need to worry about risk that can't be diversified. This depends on the stock's sensitivity to macroeconomic conditions.

Why does diversification reduce risk? Answer: The standard deviation of returns is generally higher on individual stocks than it is on the market. Because individual stocks do not move in lockstep, much of their risk can be diversified away. Stock returns are less than perfectly correlated. By spreading your portfolio accross many investments you smooth out the risk of your overall position. The risk that can be eliminated through diversification is known as unique risk.

How is the standard deviation of returns for individual common stocks or a stock portfolio calculated? Answer: The spread of outcomes on different investments is commonly measured by the variance or standard deviation of the possible outcomes. The variance is the average of the squared deviations around the average outcome, and the standard deviation is the square root of the variance. The standard deviation of the returns on a market portfolio of common stocks has averaged about 17 percent per year.

How can one estimate the opportunity cost of capital for an "average risk" project? Answer: Over the past 85 years the calculated return on a large portfolio of Canadian common stocks has averaged about 7 percentage points a year higher than the return on safe Treasury bills. This is the risk premium that investors have received for taking on the risk of investing in stocks. Long-term bonds have offered a higher return that Treasury bills but less than stocks. If the risk premium in the past is a guide to the future, we can estimate the expected return on the market today by adding that 7 percentage point expected risk premium to today's interest rate on Treasury bills. This would be the opportunity cost of capital for an average-risk project, that is, one with the same risk as a typical share of common stock.

How can a manager calculate the opportunity cost of capital for a project? Answer: The opportunity cost of capital is the return investors give up by investing in the project rather than in securities of equivalent risk. Financial managers use the capital asset pricing model to estimate the opportunity cost of capital. The COMPANY COST OF CAPITAL is the expected rate of return demanded by investors in a company, determined by the average risk of the company's assets and operations. The opportunity cost of capital depends on the use to which the capital is put. Therefore, required rates of return are determined by the risk of the project, not by the risk of the firm's existing business. The PROJECT COST OF CAPITAL is the minimum acceptable expected rate of return on a project given its risk. Your cash flow forecasts should already factor in the chances of pleasant and unpleasant surprises. Potential bad outcomes should be reflected in the discount rate only to the exte...

What is the relationship between the market risk of a security and the rate of return that investors demand of that security? Answer: The extra return that investors require for taking risk is known as the risk premium. The Canadian MARKET RISK PREMIUM - that is, the risk premium on the MARKET PORTFOLIO - averaged 7 percent between 1926 and 2010. The CAPITAL ASSET PRICING MODEL states that the expected risk premium of an investment should be proportional to both its beta and the market risk premium. The expected rate of return from any investment is equal to the risk-free interest rate plus the risk premium, so the CAPM boils down to r = rf + B(rm - rf) The SECURITY MARKET LINE is the graphical representation of the CAPM equation. The security market line relates the expected return investors demand of a security to the beta.

How do you calculate the beta of a portfolio? Answer: The relevant risk of any security is its beta, the sensitivity of its return to the return on the market portfolio. The beta of a portfolio, a group of securities, is the weighted average of the betas of each security, where each security's weight is its fraction of the portfolio value.

How can you measure and interpret the market risk, or beta, of a security? Answer: The contribution of a security to the risk of a diversified portfolio depends on its market risk. But not all securities are equally affected by fluctuations in the market. The sensitivity of a stock to market movement is known as BETA. Stocks with a beta of greater than 1.0 are particularly sensitive to market fluctuations. Those with a beta of less than 1.0 are not so sensitive to such movements. The average beta of all stocks is 1.0.

Describe the three basic steps an auditor should follow when designing tests of controls and substantive tests of transactions. Answer: The three basic steps in designing tests of controls and substantive tests of transactions are: • Determine key internal controls for each audit objective. • Design tests of controls for each control used to support a reduced control risk. • Design substantive tests of transactions to test for monetary misstatements for each objective.

The transaction-related audit objectives and the client’s methods of controlling misstatements are essentially the same for credit memos as for sales with the exception of two differences. What are the two differences from the auditor’s perspective? Answer: The first difference is materiality. In many instances, sales returns and allowances are so immaterial that auditors ignore them. The second difference is the emphasis on the occurrence objective. For sales returns and allowances, auditors usually emphasize testing recorded transactions to uncovering any theft of cash from the collection of accounts receivable that was covered up by fictitious sales returns and allowances.

If sales invoices are automatically calculated and posted by a company’s computer system, can the auditor reduce substantive tests of transactions for the accuracy objective? Answer: If the auditor determines that the computer is programmed accurately and the price list master file is authorized and correct, detailed invoice computations can be reduced or eliminated. The auditor would then focus on determining that effective computer controls exist to ensure that the computer system is properly programmed and has not been altered since it was last tested by the auditor.

For each of the following potential misstatements, provide one potential audit test that could be used to detect the misstatement. • Recorded sale for which there was no shipment • Sale recorded more than once • Shipment made to nonexistent customers Answer: The potential audit tests include the following: • Recorded sale for which there was no shipment. Vouch selected entries in the sales journal to related copies of shipping and other supporting documents. • Sale recorded more than once. Review a numerically sorted list of recorded sales transactions for duplicate numbers. The auditor may also test for proper cancellation of shipping documents. • Shipment made to nonexistent customers. Trace customer information on sales invoices to the customer master file.

When designing substantive tests of transaction for Sales, the auditor is concerned with several types of misstatements. What are these types of misstatements and are they intentional or unintentional? Answer: The auditor is concerned with sales being included in the journals for which no shipment was made, sales recorded more than once, and shipments being made to non-existent customers and recorded as sales. The first two types of misstatements can be intentional or unintentional, but the third type is always intentional.

Discuss the four business functions that result in sales transactions in a typical sales and collection cycle and, for each function, state the key documents and records involved. Answer: The four business functions that result in sales transactions, and related documents and records, are: • Processing customer orders. Key documents include customer order and sales order. • Granting credit. Customer order or sales order. • Shipping goods. Shipping document (bill of lading). • Billing customers and recording sales. Sales invoice, sales journal, summary sales report, accounts receivable master file, accounts receivable trial balance, and monthly statements.

Explain what lapping means, and discuss the internal control deficiency that allows it to occur. Also discuss the procedures the auditor can perform to detect lapping. Answer: Lapping, which is a common type of defalcation, is the postponement of entries for the collection of receivables to conceal an existing cash shortage. It involves deferring recording the cash receipts from one customer and covering the shortages with subsequent receipts from another customer. Improper segregation of duties in which a person who handles cash receipts is allowed to enter those receipts into the accounting records allows lapping to occur. The auditor can detect lapping by comparing the name, amount, and dates shown on remittance advices with cash receipts journal entries and related deposit slips.