OVERVIEW
Objective
¾
To apply discounted cash flow techniques to specific areas.LEASE v BUY CAPITAL
RATIONING
¾ Definition ¾ Methods
ASSET REPLACEMENT
DECISIONS
¾ The issue
¾ Limitations of replacement
analysis
¾ The issue
¾ Decision-making ¾ The investment decision ¾ The financing decision ¾ The final decision
1
CAPITAL RATIONING
1.1
Definition
A situation where there is not enough finance available to undertake all available positive NPV projects.
¾
Hard capital rationing – where the capital markets impose limits on the amount of finance available e.g. due to high perceived risk of the company.¾
Soft rationing – where the company itself sets internal limits on finance availability e.g. to encourage divisions to compete for funds.¾
Single-period capital rationing – where capital is in short supply in only one period.¾
Multi-period – where capital is rationed in two or more periods.1.2
Methods
1.2.1
Divisible projects
A divisible project is where the company can undertake between 0-100% of the project - infinite divisibility. However a project cannot be repeated.
¾
Calculate a “profitability index” for each project = NPV/Initial Investment¾
Rank projects according to their index¾
Allocate funds to the most effective projects in order to maximise NPV.Example 1
Projects A B C D
$000 $000 $000 $000
NPV 100 (50) 84 45
Cash flow at t0 (50) (10) (10) (15)
Cash is rationed to $50,000 at t0 Projects are divisible.
Required:
Solution
1.2.2
Non-divisible projects
A non-divisible/indivisible project must be done 100% or not at all.
¾
Do not calculate a profitability index;¾
Simply list all possible combinations of projects¾
Choose combination with highest NPV.Example 2
Detail as for example 1 but assume that projects are non-divisible.
Solution
1.2.3
Mutually-exclusive projects
Mutually exclusive projects is where two or more particular projects cannot be undertaken at the same time e.g. because they use the same land.
¾
Divide projects into groups; with one of the mutually-exclusive projects in each group.¾
Calculate the highest NPV available from each group (assume projects are divisibleunless told otherwise)
Example 3
As for example 1 but C and D are mutually exclusive.
Solution
1.2.4
Multi-period capital rationing
¾
If finance is limited in several periods then a linear programming model would have to be set up and solved in order to find the optimal investment strategy.¾
This is outside of the scope of the syllabus2
ASSET REPLACEMENT DECISIONS
2.1
The issue
¾
Assume that the company has already decided it requires a particular non-current asset.¾
A secondary decision is about how often to replace the asset.¾
For example how often should the company replace its fleet of motor vehicles or its computer equipment?¾
This is referred to as an asset replacement decision.Method:
1 Calculate the NPV of each possible replacement cycle.
2 Calculate the Annual Equivalent Cost (AEC) of each cycle
AEC = NPV/Annuity factor
Example 4
A machine costs $20,000.
Running costs Scrap proceeds
Year 1 5,000 16,000
Year 2 5,500 13,000
Company’s cost of capital = 10%
Required:
Should the machine be replaced every one or every two years?
Solution
2.2
Limitations of replacement analysis
¾
Changing technology e.g. it may be advisable to replace IT equipment more often than suggested by the above analysis.¾
Asset requirements may change over time.3
LEASE v BUY
3.1
The issue
¾
Should the company acquire an asset through: A straight purchase i.e. borrowing to buy, or A lease.¾
There are two main types of lease: Operating lease; where the asset is simply rented for a relatively short part of its useful economic life;
Financial/capital lease; where the asset is leased for most of its life.
¾
Although the distinction between operating and finance lease is important in financial reporting, it is not so relevant in financial management.¾
The important issue for financial management is the cash flows created by a lease, as compared to a straight purchase of the asset.3.2
Decision-making
TWO DECISIONS
INVESTMENT DECISION FINANCING DECISION
Does the asset give operational benefits?
Focus on the NPV of the operating cash flows
Is it cheaper to buy or lease?
Focus on the relative beefits of WDA’s from buying and the tax relief on the lease payments.
Discount these cash flows using a rate which reflects operating risk of
investment e.g average cost of capital
Discount these cash flows using after-tax cost of borrowing
Commentary
¾
The issue here is stripping financing cash flows from operating cash flows and using separate discount rates for each.3.3
The investment decision
Discount the cash flows from using the asset (sales, materials, labour, overheads, tax on net cash flows, etc) at the firm’s weighted average cost of capital (WACC).
3.4
The financing decision
Discount the cash flows specific to each financing option at the after-tax cost of debt. The assumption is that shareholders view borrowing and leasing as equivalent in terms of financial risk, so the after-tax cost of debt is an appropriate discount rate for both options. The preferred financing option will be that with the lowest NPV of cost.
The relevant cash flows for each possible method of financing are as follows. Buy asset – Purchase cost, tax saving on WDA’s, scrap
proceeds Lease asset (operating
or finance lease) – Lease payments, tax saving on lease payments
Under UK tax law all lease payments are tax allowable deductions – both for finance leases and operating leases.
3.5
The final decision
Example 5
New project
Asset costs $200,000 on the first day of a new accounting period. Scrap value $25,000 on the last day of the next accounting period. Operating inflows $150,000 for two years.
Tax at 33% and paid one year in arrears. Weighted average cost of capital 10%. Capital allowances at 25% reducing balance. Finance options:
(1) borrowing at a post-tax cost of 7%;
(2) lease for $92,500 per year in advance for two years (lease payments are tax allowable).
Required:
(a) Determine the operational benefit of the project. (b) Determine how the project should be financed. (c) Decide whether the project is worthwhile.
Solution
(a) Operational value
Time Cash flow Narrative DF @ 10% PV
$ $
Present value
________ ________
(b) Financing decision
(1) Borrow and buy flowsTime Cash flow Narrative DF @ 7% PV
$ $
________
________ (W) WDA’s
Time Tax effect
at 33% Time
$ $
(2) Leasing flows
Time Cash flow Narrative DF @ 7% PV
$ $
PV of leasing ________
________
(c) Final decision
$ PV of operating flows
PV of cheaper finance
NPV ________
Key points
³
With capital rationing it is essential to identify the nature of the projects i.e. divisible or non-divisible, mutually exclusive or not.³
With asset replacement decisions, the key is the use of Annual Equivalent Cost to compare cycles of different lengths.³
With lease vs. buy decisions, the key is to separate the financing decision from the investment decision and analyse each at a discount rate reflecting the risk of the cash flows. Also remember all lease payments are taxdeductible expenses in the UK.
FOCUS
You should now be able to:
¾
distinguish between hard and soft capital rationing;¾
apply profitability index techniques for single period divisible projects;¾
use DCF to analyse asset replacement decisions;EXAMPLE SOLUTIONS
Solution 1 — Divisible projects
Projects A B C D
Solution 2 — Non-divisible
Combinations NPV
$000 A only
C + D 100 129
... Choose C + D.
Solution 3 — Mutually exclusive
Plan
Solution 4 — Machine replacement
Replace every year
Time Cash flow Discount factor PV
Annual equivalent cost =
factor annuity
year
1NPV =
10
0
.
909
,
001
=
$
11,002
Now repeat the above procedure, assuming the machine is replaced every two years. Time Narrative Cash flow
@ 10% Discount factor value Present
Solution 5 — Lease or Buy
(a) Operational value
Time Cash flow Narrative DF @ 10% PV
(b) Financing decision
(1) Borrow and buy flows2 Balancing allowance ________ 125,000
(c) Final decision
$ PV of operating flows
PV of leasing flows (cheaper finance – see (b)) (127,431) 182,289
NPV ________ 54,858
