06. Applications of DCF Techniques

Question 1

What is the NPV decision rule for project acceptance?

Answer 1

Accept all projects with a positive NPV.

Question 2

Define capital rationing.

Answer 2

Capital rationing is a situation in which there is not enough finance (capital) available to undertake all available positive NPV projects. Therefore, capital has to be rationed.

Question 3

Differentiate between hard capital rationing and soft capital rationing.

Answer 3

Hard capital rationing - the capital markets impose limits on the amount of finance available.

Soft capital rationing - the company sets internal limits on finance availability.

Question 4

Differentiate between single-period and multi-period capital rationing.

Answer 4

Single-period capital rationing - capital is in short supply in only one period.

Multi-period capital rationing - capital is rationed in two or more periods

Question 5

List 4 reasons why capital markets may restrict the funds available to a particular company.

Answer 5

1. High business risk (ie the company’s operating cash flows are sensitive to the economic cycle).
2. High country/political risk (ie there are concerns about corporate governance or state appropriation of assets).
3. High financial risk (ie the company already has high existing levels of debt).
4. Lack of reliable independent information available about the company. This is especially relevant to small- and medium- sized entities (SMEs).

Question 6

What are 4 reasons why company directors or managers might restrict available funds for capital investment?

Answer 6

1. A preference for slower organic growth to a sudden increase in size arising from accepting several large investment projects. This particularly applies in a family-owned business that wishes to avoid hiring new managers.
2. Managers may wish to avoid raising further equity finance if this will dilute the control of existing shareholders.
3. Managers may wish to avoid issuing new debt if their expectations of future economic conditions are such that an increased commitment to fixed interest payments would be unwise.
4. To create an internal market for investment funds. This can be seen as a way of reducing the risk and uncertainty associated with investment projects, as it leads to only accepting projects with greater margins of safety.

Question 7

What is a divisible project?

Answer 7

A project is divisible if the company can make any partial or proportionate investment in it (ie between 0% and 100%). However, the project cannot be repeated.

Question 8

What is a non-divisible project?

Answer 8

A non-divisible or indivisible project must be done 100% or not at all.

Question 9

Define equivalent annual cost (EAC). What is the formula for EAC?

Answer 9

The annual cost of owning, operating and maintaining an asset over its entire life.

EAC = NPV/Annuity Factor

Question 10

Outline 3 limitations of replacement analysis.

Answer 10

1. Like-with-like replacement (in perpetuity) is rarely possible even if desirable. Asset requirements may change over time.
2. Changing technology may also require earlier replacement (eg of IT equipment) than suggested by the optimal solution.
3. Non-financial factors (eg employees may be more satisfied if their company cars are replaced more often).

Question 11

Outline one situation where using the EAB approach may be applicable.

Answer 11

If faced with mutually exclusive projects, where only one can be accepted and this same situation will be faced repeatedly (in perpetuity) and the projects have different lives, the equivalent annual benefit (EAB) approach can be used.

Question 12

What two decisions must be made when deciding whether to lease or buy an asset? Outline these decisions.

Answer 12

1. Investment decision - does the asset give operational benefits? This decision is made first. Discount cash flows from using the asset (sales, materials, labour, overheads, tax on net cash flows, etc) at the company’s WACC
2. Financing decision - is it cheaper to buy or lease? Discount cash flows specific to each financing option at the after-tax cost of debt. The preferred financing option is that either the lowest NPV or cost.

Question 13

What are some of the relevant cash flows to consider when buying or leasing an asset?

Answer 13

Buy asset
- purchase cost
- tax benefit of TAD
- scrap proceeds

Lease asset
- lease payments (assume all to be tax-allowable deductions)
- tax benefit of lease payments

Other costs maybe relevant depending on the terms of the lease agreement. Eg operational costs associated with the asset eg maintenance and insurance.

Interest payments are not relevant because they are accounted for in discounting the cost of capital.

Question 14

What are some of the implications for a lease-versus-buy decision when a business is not in a tax paying position?

Answer 14

1. There would be no tax benefit from TAD if the asset was bought.
2. No tax benefit arises from the lease payments.
3. There would be no tax shield on debt (ie interest expense on borrowings would not reduce tax expense). As such the pre-tax of debt should be used.

Question 15

What is the formula for post-tax cost of debt given the pre-tax figure?

Answer 15

Post-tax cost of debt = pre-tax cost of debt * (1 - tax rate)

Question 16

List 5 situations that may result in a business not being in a tax-paying position.

Answer 16

1. Losses in the current year.
2. Losses are brought forward from prior years.
3. Incorporation in a tax-free special economic zone.
4. Tax holidays granted by the host government.
5. Tax-exempt charity status.

Question 17

What are some implications on the financial statements when using the borrow to buy financing option?

Answer 17

1. The bank loan will be recorded in non-current liabilities and so increase the company’s reported financial gearing (debt to equity ratio).
2. Interest on the debt will reduce the company’s interest cover (ie EBIT/interest expense).
3. Overall effect will depend on profits generated by the asset as these will increase EBIt and any retained profit would increase the level of equity.

Question 18

What are some implications on the financial statements when using the lease financing option?

Answer 18

1. Both the asset and a related liability would be recognised in the statement of financial position. Reported gearing would therefore rise initially.
2. However, lease payments would be split between interest expense and repayment of principal and therefore the liability would amortise (ie reduce) over time and ultimately fall to zero. Interest expense in early years would be relatively high, tending to reduce interest cover, but lower in later years.
3. This accounting treatment applies to any lease which is longer than 12 months. Less than 12 months would simply be treated as rental expense which has no effect on the statement of financial position.

Question 19

What are some non-financial factors to consider if buying an asset is the preferred financing option?

Answer 19

1. The asset is of fundamental importance to the business and is in constant use.
2. Management wants to have absolute control over the asset.
3. To update or upgrade the asset to scale up capacity is relatively easy.
4. The asset is easily maintained (eg under a supplier’s warranty).
5. There is an active second-hand market for the asset (so it is not only financially more affordable, but can easily be disposed of).

Question 20

What are some non-financial factors to consider if leasing an asset is the preferred financing option?

Answer 20

1. The asset may only be needed for a short time or there is significant uncertainty about how long it may be used.
2. The asset requires specialist support or maintenance that is provided by the lessor.
3. The asset needs to be regularly updated or upgraded for any reason (eg due to technical obsolescence or rapid expansion).
4. The lease agreement includes options to upgrade to newer models or other flexibility.
5. Disposal of the asset at the end of its life is subject to strict regulations.