5) DCF- Special decision

Question 1

What are the three special decisions

Answer 1

Asset replacement
capital rationing
lease or buy

Question 2

For Asset replacement, what are the relevant cash flows and what CF must be ignored

Answer 2

▪ Purchase cost
▪ Maintenance costs
▪ Scrap proceeds

-Ignore sales revenue and costs not incremental

Question 3

What is the method used to in asset replacement and the steps

and the formula

Answer 3

Equivalent annual cost

Step 1) Calculate PV of the costs for each replacement cycle

Step 2) Calculate the equivalent annual cost for each cycle

Step 3) choose the cycle with the lowest EAC

EAC= PV cost over 1 replacement cycle ÷ Annuity factor for that cycle

Question 4

What are the limitations of the replacement analysis

Answer 4

EAC assumes

• Ignores trading cash flows
• Assets are replaced by identical assets indefinitely into the future. so assumes that operating efficiency stays same and no changes in technology.
• Inflation is ignored as well as tax
• There is no change in the productivity of the company e.g. the level of sales being generated by the new asset would be more productive in real life
• ignores other decision e.g. emissions form older machines which aren’t factored into the costs

The EAC method assumes that the operating efficiency of the machines will be similar. The method also assumes that the assets will be replaced in perpetuity, or at least into the foreseeable future.

Question 5

…

Answer 5

…

Question 6

What is capital rationing

Answer 6

There are times when a business will only have a limited amount of funds available to invest. In these situations a decision must be made as to how to prioritise the investments. This is the capital rationing situation.

Question 7

What is soft rationing

and explain 4 reasons for it

Answer 7

Soft capital rationing refers to restrictions on the availability of funds that arise within a company and are imposed by managers.

One of the main reason for soft rationing (limiting investment finance internally) is that managers wish to create an internal market for investment funds. It’s suggested that requiring investment projects to compete for funds means that weaker or marginal projects with only a small chance of success are avoided. This allows for the company to focus on more robust investment projects where the chance of success is higher. This cause of soft capital rationing can be seen as a way of reducing risk and uncertainty associated with investment projects as it leads to accepting projects with greater margins of safety.

other Reasons could be:
1) Managers may prefer slower organic growth rather than suggen increase in size from accepting several large investment projects (this may apply to family business who want to avoid hiring new manager)

2) Managers may wish to avoid raising further equity finance to avoid dilution of control from existing shareholders
3) Managers may wish to avoid issuing new debt if this expectation of future economic conditions are such as to suggest that an increased commitment to fixed interest payment will be unwise
e. g. to control the rate of expansion.

Question 8

What is hardrationing

Answer 8

Hard capital rationing is the term applied when the restrictions on raising funds are due to causes external to the company.

An absolute limit on the amount of finance available imposed by the lending institution. .g. banks might be unwilling to provide more than a certain amount of funds to a company due to them regarding company as risky

e.g. can be financial risk (high gearing, low interest cover) OR business risk (poor business prospect, operating cash flows too variable)

other exampels Government restrictions on bank lending would represent hard capital rationing

Question 9

What is non divisibility

Answer 9

projects cannot be part invested in.

Question 10

what is divisibility

Answer 10

projects can be part invested in (and earn a proportion of the returns).

Question 11

what is mutually exclusive

Answer 11

projects cannot be done together.

Question 12

what is mutually exclusive

Answer 12

projects cannot be done together.

Question 13

How is a decision made for indivisible projects

Answer 13

If the projects are non-divisible or indivisible, a trial and error approach to the investment decision should be taken in order to establish the optimal project mix.

Question 14

How is a decision made for divisible projects

Answer 14

If projects are divisible they should be ranked according to the profitability index. A company should priorities projects which have a higher profitability index.

Step 1) Calculate the profitability index (NPV per $1 needed in the capital restricted period) and allocate in order of their profitability index

Question 15

How is a decision made for mutually exclusive projects

Answer 15

Choose project with the highest NPV

Question 16

What is profitability index

Answer 16

Profitability index= NPV ÷ Initial Investment

Question 17

How is the decision to lease or buy an asset made?

Describe the steps

Answer 17

This decision is made by comparing the present value of (COSTS) i.e. leasing the asset with the present value of borrowing money in order to buy the asset.

Whichever present value has the lowest overall cost is the best approach.

Only calculating the PV of financing cash flows at POST TAX cost of borrowing

Step 1) Post tax cost of borrowing
Step 2) Benefits of TAD
Step 3) PV of lease payments
Step 4) PV of borrowing to buying

Question 18

What are the relevant cash flows of buying the asset

Answer 18

• The initial cost
• The scrap value
• The BENEFIT of tax allowable depreciation- NOT TAD it’self being a relevant CF

Question 19

What are the relevant cash flows of leasing the asset

Answer 19

• The annual lease payments

* The tax relief available on the annual lease payments (assume treated like an operating lease for tax purposes)

Question 20

What is an operating lease

Answer 20

It is a short term lease; renewable/cancellable every year instead of finance lease which is committed to lease over it’s economic life

Question 21

What is the relevant discount rate to use to appraise the lease vs borrow to buy decision?

Answer 21

Assumption is that buying requires the use of a bank loan (for comparison sake). The user will receive allowances against the interest payable on the loan; this affects the discount rate so we need to use the post tax cost of borrowing

Post tax cost of borrowing

= Pre tax cost of borrowing X (1- Tax rate)

Question 22

How would you approach the following question?

what are some of the reasons why capital rationing may arise?

Answer 22

The NPV decision rule, to accept all projects with a positive net present value, requires the existence of a perfect capital market where access to funds for capital investment is not restricted. In practice, companies are likely to find that funds available for capital investment are restricted or rationed.

then go onto explain hard capital rationing and soft capital rationing.

Question 23

what is the proforma for lease payment

Answer 23

• Lease payments
• (Tax relief on the payment)
  = Net Cash flow

DF @ post tax cost of borrowing

PV cost of leasing

Question 24

What is the proforma for buying

Answer 24

• (Initial Borrowing)
• Benefits of TAD
  = Net Cash flow

DF @ post tax cost of borrowing

PV cost of buying

Question 25

when working out leasing and buying, which cost if irrelevant?

Answer 25

Sales revenue

Question 26

whether a lease payment is in advance or in areears- does this matter

Answer 26

No because from a tax POV it would be reducing the profit payable at T1 It is still within the same accounting period

Question 27

When a question says, what is the minimum acceptable contract price to be received at the end of the contract- how do you answer this?

Answer 27

For a minimum contract price, the net present value must be equal to zero. You can calculate the present value of the initial cost, the initial working capital, and the recover of working capital in two years time. This comes to – 125696 Therefore if X is the contract price in two years time, the PV of X discounted for 2 years must be 125696. So X must equal 125696 / 0.826 = 152174.

Question 28

Discuss the attractions of leasing as a source of both short-term and long-term finance.

Answer 28

Leasing can act as either a source of short-term or long-term finance. Short-term leasing offers a solution to the obsolescence problem, whereby rapidly aging assets can decrease competitive advantage. Where keeping up-to-date with the latest technology is essential for business operations, short-term leasing provides equipment on short-term contracts that can usually be cancelled without penalty to the lessee. Short-term leasing can also provide access to skilled maintenance, which might otherwise need to be bought in by the lessee, although there will be a charge for this service. Long-term leasing spreads the cost of an asset over the majority of the useful life of that asset and means that the business doesn’t have to source separate finance to cover the purchase of the asset. Both short-term and long-term leasing provide access to non-current assets in cases where borrowing may be difficult or even not possible for a company. For example, the company may lack assets to offer as security, or it may be seen as too risky to lend to. Since ownership of the leased asset remains with the lessor, it can be retrieved if lease rental payments are not forthcomin