5016 - Investment and Financial Analysis - Investment Appraisal Part 2 - Impact of inflation & Taxation and Project Evaluation Under Conditions of Capital Rationing p289 - 312

Question 1

Two approaches to inflation and investment appraisal

Answer 1

• Adjust future cashflows for inflation and use a discount rate that is adjusted to inflation
• Exclude inflation from future cash flows and use a ‘real’ discount rate that excludes inflation

Question 2

How could inflation impact the WACC and discount rate

Answer 2

• Shareholders may demand higher dividends to avoid inflation impacting their benefit
• Debt providers may increase interest rates to control inflation. However, interest rates could also go down

Question 3

What is the Fisher Effect used for?

Answer 3

Used to calculate the discount rate to account for inflation

Question 4

The fisher effect formula

Answer 4

(1+R)(1+Ei) = (1+n)

R = Real interest rate/WACC
Ei = Expected inflation Rate
n = Nominal Interest Rate

Question 5

Writing Down Allowance (WDA) Definition

Answer 5

A reduction in the taxable income of a corporation due to assets acquired in a year

Question 6

Why do governments use WDA

Answer 6

To encourage investment and stimulate the economy

Question 7

Why do businesses use WDA

Answer 7

To offset the cost of deprecating fixed assets

Question 8

Writing Down Allowance in the UK

Answer 8

Depends on the item, for example with cars it is based on the amount of CO2 emissions however the ‘normal’ amount is quoted at 18%

Question 9

Corporation Tax Level in the UK

Answer 9

19%

Oil and gas companies pay 30%+10% supplementary charge so 40%

Question 10

Factors to consider in investment appraisal

Answer 10

• Past Costs
• Common future costs
• Opportunity costs
• Taxation
• Cash flow
• Year end assumptions
• Interest payments

Question 11

What is capital rationing

Answer 11

When the finance for new investment is limited to an amount that prevents acceptance of all NPV positive projects

Question 12

Hard Capital Rationing

Answer 12

Imposed externally by the market due to:

• depressed share price
• cost of share/debt issue
• company has a high level of financial risk
• government control of banks

Question 13

Soft Capital Rationing

Answer 13

Imposed internally by a firm due to:

• Budget restrictions
• Managerial desire to restrict company size

Question 14

Multi-Period Rationing

Answer 14

• When capital is rationed for more than one period then a linear programme is needed to solve
• Involves maximising an objective function (NPV of cash flow or dividend stream) subject to multiple constraints

Question 15

NPV index (NPVI) aka Profitability index (PI) explanation

Answer 15

Where projects are divisible, managers seek to maximise the present value per $ of scarce resources

Question 16

PI / NPVI calculation

Answer 16

NPV of future cash flows divided by initial outlay

Question 17

Two approaches to comparing projects with unequal lives

Answer 17

• Shortest-Common-Period-Of-Time approach
• Equivalent-annual-annuity approach

both should provide the same solution

Question 18

Annual Annuity calculation

Answer 18

i divided by 1 - (1+i) to the power -n

Question 19

What did Pike (1983) do?

Answer 19

Studied the problem of low investment sampling 208 of the largest uk industrial companies

Question 20

Main findings of Pike (1983)

Answer 20

• Problem of low investment derives from inadequate demand NOT from shortage of finance
• Capital rationing, if it existed, tended to be soft rationing
• Smaller, less profitable, high risk firms are most affected

Question 21

Main reasons for not investing found by Pike (1983)

Answer 21

• General economic uncertainty
• Lack of profitable opportunities
• Reluctance to increase borrowing levels
• For small, low profit, high risk companies capital constraints where the biggest reason

Question 22

During the recession the trend on lending was what?

Answer 22

The growth in lending decreases to below 0

Question 23

How do firms handle capital rationing?

Answer 23

1. Reduce investment search activity
2. Emphasise payback
3. Change Profitability criteria

Question 24

What did Mukherjee and Hingorani (1999) analyse?

Answer 24

Analysed the response of 102 large US Firms

Question 25

What did Mukherjee and Hingorani (1999) find?

Answer 25

64% of firms encountered capital constraints often due to:

• Reluctance to raise gearing levels
• Company budgets tied to internally available fund
• Company reluctance to accept high risk and or low NPV Projects
• To discourage middle managers’ optimistic forecast bias.

82% of firms claimed capital rationing was internally imposed, so soft capital rationing.