Chapter 5 - Asset Investment Decisions and Capital Rationing Flashcards
What is leasing?
Effectively financing the purchase of the asset with the lease contract
What is buying?
Acquiring the asset with separate finance arranged for the purchase
What are the cash flows for leasing?
- the lease payments
- the tax relief on the lease payments
What is leasing a form of?
debt financing
When would the lease payments be paid?
at the start of a year
If a lease payment is at the start of the year, when would the tax saving occur?
it will be two years later if tax is paid a year in arrears
Will the company leasing the car be able to claim any capital allowances and why?
No, because the company (lessee) won’t own the car the lessor retains ownership so they are able to claim it but not both
What is the discount rate for leasing and buying?
Post tax cost of borrowing (cost of borrowing x (1-tax rate))
What are the cash flows for buying?
- the purchase payment and scrap value
- the tax savings from tax-allowable depreciation
How do we calculate the equivalent annual cost?
PV of costs / Annuity factor for year n
n = length of replacement period in years
How is the decision make when EAC is calculated for year of the years?
the lowest EAC is chosen
In regards to EAC what is the assumption about trading cash flows?
Trading cash flows from the use of the asset are ignored as they are assumed to be similar whichever asset/replacement cycle is chosen.
What is the limitation of the assumption on trading cash flows?
in reality, using an older asset may lead to lower operating cash flows from reduced productivity or quality.
In regards to EAC what is the assumption about operating efficiencies?
Operating efficiencies of machines will be similar with differing machines and with differing ages
What is the limitation of the assumption on operating efficiencies?
In reality, efficiency is likely to reduce over time and some suppliers may produce more reliable equipment than others
In regards to EAC what is the assumption about replacement cycle?
the assets will be replaced in perpetuity, or at least into the foreseeable future.
What is the limitation of the assumption on replacement cycle?
in reality, changing technology and product updates mean that the same asset or set of assets will not be used for the foreseeable future.
In most EAC questions what is ignored?
tax and inflation, as well as other non-financial aspects
What is the limitation of the assumption to ignore tax and inflation?
in reality, prices and costs change over time due to inflation. Prices applicable to the current asset replacement cycle may not therefore be repeated for the next one
With and EAB which project would we choose?
The highest EAB - same technique as EAC
What is capital rationing?
Where there is insufficient funds to take on positive NPV projects
What are the two forms of capital rationing?
- Hard capital rationing
- Soft capital rationing
What is hard capital rationing?
an absolute limit on financing available is imposed by the funders of the business. The business cannot raise further cash
What is soft capital rationing?
an internally imposed limit on investment capital. This is contrary to the rational view of shareholder wealth maximisation.
What is multi period rationing?
where funds are rationed in more than one period.
What is single period rationing?
where funds are limited in one period only
What are divisible projects?
can be done in whole or in part e.g., whole projects needs $10m investment and earns $2m NPV
What is the method in order to calculate divisible projects?
- Calculate profitability index (PI) for each project
PI = NPV / initial investment amount - Use the PI to rank the projects
- Allocate available funding in ranking order
What method is used for approaching indivisible projects?
Trial and error method:
- determine all possible combinations of projects
- pick the combination with the largest overall NPV
If a project is indivisible then what happens to the project?
it must be done in its entirety or not at all
What are mutually exclusive projects?
projects that cannot be done together
What is the approach to doing mutually exclusive projects?
divisible or indivisible method, except:
- optimum solution cannot contain both projects
- for divisible, produce separate result for each project being selected
- choose combination with highest overall NPV
