Chapter 5 - Asset Investment Decisions and Capital Rationing

Question 1

What is leasing?

Answer 1

Effectively financing the purchase of the asset with the lease contract

Question 2

What is buying?

Answer 2

Acquiring the asset with separate finance arranged for the purchase

Question 3

What are the cash flows for leasing?

Answer 3

• the lease payments
• the tax relief on the lease payments

Question 4

What is leasing a form of?

Answer 4

debt financing

Question 5

When would the lease payments be paid?

Answer 5

at the start of a year

Question 6

If a lease payment is at the start of the year, when would the tax saving occur?

Answer 6

it will be two years later if tax is paid a year in arrears

Question 7

Will the company leasing the car be able to claim any capital allowances and why?

Answer 7

No, because the company (lessee) won’t own the car the lessor retains ownership so they are able to claim it but not both

Question 8

What is the discount rate for leasing and buying?

Answer 8

Post tax cost of borrowing (cost of borrowing x (1-tax rate))

Question 9

What are the cash flows for buying?

Answer 9

• the purchase payment and scrap value
• the tax savings from tax-allowable depreciation

Question 10

How do we calculate the equivalent annual cost?

Answer 10

PV of costs / Annuity factor for year n
n = length of replacement period in years

Question 11

How is the decision make when EAC is calculated for year of the years?

Answer 11

the lowest EAC is chosen

Question 12

In regards to EAC what is the assumption about trading cash flows?

Answer 12

Trading cash flows from the use of the asset are ignored as they are assumed to be similar whichever asset/replacement cycle is chosen.

Question 13

What is the limitation of the assumption on trading cash flows?

Answer 13

in reality, using an older asset may lead to lower operating cash flows from reduced productivity or quality.

Question 14

In regards to EAC what is the assumption about operating efficiencies?

Answer 14

Operating efficiencies of machines will be similar with differing machines and with differing ages

Question 15

What is the limitation of the assumption on operating efficiencies?

Answer 15

In reality, efficiency is likely to reduce over time and some suppliers may produce more reliable equipment than others

Question 16

In regards to EAC what is the assumption about replacement cycle?

Answer 16

the assets will be replaced in perpetuity, or at least into the foreseeable future.

Question 17

What is the limitation of the assumption on replacement cycle?

Answer 17

in reality, changing technology and product updates mean that the same asset or set of assets will not be used for the foreseeable future.

Question 18

In most EAC questions what is ignored?

Answer 18

tax and inflation, as well as other non-financial aspects

Question 19

What is the limitation of the assumption to ignore tax and inflation?

Answer 19

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

Question 20

With and EAB which project would we choose?

Answer 20

The highest EAB - same technique as EAC

Question 21

What is capital rationing?

Answer 21

Where there is insufficient funds to take on positive NPV projects

Question 22

What are the two forms of capital rationing?

Answer 22

• Hard capital rationing
• Soft capital rationing

Question 23

What is hard capital rationing?

Answer 23

an absolute limit on financing available is imposed by the funders of the business. The business cannot raise further cash

Question 24

What is soft capital rationing?

Answer 24

an internally imposed limit on investment capital. This is contrary to the rational view of shareholder wealth maximisation.

Question 25

What is multi period rationing?

Answer 25

where funds are rationed in more than one period.

Question 26

What is single period rationing?

Answer 26

where funds are limited in one period only

Question 27

What are divisible projects?

Answer 27

can be done in whole or in part e.g., whole projects needs $10m investment and earns $2m NPV

Question 28

What is the method in order to calculate divisible projects?

Answer 28

1. Calculate profitability index (PI) for each project
   PI = NPV / initial investment amount
2. Use the PI to rank the projects
3. Allocate available funding in ranking order

Question 29

What method is used for approaching indivisible projects?

Answer 29

Trial and error method:
- determine all possible combinations of projects
- pick the combination with the largest overall NPV

Question 30

If a project is indivisible then what happens to the project?

Answer 30

it must be done in its entirety or not at all

Question 31

What are mutually exclusive projects?

Answer 31

projects that cannot be done together

Question 32

What is the approach to doing mutually exclusive projects?

Answer 32

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