Chapter 5 - Asset Investment Decisions And Capital Rationing

Question 0

Cost of capital

Answer 0

Post tax cost of borrowing = Cost of borrowing x (1- Tax rate)

Question 1

Lease versus buy

Answer 1

Leasing - The asset is never owned by the user company from the perspective of the taxman.

The relevant cash flows would be:

1. The lease payments.
2. Tax relief on the lease payments.

Buying - Requires the use of a bank loan. The user is the owner of the asset.

The relevant cash flows would be:

1. The purchase cost.
2. Any residual value.
3. Any associated tax implications due to WDAs.

Question 2

Equivalent annual costs (EAC)

Answer 2

EAC = PV of costs/ Annuity factor

The optimum replacement period will be the period that has the lowest EAC although other factors may influence the decision.

Question 3

Equivalent annual benefit (EAB)

Answer 3

EAB = NPV of project/ Annuity factor

Question 4

Capital rationing

Answer 4

Hard capital rationing: An absolute limit on the amount of finance available is imposed by the lending institutions.

Soft capital rationing: A company may impose its own rationing on capital. This is contrary to the rational view of shareholder wealth maximisation.

Question 5

The profitability index (PI) and divisible projects.

Answer 5

The aim is to maximise the NPV earned per $1 invested in projects.
Where the projects are divisible and earn corresponding returns to scale.

1. Calculate a PI for each project
2. Rank the projects according to their PI
3. Allocate funds according to the projects ranking until they are used up.

PI = NPV/ Investment

NB. If a project is indivisible, it must be done in its entirety or not at all. There is no need to calculate a PI and rank as above.