Chapter 5 - DCF and special decision

Question 1

What are the three assumptions of the Equivalent Annual Cost method?

Answer 1

• Assets are replaced by identical assets
• Inflation is ignored
• There is no change in the productivity of the company

Question 2

What is soft capital rationing?

Answer 2

Funds are internally rationed e.g. to control the rate of expansion.

Question 3

What is hard capital rationing?

Answer 3

Funds are externally rationed e.g. banks might be unwilling to provide more than a certain
amount of funds to a company

Question 4

What does Mutually exclusive mean?

Answer 4

Projects cannot be done together

Question 5

Non-divisibility

Answer 5

Projects cannot be part invested in.

Question 6

Divisible

Answer 6

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

Question 7

What is the profitability index?

Answer 7

(NPV)÷(Initial investment)

Question 8

What are the relevant cashflows associated with borrowing to buy an asset?

Answer 8

• The initial cost
• The scrap value
• The benefits of tax allowable depreciation

Question 9

What are the relevant cash flows associated with leasing the asset?

Answer 9

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

Question 10

What is the post tax cost of borrowing?

Answer 10

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