Chapter 9 - Discounted Cash Flows - Further Aspects Flashcards
What is capital rationing
Capital rationing is a term used to cover the situation where the company has limited funds available for investment
What are the types of capital rationing
- Hard capital rationing where there is on only a limited amount available to be borrowed
- Soft capital rationing where the company decides itself to place a limit on the amount it is prepared to borrow
What does infinitely divisible means with capital rationing ?
We can do any fraction of a project. For example we can do 50% of project A but can’t do more than the 100% of the project
How to work out which project when there is capital analysis and are infinity divisible ?
Similar to key factor analysis,
Divide the npv by the capital invested like with the limited source
How to work out the project when there is capital analysis and are NOT infinitely divisible ?
Not infinitely means that we can’t take a fraction of a project
No easy way so have to do it the long way, try
A + B + C or B+C+D or A+C+D etc we have to pick 3 out of the 4 options based on the total npv
What is “replacement” in regards to discounted cash flow
For example with cars, a company might give out company cars out but when do you replace them ? The older it gets the more it will cost to repair old parts etc plus the less you would be able to sell it for the older it gets.
How to calculate the optimum replacement time ?
Do mini cash flows for each option, for example if question asks when best to replace car, 1,2 of 3 years. Do a mini cash flow discounting to present value for 1 year then 2 then 3 to see which gives the best present value
However comparing 1 year and 3 years wouldn’t work because you need to work out the per year cost, especially for year 2 and 3. For example if we worked out the cost of replacing every two years then this would be relevant for year 2,4,6,8 etc but we want to compare against every 3 years not 4 so do this…
To do this you need a formula called the “equivalent annual cost”
EAC = present value of first machine / annuity discount factor for replacement period at cost of capital
For example if we were doing a 2 year replacement, take the full present value 72,972 / 1.626 (the 1.626 is the annuity factor for 2 years for the 15% cost of capital in the question ) = 44,878.
44,878 is the annual cost of replacing the machine every 2 years forever and to prove it out 2 x 44k @ 1.626 = the 72k above
What is lease vs buy
In order to decide whether to lease or buy the asset we need to calculate the PV of the costs of buying the asset with the PV of the costs of leasing
How is tax different in lease and buy
- There is capital allowance on lease items though even though it may say reducing balance, keep it the same amount each year. E.g if it is 35,000 per year to lease @30% CT then the saving would be 10,500 per year
- When to record the capital allowance saving for lease when question says “payable one year after the end of the financial year” you don’t start the saving at year 0 or year 1 but year 2
- When is capital allowance saving for buying, well regardless of what says in question when you buy the asset you are immediately due savings, that would be in year 0 and question says “payable one year after…” therefore recognise in year 1
How many years do we calculate capital allowance for ?
Imagine we use the machine for 4 years well if we buy at the start of financial year then it would be 4 but if bought at end of financial year it would be 5 because we are due savings immediately on purchase, even if for one day and then 4 years
How to deal with corporation tax on lease vs buy
Regardless of whether we buy or lease, the revenue should be the same and therefore we ignore this element as they will net each other out
What interest rate do we discount at ?
We always discount at the after tax interest rate of borrowing
What is the difference between the after tax and before tax interest rate ?
Let’s say we pay interest at 10%, because interest reduces taxable profits and therefore pay more interest it saves you corporation tax as less profits to tax then even though you will be paying tax at 10% you will be saving tax of 30% of it (30/10 = 3%) so in theory the after tax is 7%
Rule to working out tax for lease and buy
If one year delay in tax
- if first cash flow is on the first day of the accounting period then the first tax effect is at year/time 2
- if first cash flow is on last day if accounting period then the first tax effect is at year/time 1
