investment decision making pt2

Question 1

Asset replacement

Answer 1

how often to replace an asset, where decisions are repeatable, NPVs cannot easily be compared

when cash flows do not inflate, the quickest way to determine the optimal replacement cycle is to calculate the Equivalent annual cost (EAC)

EAC = NPV of one cycle of replacement/ AF for this cycle length (use annuity table)

EAC calculates an annuity. this annuity is the equivalent of money payable each year of the assets life

Question 2

Capital rationing - two types

Answer 2

the situation where insufficient funds exist to undertake all positive NPV projects, so a choice must be made

types:

Hard- external limits exist on funds available (e.g. caps on borrowing, covenants)

Soft- Internal constraints imposed (i.e. budgets/policy amounts)

Question 3

Divisible v Indivisible projects

Answer 3

Divisible :

• projects ranked by NPV per £ capital outlay
• can be fully or partially completed
• most profitable chosen first with spare funds used for next and so on till all capital is allocated.

NPV/initial outlay

Indivisible projects:

sometimes a project can either be completed in full, or not at all

use trial and error

Mutually exclusive projects- some can’t be done together- use trial and error

project synergy- sometimes by doing projects in combination there may be some synergy (extra NPV), e.g. cost savings

Question 4

Shareholder value analysis (7 elements)

Answer 4

SVA- process of analysing the activities of a business to identify how they will result in increasing shareholder wealth

5 key drivers

1- Sales growth rate- Increased sales vol-greater contribution and profit- increased shareholder wealth

2-operating profit margin- enhance value by removing non value adding activities-saving unnecessary costs-increase PMs

3-corporation tax rate- directors have no influence, other than tax avoidance schemes

4- investment in NCAs- right balance between investment to maintain operating ability and unnecessary expenditure

5-investment in working capital- value created by increasing operating activity without extending operating cycle. achieved by lean principles e.g. JIT and effective credit control to encourage early payment.

6- cost of capital- value enhanced by cheaper long term finance, due to reduction in cost of capital

7- longer the life of a cash generating activity, more opportunity to deliver value, making it more important to shareholders

Question 5

Real Options

Answer 5

real options can increase the value of a project

project worth = traditional NPV + value of any real options

Follow on options- experience gained from initial investment increases future profitability (R&D)

Abandonment options - possibility to sell if things go wrong? (backup option)

Timing options- sometimes ‘option to wait’ for the best time to invest- ie wait to harvest

Growth options- New tech, deregulation etc present uncertainty, investing may cause a loss. options to delay or complete part of a project can be valuable

Flexibility options- beneficial to use a project with multiple uses, cheaper in long run. ie dual fuel power station (volatile gas prices) instead of demolishing power station and building nuclear one.

Question 6

investing overseas risks

Answer 6

political risks:

government action can render assets worthless or alter ability to expatriate cash. includes quotas, change in tax or seizing assets

strategies to limit risk- negotiate, insurance, use of contractors and joint ventures

Product and cultural risks:

risks relating to customs, tastes, laws and language

existing products/services may be unacceptable in certain markets (sale of alcohol) or may have to be altered to suit target market