Investment decisions and Capital Rationing Flashcards
When making a lease of buy decision what cash flows will need to be considered for each?
Leasing
- Lease payments to be made - take care with the timing of these as they are usually made at the start of a year.
- Tax relief - on value of lease payments, again consider period payment is made and if tax is payable in arrears.
- TAD does not apply here as the business does not control the asset.
Buying
- Both purchase costs and any expected scrap proceeds should be included.
- TAD can be claimed, watch out for timings.
NOTE - these type of calculations will likely make use of annuity factors as the lease payment will be for s fixed annual amount.
Also remember where lease payments are at the beginning of the year this is an advanced annuity (AF for years 1-N + 1)
For both the post tax cost of borrowing should be used for the discount factor this takes in to account the impact of tax relief for interest payment, this is calculated as:
Cost of borrowing (Cost of capital) x (1 - Tax rate)
What other decisions regarding assets may need to be evaluated and how is this done?
Replacement decisions may also need to be evaluated, as in how frequently should an asset be replaced.
- Assets may last differing periods of time, this will need to be taken in to account when evaluating.
- Assets may need to be replaced at regular intervals.
The method used to evaluate these decisions is Equivalent Annual Cost - where the PV of each replacement option is converted to a comparable figure using annuity factors.
EAC = PV of Costs / Annuity factor for year N
N = AF for no of years at stated cost of capital.
The option with the lowest EAC would be chosen.
What is capital rationing and why might it be applied?
Capital rationing is essentially a limiting factor on the level of investment a business can undertake in a period (or multiple periods)
The source of the limit may be:
- External - known as Hard Capital rationing - where the limiting factor is the level of financing the business can access, this may be restricted due to existing borrowing, business performance not meeting lending criteria, or other factors.
- Internal - known as Soft Capital rationing - where this limit is due to internal decisions to restrict the level of investment in a period, this is technically counter to the main business objective of Shareholder wealth maximisation and may occur for several reasons, the business may be planning investment for future periods that current period investment may restrict. If investment is to be funded from business reserves rationing may relate to levels of dividends the business wishes to pay.
What are divisible and indivisible projects, and what investment evaluation may be required in relation to them?
A divisible project is simple a project that can be paid for in part and still move forward, with an indivisible project being one which must be funded in full to be valid, e.g.
- A project to install a new production line comprising several pieces of interrelated machinery would be indivisible, as the project outcomes can only be achieved with all parts in place.
Where a business has less investment available than potential projects divisible and indivisible projects are relevant.
Profitability indexes for each project should be calculated and ranked to establish most appropriate investment decision:
Profitability index = NPV/initial investment.
- Where there are indivisible projects the optimal investment mix can be found through trial and error.
- Where there are mutually exclusive projects each combination should be evaluated to identify the highest overall NPV.
What are the assumptions and limitations in relation to Equivalent annual cost?
- Trading Cashflows - these are assumed to be the same for all potential replacements. In reality older assets tend to have higher running costs and may also be less efficient (more down time)
- Operating efficiencies will be the same - see above
- Assets will be replaced for the foreseeable future - in reality plant may be no longer required due to discontinued product lines etc.
- Tax and inflation are generally ignored - so assumed that purchase/sale prices will remain static. Reality prices generally increase YoY.
- Non Financial aspects are ignored.
What is the difference between risk and uncertainty and how does this affect investment appraisal?
Risk - Quantifiable, possible outcomes will have associated probabilities
Uncertainty - unquantifiable, outcomes cannot be mathematically modelled.
Risk, uncertainty and associated probabilities are relevant when carrying out sensitivity analysis and probability analysis on investments
What is sensitivity analysis and how is it relevant to investment decisions?
Sensitivity analysis is determining the impact changes to one or more cashflows (or associated variables) will have on the projects overall NPV.
It is expressed as a % and lower values indicate higher sensitivity.
Sensitivity margin = NPV of project/PV of cash flows under consideration x 100%
Cash flows under consideration - these may be:
- A single cash flow e.g. revenue - would be impacted by a change in sale price
- The net of multiple cash flows e.g. revenue and variable costs - would be impacted by changes in sales volumes.
- Sensitivity to changes in the discount rate, range between the discount rate and the IRR calculated as (DR-IRR)/DR x 100%
- Cash flows may need to be adjusted to net of tax = PV - (PV x tax rate x discount factor). Note the discount factor is only included where the tax is paid in arrears.
What is Expected value how is it determined for a project and what benefit does it give to investment analysis?
Expected value is an end result of probability analysis, it recognises that there may be more than one outcome for a potential project and is calculated to give a value that is weighted based on the probability of each outcome.
Calculated as - EV = sum(probability factor x Future outcome)
This is not a definitive invest/don’t invest result as the decision will also come down to how risk adverse a business is.
Joint Probabilities - where there is a possibility of more than one thing occurring a joint probability will need to be analysed:
- AND - where both things occur. multiply the probability of each thing together.
- OR (mutually exclusive) - Add the probabilities together
- OR (not mutually exclusive) - Add probabilities together then deduct the joint probability.
What are adjusted and discounted payback and what benefits to they give as an investment appraisal method?
Adjusted payback - where the payback period required is shortened, this serves to reduce risk as earlier cash flows are deemed less risky. The accuracy of expected cash flows will decline as time from T0 increases.
Discounted Payback - discounted cash flows are used taking in to account the time impact of money.
Risk adjusted discount rates - basically building some headroom in to an appraisal, increased discount rate will give a lower NPV making it harder to reach approval target.
