Topic 5 - Special Investment Decisions Flashcards
How to calculate Lease Vs Buy?
Leases:
Figure out the timing of the lease payments, calculate tax relief (Lease payment x tax rate) because lease payments are tax deductible = net cashflows. multiply net cashflows by discount rate and add together to get total net present value.
Borrowing:
Calculate TAD (Depreciation Per annum x tax rate), add initial cost, TAD and residual value together = Total present value then multiply by discount rate =NPV
If lease payments have to be paid at the start of the year and Tax is paid one year in arrears, in what period do they affect? in terms of T Times?
Lease payments are paid on T0 and tax is paid in T2?
What is the approach to asset replacement decision?
1.) Calculate relevant cashflows for each scenerio.
2.) Discount to calculate present value of each scenerio.
3.) Calculate equivalent annual cost (Formula)
4.) Choose replacement cycle with lowest EAC
What is the equivalent annual cost? and how to calculate it?
EAC = PV of cost for one replacement cycle / Annuity rate of cost of capital.
Note : PV of cost for one replacement cycle is teh cash flow for the amount of time e.g 3 years = until T3
What are the assumptions needed to calculate the equivalent annual cost method?
It is same asset being replaced, no upgrades
Inflation is ignored
There is no change in productivity e.g level of demand doesnt change.
What are the definitions of the following:
Soft Capital Rationing
Hard Capital Rationing
Non-Divisable
Divisable
Mutually-exclusive.
Capital rationing is when a company is unable to take on every positive NPV project as it may not always be available.
Soft capital rationing - is when a company will enforce restriction on themselves.
Hard capital rationing - This is due to external factors imposing restrictions on finance.
Non-Divisable - This is when we can’t just invest in part of an investment, has to be all or nothing.
Divisable - This is when we can invest in part of an invetsment.
Mutually Exclusive - If two projects are mutually excluive then they can’t both be undertaken, its not possible to do both.
How to approach a single period capital rationing decision?
Non-divisable = Trail and error - Calculate the total NPV for all possible combinations of the projects given the capital available.
Divisable = Profitablity Index - Calculate the profitability index for each investment project. Then rank the project by PI. Then allocate the funds in the order of the ranking if there is a remianing balance that doesn’t cover the next invetsment fully we can divide the remaining balance by the initial investment of the final invesntment to give us a percentage which we can apply to the NPV of that project to get the full divisbale NPV value.
What is the proftiability index and what is the formula?
PI = NPV / Initial investment.
What are the reason for hard capital rationing?
High gearing - high level of debt in its capital structure.
Low credit rating - poor ability to repay borrowings
State of economy - Recession, Bank unwilling to lend money.
High risk venture - investor unsure about potential returns if its a new industry or company. Unproven
Poor growth prospects - Declining industry
Covenants - Restrictions from existing lenders.
Lack of security - Low amount of assets to sercure the investment.
What are the reasons for soft capital rationing?
Control Growth - Making sure they don’t grow to quickly so they can manage the company effectivly and its doesnt get out of hand.
Focus investment - They want to focus on specific investments instead of all as they are more interested in a specific area e.g AI developments.
Lack of management skill - They may not have the experiance or skill to juggle all possible positive NPV projects
