ACCA paper f9 financial management study materials F9FM session06 d08

Ü The important issue for financial management is the cash flows created by a lease, as compared to a straight purchase of the asset.. Focus on the NPV of the operating cash flows Is it

OVERVIEW

Objective

Ü To apply discounted cash flow techniques to specific areas

LEASE v BUY

CAPITAL

RATIONING

Ü Definition

Ü Methods

ASSET REPLACEMENT DECISIONS

Ü The issue

Ü Limitations of replacement

analysis

Ü The issue

Ü Decision-making

Ü The investment decision

Ü The financing decision

Ü The final decision

DCF APPLICATIONS

1 CAPITAL RATIONING

1.1 Definition

A situation where there is not enough finance available to undertake all

available positive NPV projects

Ü Hard capital rationing – where the capital markets impose limits on the amount of finance available e.g due to high perceived risk of the company

Ü Soft rationing – where the company itself sets internal limits on finance availability e.g

to encourage divisions to compete for funds

Ü Single-period capital rationing – where capital is in short supply in only one period

Ü Multi-period – where capital is rationed in two or more periods

1.2 Methods

1.2.1 Divisible projects

A divisible project is where the company can undertake between 0-100% of the project - infinite divisibility However a project cannot be repeated

Ü Calculate a “profitability index” for each project = NPV/Initial Investment

Ü Rank projects according to their index

Ü Allocate funds to the most effective projects in order to maximise NPV

Example 1

Cash is rationed to $50,000 at t0

Projects are divisible

Required:

Determine the optimal investment plan

Solution

1.2.2 Non-divisible projects

A non-divisible/indivisible project must be done 100% or not at all

Ü Do not calculate a profitability index;

Ü Simply list all possible combinations of projects

Ü Choose combination with highest NPV

Example 2

Detail as for example 1 but assume that projects are non-divisible

Solution

1.2.3 Mutually-exclusive projects

Mutually exclusive projects is where two or more particular projects cannot be undertaken

at the same time e.g because they use the same land

Ü Divide projects into groups; with one of the mutually-exclusive projects in each group

Ü Calculate the highest NPV available from each group (assume projects are divisible unless told otherwise)

Ü Choose the group with the highest NPV

Example 3

As for example 1 but C and D are mutually exclusive

Solution

1.2.4 Multi-period capital rationing

Ü If finance is limited in several periods then a linear programming model would have to

be set up and solved in order to find the optimal investment strategy

Ü This is outside of the scope of the syllabus

2.1 The issue

Ü Assume that the company has already decided it requires a particular non-current asset

Ü A secondary decision is about how often to replace the asset

Ü For example how often should the company replace its fleet of motor vehicles or its computer equipment?

Ü This is referred to as an asset replacement decision

Method:

1 Calculate the NPV of each possible replacement cycle

2 Calculate the Annual Equivalent Cost (AEC) of each cycle

AEC = NPV/Annuity factor

3 Choose the cycle with the lowest AEC

Example 4

A machine costs $20,000

Running costs Scrap proceeds

Company’s cost of capital = 10%

Required:

Should the machine be replaced every one or every two years?

Solution

2.2 Limitations of replacement analysis

Ü Changing technology e.g it may be advisable to replace IT equipment more often than suggested by the above analysis

Ü Asset requirements may change over time

Ü Non-financial factors e.g employees may be more satisfied if their company cars are replaced more often

3 LEASE v BUY

3.1 The issue

Ü Should the company acquire an asset through:

̌ A straight purchase i.e borrowing to buy, or

̌ A lease

Ü There are two main types of lease:

̌ Operating lease; where the asset is simply rented for a relatively short part of its useful economic life;

̌ Financial/capital lease; where the asset is leased for most of its life

Ü Although the distinction between operating and finance lease is important in financial reporting, it is not so relevant in financial management

Ü The important issue for financial management is the cash flows created by a lease, as compared to a straight purchase of the asset

3.2 Decision-making

TWO DECISIONS

Does the asset give operational benefits?

Focus on the NPV of the operating cash

flows

Is it cheaper to buy or lease?

Focus on the relative beefits of WDA’s from buying and the tax relief on the lease payments

Discount these cash flows using a rate

which reflects operating risk of

investment e.g average cost of capital

Discount these cash flows using

after-tax cost of borrowing

Commentary

Ü The issue here is stripping financing cash flows from operating cash flows and

using separate discount rates for each

Ü Examination questions may focus merely on the financing decisions

3.3 The investment decision

Discount the cash flows from using the asset (sales, materials, labour, overheads, tax on net

cash flows, etc) at the firm’s weighted average cost of capital (WACC)

3.4 The financing decision

Discount the cash flows specific to each financing option at the after-tax cost of debt The assumption is that shareholders view borrowing and leasing as equivalent in terms of

financial risk, so the after-tax cost of debt is an appropriate discount rate for both options The preferred financing option will be that with the lowest NPV of cost

The relevant cash flows for each possible method of financing are as follows

Buy asset – Purchase cost, tax saving on WDA’s, scrap

proceeds Lease asset (operating

or finance lease) – Lease payments, tax saving on lease payments

Under UK tax law all lease payments are tax allowable deductions – both for finance leases and operating leases

3.5 The final decision

If the NPV of the cost of the best finance source is less than the NPV of the operating cash flows, then the project should be undertaken

Example 5

New project

Asset costs $200,000 on the first day of a new accounting period

Scrap value $25,000 on the last day of the next accounting period

Operating inflows $150,000 for two years

Tax at 33% and paid one year in arrears

Weighted average cost of capital 10%

Capital allowances at 25% reducing balance

Finance options:

(1) borrowing at a post-tax cost of 7%;

(2) lease for $92,500 per year in advance for two years (lease payments

are tax allowable)

Required:

(a) Determine the operational benefit of the project

(b) Determine how the project should be financed

(c) Decide whether the project is worthwhile

Solution

(a) Operational value

Time Cash flow Narrative DF @ 10% PV

∴

(b) Financing decision

(1) Borrow and buy flows

Time Cash flow Narrative DF @ 7% PV

(W) WDA’s

at 33% Time

(2) Leasing flows

Time Cash flow Narrative DF @ 7% PV

(c) Final decision

$

PV of operating flows

PV of cheaper finance

Key points

ÐWith capital rationing it is essential to identify the nature of the projects

i.e divisible or non-divisible, mutually exclusive or not

ÐWith asset replacement decisions, the key is the use of Annual Equivalent

Cost to compare cycles of different lengths

ÐWith lease vs buy decisions, the key is to separate the financing decision

from the investment decision and analyse each at a discount rate reflecting

the risk of the cash flows Also remember all lease payments are tax

deductible expenses in the UK

FOCUS

You should now be able to:

Ü distinguish between hard and soft capital rationing;

Ü apply profitability index techniques for single period divisible projects;

Ü use DCF to analyse asset replacement decisions;

Ü apply DCF methods to projects involving lease or buy problems

EXAMPLE SOLUTIONS

Solution 1 — Divisible projects

Investment

NPV

50

100

10

) 50 (

10

84

15

45

AVAILABLE 50

_

40

_

25

_

Solution 2 — Non-divisible

$000

A only

Choose C + D

Solution 3 — Mutually exclusive

Group 1 Group 2

NPV

$ 100 50 (50) 10 84 10 100 50 (50) 10 45 15

Index

_

2 _

_

(5) _

_

8.4 _

_

2 _

_

(5) _

_

3 _

Plan

NPV Capital NPV Capital

Accept C and 0.8A

Solution 4 — Machine replacement

Replace every year

Time Cash flow Discount factor PV

1 Running costs (5,000) 0.909 (4,545)

Annual equivalent cost =

factor annuity

year

909 0

001 ,

Now repeat the above procedure, assuming the machine is replaced every two years

Time Narrative Cash flow

@ 10% Discount factor value Present

0

1

2

2

Purchase

Running costs

Running costs

Scrap proceeds

(20,000) (5,000) (5,500) 13,000

1 0.909 0.826 0.826

(20,000) (4,545) (4,543) 10,738

NPV = (18,350)

736 1

350 , 18 AF 10%

year 2

350 ,

Conclusion Replace every two years

Solution 5 — Lease or Buy

(a) Operational value

Time Cash flow Narrative DF @ 10% PV

1–2

2–3 (49,500) 150,000 Project returns Tax on above 1.736 1.578 (78,111) 260,400

182,289 _

(b) Financing decision

(1) Borrow and buy flows

Time Cash flow Narrative DF @ 7% PV

0

2

2

3

(200,000) 25,000 16,500 41,250

Purchase cost Sale proceeds (W)

(W)

1 0.873 0.873 0.816

(200,000) 21,825 14,405 33,660

(130,110)

(W) WDA’s

at 33% Time

0

1 Purchase WDA at 25% (50,000) 200,000 16,500 2

WDV b/f

2 Balancing allowance

125,000

(2) Leasing flows

Time Cash flow Narrative DF @ 7% PV

0–1

2–3 (92,500) 30,525 Lease payments Tax relief thereon 0.873 + 0.816 1.935

= 1.689

(178,988) 51,557

(127,431)

Conclusion: The cheapest method of finance is to lease

(c) Final decision

$

PV of operating flows

PV of leasing flows (cheaper finance – see (b)) (127,431) 182,289

54,858 The asset should be acquired using a lease