江西财经大学会计学院 Topic D Investment appraisal

江西财经大学会计学院 PART D-7 Investment decisions

江西财经大学会计学院 Topic list

江西财经大学会计学院 Study guide

江西财经大学会计学院 Exam guide As well as using the techniques covered in this chapter, you may be asked to discuss their drawbacks. A calculation and comment on the return on capital employed (accounting rate on return) forms a 5 mark part of a question in the Pilot Paper.

江西财经大学会计学院 Investment decisions Investment Payback Return on capital employed

江西财经大学会计学院 Investment Fast forward Investment can be divided into capital expenditure and revenue expenditure and can be made in non-current assets or working capital.

江西财经大学会计学院 Investment Key term Capital expenditure is expenditure which results in the acquisition of non-current assets or an improvement in their earning capacity. It is not charged as an expense in the income statement; the expenditure appears as a non-current asset in the balance sheet. Revenue expenditure is charged to the income statement and is expenditure which is incurred: (a) For the purpose of the trade of the business - this includes expenditure classified as selling and distribution expenses, administration expenses and finance charges (b) To maintain the existing earning capacity of non-current assets

江西财经大学会计学院 Investment Non-current asset investment and working capital investment Investment by the commercial sector Investment by not-for-profit organizations

江西财经大学会计学院 Non-current asset investment and working capital investment Investment can be made in non-current assets or working capital. (a) Investment in non-current assets involves a significant elapse of time between commitment of funds and recoupment of the investment. Money is paid out to acquire resources which are going to be used on a continuing basis within the organization. (b) Investment in working capital arises from the need to pay out money for resources (such as raw materials) before it can be recovered from sales of the finished product or service. The funds are therefore only committed for a short period of time.

江西财经大学会计学院 Investment by the commercial sector Plant and machinery Research and development Advertising Warehouse facilities

江西财经大学会计学院 Investment by not-for-profit organizations Investment by not-for-profit organizations differs from investment by commercial organizations for several reasons. (a) financial return. (b) lowest present value of cost & social costs and social benefits of investments. (c) cost of capital

江西财经大学会计学院 The capital budgeting process Fast forward Capital budgeting is the process of identifying, analyzing and selecting investment projects whose returns are expected to extend beyond one year.

江西财经大学会计学院 The capital budgeting process Creation of capital budgets The investment decision-making process Origination of proposals Project screening Analysis and acceptance Monitoring the progress of the project

江西财经大学会计学院 The investment decision-making process Fast forward A typical model for investment decision making has a number of distinct stages. Origination of proposals Project screening Analysis and acceptance Monitoring and review

江西财经大学会计学院 Project screening What is the purpose of the project? Does it 'fit' with the organization's long-term objectives? Is it a mandatory investment, for example to conform with safety legislation? What resources are required and are they available, e.g. money, capacity, labor? Do we have the necessary management expertise to guide the project to completion? Does the project expose the organization to unnecessary risk? How long will the project last and what factors are key to its success? Have all possible alternatives been considered?

江西财经大学会计学院 Analysis and acceptance Step 1 Complete and submit standard format financial information as a formal investment proposal. Step 2 Classify the project by type (to separate projects into those that require more or less rigorous financial appraisal, and those that must achieve a greater or lesser rate of return in order to be deemed acceptable). Step 3 Carry out financial analysis of the project. Step 4 Compare the outcome of the financial analysis to predetermined acceptance criteria. Step 5 Consider the project in the light of the capital budget for the current and future operating periods. Step 6 Make the decision (go/no go). Step 7 Monitor the progress of the project.

江西财经大学会计学院 Financial analysis What cash flows/profits will arise from the project and when? Has inflation been considered in the determination of the cash flows? What are the results of the financial appraisal? Has any allowance been made for risk, and if so, what was the outcome?

江西财经大学会计学院 Qualitative issues (a) What are the implications of not undertaking the investment, e.g. adverse effect on staff morale, loss of market share? (b) Will acceptance of this project lead to the need for further investment activity in future? (c) What will be the effect on the company's image? (d) Will the organization be more flexible as a result of the investment, and better able to respond to market and technology changes?

江西财经大学会计学院 Qualitative issues The type of investment Its perceived riskiness The amount of expenditure required

江西财经大学会计学院 Monitoring the progress of the project Fast forward During the project's progress, project controls should be applied to ensure the following. Capital spending does not exceed the amount authorized. The implementation of the project is not delayed. The anticipated benefits are eventually obtained.

江西财经大学会计学院 Relevant cash flows Fast forward Relevant costs of investment appraisal include opportunity costs, working capital costs and wider costs such as infrastructure and human development costs. Non-relevant costs include past costs and committed costs.

江西财经大学会计学院 Relevant cash flows in investment appraisals Exam focus point Examiners often complain that students often include non-relevant costs in investment appraisals.

江西财经大学会计学院 Relevant cash flows in investment appraisals Opportunity costs Example: opportunity costs Tax Residual value Working capital

江西财经大学会计学院 Opportunity costs These are the costs incurred or revenues lost from diverting existing resources from their best use.

江西财经大学会计学院 Example: opportunity costs If a salesman, who is paid an annual salary of $30,000, is diverted to work on a new project and as a result existing sales of $50,000 are lost, the opportunity cost to the new project will be the $50,000 of lost sales. The salesman's salary of $30,000 is not an opportunity cost since it will be incurred however the salesman's time is spent.

江西财经大学会计学院 Tax The extra taxation that will be payable on extra profits, or the reductions in tax arising from capital allowances or operating losses in any year. We shall consider the effect of taxation in Chapter 9.

江西财经大学会计学院 Residual value The residual value or disposal value of equipment at the end of its life, or its disposal cost.

江西财经大学会计学院 Working capital If a company invests $20,000 in working capital and earns cash profits of $50,000, the net cash receipts will be $30,000. Working capital will be released again at the end of a project's life, and so there will be a cash inflow arising out of the eventual realization into cash of the project's inventory and receivables in the final year of the project.

江西财经大学会计学院 Other relevant costs Costs that will often need to be considered include: Infrastructure costs Marketing costs Human resource costs

江西财经大学会计学院 Relevant benefits of investments Fast forward Relevant benefits from investments include not only increased cash flows, but also savings and better relationships with customers and employees.

江西财经大学会计学院 Types of benefit The benefits from a proposed investment must also be evaluated. These might consist of benefits of several types. (a) Savings because assets used currently will no longer be used. The savings should include: (i) Savings in staff costs (ii) Savings in other operating costs, such as consumable materials (b) Extra savings or revenue benefits because of the improvements or enhancements that the investment might bring: (i) More sales revenue and so additional contribution (ii) More efficient system operation (iii) Further savings in staff time, resulting perhaps in reduced future staff growth (c) Possibly, some one-off revenue benefits from the sale of assets that are currently in use, but which will no longer be required.

江西财经大学会计学院 Types of benefit Some benefits might be intangible, or impossible to give a money value to. (a) Greater customer satisfaction, arising from a more prompt service (e.g. because of a computerized sales and delivery service). (b) Improved staff morale from working with higher- quality assets. (c) Better decision making may result from better information systems.

江西财经大学会计学院 Example: Relevant cash flows

江西财经大学会计学院 Payback Fast forward The payback method of investment appraisal and the ROCE/ARR/ROI methods of investment appraisal are popular appraisal techniques despite their limitations (of which you should be aware). Payback is the amount of time it takes for cash inflows = cash outflows

江西财经大学会计学院 Payback Exam focus point Exam questions often ask about the pros and cons of the payback method.

江西财经大学会计学院 Payback Key term Payback is the time it takes the cash inflows from a capital investment project to equal the cash outflows, usually expressed in years.

江西财经大学会计学院 Why is payback alone an inadequate investment appraisal technique

江西财经大学会计学院 Disadvantages of the payback method Text book : P136

江西财经大学会计学院 Advantages of the payback method Text book : P136

江西财经大学会计学院 Return on capital employed

江西财经大学会计学院 Return on capital employed Unfortunately, there are several different definitions of 'return on capital employed'. One of the most popular is as follows.

江西财经大学会计学院 Return on capital employed

江西财经大学会计学院 Return on capital employed Exam focus point The Pilot Paper states that the ROCE calculation should be based on the average investment.

江西财经大学会计学院 Example: The return on capital employed

江西财经大学会计学院 The ROCE and the comparison of mutually exclusive projects The ROCE method of capital investment appraisal can also be used to compare two or more projects which are mutually exclusive. The project with the highest ROCE would be selected (provided that the expected ROCE is higher than the company's target ROCE).

江西财经大学会计学院 Example: The ROCE and mutually exclusive projects

江西财经大学会计学院 The drawbacks to the ROCE method of capital investment appraisal Text book : P138

江西财经大学会计学院 Chapter Roundup Text book : P139

江西财经大学会计学院 Quick Quiz 1

江西财经大学会计学院 Quick Quiz 2

江西财经大学会计学院 Answers to Quick Quiz

江西财经大学会计学院 PART D-8 Investment appraisal using DCF methods

江西财经大学会计学院 Topic list

江西财经大学会计学院 Study guide

江西财经大学会计学院 Exam guide You may be asked to discuss the relative merits of the various investment appraisal techniques as well as demonstrate your ability to apply the techniques themselves. Investment appraisal is examined in question 4 of the Pilot Paper in this way.

江西财经大学会计学院 Investment appraisal using DCF methods Discounted cash flow The net present value method The internal rate of return method NPV and IRR compared Assessment of DCF methods of project appraisal

江西财经大学会计学院 Discounted cash flow Fast forward There are two methods of using DCF to evaluate capital investments, the NPV method and the IRR method.

江西财经大学会计学院 Compounding

江西财经大学会计学院 Discounting Key term Present value is the cash equivalent now of a sum of money receivable or payable at a stated future date, discounted at a specified rate of return

江西财经大学会计学院 Discounting

江西财经大学会计学院 Discounting

江西财经大学会计学院 Question Spender expects the cash inflow from an investment to be $40,000 after 2 years and another $30,000 after 3 years. Its target rate of return is 12%. Calculate the present value of these future returns, and explain what this present value signifies.

江西财经大学会计学院 The cost of capital The cost of capital has two aspects to it. (a) It is the cost of funds that a company raises and uses. (b) The return that investors expect to be paid for putting funds into the company. It is therefore the minimum return that a company should make from its own investments, to earn the cash flows out of which investors can be paid their return.

江西财经大学会计学院 The cost of capital Fast forward The NPV method of investment appraisal is to accept projects with a positive NPV. Ensure that you are aware of the three conventions concerning the timings of cash flows. An annuity is a constant cash flow for a number of years. A perpetuity is a constant cash flow forever.

江西财经大学会计学院 The net present value method Key terms Net present value or NPV is the value obtained by discounting all cash outflows and inflows of a capital investment project by a chosen target rate of return or cost of capital.

江西财经大学会计学院 The net present value method

江西财经大学会计学院 Example: NPV

江西财经大学会计学院 (a) A cash outlay to be incurred at the beginning of an investment project ('now') occurs in year 0. The present value of $1 now, in year 0, is $1 regardless of the value of r. (b) A cash outlay, saving or inflow which occurs during the course of a time period (say, one year) is assumed to occur all at once at the end of the time period (at the end of the year). Receipts of $10,000 during year 1 are therefore taken to occur at the end of year 1. (c) A cash outlay or receipt which occurs at the beginning of a time period (say at the beginning of one year) is taken to occur at the end of the previous year. Therefore a cash outlay of $5,000 at the beginning of year 2 is taken to occur at the end of year 1.

江西财经大学会计学院 Timing of cash flows: conventions used in DCF Exam focus point Examiners' reports suggest that candidates often get the timing of cash flows wrong, particularly initial investment, working capital and tax.

江西财经大学会计学院 Discount tables for the PV of $1

江西财经大学会计学院 Discount tables for the PV of $1 Exam focus point Remember that interest should not be included in the calculation; it is allowed for in the discount rate.

江西财经大学会计学院 Question LCH manufactures product X which it sells for $5 per unit. Variable costs of production are currently $3 per unit, and fixed costs 50c per unit. A new machine is available which would cost $90,000 but which could be used to make product X for a variable cost of only $2.50 per unit. Fixed costs, however, would increase by $7,500 per annum as a direct result of purchasing the machine. The machine would have an expected life of 4 years and a resale value after that time of $10,000. Sales of product X are estimated to be 75,000 units per annum. LCH expects to earn at least 12% per annum from its investments. Ignore taxation. You are required to decide whether LCH should purchase the machine.

江西财经大学会计学院 Annuity tables

江西财经大学会计学院 Question If you have not used them before, check that you can understand annuity tables by trying the following exercise. (a) What is the present value of $1,000 in contribution earned each year from years 1-10, when the required return on investment is 11%? (b) What is the present value of $2,000 costs incurred each year from years 3-6 when the cost of capital is 5%?

江西财经大学会计学院 Annual cash flows in perpetuity Formula to learn When the cost of capital is r, the cumulative PV of $1 per annum in perpetuity is $1/r.

江西财经大学会计学院 Question An organization with a cost of capital of 14% is considering investing in a project costing $500,000 that would yield cash inflows of $100,000 per annum in perpetuity. Required Assess whether the project should be undertaken.

江西财经大学会计学院 Annual cash flows in perpetuity Exam focus point Examiners have often commented that candidates are often unable to evaluate cash flows in perpetuity.

江西财经大学会计学院 The internal rate of return method Fast forward The IRR method of investment appraisal is to accept projects whose IRR (the rate at which the NPV is zero) exceeds a target rate of return. The IRR is calculated using interpolation.

江西财经大学会计学院 The internal rate of return method

江西财经大学会计学院 Example: the IRR method A company is trying to decide whether to buy a machine for $80,000 which will save costs of $20,000 per annum for 5 years and which will have a resale value of $10,000 at the end of year 5. If it is the company's policy to undertake projects only if they are expected to yield a DCF return of 10% or more, ascertain whether this project be undertaken.

江西财经大学会计学院 Question

江西财经大学会计学院 NPV and IRR compared Fast forward There are advantages and disadvantages to each appraisal method. Make sure that you can discuss them.

江西财经大学会计学院 Advantages and disadvantages of IRR method

江西财经大学会计学院 Non-conventional cash flows

江西财经大学会计学院 Non-conventional cash flows

江西财经大学会计学院 Non-conventional cash flows Exam focus point You need to be aware of the possibility of multiple IRRs, but the area is not examinable at a computational level.

江西财经大学会计学院 Mutually exclusive projects Text book : P152

江西财经大学会计学院 Summary of NPV and IRR comparison Text book : P153

江西财经大学会计学院 Assessment of DCF methods of project appraisal Fast forward DCF methods of appraisal have a number of advantages over other appraisal methods. The time value of money is taken into account. The method takes account of all of a project's cash flows. It allows for the timing of cash flows. There are universally accepted methods of calculating the NPV and IRR.

江西财经大学会计学院 Advantages of DCF methods Uncertainty Inflation

江西财经大学会计学院 Problems with DCF methods

江西财经大学会计学院 The use of appraisal methods in practice Text book : P154

江西财经大学会计学院 Chapter Roundup Text book : P155

江西财经大学会计学院 Quick Quiz

江西财经大学会计学院 Answers to Quick Quiz

江西财经大学会计学院 PART D-9 Allowing for inflation and taxation

江西财经大学会计学院 Topic list

江西财经大学会计学院 Study guide

江西财经大学会计学院 Exam guide As well as bringing inflation into your DCF calculations, you may be asked to explain the differences between real and nominal rates. Pilot Paper question 4 incorporates inflation and taxation aspects in an NPV calculation and this is the level of difficulty you can expect in your exam.

江西财经大学会计学院 Allowing for inflation and taxation Allowing for inflation Allowing for taxation NPV layout

江西财经大学会计学院 Allowing for inflation Fast forward Inflation is a feature of all economies, and it must be accommodated in financial planning. Real cash flows (ie adjusted for inflation) should be discounted at a real discount rate. Nominal cash flows should be discounted at a nominal discount rate.

江西财经大学会计学院 Formula (1 + i) = (1 + r)(1 + h) Where h = rate of inflation r = real rate of interest i = nominal (money) rate of interest

江西财经大学会计学院 Example: Inflation

江西财经大学会计学院 Inflation Exam focus point You may be asked in the exam to explain the difference between a real and nominal terms analysis.

江西财经大学会计学院 Do we use the real rate or the nominal rate The rule is as follows (a) If the cash flows are expressed in terms of the actual number of dollars that will be received or paid on the various future dates, we use the nominal rate for discounting. (b) If the cash flows are expressed in terms of the value of the dollar at time 0 (that is, in constant price level terms), we use the real rate.

江西财经大学会计学院 Do we use the real rate or the nominal rate

江西财经大学会计学院 The advantages and misuses of real values and a real rate of return Text book : P160

江西财经大学会计学院 Example 1 Rice is considering a project which would cost $5,000 now. The annual benefits, for four years, would be a fixed income of $2,500 a year, plus other savings of $500 a year in year 1, rising by 5% each year because of inflation. Running costs will be $1,000 in the first year, but would increase at 10% each year because of inflating labor costs. The general rate of inflation is expected to be 71/2% and the company's required nominal rate of return is 16%. Is the project worthwhile? Ignore taxation.

江西财经大学会计学院 Example 2 Mr Gable has just received a dividend of $1,000 on his shareholding in Gonwithy Windmills. The market value of the shares is $8,000 ex div. What is the (nominal) cost of the equity capital, if dividends are expected to rise because of inflation by 10% in years 1, 2 and 3, before levelling off at this year 3 amount?

江西财经大学会计学院 Expectations of inflation and the effects of inflation Text book : P162

江西财经大学会计学院 Mid-year and end of year money values Text book : P162

江西财经大学会计学院 Allowing for taxation Fast forward Taxation is a major practical consideration for businesses. It is vital to take it into account in making decisions. In investment appraisal, tax is often assumed to be payable one year in arrears. Tax-allowable depreciation details should be checked in any question you attempt.

江西财经大学会计学院 Allowing for taxation Exam focus point Check any question involving tax carefully to see what assumptions about tax rates are made. Also look out for questions which state that tax is payable in the same year as that in which the profits arise.

江西财经大学会计学院 Tax-allowable depreciation

江西财经大学会计学院 Tax-allowable depreciation Exam focus point Examination questions often assume that this loss will be available immediately, though in practice the balance less the sale price continues to be written off at 25% a year as part of a pool balance.

江西财经大学会计学院 Tax-allowable depreciation Exam focus point A common mistake in exams is to include the tax-allowable depreciation itself in the NPV calculation; it is the tax effect of the allowance that should be included.

江西财经大学会计学院 Example: Taxation A company is considering whether or not to purchase an item of machinery costing $40,000 in 20X5. It would have a life of four years, after which it would be sold for $5,000. The machinery would create annual cost savings of $14,000. The machinery would attract tax allowable depreciation of 25% on the reducing balance basis which could be claimed against taxable profits of the current year, which is soon to end. A balancing allowance or charge would arise on disposal. The rate of tax is 30%. Tax is payable one year in arrears. The after-tax cost of capital is 8%. Assume that tax payments occur in the year following the transactions. Should the machinery be purchased?

江西财经大学会计学院 An alternative and quicker method of calculating tax payments or savings

江西财经大学会计学院 Taxation and DCF Text book : P164

江西财经大学会计学院 Question 1 A company is considering the purchase of an item of equipment, which would earn profits before tax of $25,000 a year. Depreciation charges would be $20,000 a year for six years. Tax-allowable depreciation would be $30,000 a year for the first four years. Tax is at 30%. What would be the annual net cash inflows of the project: (a) For the first four years (b) For the fifth and sixth years assuming that tax payments occur in the same year as the profits giving rise to them, and there is no balancing charge or allowance when the machine is scrapped at the end of the sixth year?

江西财经大学会计学院 Question 2 A company is considering the purchase of a machine for $150,000. It would be sold after four years for an estimated realizable value of $50,000. By this time tax- allowable depreciation of $120,000 would have been claimed. The rate of tax is 30%. What are the tax implications of the sale of the machine at the end of four years?

江西财经大学会计学院 Taxation and DCF Exam focus point In reality, company income tax may be paid quarterly but the timing is simplified in a DCF calculation and an exam question will tell you what assumptions to use.

江西财经大学会计学院 NPV layout

江西财经大学会计学院 Chapter Roundup Text book : P165

江西财经大学会计学院 Quick Quiz 1

江西财经大学会计学院 Quick Quiz 2

江西财经大学会计学院 Answers to Quick Quiz

江西财经大学会计学院 PART D-10 Project appraisal and risk

江西财经大学会计学院 Topic list

江西财经大学会计学院 Study guide

江西财经大学会计学院 Exam guide Risk and uncertainty are increasingly examinable in financial management exams and sensitivity calculations are particularly important. You will need to be able to explain these techniques as well as be confident and competent with the calculations.

江西财经大学会计学院 Project appraisal and risk Risk and uncertainty Sensitivity analysis Probability analysis Other risk adjustment techniques

江西财经大学会计学院 Risk and uncertainty Fast forward Risk can be applied to a situation where there are several possible outcomes and, on the basis of past relevant experience, probabilities can be assigned to the various outcomes that could prevail. Uncertainty can be applied to a situation where there are several possible outcomes but there is little past relevant experience to enable the probability of the possible outcomes to be predicted. There are a wide range of techniques for incorporating risk into project appraisal.

江西财经大学会计学院 A distinction should be made between the terms risk and uncertainty

江西财经大学会计学院 A distinction should be made between the terms risk and uncertainty Exam focus point Make sure you can explain the difference between risk and uncertainty. This was required in December 2007 and the examiner commented that it caused difficulties.

江西财经大学会计学院 Sensitivity analysis Fast forward Sensitivity analysis assesses how responsive the project's NPV is to changes in the variables used to calculate that NPV. One particular approach to sensitivity analysis, the certainty- equivalent approach, involves the conversion of the expected cash flows of the project to riskless equivalent amounts.

江西财经大学会计学院 Sensitivity analysis Key term Sensitivity analysis is one method of analyzing the risk surrounding a capital expenditure project and enables an assessment to be made of how responsive the project's NPV is to changes in the variables that are used to calculate that NPV.

江西财经大学会计学院 Sensitivity analysis The NPV could depend on a number of uncertain independent variables. Selling price Sales volume Cost of capital Initial cost Operating costs Benefits

江西财经大学会计学院 Sensitivity analysis

江西财经大学会计学院 Example: Sensitivity analysis

江西财经大学会计学院 Weaknesses of this approach to sensitivity analysis Text book : P172

江西财经大学会计学院 Question

江西财经大学会计学院 Weaknesses of this approach to sensitivity analysis Exam focus point Examiners have commented that sensitivity analysis is often confused with the internal rate of return.

江西财经大学会计学院 The certainty-equivalent approach Another method is the certainty-equivalent approach. By this method, the expected cash flows of the project are converted to riskless equivalent amounts. The greater the risk of an expected cash flow, the smaller the 'certainty-equivalent' value (for receipts) or the larger the certainty equivalent value (for payments).

江西财经大学会计学院 Example: Certainty-equivalent approach

江西财经大学会计学院 Probability analysis Fast forward A probability analysis of expected cash flows can often be estimated and used both to calculate an expected NPV and to measure risk. The standard deviation of the NPV can be calculated to assess risk when the construction of probability distributions is complicated.

江西财经大学会计学院 Step Step 1 Calculate an expected value of the NPV Step 2 Measure risk, for example in the following ways. (a) By calculating the worst possible outcome and its probability. (b) By calculating the probability that the project will fail to achieve a positive NPV. (c) By calculating the standard deviation of the NPV.

江西财经大学会计学院 Example: Probability estimates of cash flows A company is considering a project involving the outlay of $300,000 which it estimates will generate cash flows over its two year life at the probabilities shown in the following table.

江西财经大学会计学院 Problems with expected values There are the following problems with using expected values in making investment decisions. An investment may be one-off, and 'expected' NPV may never actually occur Assigning probabilities to events is highly subjective Expected values do not evaluate the range of possible NPV outcomes

江西财经大学会计学院 Other risk adjustment techniques Simulation Adjusted payback Risk-adjusted discount rates

江西财经大学会计学院 Simulation Fast forward Other risk adjustment techniques include the use of simulation models, adjusted payback and risk-adjusted discount rates.

江西财经大学会计学院 Example: Simulation model

江西财经大学会计学院 Adjusted payback Text book : P178

江西财经大学会计学院 Risk-adjusted discount rates Text book : P178

江西财经大学会计学院 Chapter Roundup Text book : P179

江西财经大学会计学院 Quick Quiz

江西财经大学会计学院 Answers to Quick Quiz

江西财经大学会计学院 PART D-11 Specific investment decisions

江西财经大学会计学院 Topic list

江西财经大学会计学院 Study guide

江西财经大学会计学院 Exam guide You may be asked to calculate the results of different options and careful, methodical workings will be essential. These calculations can be quite difficult and will need lots of practice.

江西财经大学会计学院 Specific investment decisions Lease or buy decisions Asset replacement decisions Capital rationing

江西财经大学会计学院 Lease or buy decisions Fast forward Leasing is a commonly used source of finance. We distinguish three types of leasing: Operating leases (lessor responsible for maintaining asset) Finance leases (lessee responsible for maintenance) Sale and leaseback arrangements

江西财经大学会计学院 The nature of leasing Key terms Leasing is a contract between a lessor and a lessee for hire of a specific asset selected from a manufacturer or vendor of such assets by the lessee. The lessor has ownership of the asset. The lessee has possession and use of the asset on payment of specified rentals over a period.

江西财经大学会计学院 Examples of lessors Banks Insurance companies

江西财经大学会计学院 Types of asset leased Office equipment Computers Cars Commercial vehicles Aircraft Ships Buildings

江西财经大学会计学院

Operating leases Key term Operating lease is a lease where the lessor retains most of the risks and rewards of ownership.

江西财经大学会计学院 Finance leases Key term A finance lease is a lease that transfers substantially all of the risks and rewards of ownership of an asset to the lessee. It is an agreement between the lessee and the lessor for most or all of the asset's expected useful life.

江西财经大学会计学院 Example: A motor lease The primary period of the lease might be three years, with an agreement by the lessee to make three annual payments of $6,000 each. The lessee will be responsible for repairs and servicing, road tax, insurance and garaging. At the end of the primary period of the lease, the lessee may have the option either to continue leasing the car at a nominal rent (perhaps $250 a year) or to sell the car and pay the lessor 10% of the proceeds.

江西财经大学会计学院 Sale and leaseback Key term Sale and leaseback is when a business that owns an asset agrees to sell the asset to a financial institution and lease it back on terms specified in the sale and leaseback agreement.

江西财经大学会计学院 Attractions of leasing Text book : P184

江西财经大学会计学院 Lease or buy decisions Fast forward The decision whether to lease or buy an asset is a financing decision which interacts with the investment decision to buy the asset. Identify the least-cost financing option by comparing the cash flows of purchasing and leasing. The cash flows are discounted at an after-tax cost of borrowing.

江西财经大学会计学院 Lease or buy decisions Exam focus point Remember that the decisions made by companies are not solely made according to the results of calculations like these. Other factors (short-term cash flow advantages, flexibility, use of different costs of capital) may be significant.

江西财经大学会计学院 The position of the lessor Exam focus point So far, we have looked at examples of leasing decisions from the viewpoint of the lessee. You may be asked to evaluate a leasing arrangement from the position of the lessor. This is rather like a mirror image of the lessee's position.

江西财经大学会计学院 Example: Lessor's position

江西财经大学会计学院 Question The management of a company has decided to acquire Machine X which costs $63,000 and has an operational life of four years. The expected scrap value would be zero. Tax is payable at 30% on operating cash flows one year in arrears. Tax allowable depreciation is available at 25% a year on a reducing balance basis. Suppose that the company has the opportunity either to purchase the machine or to lease it under a finance lease arrangement, at an annual rent of $20,000 for four years, payable at the end of each year. The company can borrow to finance the acquisition at 10%. Should the company lease or buy the machine?

江西财经大学会计学院 Asset replacement decisions Fast forward DCF techniques can assist asset replacement decisions. When an asset is being replaced with an identical asset, the equivalent annual cost method can be used to calculate an optimum replacement cycle.

江西财经大学会计学院 Equivalent annual cost method

江西财经大学会计学院 Example: replacement of an identical asset

江西财经大学会计学院 Equivalent annual benefit Key term The equivalent annual benefit is the annual annuity with the same value as the net present value of an investment project.

江西财经大学会计学院 Capital rationing Key terms Capital rationing: a situation in which a company has a limited amount of capital to invest in potential projects, such that the different possible investments need to be compared with one another in order to allocate the capital available most effectively. Soft capital rationing is brought about by internal factors; hard capital rationing is brought about by external factors.

江西财经大学会计学院 Soft and hard capital rationing Text book : P190

江西财经大学会计学院 Relaxation of capital constraints Text book : P190

江西财经大学会计学院 Relaxation of capital constraints Key term Profitability index is the ratio of the present value of the project's future cash flows (not including the capital investment) divided by the present value of the total capital investment.

江西财经大学会计学院 Example: Capital rationing

江西财经大学会计学院 Problems with the Profitability Index method Text book : P192

江西财经大学会计学院 Question

江西财经大学会计学院 Postponing projects We have so far assumed that projects cannot be postponed until year 1. If this assumption is removed, the choice of projects in year 0 would be made by reference to the loss of NPV from postponement.

江西财经大学会计学院 Example: Postponing projects

江西财经大学会计学院 Example: Postponing projects

江西财经大学会计学院 Single period rationing with non- divisible projects Text book : P194

江西财经大学会计学院 Example: single period rationing with non-divisible projects

江西财经大学会计学院 Chapter Roundup Text book : P195

江西财经大学会计学院 Quick Quiz 1

江西财经大学会计学院 Quick Quiz 2

江西财经大学会计学院 Answers to Quick Quiz

江西财经大学会计学院 Revision P19-28 Investment appraisal 16-27