ACCA Financial Management

Topic Area:

- Investment Appraisal – Part 2

- Supplementary Notes

- Practice Questions
ACCA Paper F9 - Financial Management

Investment Appraisal Sessions 3 & 4

CAPITAL RATIONING

1 Introduction

Capital rationing refers to situation where the firm’s finance is limited (scarce resource is capital) so that
it cannot invest in all the positive NPV projects available.

Two reasons for capital rationing:

(i) Hard (External) Capital rationing:
Inability to borrow
- Bank unwilling to lend because of poor past performance or lack of asset backing
- Interest rate too high
- Government policies (eg. credit policy & Interest rate policy)
Shareholders reluctant to subscribe new shares
Any other reasons of fund shortage arise from outside the company

(ii) Soft (Internal) Capital rationing

Lack of good advance planning results in sudden shortage of fund
Cash limits imposed by management(head office)
Any other reasons arise internally

Two types of capital rationing:

(i) Single period rationing
(ii) Multi-period rationing

2 Single Period Rationing

This refers to the capital is limited for one period only (eg. one year) . If the projects to be selected are
divisible, the basic rule of contribution per limiting factor can be applied. This is done by using
profitability index.(PI)

project NPV (not include capital investment)

PI = PV of outlay in year of shortage

If the projects are non-divisible, we have no choice but just select the optimum project(s) by trial &error.
(see practice question behind)

Note: If the projects are mutually exclusive, you can only select one of them (non-divisible)

Illustration

Bamboo Ltd has four projects available which are fully divisible, the fund available now is limited to
$300. Select the best combination of projects.

Project Initial outlay NPV PI Ranking

A $100 $80 0.8 2
B 60 50 0.83 1
C 70 35 0.5 3
D 200 96 0.48 4
 ACCA Paper F9 - Financial Management

Investment Appraisal Sessions 3 & 4

Allocation of projects:
Funds available $300
Allocate to : B (60)
240
A (100)
140
C (70)
70
D (70)

Disadvantages of Profitability Index (PI)

Only applicable on divisible projects
Selection method is too simple
Limited use of projects with differing cash flow patterns
Without consideration of project absolute size

3 Single Period Rationing with Non-divisible Projects

Projects are non-divisible then the method mentioned above is not applicable. Another way to deal with
this situation is to use trial and error and test the NPV available from different combinations of projects.

Illustration

Nottingham Ltd has capital of $950,000 for investment. There are three projects, P, Q and R, for
consideration. The company wants to invest in whole projects, but surplus funds can be invested. If
cost of capital is 20%, which combination of projects give the highest NPV?:
Investment Investment PV of
Project required inflows at 20%
$000 $000
P 400 565
Q 500 670
R 300 488

Possible investment combinations for pairs of P, Q and R are as follows:

Required PV of NPV from
Projects investment inflows projects
$000 $000 $000
P and Q 900 1,235 335
P and R 700 1,053 353
Q and R 800 1,158 358

As combination of Q and R provides the highest NPV, it is suggested to invest $800,000 in these
projects and the unused funds invest externally.
 ACCA Paper F9 - Financial Management

Investment Appraisal Sessions 3 & 4

FINANCING DECISION AND REPLACEMENT POLICY

1 Introduction

This lecture covers two main areas, ie financing, which will consider lease vs buy decision, followed by
asset replacement policy or optimal replacement period.

2 Lease vs Buy

Leases are contractual agreements between a lessor (the owner) and a lessee (the user) governing the
use of assets. The decision to be made here is either to lease an asset or to borrow money and buy the
asset. Financial accounting distinguishes two types of leases, namely, financial lease and operating
lease based on the interpretation of IFRS16. The key accounting phase is that a finance lease
transfers substantially all rewards and risks of ownership to the lessee. Thus, the finance leases tend to
be longer term to pass on to the lessee most of the asset’s rewards (the asset is usually leased once)
as well as transferring most of its risks such as maintenance, insurance and repair costs and even the
burden of eventually selling the assets (that is the risk of selling).

Note: IFRS16 eliminates the classification of lease are either operating lease or financing lease. But
lessors continue to classify them differently.

3 Types of leases

Finance leases are usually split into two parts:

(i) the primary period, during which time the lessor will require regular installments to be paid to
provide a required return. During this time the lease is either non-cancelable, or there will be
high penalties if the lessee cancels - the lessor does not want the asset back!!

(ii) the secondary period, once the primary period expires, some finance leases offer the right to
buy the asset or to continue leasing it at a nominal or `peppercorn rent’.

Operating leases, on the other hand, tend to be short term, such as leasing a car or machine for a
couple of weeks only. The leasor will lease the asset many times and needs many leases to earn a
worthwhile return. In addition it is the lessor who will be responsible for the actual sale of the asset;
alone with all other risks such as maintenance and insurance.

Neither lease transfers legal title to the lessee.

Summary differences between finance lease and operating lease:

Finance lease Operating lease

One lease exists for the whole useful life of the Several leases exist for the asset useful life
asset
The lessor does not retain the risks or rewards of The lessor normally carries out repairs &
ownership. maintenance
Lease agreement cannot be cancelled The lease can be cancelled at short notice
The substance of the transaction is the purchase The substance of the transaction is the short-term
of the asset by the lessee financed by a loan from rental of an asset.
the lessor
 ACCA Paper F9 - Financial Management

Investment Appraisal Sessions 3 & 4

4 An Evaluation

The decision to lease or buy can be made by calculating the NPV of each alternative and choosing the
lower cost. The two implications must be considered are:

(a) Purchasing an asset provides the company with capital allowances (eg. 25% p.a. on reducing
balance basis)
(b) Leasing an asset is a tax-allowable expenses (eg. saving 33% of the lease payment itself in
tax).

SUMMARY OF THE MAIN DIFFERENCE BETWEEN ALTERNATIVE FINANCING METHODS:

Borrow to buy: Lease Hire Purchase

1. Own the asset, thus can Cannot claim CA as no Can claim same CA as if
claim CA ownership buy the asset by cash
2. BA/BC arises on disposal No BA/BC BA/BC arises on disposal
3. Capital cost incurred Lease payment involved, Deposit & Installment
(in Yr 0) benefit from tax relief on payment involved, tax
lease payment relief on interest element
of installment
4. Scrap value earned at No scrap value Scrap value earned at
time of disposal time of disposal

5 Replacement Policy

This technique is used when deciding the best time to replace an asset. For example when is the best
time to replace an old machine with a new one? After one year, after two years, after three years or
when?

The first task is to establish what the policies are. For example if the maximum life of the machine is four
years, there are four replacement policies : to replace every year, every two years, every three years or
every four years.

There are two methods, which lead to the same decision:

1. Establish the lowest common multiple of years for the various policies. Compute the NPV for each
policy over this number of years. For example, if the machine maximum life is 4 years, the lowest
common multiple is 12 years in which time:
- a machine replaced every year will be replaced 12 times
- a machine replaced every two years will be replaced 6 times
- a machine replaced every three years will be replaced 4 times
- a machine replaced every four years will be replaced 3 times.

2. Examine the NPV of one complete cycle from purchase to sale, for each replacement policy. Divide
by the appropriate annuity factor to get the equivalent annual amount. The second method is much
easier and leads to the same decision. Thus, the second method is the method to be used in your
exam. The first method is just for illustration only!
 ACCA Paper F9 - Financial Management

Investment Appraisal Sessions 3 & 4

Both methods make the assumptions that:

1. Whichever replacement period chosen, it will be consistently used.
2. No new models of machine become available with different cost characteristics (i.e. there is no
technical innovation, which is totally unrealistic).
3. There is no inflation or if there is, then cost of capital and costs are given in real terms. To handle
inflation with money cash flows in this type of example is much more complex.

The relevant cash flows for this type of decision are:

- Original purchase price
- Running costs/Operating costs include maintenance costs which get more expensive
each year as the machine gets older
- Resale value, which falls each year.

Illustration

The director of your company are considering the best length of time to keep a series A machine before
replacing it. A new machine , which has a maximum life of 4 years, costs $45,800. Other relevant costs
and trade in values are shown below:

End of year 1 2 3 4
Operating costs (19,200) (20,400) (21,700) (23,300)
Maintenance costs (5,600) (7,700) (10,800) (14,200)
(24,800) (28,100) (32,500) (37,500)
Resale value, if sold 29,200 20,000 9000 1600
4,400 (8,100) (23,500) (35,900)

Cost of new machine

If acquired (45,800) (45,800) (45,800) (45,800)
(41,400) (53,900) (69,300) (81,700)

The cost of capital is 10%

Solution:

Policy: DF Present value for replacing every

Replace every Year 2 yea rs 3 years 4 years 10% Year 2 years 3 years 4 years
Cashflows:
End of year
0 -45,800 -45,800 -45,800 -45,800 1.0000 -45,800 -45,800 - 45,800 -45,800
1 4400 -24,800 -24,800 -24,800 0.9091 4000 -22,546 - 22,546 -22,546
2 -8100 -28,100 -28,100 0.8264 -6694 - 23,222 -23,222
3 -23,500 -32,500 0.7513 - 17,656 -24,417
4 -35,900 0.683 -24,520
NPVs -41,800 -75,040 -109,224 -140,505
Annuity factor 0.90 91 1.7360 2.4870 3.1700
AEV -45,980 -43,226 - 43,918 -44,323

DECISION: Select Replacement policy of 2 years (lowest NPV/AEV of costs)

AEV is also known as Equivalent Annual Cost (EAC), and Annual Equivalent Cost (AEC)
 ACCA Paper F9 - Financial Management
Investment Appraisal Sessions 3 & 4

INVESTMENT APPRAISAL UNDER RISK

1 Introduction

As investment appraisal also involves estimation of future cash flows and future happening, element of
risk may be incorporated in the decision analysis . There are many different ways in incorporating risk
and uncertainty, the most common ways are:
(a) Sensitivity analysis;
(b) Expected value using probabilities;
(a) Decision tree analysis; and
(b) Simulation

2. Sensitivity Analysis

Sensitivity analysis looks at each input variable in turn to calculate how sensitive the NPV is to any
change in that variable. The procedures involving the change to an input variable (or even two or more
input variables) such as life of the project, capital cost, etc and to observe the effect on the output such
as NPV, contribution , etc.

The starting point for a sensitivity analysis is the NPV using the most likely value or best estimate for
each key variable. Taking the resulting `base case’ NPV as a reference point, the aim is to identify those
factors which have the greatest impact on the profitability of the project if their realised values deviate
from expectations. This is done by finding the input values required to make NPV = 0. Note : One input
is tested at each time.

Problems of sensitivity analysis include:

1. It deals with changes in isolation and tends to ignore interactions between variables
2. It may reveal critical factors over which managers have no control, thus offering no guide to
action.
3. It gives no indication of the likelihood of the variation under consideration. Variations in a factor
which are potentially sensitive but have a minimal chance of occurrence provide little cause of
concern.

Illustration

C & J Co is considering a project with the following cash flows

Year Initial Variable Cash inflows Net cash

Investment costs
$000 $000 $000 $000
0 7,000
1 (2,000) 6,500 4,500
2 (2,000) 6,500 4,500

Cash flows arise from selling 650,000 units at $10 per unit. C & J Co has a cost of capital of 8%.

Required

Measure the sensitivity of the project to changes in initial investment and variable costs.
 ACCA Paper F9 - Financial Management
Investment Appraisal Sessions 3 & 4

Solution:

The PVs of the cash flow are as follows.

Discount PV of initial PV of variable PV of cash PV of net
Year factor 8% investment costs inflows cash flow
$000 $000 $000 $000
0 1.000 (7,000) (7,000)
1 0.926 (1,852) 6,019 4,167
2 0.857 (1,714) 5,571 3,857
(7,000) (3,566) 11,590 1,024

(a) Initial investment

Sensitivity = (1,024 / 7,000) x 100% = 14.6%

(b) Variable costs

Sensitivity = (1,024 / 3,566) x 100% = 28.7%

3 Expected NPV and Probabilities

Another way of dealing with the uncertainty of future cash flows is to assign probabilities of occurrence
to them, and calculate the expected cash flows and expected NPV. Therefore, in your exam if
probabilities are given, just simply calculate the expected cash flow for the variable where probabilities
are assigned to, and proceed your answer as usual.

Problems of expected value include:

(a) An investment may be one-off, and expected NPV may never actually occur
(b) Assignment of probabilities to events is highly subjective.
(c) Expected values do not evaluate the range of possible NPV outcomes.
(d) Expected values do not take into account the measurement of risk, unless standard deviation
is used.

4 Simulation model

Simulation models apply probability distributions to all of the variables that make up an NPV analysis.
The computer is then used to generate random numbers which can be applied to these variables in
order to produce a possible NPV..

Limitation of Simulation Model:

1. The need to assign probabilities to variables is difficult.
2. No decision rule is given. Although the expected NPV may be positive, the company may not
wish to invest if there is a possibility of a negative NPV arising.
3. As with the capital rationing, the Simulation Model also uses a discount rate which prejudges
how risky the project eventually turns out to be in the simulation (the risk-free rate is often used
to avoid prejudging risk)
4. Finally, the model and the associated software can be complex and expensive to run.
 ACCA Paper F9 - Financial Management
Investment Appraisal Sessions 3 & 4

DEALING WITH TAX

EXAMPLE 1
 ACCA Paper F9 - Financial Management
Investment Appraisal Sessions 3 & 4

EXAMPLE 2

DEALING WITH INFLATION

 ACCA Paper F9 - Financial Management
Investment Appraisal Sessions 3 & 4

ILLUSTRATION>INFLATION
 ACCA Paper F9 - Financial Management
Investment Appraisal Sessions 3 & 4

EXAMPLE 3
 CCA Paper F9 - Financial Management
Investment Appraisal Sessions 3 & 4

EXAMPLE 4

EXAMPLE 5

DEALING WITH WORKING CAPITAL

EXAMPLE 6
 ACCA Paper F9 - Financial Management
Investment Appraisal Sessions 3 & 4
 ACCA Paper F9 - Financial Management
Investment Appraisal Sessions 3 & 4

ASSET REPLACEMENT DECISION

 ACCA Paper F9 - Financial Management
Investment Appraisal Sessions 3 & 4

EQUIVALENT ANNUAL BENEFIT

LEASE VS BUY DECISION

 ACCA Paper F9 - Financial Management
Investment Appraisal Sessions 3 & 4
 ACCA Paper F9 - Financial Management
Investment Appraisal Sessions 3 & 4
 ACCA Paper F9 - Financial Management
Investment Appraisal Sessions 3 & 4
ILLUSTRATION > PAYBACK LIMITATION
pRACTICE MCQS