Paper F9 Financial Management Cai Ji-fu Accounting School

Specific investment decisions Chapter 11 Specific investment decisions

Topic list Lease or buy decisions Asset replacement decisions Capital rationing

Exam guide 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.

1 Lease and 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

1.1 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 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.

Lease and buy decisions Lease is a contract under which one party, the lessor (owner) of an asset, agrees to grant the use of that asset to another, the lessee, in exchange for periodic rental payments. Leasing is a form of financing whereby an asset can be used within a business without it necessarily being bought outright.

1.1 The nature of leasing Examples of lessors Types of asset leased Banks Insurance companies Types of asset leased Office equipment Computers Cars Commercial vehicles Aircraft Ships Buildings

1.1 The nature of leasing Types of leases Financial leases Operating leases Sales and leaseback

The criteria distinguishing finance lease from operating lease Financing leases One lease exists for the whole usually life of the asset. The lessor doesn’t usually deal directly in this type of asset. The lessor doesn’t retain the risk or rewards of ownership. The lease agreement can’t be cancelled. The leasee has a liability for all payment. The substance of the transaction is the purchase of the asset by the lessee financed by a loan from the lessor, i.e. it is effectively a source of medium to long term debt finance. Operating lease The lease period is less than the useful life of asset. The lessor relies on subsequent leasing or eventual sale of the asset to cover his capital outlay and show a profit. The lessor may very well carry on a trade in this type of asset. The leassor normally responsible for repairs and maintenance The lease can sometimes be cancelled at short notice. The substance of transaction is the short term rental of an asset

1.2 Operating leases Key term Operating leases is a lease where the lessor retains most of the risks and rewards of ownership. Operating leases are rental agreements between a lessor and a lessee. The lessor supplies the equipment to the lessee The lessor is responsible for servicing and maintaining the leased equipment The period of lease is fairly short, less than the expected economic life of the asset.

1.3 Financial leases Key term A financial lease is a lease where the 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.

1.5 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. The business retains use of the asset but has the funds from the sales, whilst having to pay rent.

1.6 Attractions of leasing The supplier of the equipment is paid in full at the beginning The lessor invests finance by purchasing assets from supplier and makes a return out of the lease payments from the lessee. The lessor will also get capital allowances on his purchase of the equipment.

1.6 Attractions of leasing Leasing may have advantages for the lessee: The lessee may not have enough cash to pay for the asset, and would have difficulty obtaining a bank loan to buy it. If so the lessee has to rent the asset to obtain use of it at all. Finance leasing may be cheaper than a bank loan The lessee may find the tax relief available advantageous

1.6 Attractions of leasing Operating leases have further advantages. The leased equipment doesn’t have to be shown in the lessee’s published balance sheet, and so the lessee’s balance sheet shows no increase in its gearing ratio. The equipment is leased for a short period than its expected useful life. If the equipment becomes out of date before the end of its expected life, the lessee doesn’t have to keep on using it. The lessor will bear the risk of having to sell obsolete equipment secondhand.

1.7 Lease or buy decisions Fast forward The decision whether to lease or buy an asset involves two steps: The acquisition decision: is that worth having? Test by discounting project cash flows at a suitable cost of capital. The financing decision: if the asset should be acquired, compare the cash flows of purchasing and leasing or HP arrangements. The cash flows can be discounted at an after-tax cost of capital.

1.7 Lease or buy decisions An acquisition decision is made on whether the asset is worth having. The present values of operational costs and benefits from using the asset are found to derive a NPV. A financing decision is then made if the acquisition is justified by a positive NPV. This is the decision on whether to lease or buy.

1.7 Lease or buy decisions Non-taxpaying organization The cost of capital that should be applied to the cash flows for the acquisition decision is the cost of capital that the organization would normally apply to its project evaluations The cost of capital that should be applied to the cash flows for the financing decision is the cost of borrowing We assume that if the organization decided to purchase the equipment, it would finance the purchase by borrowing funds. We therefore compare the cost of borrowing with the cost of leasing (or hire purchase) by this cost of borrowing to the financing cash flows.

1.7 Lease or buy decisions Tax-paying organization Discount the cash flows of the acquisition decision at the firm’s after-tax cost of capital. Discount the cash flows of financing decision at the after-tax cost borrowing.

1.7 Lease or buy decisions Evaluating the project assuming that the asset is bought Unless told otherwise, assuming its cash flows are of the same level of risk as those from existing operations, the discount rate will often be approximated by the company’s existing cost of capital. The cash flows to which this discount rate should be applied will be: Asset flows-initial cost and residual value Working capital flows Net cash operating inflows Tax relief on capital allowances Tax on operating inflows

1.7 Lease or buy decisions Evaluating the project assuming that the asset is leased The leasing decision will be made by computing the NPV of the project with leasing cash flows. The discount rate is the company’s existing cost of capital. The cash flows to which this discount rate should be applied will be: Lease costs Tax relief on lease costs Working capital flows Net cash operating inflows Tax on operating inflows Note that the initial cost of the asset, its residual value and associated tax implications have been removed as these are all dependent on the asset being bought.

1.7 Lease or buy decisions A disadvantage of the traditional approaches to making a lease or buy decision is that if there is a negative NPV when the operational cash flows of the project are discounted at the firm’s cost of capital, the investment will be rejected out of hand. However, the cost of leasing might be so low that the project would be worthwhile provided the leasing option were selected. This suggests that an investment opportunity should not be rejected without first giving some thought to its financing costs.

1.7 Lease or buy decisions Other methods of making lease or buy decisions: Making the financing decision first Compare the cost of leasing with the cost of purchase, and select the cheaper method of financing, then calculate the NPV of the project on the assumption that the cheaper method of financing is used. Combine the acquisition and financing decisions together into a single-stage decision. Calculate an NPV for the project if the machine is purchased, and secondly if the machine is leased. Select the method of financing which giving the higher NPV, provided that the project has a positive NPV.

1.7 Lease or buy decisions Since operating leases are a form of renting, the only cash flows to consider for this type of leasing are the lease payments and the tax saved. Operating lease payments are allowable expenses for tax purpose. 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 flows advantages, flexibility, use of different costs of capital) may be significant.

1.10 The position of the lessor Exam focus point You may be asked to evaluate a leasing arrangement from the position of the lessor. The lessor will receive tax allowable depreciation on the expenditure, and the lease payments will be taxable income.

2 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.

2 Asset replacement decisions DCF method can be used in asset replacement decisions, to assess when and how frequently an asset should be replaced. When an asset is to be replaced by an ‘identical asset’, the problem is to decide the optimum interval between replacements. As the asset gets older, it may cost more to maintain and operate, its residual value will decrease, and it may lose some productivity/operating capability.

2.1 Equivalent annual cost method Key term The equivalent annual cost is the equal annual cash flow (annuity) to which a series of uneven cash flows is equivalent in PV terms. The equivalent annual cost method is the quickest method to use in a period of no inflation. Calculate the present value of costs for each replacement cycle over one cycle only These costs are not comparable because they refer to different time period, whereas replacement is continuous.

2.1 Equivalent annual cost method Turn the present value of costs for each replacement cycle into an equivalent annual cost (annuity) The optimum replacement period (cycle) will be the period that has the lowest equivalent annual cost.

Asset replacement decisions The factors to be considered when making replacement decisions are as follows: Capital cost of new equipment-the higher cost of equipment will have to be balanced against known or possible technical improvements Operating costs – operating costs will be expected to increase as machinery deteriorates over time. This is the result of: Increased repair and maintenance costs Loss of production due to ‘down-time’ resulting from increased repair and maintenance time Lower quality and quantity of output

Asset replacement decisions The factors to be considered when making replacement decisions are as follows: Resale value – the extent to which old equipment can be traded in for new Taxation and investment incentives Inflation – both the general price level change, and relative movements in the prices of input and outputs

Asset replacement decisions Determining the optimum replacement period (cycle) will largely be influenced by: The capital cost/resale value of asset-the longer the period, the less frequently these will occur The annual operating costs of running the assets-the longer the period, the higher these will become.

3 Capital rationing Fast forward Capital rationing may occur due to internal factors (soft capital rationing) or external factors (hard capital rationing) Capital rationing arises when an organization is restricted in the amount of funds available to initiate all worthwhile projects (i.e. projects that have a positive net present value).

3 Capital rationing Key terms Capital rationing : a situation in which a company has a limited amount of capital to invest in potential project, such that the different possible investments need to be compared with one another in order to allocate the capital available most effectively. Capital rationing is a situation where a constraint (or budget ceiling) is placed on the total size of capital expenditures during a particular period.

3 Capital rationing Capital rationing is defined as the situation where a firm has more positive NPV projects available than it can adopt due to a shortage of funds. Hard (external) capital rationing is brought about by external factors. Soft (internal) capital rationing is brought about by internal factors If an organization is in a capital rationing situation it will not be able to enter into all projects with positive NPVs because there is not enough capital for all the investments.

3.1 Soft and hard capital rationing Soft capital rationing may arise for one of the following reasons Management may be reluctant to issue additional share capital because of concern that may lead to outsiders gaining control of the business. Management may be unwilling to issue additional share capital if it will lead to a dilution of earnings per share. Management may not want to raise additional debt capital because they do not wish to be committed to large fixed interest payments. Management may wish to limit investment to a level that can be financed solely from retained earnings. Capital expenditure budgets may restrict spending

3.1 Soft and hard capital rationing Hard capital rationing may arise for one of the following reasons Raising money through the stock market may not be possible if share capital are depressed There may be restrictions on bank lending due to government control. Lending institutions may consider an organization to be risky to granted further loan facilities. The costs associated with making small issues of capital may be too great.

3.2 Relaxation of capital constraints It might seek joint venture partners with which to share projects. As an alternative to direct investment in a project, the company may be able to consider a licensing or franchising agreement with another enterprise, under which the licensor/franchisor company would receive royalties. It may be possible to contract out parts of a project to reduce the initial capital outlay required.

3.2 Relaxation of capital constraints The company may seek new alternative sources of capital Venture capital Debt finance secured on the assets of the project Sale and leaseback of property or equipment Grant aid More effective capital management

3.3 Single period capital rationing Fast forward When capital rationing occurs in a single period, projects are ranked in terms of probability index.

3.3 Single period capital rationing Assumptions on single period capital rationing It a company does not accept and undertake a project during the period of capital rationing, the opportunity to undertake it is lost. The project can’t be postponed until a subsequent period when no capital rationing exists. There is complete certainty about the outcome of each project, so that the choice between projects is not affected by consideration of risk Projects are divisible, so that it is possible to undertake, say, half of project X in order to earn half of the NPV of the whole project.

3 Capital rationing Types of capital rationing Single-period Shortage of funds now, but funds are expected to be freely available in all later period. Multi-period Where the period of funds shortages is expected to extend over a number of years, or even indefinitely.

Capital rationing Project divisibility (Categories of projects ) Divisible projects-either the whole project, or any fraction of the project, may be undertaken, if a fraction only is undertaken, then both initial investment and cash inflows are reduced pro rata. Indivisible projects-either the project must be undertaken in its entirety, or not at all. In reality, almost all projects are indivisible. However, the assumption of divisibility enables the easier use of mathematical tools.

Capital rationing Single-period capital rationing multi-period capital rationing Divisible project indivisible project Divisible project Profitability index Trial and error Linear programming The objective of all capital rationing exercise is the maximisation of the total NPV of the chosen project’s cash flows at the cost of capital.

3.3 Single-period capital rationing-divisible projects Decision method Maximizing NPV is achieved in these circumstances by ranking projects according to their profitability index (cost-benefit ratio), then allocating funds accordingly until they are exhausted.

3.3 Single-period capital rationing-divisible projects Key term The profitability index (PI) or benefit-cost ratio is the ratio of the PV of the project’s future cash flows (not including the capital investment) divided by the PV of the total capital investment of the project The profitability index (PI) of a project is the PV of future cash flows per 1$ invested

3.3 Single-period capital rationing- divisible projects Acceptance criterion A project is acceptable under the PI if: PI > 1 A selection of projects with the highest profitability indices will result in the maximum NPV for limited funds available. For a single-period capital rationing between divisible projects, use the PI to rank project.

3.3 Single-period capital rationing- divisible projects Problems with the probability index method The approach can only be used if projects are divisible. The selection criterion is fairly simplistic, taking no account of the possible strategic value of individual investment in the context of the overall objectives of the organization. The method is of limited use when projects have differing cash flow patterns. The profitability index ignore the absolute size of individual projects. A project with a high index might be very small and therefore only generate a small NPV.

3.5 Postponing projects We have so far assumed that projects can’t be postponed until year 1. if the assumption is removed, the choice of projects in year 0 would be made by reference to the loss of NPV from postponement.

3.5 Single period rationing with non-divisible projects In these circumstances, the objective can only be achieved by selecting from amongst the available projects on a trial and error basis. Because of the problem of indivisibility this may leave some funds unutilized. For single-period capital rationing between indivisible projects, use trial and error and test the NPV available from different combinations of project.

3.5 Single period rationing with non-divisible projects As well as the specific investment opportunities available, consideration should also given to investing surplus funds arising in one period, even at rates lower than the cost of capital, in order to increase funds available in later periods