ACCA paper f9 financial management study materials F9FM session06 d08

SESSION 06 – APPLICATIONS OF DCF OVERVIEW Objective To apply discounted cash flow techniques to specific areas DCF APPLICATIONS CAPITAL RATIONING Definition Methods ASSET REPLACEMENT DECISIONS The issue Limitations of replacement analysis LEASE v BUY The issue Decision-making The investment decision The financing decision The final decision 0601 SESSION 06 – APPLICATIONS OF DCF CAPITAL RATIONING 1.1 Definition A situation where there is not enough finance available to undertake all available positive NPV projects 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 Soft rationing – where the company itself sets internal limits on finance availability e.g to encourage divisions to compete for funds Single-period capital rationing – where capital is in short supply in only one period 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 Calculate a “profitability index” for each project = NPV/Initial Investment Rank projects according to their index Allocate funds to the most effective projects in order to maximise NPV Example Projects NPV Cash flow at t0 A $000 100 (50) Cash is rationed to $50,000 at t0 Projects are divisible Required: Determine the optimal investment plan 0602 B $000 (50) (10) C $000 84 (10) D $000 45 (15) SESSION 06 – APPLICATIONS OF DCF Solution 1.2.2 Non-divisible projects A non-divisible/indivisible project must be done 100% or not at all Do not calculate a profitability index; Simply list all possible combinations of projects Choose combination with highest NPV Example Detail as for example 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 Divide projects into groups; with one of the mutually-exclusive projects in each group Calculate the highest NPV available from each group (assume projects are divisible unless told otherwise) Choose the group with the highest NPV 0603 SESSION 06 – APPLICATIONS OF DCF Example As for example but C and D are mutually exclusive Solution 1.2.4 Multi-period capital rationing 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 This is outside of the scope of the syllabus ASSET REPLACEMENT DECISIONS 2.1 The issue Assume that the company has already decided it requires a particular non-current asset A secondary decision is about how often to replace the asset For example how often should the company replace its fleet of motor vehicles or its computer equipment? This is referred to as an asset replacement decision Method: Calculate the NPV of each possible replacement cycle Calculate the Annual Equivalent Cost (AEC) of each cycle AEC = NPV/Annuity factor 0604 Choose the cycle with the lowest AEC SESSION 06 – APPLICATIONS OF DCF Example A machine costs $20,000 Year Year Running costs 5,000 5,500 Scrap proceeds 16,000 13,000 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 Changing technology e.g it may be advisable to replace IT equipment more often than suggested by the above analysis Asset requirements may change over time Non-financial factors e.g employees may be more satisfied if their company cars are replaced more often 0605 SESSION 06 – APPLICATIONS OF DCF LEASE v BUY 3.1 The issue Should the company acquire an asset through: A straight purchase i.e borrowing to buy, or A lease 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 Although the distinction between operating and finance lease is important in financial reporting, it is not so relevant in financial management 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 INVESTMENT DECISION FINANCING DECISION Does the asset give operational benefits? Is it cheaper to buy or lease? Focus on the NPV of the operating cash flows 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 The issue here is stripping financing cash flows from operating cash flows and using separate discount rates for each Examination questions may focus merely on the financing decisions 0606 SESSION 06 – APPLICATIONS OF DCF 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 0607 SESSION 06 – APPLICATIONS OF DCF Example 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) (b) (c) Determine the operational benefit of the project Determine how the project should be financed Decide whether the project is worthwhile Solution (a) Operational value Time Cash flow $ Narrative DF @ 10% PV $ Present value ∴ 0608 SESSION 06 – APPLICATIONS OF DCF (b) Financing decision (1) Borrow and buy flows Time Cash flow $ Narrative DF @ 7% PV $ (W) WDA’s Time $ Tax effect at 33% $ Time (2) Leasing flows Time Cash flow $ Narrative DF @ 7% PV $ PV of leasing (c) Final decision PV of operating flows PV of cheaper finance NPV $ 0609 SESSION 06 – APPLICATIONS OF DCF Key points With capital rationing it is essential to identify the nature of the projects i.e divisible or non-divisible, mutually exclusive or not With asset replacement decisions, the key is the use of Annual Equivalent Cost to compare cycles of different lengths With 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: distinguish between hard and soft capital rationing; apply profitability index techniques for single period divisible projects; use DCF to analyse asset replacement decisions; apply DCF methods to projects involving lease or buy problems 0610 SESSION 06 – APPLICATIONS OF DCF EXAMPLE SOLUTIONS Solution — Divisible projects Projects NPV Cash flow at t0 A $000 100 (50) B $000 (50) (10) C $000 84 (10) D $000 45 (15) NPV Investment 100 50 ( 50 ) 10 84 10 45 15 Cost benefit ratio =2 Reject = 8.4 =3 Rank Plan: CASH _ NPV _ AVAILABLE C 50 (10) _ 84 D 40 (15) _ 45 50% A 25 (25) _ 50 _ – $179 _ Solution — Non-divisible Combinations NPV $000 100 129 A only C+D Choose C + D Solution — Mutually exclusive NPV $ A 100 50 _ Group $000 B (50) 10 _ A 100 50 _ Group $000 B (50) 10 _ C 84 10 _ D 45 15 _ Index _ (5) _ 8.4 _ _ (5) _ _ Rank Reject Reject 0611 SESSION 06 – APPLICATIONS OF DCF Plan NPV Accept C 84 Accept 0.8 A 80 _ Capital 50 (10) _ (40) _ NPV Accept D 45 Accept 0.7 A 70 _ 164 _ Capital 50 (15) _ (35) _ 115 _ Accept C and 0.8A Solution — Machine replacement Replace every year Time 1 Purchase Running costs Scrap proceeds Cash flow (20,000) (5,000) 16,000 Discount factor 0.909 0.909 NPV = Annual equivalent cost = PV (20,000) (4,545) 14,544 (10,001) 10,001 NPV = $11,002 = year 0.909 annuity factor Now repeat the above procedure, assuming the machine is replaced every two years Time 2 Narrative Purchase Running costs Running costs Scrap proceeds Cash flow @ 10% (20,000) (5,000) (5,500) 13,000 Discount factor value 0.909 0.826 0.826 18 ,350 18 ,350 Annual equivalent = = = $10 ,570 year 10% AF 1.736 Conclusion Replace every two years 0612 Present (20,000) (4,545) (4,543) 10,738 NPV = (18,350) SESSION 06 – APPLICATIONS OF DCF Solution — Lease or Buy (a) Operational value Time Cash flow $ 150,000 (49,500) 1–2 2–3 Narrative DF @ 10% Project returns Tax on above 1.736 1.578 Present value PV $ 260,400 (78,111) _ 182,289 _ (b) Financing decision (1) Borrow and buy flows Time Cash flow $ (200,000) 25,000 16,500 41,250 2 Narrative DF @ 7% Purchase cost Sale proceeds (W) (W) 0.873 0.873 0.816 PV $ (200,000) 21,825 14,405 33,660 (130,110) (W) WDA’s Time Purchase WDA at 25% $ 200,000 (50,000) WDV b/f Sale 150,000 25,000 Balancing allowance 125,000 Tax effect at 33% $ Time 16,500 41,250 (2) Leasing flows Time 0–1 2–3 Cash flow $ (92,500) 30,525 Narrative Lease payments Tax relief thereon PV of leasing flows DF @ 7% 1.935 0.873 + 0.816 = 1.689 PV $ (178,988) 51,557 (127,431) Conclusion: The cheapest method of finance is to lease 0613 SESSION 06 – APPLICATIONS OF DCF (c) Final decision PV of operating flows PV of leasing flows (cheaper finance – see (b)) $ 182,289 (127,431) NPV 54,858 The asset should be acquired using a lease 0614 ... lease is important in financial reporting, it is not so relevant in financial management The important issue for financial management is the cash flows created by a lease, as compared to a straight... useful economic life; Financial/ capital lease; where the asset is leased for most of its life Although the distinction between operating and finance lease is important in financial reporting,... equipment more often than suggested by the above analysis Asset requirements may change over time Non -financial factors e.g employees may be more satisfied if their company cars are replaced more often