Chapter 6

Question 1

Capital rationing

Answer 1

A situation where there are not enough funds to accept all positive projects so capital has to be rationed

Question 2

Hard capital rationing

Answer 2

Capital markets impose limits on available finance

Question 3

Soft capital rationing

Answer 3

The organization internally sets limit on finance

Question 4

Single period capital rationing

Answer 4

Capital is in short supply in only one period

Question 5

Multi period capital rationing

Answer 5

Capital is rationed in two or more periods

Question 6

Divisible project

Answer 6

A project is divisible if a company can make a partial or proportionate investment but the project cannot be repeated

Question 7

Steps for rationing a divisible project

Answer 7

Calculate profitability index
NPV/Capital investment
Rank projects according to their index
Allocate funds to the most effective project in order to Maximise NPV

Question 8

Non divisible project

Answer 8

A non divisible project must be 100% done or none at all

Steps
Do not calculate a profitability index
List all possible combos
Choose the best one

Question 9

Mutually exclusive divisible projects

Answer 9

Two or more particular projects cannot be undertaken at the same time for eg (they use the same land) but they can be divisible

Question 10

Multi period capital rationing

Answer 10

If finance is limited in several periods, a linear programming model would have to be set up and be solved to find the optimal investment strategy

Question 11

Asset replacement decision

Answer 11

How often an asset should be replaced

Question 12

Steps in the asset replacement decision process

Answer 12

1. Calculate the NPV of each possible replacement cycle
2. Calculate the equivalent annual cost of each cycle
   EAC = NPV/Annuity factor
3. Choose the cycle with the lowest EAC

Question 13

Equivalent annual cost

Answer 13

Annual cost of owning, operating and maintaining an asset over its entire life

Question 14

Formula for EAC

Answer 14

NPV/Annuity factor

Question 15

Why capital markets restrict funds ?

Answer 15

High business risk
High country/political risk .
High financial risk (i.e. the company already has high existing levels of debt).
Lack of reliable independent information available about the company. T

Question 16

Reasons why company directors may restrict capital

Answer 16

A preference for slower organic growth to a sudden increase in size arising from accepting several large investment projects.
Managers may wish to avoid raising further equity finance if this will dilute the control of existing shareholders.
Managers may wish to avoid issuing new debt if their expectations of future economic conditions are such that an increased commitment to fixed interest payments would be unwise.
To create an internal market for investment funds. This can be seen as a way of reducing the risk and uncertainty associated with investment projects, as it leads to only accepting projects with greater margins of safety.

Question 17

Limitations of replacement analysis

Answer 17

Like-with-like replacement (in perpetuity) is rarely possible even if desirable. Asset requirements may change over time.
Changing technology may also require earlier replacement (e.g. of IT equipment) than suggested by the optimal solution.
Non-financial factors (e.g. employees may be more satisfied if their company cars are replaced more often.)

Question 19

Note

Answer 19

If the IRR of a project exceeds the hurdle rate established by management, the project should be accepted because it will have a positive NPV

Question 20

Note

Answer 20

If the IRR of a project exceeds the hurdle rate established by management, the project should be accepted because it will have a positive NPV

Question 21

Implications of borrow to buy for asset

Answer 21

The bank loan (or loan notes) will be recorded in non-current liabilities and so increase the company’s reported level of financial gearing (debt to equity ratio).
Interest on the debt will reduce the company’s interest cover (i.e. earnings before interest and tax (EBIT) divided by interest expense).
However, the overall effect also depends on the profits generated by the asset as these will increase EBIT and any retained profit would increase the level of equity

Question 22

Implications for leasing for an asset

Answer 22

Both the asset and a related liability would be recognised in the statement of financial position (as for the borrow-to-buy option). Reported financial gearing would therefore rise initially.
However, lease payments would be split between interest expense and repayment of principal and therefore the liability would amortise (i.e. reduce) over time and ultimately fall to zero. Interest expense in early years would be relatively high, tending to reduce interest cover, but lower in later years.
This accounting treatment applies to any lease which is longer than 12 months. Less than 12 months would simply be treated as rental expense which has no effect on the statement of financial position.

Question 23

Why would buying an asset be the preferred option

Answer 23

The asset is of fundamental importance to the business and is in constant use;
Management wants to have absolute control over the asset;
To update or upgrade the asset to scale up capacity is relatively easy;
The asset is easily maintained (e.g. under a supplier’s warranty);
There is an active second-hand market for the asset (so it is not only financially more affordable, but can easily be disposed of).

Question 24

Implications of leasing an asset

Answer 24

The asset may only be needed for a short time or there is significant uncertainty about how long it may be used;
The asset requires specialist support or maintenance that is provided by the lessor;
The asset needs to be regularly updated or upgraded for any reason (e.g. due to technical obsolescence or rapid expansion);
The lease agreement includes options to upgrade to newer models or other flexibility;
Disposal of the asset at the end of its life is subject to strict regulations