mutually exclusive projects + capital rationing Flashcards
(17 cards)
what should you ensure you do if you’re working out the NPV of cash flows that are even for each year?
use the annuity rate/cumulative PV!
what should you do if a cash flow starts in y2 and is the same until the end of y6, how should you calculate the PV?
the cumulative rate for year six should be read from the tables and the rate for year one subtracted from it.
The resulting figure should then be multiplied by the annual (not the cumulative) cash flow to obtain the total net present value
apart from annualised cash flows how can you compare projects of different lengths?
profitability index -
NPV/initial investment
does NPV/IRR change depending on project life?
NPV - yes because it’s discounting each cash flow
IRR - no because it’s return per pound
how do you work out annualised equivalent of NPV?
NPV worked out normally/annuity rate
what is important to consider when looking at different length mutually exclusive projects?
the choice also depends on the degree of freedom the org has to reinvest when the shorter lived project ends. if the org is forced to reinvest in similar assets at this point, then compare over equal lifetimes. this will arise if the assets are manufacturing equipment, where the org knows the product will be made for many years ahead. or, when choosing between types and sizes of vehicles for production distribution.
if the org isn’t going to invest in similar assets, don’t do this. e.g., different marketing strategies for a novelty product. clearly makes no sense to repeat cash flows because product can only be launched once.
what are the two types of asset replacement cycle decisions?
1 - considering mutually exclusive options with unequal lives
2 - calculating an optimum replacement cycle
what is the equivalent annual cost?
basically a method of discounting especially for asset replacement decisions but also has value when comparing sensitivity of variables where projects have unequal lives. when PV of a capital project is expressed as an annual amount, this = annual equivalent cost
EAC = PV of costs / annuity factor for lifetime
remember this should be lower as it COSTS
what are the factors when deciding on replacement cycles of an asset?
capital cost of new equipment
operating costs - expect to increase as asset ages/deteriorates over time. repair costs, but also loss of production and lower quality/quantity of output.
resale value
taxation/investment incentives
inflation - and relative movements in prices of inputs and outputs.
what are the limitations of asset replacement analysis?
assumes that firm replaces like with like each time it needs
ignores:
changing technology
inflation - optimum cycle can vary over time
change in production plans
what is capital rationing? what is the objective?
capital rationing = restriction on ability to invest capital funds, caused by internal budget ceiling imposed by management (soft) or external limitations (hard), such as additional funds not being available.
objective is to maximise total NPV of chosen project’s cash flows at cost of capital.
what assumption in NPV requires qualification for capital rationing? what are the qualifications?
NPV assumes funds will always be forthcoming for a project which offers the prospect of adequate ROI. this needs some qualification:
subjective judgement - prospects are subjective judgements and there may be problems communicating that judgement to whoever holds the purse strings.
unwillingness to seek other capital sources - may mean ceding control. usual response to this is to use a discount rate higher than cost of capital, and trade off further back up the profit-growth graph.
emphasis on short term accounting - undue emphasis on these numbers (reported profits, return on asset ratios). response is to evaluate in NPV terms, but select those which have the most attractive accounting profile.
shortage of resources - e.g. engineering skills. appropriate response here is extension of marginal costing principle of maximising contribution, using NPV per unit of limiting factor.
single biggest problem in practice - opportunities don’t surface at the same time, and choices are made without all the information you’d like.
when does project ranking become most important?
when capital rationing in place the ranking of the projects becomes important. various methods of investment appraisal often give conflicting ranking of investment priorities. Methods of determining how the investment decision should be made will depend on the type of capital rationing.
how should single period capital rationed investment decisions be made?
only slight modification to NPV rule required. overall return is maximised by maximising return per unit of limiting factor. Those with highest NPV per $1 should be selected.
profitability index = PV of cashflows / initial investment
NB - when projects are indivisible, use of profitability index may lead to incorrect ranking. investment selection therefore needs to be undertaken by examining total NPV values of all possible combinations of whole projects that don’t exceed amount of capital available. may also be a small amount of unused capital with each combo.
what does it mean if a project is single period capital rationed?
single period - capital rationed at present (Y0), but will be freely available in the future.
what does it mean if an investment decision is multi period capital rationed?
multi period - rationed over a range of periods now and in the future
what is the optimal investment plan when a project is multi-period capital rationed?
optimal investment plan
calculate PI for each project
rank according to PI
allocate funds until used (if divisible)
if indivisible
need to compare every combination of projects, especially if there are a lot of combos! index match formula on NPVs makes this fairly easy tbh
