Week 3 Flashcards
(23 cards)
What is Capital Rationing?
What is Hard Capital Rationing & reasons?
What is soft Captial Rationing & reasons?
Capital rationing occurs when a company cannot completely maximise SH wealth because of insufficient funds.
Hard Capital Rationing - a limit put on the amount of finance available is imposed by lending instituions
*Industry wide factors that are limiting funds.
*Company specific factors such as lack of or poor track record, lack of asset security or poor management team
Soft Capital Rationing - occurs when a company imposes its own rationing - this is contrary to the rational view of SH maximisation.
*Limited management skills available
*Desire to maximise return of a limited range of investments
Improving investment conditions - reluctance to commit to long term projects.
Capital Rationing
Profitability Index Formula
PI = NPV/Investment
Capital Rationing
Divisible Projects
If a project is divisable, any fraction of the project can be undertaken and the returns generated are expected to be in exact proportion of the investment.
The main aim of CR is to maximise the NPV per $1
Capital Rationing
Indivisible Projects
What happens if all capital rationing is not spent?
Indivisible projects are projects that can only be accepted in whole.
IF the highest NPV comes from a combination of projects that doesnt fully utilise the funds –> note that the assumption is that un-utilised funds will earn a return equivalent to the cost of capital and hence generate a NPV of zero but this might not be the case.
Investment Appraisal under uncertainty
Sensitivity Analysis Formula
What does it measure?
Sensitivity Margin = NPV/PV of flow under consideration expressed as a %.
Measures the maximum change in a given parameter before a project becomes unviable.
Investment Appraisal under uncertainty
Sensitivity Analysis Advantages
- Simple and easy to calculate - the number is easy to explain because it is in a percentage format. –> it is in addition to NPV and provides more info e.g if a manager finds that the NPV of a project is incredibly sensitive to sales price changes then the manager can evaluate the risk of this happening.
- Identifying critical estimates - performing sensitivity analysis on each of the variables will identify those which are most sensitive and managers will be able to focus attention to make sure that element goes to plan
Investment Appraisal under uncertainty
Sensitivity Analysis Disadvantages
- The assumption is that only one variable changes at a time, this means that it can be over simplistic because in reality this is often not the case. E.g petrol station, costs of oil rises –> costs rise but they might chose to pass on cost to customers and selling price will then rise.
- Does not assess the likelihood of a variable changing - managers will need to use their judgement to interpret.
- Does not directly identify a correct accept/reject decision for a project unlike if only NPV is used.
Probability Analysis
What is it?
When can it be used?
Where there are several possible outcomes, probabilities can be assinged to each to show the likelihood of each occuring.
1) Calculate an expected value i.e the weighted average of all possible outcomes based on probability estimates
2) Measure risk by:
* Calculating the worst possible outcome and its probability
* Calculating the probability that the project will fail i.e a negative NPV
Probability Analysis
EV Formula
EV = sum of PX
P= the probability of an outcome X= the value of an outcome
Probability Analysis
What is the EV?
The weighted average of the outcomes, with the weightings based on the probability estimates.
It does not represent what the outcome will be, nor does it represent the most likely result.
It represents the average pay-off per occasion if the project were repeated many times i.e in the long run
- i.e if sales price fluctate between £10,£20,£30 in the future then the average long run price will be the average of these.
Probability Analysis
Advantages of EV
- Takes risk into account by considering the probability of each possible outcome and therefore is more sophisticated than single value forecasts.
- The information is reduced to a single number which makes it easier for decision making
- Calculations are relatively simple and easy to calculate
Probability Analysis
Disdvantages of EV
- Highly relies on the determination of probability levels which can be complicated and these are subjective which could influence the result of the calculation
- The answer is only a long-run average and means that it is of more use if the project is repeated but has very little value for a one off project
- Risk neutral decision i.e it ignores an ivnestors attitude to risk by considering outcomes that may be disregarded dependent on attitude.
Probability Analysis
Joint Probalities
How to calculate
- probability of one thing AND another thing happening
- probability of one thing OR another thing happening (if the two events are mutually exclusive)
- probability of one thing OR another thing happening (if not mutally exclusive)
Probability of one thing AND another thing happening
-i.e the probability of pulling a diamond card, putting it back then pulling a club card
Mulitply the probabilites of each together
Probability of one thing OR another thing happening (if the two events are mutually exclusive)
-i.e pulling a diamond or a club card from a pack of cards
Add the probabilities together
Probability of one thing OR another thing happening (if not mutally exclusive)
-i.e pulling a club and a diamond card from a pack of cards
add the probabilities together and then deduct the likelihood of them happening together by mutliplying them together
Investment Appraisal under uncertainty
What is Discounted Payback
(Need to know and calculate)
The discounted payback period has the normal principles of payback period but takes into consideration the time value of money.
Risk can be relfected by using the discounted cash flows in the calculation - it means that the payback period will likely be longer and therefore more prudent.
Further Techniques for adjusting for risk and uncertainty
Won’t be asked to calculate but maybe to interpret the output.
Simulation
- What is it?
- Advantages?
- Disadvantages?
Simulation – Improves on sensitivity analysis by looking at the impact of many variables changing at the same time – uses mathematical models, it produces a distribution of possible outcomes of the project
Advantages
- it includes all possible outcomes in the decision making process
- it is a relatively easily understood technique
Disadvantages
- models can be extremely complicated and the time and costs involved in their construction can be more than is gained from the improved decision
- Probability distributions may be difficult to formulate.
Further Techniques for adjusting for risk and uncertainty
Won’t be asked to calculate but maybe to interpret the output.
Adjusted Payback
From looking at the basic payback method as a form of investment appraisal – one way of dealing with the risk is to shorten the payback period required.
This places more emphasis on the earlier cash flows which are considered to be less risky.
However, given the disadvantages of payback as a method, this is rarely recommended
Further Techniques for adjusting for risk and uncertainty
Won’t be asked to calculate but maybe to interpret the output.
Risk Adjusted Rate
The discount rate we have assumed so far is the rate that reflects either:
- The cost of borrowing funds i.e the cost of capital
- The underlying required return of return
- Or a mix of the both
Applying the existing discount rate or cost of capital/ to an investment assumes that the existing rate will remain unchanged.
If the project is significant in size and likely to result in additional risks then a project specific or risk adjusted discount rate should be used – an increased discount rate is often successful in eliminating marginal projects and the addition is called a risk premium.
Lease vs Buy
LEASE
Assumptions & Implications & Relevant Cash Flows
Assumption
The asset is never ‘owned’ by the user compnay from the perspective of the taxman.
Implications
* The finance company receives the tax allowable depreciation as the owner of the asset
- The user receives no tax-allowable depreciation but is able to offset the full rental payment against tax
Relevant CFs
- The lease payments
- The tax relief on the lease payments
Lease vs Buy
BUY
Assumptions & Implications & Relevant Cash Flows
Assumption
Buying requires the use of a bank loan (for the sake of comparability). The user is the owner of the asset.
Implications
* The user will receive tax-allowable depreciation on the asset and tax relief for the interest payable on the loan
Relevant CFs
- The purchase cost
- Any residual value
- Any associated tax implications due to the tax-allowable depreciation
Replacement Decisions using Equivalent Annual Cost (EAC)
When is it used?
What is EAC?
What is the EAC Formula?
When is it used?
Where there are competing replacements for a particular asset.
What is EAC?
EAC is the equal annual CF to which a series of uneven cash flows is equivalent in PV Terms
What is the EAC Formula?
EAC = PV of costs/Annuity Factor
Assumptions of EAC
- Cash inflows from trading are ignored on the basis that they will be similar regardless of the replacement decision although in practice, an older asset may result in lower quality and could affect sales.
- The operating efficiency of machines will be similar with differing machines or ages. In reality this will be different.
- Non-financial aspects will be ignored i.e pollution and safety.
Limitations of Replacement Analysis
- Changing Technology - machines fast become obsolete and can only be replaced with a more up-to-date model which will be more efficient and perhaps perform different functions
- Inflation - the increase in prices over time alters the cost structure - meaning that the optimal replacement cycle can vary over time.
- Changes in production plans - firms cannot predict with accuracy the market environment they will be facing in the future and the need for the asset.
Equivalent Annual Benefits
What is EAB
What is the formula?
The EAB is the annual annuity with the same value as the NPV of an investment project.
EAB = NPV of project/Annuity Factor
