Chapter 7

Specific Decision
Overview:

Asset Replacement
Leaseand Buy

Capital Rationaing

Asset replacement decisions

1 .Asset replacement cycle
DCF techniques can be useful in asset replacement decisions to assess how
frequently a noncurrent asset that is in continual use in a business (e.g., delivery
vehicles) should be replaced.
If an asset is replaced less frequently, then it has a longer replacement cycle (the
length of time between an asset being purchased and the asset being replaced).

The ideal replacement cycle will minimize the costs per year over the
replacement cycle. This is calculated as an equivalent annual cost (EAC)
Formula

Any revenue resulting from the use of the asset will be disregarded as this will
occur in any case, whatever the replacement cycles, and is therefore not a
relevant cash flow.
Definition
Equivalent annual cost: Expresses the present value of the costs of an asset
replacement cycle as a cost per year.

Illustration 1
A company uses machinery which has the following costs and resale values over
its three year life (per machine).
Year 1 Year 2 Year 3
Purchase cost: $25,000 $ $ $
Running costs (cash expenses) (7,500) (11,000) (12,500)
Resale value (end of year) 15,000 10,000 7,500
The organization’s cost of capital is 10%.
Required
Identify how frequently the asset should be replaced. 7,500
Step 1 Replacement Cost Analysis
Year Discount Replace Every Replace Every 2 Replace Every 3
Factors Year Years Years
($)
Cash PV at Cash PV at Cash PV at
Flow ($) 10% ($) Flow 10% ($) Flow 10% ($)
($) ($)
0 - (25,000) (25,000) (25,000) (25,000) (25,000) (25,000)

1 0.909 (7,500) (6,818) (7,500) (6,818) (7,500) (6,818)

15000
13635
2 0.826 (11,000) (9,086) (11,000) (9,086)
10,000 8,260
3 0.751 (12,500) (9,388)
7,500 5,633

Present Value of Cost Over One Replacement Cycle:

• Replace Every Year: (18,183)

• Replace Every 2 Years: (32,644)
• Replace Every 3 Years: (44,659)

Step 2 Calculate the equivalent annual cost (EAC).

We use a discount rate of 10% and an annuity (cumulative discount) factor for
each replacement cycle.

(1) Replacement every year:

EAC = $(18,183)/0.909 = $(20,003)

(2) Replacement every two years:

EAC = $(32, 644)/1,736 = $(18,804)
(3) Replacement every three years:
EAC = $(44,659)/2,487 = $(17,957)

The optimum replacement policy is the one with the lowest EAC. Here, this is
every three years.

Illustration 3
Naurfold regularly buys new delivery vans. Each van costs $30,000, has running
costs of $3,000and a scrap value of $10,000 in its first year. In its second year
the van has higher running costs of $4,000, and a lower scrap value of $7,000.
Vehicles are not kept for more than two years for reliability reasons.
Required
Using Naurfold's cost of capital of 15%, identify how often the van should be
replaced (ignore tax).

Solution
Yearly Cycles Compared: Every Year
Time $ DF @ 15% PV
0 (30,000) 1.0 (30,000)

1 7,000 0.870 6,090

Total PV 23,910

Annuity Factor for 1 Year 0.870

EAC (27,483)
Yearly Cycles Compared: Every 2 Years
Time $ DF @ 15% PV

0 (30,000) 1.0 (30,000)

1 (30,00) 0.870 (26,10)

2 3,000 0.756 2,268

Total PV 30,342

2-Year Annuity Factor 1.626

EAC (18,661)

Assets with different useful lives

The same technique is also useful for deciding whether, when considering non-
current assets that are in continual use within a business, it is better to invest in a
cheaper asset with a shorter expected life or a more expensive asset with a
longer expected life.
Again, the ideal replacement cycle will minimize the costs per year over the
replacement cycle, i.e., the equivalent annual cost (EAC).
Drawbacks
This approach only focuses on cost and fails to recognize that as an asset gets
older there could be. problems with reliability or quality as the asset ages (or that
it becomes obsolete as innovative technology emerges, or new markets emerge).

Exam Tip:
A common error is that students include the residual value in more than one year.
Be careful to only include the residual value once, in the final year.
Equivalent annual benefit (EAB)
Equivalent annual benefit: Expresses the NPV from a project as an annuity, i.e. a
constant cashflow per year.
Formula
The equivalent annual benefit = NPV of project/Annuity factor

Example
Project A has an NPV of $8.22m and an expected life of six years.
Given a discount rate of 12%, the annuity factor for six years at 12% is 4.111 so
project A will have an equivalent annual annuity of 8.22/4.111 = 2.00
An alternative project B with an NPV of $8.90m and an expected life of seven
years will have an equivalent annual annuity of 8.90/4.564 = 1.95
(the annuity factor for seven years at 12% is 4.564)
Project A will therefore be ranked higher than project B, despite having a lower
[Link] method is a useful way of comparing projects with unequal lives.

Drawbacks
This approach only makes sense if the projects are being continually renewed
(this assumption of continual replacement was also used in the EAC approach). If
this is not the case, then the project with the highest NPV (Project B in the
previous illustration) would be chosen.
Lease vs Buy.
After deciding on the viability of an investment using NPV analysis, a separate
decision may be needed to determine whether a lease would be a more suitable
source of finance than an outright purchase using a loan.
Definition
Lessor: A lessor receives lease payments.
Lessee: A lessee makes lease payments.
Types of leases
[Link] that minimize risk to the lessee
Some leases, often short-term leases, are rental agreements between a lessor
and a lessee that are structured so that the lessor retains most of the risks of
ownership, i.e. the lessor is responsible for servicing and maintaining the leased
equipment. The risk of ownership is also minimized for the lessee because if
there is a change in technology then the lessee can exit from the rental.
agreement at the end of the lease term and is therefore not tied in to using assets
that are technologically out of date.
2. Leases that are purely a source of finance
Some leases are long-term arrangements that transfer the risks and rewards of
ownership of an asset to the lessee. These are agreements between the lessee
and the lessor for most or all the asset's expected useful life.
The lessee is responsible for the upkeep, service, and maintenance of the asset.
This can be a cheaper source of finance than a bank loan if the lessor buys a
large quantity of assets (e.g., aircraft) and obtains bulk purchase discounts as a
result; some of the savings from such discounts can be shared with the lessee in
the form of lower rental payments.
Benefits of leasing:

Benefits Discussion
A firm that cannot get a bank loan to fund the purchase of an
asset (capital rationing – see next section for further
Availability
discussion); the same bank that refused the loan will often be
happy to offer a lease.
Avoiding loan Loan covenants may act as a restriction on the ability of a
covenants company to borrow in future.

Numerical analysis
The benefits of leasing compared to using a loan to buy an asset can be
assessed using a discounted cash flow approach.
Note that the assessment of the cost of the loan should not include the interest
repayments on the loan.
For example, the NPV of the repayments on a loan for $10,000 that is repayable
in one-year at10% interest is calculated as: $10,000 x 1.1 x 0.909 = $9999
The present value of the loan repayment is therefore the same as the amount
borrowed. So, the cost of a loan is simply the initial amount of the loan, here
$10,000.
Approach 1: Two separate NPVs
This evaluates the NPV of the cost of the loan and the NPV of the cost of the
lease separately, and simply chooses the cheapest option.
Step 1 The costs of leasing using the post-tax cost of debt as the discount factor.
This could include lease payments, and the tax saved on lease payments.
Step 2 The costs of the loan using the post-tax cost of debt as the discount factor.
This could include the cost of the loan (i.e., the initial amount of the loan), netted
against the savings from the scrap value of the asset and the tax saved on tax
allowable depreciation.
Comparing step 1 to step 2 shows whether a lease or a bank loan is the cheaper
cost of finance.
Illustration
Brown Co has decided to invest in a new machine which has a ten-year life and
no residual value. The machine can either be:
• Purchased now for $50,000 with a bank loan; or
• It can be leased for ten years with lease rental payments of $8,000 per annum
payable at the end of each [Link] cost of capital is 9% and taxation should be
ignored.
Required
Compare cost of two financing option.

Solution
Present value of leasing costs
Cash is paid in time periods 1-10.
PV = Annuity factor at 9% for 10 years x $8,000
= 6.418 x $8,000 = $51,344
Present value of purchase with a loan
This is simply the amount of the loan, i.e. $50,000.
If the machine was purchased now, it would cost $50,000 (the cost of a bank loan
is simply the amount borrowed).
The purchase with a loan is therefore the least-cost financing option.

Exam Tip:
Be careful with the timing of the cash flows with lease payments; sometimes
lease payments are. made at the start of the year (i.e., in advance). In the
previous illustration this would mean that the cash flows would be received in
time periods 0-9, which would affect the discount factor used.

Approach 2: Single NPV

An alternative method is to evaluate the NPV of the cost and benefits of using a
lease in one calculation.
Step 1 The costs of leasing
This could include lease payments, and the opportunity costs of not buying the
asset including lost tax allowable depreciation and lost scrap revenue.
Step 2 The benefits of leasing
By leasing, the lessee avoids the need to buy the asset and therefore saves
money by not having to pay for the initial outlay (which, as discussed earlier,
reflects the present value of the loan repayments that are saved). The lessee
may also save on maintenance costs if maintenance is provided by the lessor.
Step 3 Discount the net cash flows (i.e. the costs net of the benefits)
The post-tax cost of debt is used. If the resulting NPV is positive, it means the
lease is cheaper than the post-tax cost of a loan.
Exam Tip
A common error is to use the weighted average cost of capital (WACC) in a lease
vs buy analysis.
This is incorrect because the WACC is higher than the cost of debt because it is
used to discount project cash flows that have a measure of risk; however, finance
cash flows are not risky.
Remember to use the post-tax cost of debt for lease vs buy calculations.

Illustration
A company has decided to undertake an investment project which involves the
acquisition of a machine which costs $10,000. The machine has a five-year life
with 0 scrap value; 20% straight-line writing down allowances are available.
It could finance the acquisition with a bank loan at 7.143% pre-tax and purchase
the asset outright or make five equal lease payments of $2,500 in arrears.
Tax is 30% payable in the same year in which profits are made.
Required
Evaluate the lease from the lessee's viewpoint.
Solution
Post-tax cost of debt = 7.143% x (1 - 0.3) = 5%
Tax allowable depreciation (TAD) = $10,000/5 = $2,000 per year
Tax saved on tax allowable depreciation = $2,000 x 0.3 = $600
Tax saved on lease payment = $2,500 x 0.3= $750

Approach 1: Two Separate NPVs (Cost of a Lease)

Category Time 0 Time 1–5

Lease ($) - (2,500)

Tax Saved ($) - 750
Total ($) - (1,750)

DF @ 5% - 4.329
 Category Time 0 Time 1–5

PV ($) - (7,576)

NPV ($) -7,576

Cost of Purchase with a Loan

Category Time 0 Time 1–5
Outlay ($) (10,000) -

Tax Saved on TAD ($) - 600

Total ($) (10,000) 600

DF @ 5% 1.000 4.329

PV ($) (10,000) 2,597

NPV ($) -7,403

Conclusion:
The lease is more expensive by $173.
Approach 2: One Single NPV (Benefits and Cost of Lease)
Category Time 0 Time 1–5

Cost Saved ($) 10,000 -

Tax Benefit of TAD ($) - (600)

Lease ($) - (2,500)

Tax Saved on Lease ($) - 750

Total ($) 10,000 (2,350)

DF @ 5% 1.000 4.329

PV ($) 10,000 (10,173)

NPV ($) -173

Conclusion:
The lease is more expensive by $173.
Either Approach 1 or Approach 2 can be used; there is no need to use both.

Benefits to the lessor

Benefit Explanation
Attract Companies (e.g., car makers) offer leases to attract customers to
customers acquire their final product.
Returns on The lessor invests finance by purchasing assets and making a
finance return out of the lease payments from the lessee. The lessor will
 Benefit Explanation
also get tax-allowable depreciation on the purchase of the
equipment.

Capital rationing

Capital rationing: Arises when there is insufficient capital to invest in all

available projects which have positive NPVs, i.e. capital is a limiting factor.

In this exam, you only need to be able to analyze situations where this is a
problem in a single year.

Reasons
Capital rationing arises for two main reasons:
(a) Hard capital rationing
This is where a firm cannot get finance from the capital markets, because:
• Investors are unwilling or unable to invest more equity finance, or
• Lending institutions consider an organization to be too risky to be granted funds.
• Capital markets are depressed and reluctant to lend to businesses because of
fear of an economic downturn

(b) Soft capital rationing

This is an internal management decision to restrict capital spending and may
happen because:
• Management may be reluctant to issue additional share capital because of a
concern that this may lead to outsiders gaining control of the business or due to
the dilutive impact one 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 and want to keep the firm's
gearing under control.
Creating competition for a limited pool of funds encourages divisions to search for
the very best possible projects.

Note that when an organization adopts a policy that restricts funds available for
investment, such a policy may be less than optimal as the organization may reject
projects with a positive NPV and for go opportunities that would have enhanced
the market value of the organization

Capital rationing techniques.

Divisible projects:
Divisible projects: A project that can be scaled down and done in part.

When projects are divisible, investment funds are a limiting factor and
management should follow the decision rule of maximizing the use of this limiting
factor by selecting the projects whose cash inflows have the highest return (in
present value terms) per $1 of capital invested. This is measured by the
profitability index (PI).
The profitability index = Present value of cash inflows/Initial cash outflow. The
critical value of the Pl is 1. Any value above this indicates that the project has a
positive net present value (i.e. the present value of the cash inflows is greater
than the cash outflows);the higher the PI the higher the return delivered by a
project per $1 invested.

Illustration
Suppose that Hard Times Co is considering four projects, W, X,Y, and Z.
Relevant details are as follows:
Project Investment Present NPV Profitability Ranking Ranking
Required Value of ($) Index (PI) as per as per PI
($) Cash NPV
Inflows ($)
W (10,000) 11,240 1,240 1.12 3 1
X (20,000) 20,991 991 1.05 4 4
Y (30,000) 32,230 2,230 1.07 2 3
Z (40,000) 43,801 3,801 1.10 1 2

Required
Calculate the NPV from investing in the optimal combination of projects if only
$60,000 was available for capital investment.
Solution
If we adopt the profitability index approach, the selection of projects will be as
follows:
Project Priority Outlay ($)
W 1st 10,000
Z 2nd 40,000
Y (balance) 3rd 10,000 (1/3 of $30,000)
Total Outlay 60,000
Because only 1/3 of project Y can be afforded, this means total NPV will be:
Project NPV ($)
W 1,240
Z 3,801
Y (balance) 743 (1/3 of $2,230)
Total NPV 5,784

Non-divisible projects
Non-divisible project: A project that must be undertaken completely or not at all;
i.e. it is not possible to scale down the project and do it in part.

Where a project cannot be done in part, the choice facing a company is not how
to spend each$1 so the PI should not be used.
The appropriate technique here is to:
• Identify which project combinations are affordable
• Select the project combination with the highest NPV

The technique that needs to be applied depends on whether projects are divisible
or not, so look out for this in assessment questions
Illustration
Short O'Funds has capital of $95,000 available for investment in the forthcoming
period. The directors decide to consider projects P, Q and R only. They wish to
invest only in whole projects.

Investment Required Present Value of Inflows at 20%

Project
($’000) ($’000)
P 40 56.5
Q 50 67.0
R 30 48.8
Required
Which combination of projects will produce the highest NPV at a cost of capital of
20%?
Solution
The investment combinations we need to consider are the various possible pairs
of projects P, Q and R.
The NPV of each affordable combination of projects is calculated as the total
Present Value (PV) of inflows from each project minus the required investment for
each project.
Required Investment PV of Inflows NPV from Projects
Projects
($’000) ($’000) ($’000)
P and Q 90 123.5 33.5

P and R 70 105.3 35.3

Q and R 80 115.8 35.8

The highest NPV will be achieved by undertaking projects Q and R.

Illustration
A company has maximum capital to invest of $800,000. Five capital projects have
been identified which are of similar risk. The initial analysis shows the following:
Project Required Initial Outlay ($) NPV ($) Profitability Index
No 1 $298,000 $128,000 1.429
No 2 $240,000 $100,000 1.416
No 3 $400,000 $160,000 1.400
No 4 $160,000 $60,000 1.375
No 5 $798,000 $239,000 1.300
Projects cannot be postponed, and multiples of the same project are not allowed.
Required
What is the optimal combination of projects to maximize NPV, assuming:
(1) Projects are divisible. (Include a working to demonstrate how the profitability
index numbers have been calculated for one of the projects.)
(2) Projects are not divisible.
Calculations as follows:
1) Profitability index of project no 1 = (128,000 + 298,000)/298,000 = 1.4295
NPV per unit of limiting factor.
NPV per Limiting Outlay Amount of Project
Rank Project NPV ($)
Factor ($) (%)
1st No 1 1.4295 $298,000 100 $128,000
2nd No 2 1.4166 $240,000 100 $100,000
3rd No 3 1.4 $262,000 65.5 $104,800
Total $800,000 $332,800

2) Project 5 gives an NPV of $288,000

Cumulative NPV from Projects 1, 2 and 4 = $288,000
From projects 2, 3, 4 = $320,000 - this is the best combination.

Drawbacks of methods
The methods used for dealing with capital rationing make a number of
assumptions. These can be regarded as limitations. These include:
• Capital rationing is for a single period only.
• Projects are independent, i.e., the success of one project is not affected if
another project does not proceed.
• It is not possible to delay any projects.
• Multiples of a single project are not allowed.
 • It is not possible to share the investment in any projects with another
organization (e.g. by forming a joint venture).

Practical points
The drawbacks of the methods hint at some practical issues that can be used to
manage capital. rationing, including:
A. Delaying one or more projects to a subsequent period where capital
rationing may be less of an issue.
B. Finding new sources of finance, such as leasing or government grants to
get around the unwillingness of capital markets to provide finance.
C. Entering a joint venture with a partner to share the capital outlay on one or
more projects.
D. Issuing new capital (if soft capital rationing exists, this may be possible).

Assignment
Question 1
The profitability index is a variation of which of the following capital
budgeting models?
A. Internal rate of return
B. Return on investment
C. Net present value
D. Discounted payback
Solution C

Question 2
Progress Co has the following non-divisible projects available:
Project Initial investment Present value of cash inflows Profitability index

$ $
1 200,000 300,000 1.50
2 450,000 725,000 1.61
3 350,000 425,000 1.21
4 900,000 1,300,000 1.44
5 600,000 1,000,000 1.67
Assuming the company has $1m to invest in capital projects, which
combination of projects should Progress Co accept?
A.1 and 5
B.2 and 4
C.3 and 5
D.1, 2 and 3
Solution A
Question 3
A company should accept all positive NPV projects when which of the
following conditions is true?
A. A. It has extremely limited resources for capital investment
B. B. It has excess cash on its statement of financial position
C. [Link] has unlimited resources for capital investment
D. [Link] currently has limited resources for capital investment but is planning to
issue new equity
Solution C
Question 4
A company will lease new machinery. The lease term is five years and lease
payments of $10,000 will be made annually in advance.
What is the present value of the lease payments, using a discount rate of
10%?
A.$4,170
B.$6,209
C.$37,910
D.$41,700
Solution D
Question5
Question
How is the equivalent annual cost calculated?
[Link] × Annuity factor
[Link] × Perpetuity factor
[Link]/Annuity factor
[Link]/Perpetuity factor
Solution C
Summary
• Capital rationing occurs when insufficient finance (capital) is available to
undertake all positive NPV projects available.
• With capital rationing, it is essential to identify the nature of the projects
(i.e., divisible, or non-divisible, mutually exclusive or not).
• A divisible project is one in which the company can undertake between 0%
and 100% of the project. A non-divisible/indivisible project must be done
100% or not at all.
• The profitability index for a project is its NPV divided by its initial
investment.
• Profitability indexes can be used to rank divisible projects.
• For asset replacement decisions, use the equivalent cost (EAC) method to
compare cycles of different lengths.
• The EAC is calculated as NPV/Annuity factor.
• The lowest EAC is chosen in making the replacement decision.
• For lease or buy decisions, separate the financing decision from the
investment decision and analyze each at a discount rate reflecting the risk
of the cash flows.
• In assessing a lease cost, assume that all lease payments are tax-
deductible expenses.
• If the PV of the cost of the best finance source is less than the PV of the
operating cash flows, the project should be undertaken.