ACCA F9 Financial Management - 2010 - Study text

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Chapter 11: Capital investment appraisal: further aspects

Asset replacement decisions

 The nature of asset replacement decisions

 The cash flows to consider

 Methods of evaluation

 Equivalent annual cost method

2 Asset replacement decisions

2.1 The nature of asset replacement decisions

An asset replacement decision involves deciding how frequently a non-current asset

should be replaced, when it is in regular use, so that when the asset reaches the end

of its useful life, it will be replaced by an identical asset.

In other words, this type of decision is about what is the most appropriate useful

economic life of a non-current asset, and how frequently it should be replaced.

Here we are not dealing with a one-off decision about whether or not to acquire an

asset. Instead we are deciding when to replace an asset we are currently using with

another new asset; and then when the new asset has been used up, replacing it

again with an identical asset; and so on in perpetuity. We are evaluating the cycle of

replacing the machine – considering the various options for how long we should

keep it before replacing it.

The decision rule is that the preferred replacement cycle for an asset should be the

least-cost replacement cycle. This is the frequency of replacement that minimises the

PV of cost.

2.2 The cash flows to consider

The cash flows that must be considered when making the asset replacement

decision are:

 The capital cost (purchase cost) of the asset

 The maintenance and operating costs of the asset: these will usually increase

each year as the asset gets older

 Tax relief on the running costs (which are allowable expenses for tax purposes)

 Tax relief on the asset (tax-allowable depreciation)

 The scrap value or resale value of the asset at the end of its life.

The main problem with evaluating an asset replacement decision is comparing these

costs over a similar time frame. For example, how can we compare the PV of costs

for asset replacement cycles of one, two, three, four and five years?

For example, you cannot simply compare the PV of cost over a two-year

replacement cycle with the PV of cost over a three-year replacement cycle, because

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you would be comparing costs over two years with costs over three years, which is

not a fair comparison.

2.3 Methods of evaluation

A method is needed for comparing the different replacement cycles over a common

period of time. There are three methods of doing this:

 the lowest common multiple method

 the finite time method

 the equivalent annual cost method: this is the method normally used.

The equivalent annual cost method is the method normally used, and the only one

of these three methods that you need to know for your examination. It is the only

method described here.

2.4 The equivalent annual cost method

The equivalent annual cost method of calculating the most cost-effective

replacement cycle for assets is as follows:

 For each choice of replacement cycle, the PV of cost is calculated over one full

replacement cycle, with the asset purchased in year 0 and disposed of at the end

of the life cycle.

 This PV of cost is then converted into an equivalent annual cost or annuity. The

equivalent annual cost is calculated by dividing the PV of cost of the life cycle by

the annuity factor for the cost of capital, for the number of years in the life cycle.

Equivalent annual cost for

replacement every n years

= Net PV of costs over one replacement cycle

Annuity factor for Years 1 - n

 The replacement cycle with the lowest equivalent annual cost is selected as the

least-cost replacement cycle.

Example

NTN is considering its replacement policy for a particular machine, which it intends

to replace every year, every two years or every three years. The machine has

purchase cost of $17,000 and a maximum useful life of three years. The following

information is also relevant:

Year

Maintenance/running

costs of machine

Scrap value if sold

at end of year

1 1,900

8,000

2 2,400

5,500

3 3,750

4,000

Chapter 11: Capital investment appraisal: further aspects

The cost of capital for NTN is 10%.

What is the optimum replacement cycle? Ignore taxation. Use the equivalent annual

cost method.

Answer

Replace every year



Year



Cashflow

Discount

factorat

10%



PV

 $ $

0 Purchase (17,000) 1.000 (17,000)

1 Maintenancecosts (1,900) 0.909 (1,727)

1 Resalevalue 8,000 0.909 7,272

 PVofcost (11,455)

Equivalent annual cost = PV of cost/Annuity factor at 10% for 1 year

= $11,455/0.909 = $12,602.

Replace every two years



Year



Cashflow

Discount

factorat

10%



PV

 $ $

0 Purchase (17,000) 1.000 (17,000)

1 Maintenancecosts (1,900) 0.909 (1,727)

2 Maintenancecosts (2,400) 0.826 (1,982)

2 Resalevalue 5,500 0.826 4,543

 PVofcost (16,166)

Equivalent annual cost = PV of cost/Annuity factor at 10% for 2 years

= $16,166/1.736 = $9,312.

Replace every three years



Year



Cashflow

Discount

factorat10%



PV

 $ $

0 Purchase (17,000) 1.000 (17,000)

1 Maintenancecosts (1,900) 0.909 (1,727)

2 Maintenancecosts (2,400) 0.826 (1,982)

3 Maintenancecosts (3,750) 0.751 (2,816)

1 Resalevalue 4,000 0.751 3,004

 PVofcost(20,521)

Equivalent annual cost = PV of cost/Annuity factor at 10% for 3 years

= $20,521/2.487 = $8,251.

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Summary

Replace Equivalentannual

cost

 $

Everyyear 12,602

Everytwoyears 9,312

Everythreeyears 8,251

Conclusion

The least-cost decision is to replace the asset every three years, because a three-year

replacement cycle has the lowest equivalent annual cost.

Exercise 1

LONG is considering its replacement policy for an item of equipment which has a

maximum useful life of four years. The machine has purchase cost of $30,000. The

following information is also relevant:



Year

Maintenance/runn

ingcostsof

machine

Scrapvalueifsold

atendofyear

 $ $

1 4,000 15,000

2 5,000 10,000

3 6,500 6,000

4 8,000 1,000

The cost of capital for LONG is 12%.

What is the optimum replacement cycle? Ignore taxation.

Chapter 11: Capital investment appraisal: further aspects

Capital rationing decisions

 The nature of capital rationing

 Single period capital rationing: divisible projects

 Single period capital rationing: non-divisible projects

3 Capital rationing decisions

3.1 The nature of capital rationing

Capital rationing occurs where there are insufficient funds available to invest in all

projects that have a positive Net Present Value. Capital is in short supply; therefore

a decision has to be made about which investment projects to invest in with the

capital that is available.

There are two types of capital rationing.

 Hard capital rationing: This occurs when the shortage of capital is imposed by

external factors, such as the refusal by a bank to advance any more money or an

inability to raise more capital by issuing new shares or bonds.

 Soft capital rationing: This occurs when the shortage of capital is imposed

internally by management decision, such as setting limits to the capital budget

for the year. In other words, the directors of a company might decide that in the

capital budget, total capital spending must not exceed a specified amount

3.2 Single period capital rationing: divisible projects

Single period capital rationing describes a situation where the capital available for

investment is in limited supply, but for one time period only (one year only). The

limitation in supply is usually ‘now’ – in Year 0. In all other time periods, capital

will be in unlimited supply.

A decision needs to be made about which projects to invest in. Projects will not be

undertaken unless they have a positive NPV, but when there is capital rationing a

choice must be made between alternative projects that all have a positive NPV.

The method of reaching the decision about which projects to select for investment

depends on whether the investments are fully divisible, or indivisible.

Fully divisible projects

Assumption: Projects are fully divisible and therefore a part-investment can be

made in a capital project leading to a partial return (proportional to the amount

invested). For example suppose that an investment costing $100,000 is fully divisible

and has an expected NPV of + $20,000. If capital is in short supply, it would be

possible to invest a proportion of the $100,000, to obtain the same proportion of the

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NPV of + $20,000. For example, it would be possible to invest only $50,000 in the

project and the expected NPV would then be + $10,000.

Deciding which projects to invest in: When projects are fully divisible, the projects

selected for investment should be those that maximise the total NPV per $1 of

capital invested (in the year of capital rationing). The technique is to calculate for

each project the NPV per $1 of capital invested (in the year of capital rationing), and

to prioritise the projects for investment by ranking them in order of NPV per $1

invested.

The ratio of NPV to capital investment is sometimes called the profitability index.

The decision rule is therefore to invest in the projects with the highest profitability

index, up to the limit of the investment capital available.

Example

Capital for investment is limited in Year 0 to $5,000. There are four investment

projects available with a positive NPV, but these require a total of $10,000 for

investment. All four projects are fully divisible. The investment required for each

project and the project NPVs are as follows:

Project I

III

Investment in Year 0 $5,000

$2,100

$1,400

$1,500

NPV $6,250

$4,200

$1,540

$1,950

Which projects should be selected for investment, in order to maximise the total

NPV?

Answer

Rank the projects in order of profitability index (NPV per $1 invested in the year of

capital rationing).

Project I II III IV

InvestmentinYear0 $5,000 $2,100 $1,400 $1,500

NPV $6,250 $4,200 $1,540 $1,950

Profitabilityindex $1.25 $2.00 $1.10 $1.30

Ranking 3



The investment plan should be:

Project Invest NPV

 $ $

II 2,100 4,200

IV 1,500 1,950



––––––––

–

–––––––

 3,600 6,150

I

(

balance

)

* 1,400 1,750



––––––––

–

–––––––

Total 5,000 7,900



––––––––

–

–––––––

*The NPV earned is proportional to the investment = $1,400 × 1.25 = $1,750.

Chapter 11: Capital investment appraisal: further aspects

3.3 Single period capital rationing: non-divisible projects

When investment projects are non-divisible, the investment in a project can be either

0% or 100%, and nothing else. Part-investment is not possible.

The selection of investments should be those that offer the maximum NPV with the

capital available. Finding the combination of projects that maximises NPV is a

matter of trial-and-error, and testing all the possible combinations of investments

that can be undertaken with the capital available.

Example

Suppose that in the previous example, all four projects are non-divisible, and that

capital is limited in Year 0 to $5,000. The possibilities would be assessed as follows:

Combination Amountofinvestment NPV

 $ $

Ionly 5,000 6,250

II,IIIandIV 2,100+1,400+1,500=5,000 4,200+1,540+1,950=7,690

No other combinations of investment are possible with the amount of capital

available.

The decision that would maximise NPV is to invest in Projects II, III and IV.

Paper F9: Financial management

Paper F9

Financial management

CHAPTER

Sources of equity finance

Contents

1 Sourcesoflong‐termandshort‐termfinance

2 Raisingnewequityexternally

3 Rightsissues

4 Dividendpolicy

Paper F9: Financial management

Sources of long-term and short-term finance

 Sources of finance and financial management

 Sources of short-term funds

 Sources of long-term funds

 Introduction to equity finance

 Internal sources of finance and dividend policy

1 Sources of long-term and short-term finance

1.1 Sources of finance and financial management

An important aspect of financial management is the choice of methods of financing

for a company’s assets. Companies use a variety of sources of finance and the aim

should be to achieve an efficient capital structure that provides:

 a suitable balance between short-term and long-term funding

 adequate working capital

 a suitable balance between equity and debt capital in the long-term capital

structure.

1.2 Sources of short-term funds

Sources of short-term funding are used to finance some current assets. (In some

cases, companies operate with current liabilities in excess of current assets, but this

is unusual.)

Most of the usual sources of short-term finance have been described in an earlier

chapter on working capital. Briefly, these are:

 bank overdraft

 short-term bank loans

 suppliers (trade payables).

The main points to note about these sources of finance are as follows.

Bank overdraft

A company might arrange a bank overdraft to finance its need for cash to meet

payment obligations. An overdraft facility is negotiated with a bank, which sets a

limit to the amount of overdraft that is allowed. From the point of view of the bank,

the company should be expected to use its overdraft facility as follows:

 The overdraft should be used to finance short-term cash deficits from

operational activities. The company’s bank balance ought to fluctuate regularly

between deficit (overdraft) and surplus. There should not be a ‘permanent’

ACCA F9 Financial Management - 2010 - Study text - Emile Woolf Publishing

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