SESSION 06 APPLICATIONS OF DCF

0601
OVERVIEW
Objective
To apply discounted cash flow techniques to specific areas.






LEASE v BUY
CAPITAL
RATIONING
Definition
Methods
ASSET
REPLACEMENT
DECISIONS
The issue
Limitations of replacement
analysis
The issue
Decision-making
The investment decision
The financing decision
The final decision
DCF
APPLICATIONS

SESSION 06 APPLICATIONS OF DCF
0602
1 CAPITAL RATIONING
1.1 Definition

A situation where there is not enough finance available to undertake all
available positive NPV projects.


Hard capital rationing where the capital markets impose limits on the amount of
finance available e.g. due to high perceived risk of the company.
Soft rationing where the company itself sets internal limits on finance availability e.g.
to encourage divisions to compete for funds.
Single-period capital rationing where capital is in short supply in only one period.
Multi-period where capital is rationed in two or more periods.
1.2 Methods
1.2.1 Divisible projects
A divisible project is where the company can undertake between 0-100% of the project -
infinite divisibility. However a project cannot be repeated.
Calculate a profitability index for each project = NPV/Initial Investment
Rank projects according to their index
Allocate funds to the most effective projects in order to maximise NPV.

Example 1

Projects A B C D
$000 $000 $000 $000
NPV 100 (50) 84 45
Cash flow at t
0
(50) (10) (10) (15)

Cash is rationed to $50,000 at t
0
Projects are divisible.
Required:
Determine the optimal investment plan.

SESSION 06 APPLICATIONS OF DCF
0603
Solution











1.2.2 Non-divisible projects
A non-divisible/indivisible project must be done 100% or not at all.
Do not calculate a profitability index;
Simply list all possible combinations of projects
Choose combination with highest NPV.
Example 2

Detail as for example 1 but assume that projects are non-divisible.
Solution

1.2.3 Mutually-exclusive projects
Mutually exclusive projects is where two or more particular projects cannot be undertaken
at the same time e.g. because they use the same land.
Divide projects into groups; with one of the mutually-exclusive projects in each group.
Calculate the highest NPV available from each group (assume projects are divisible
unless told otherwise)
Choose the group with the highest NPV
SESSION 06 APPLICATIONS OF DCF
0604
Example 3

As for example 1 but C and D are mutually exclusive.
Solution







1.2.4 Multi-period capital rationing
If finance is limited in several periods then a linear programming model would have to
be set up and solved in order to find the optimal investment strategy.
This is outside of the scope of the syllabus
2 ASSET REPLACEMENT DECISIONS
2.1 The issue
Assume that the company has already decided it requires a particular non-current asset.
A secondary decision is about how often to replace the asset.
For example how often should the company replace its fleet of motor vehicles or its
computer equipment?
This is referred to as an asset replacement decision.
Method:
1 Calculate the NPV of each possible replacement cycle.

2 Calculate the Annual Equivalent Cost (AEC) of each cycle

AEC = NPV/Annuity factor
3 Choose the cycle with the lowest AEC.

SESSION 06 APPLICATIONS OF DCF
0605
Example 4

A machine costs $20,000.
Running costs Scrap proceeds
Year 1 5,000 16,000
Year 2 5,500 13,000

Companys cost of capital = 10%
Required:
Should the machine be replaced every one or every two years?


Solution















2.2 Limitations of replacement analysis
Changing technology e.g. it may be advisable to replace IT equipment more often than
suggested by the above analysis.
Asset requirements may change over time.
Non-financial factors e.g. employees may be more satisfied if their company cars are
replaced more often.
SESSION 06 APPLICATIONS OF DCF
0606
3 LEASE v BUY
3.1 The issue
Should the company acquire an asset through:
A straight purchase i.e. borrowing to buy, or
A lease.

There are two main types of lease:
Operating lease; where the asset is simply rented for a relatively short part of its
useful economic life;
Financial/capital lease; where the asset is leased for most of its life.
Although the distinction between operating and finance lease is important in financial
reporting, it is not so relevant in financial management.
The important issue for financial management is the cash flows created by a lease, as
compared to a straight purchase of the asset.
3.2 Decision-making



















TWO DECISIONS
INVESTMENT DECISION FINANCING DECISION
Does the asset give operational benefits?
Focus on the NPV of the operating cash
flows
Is it cheaper to buy or lease?
Focus on the relative beefits of
WDAs from buying and the tax
relief on the lease payments.
Discount these cash flows using a rate
which reflects operating risk of
investment e.g average cost of capital
Discount these cash flows using
after-tax cost of borrowing

Commentary

The issue here is stripping financing cash flows from operating cash flows and
using separate discount rates for each.
Examination questions may focus merely on the financing decisions.

SESSION 06 APPLICATIONS OF DCF
0607
3.3 The investment decision
Discount the cash flows from using the asset (sales, materials, labour, overheads, tax on net
cash flows, etc) at the firms weighted average cost of capital (WACC).
3.4 The financing decision
Discount the cash flows specific to each financing option at the after-tax cost of debt. The
assumption is that shareholders view borrowing and leasing as equivalent in terms of
financial risk, so the after-tax cost of debt is an appropriate discount rate for both options.
The preferred financing option will be that with the lowest NPV of cost.
The relevant cash flows for each possible method of financing are as follows.
Buy asset Purchase cost, tax saving on WDAs, scrap
proceeds
Lease asset (operating
or finance lease)
Lease payments, tax saving on lease payments
Under UK tax law all lease payments are tax allowable deductions both for finance leases
and operating leases.

3.5 The final decision
If the NPV of the cost of the best finance source is less than the NPV of the operating cash
flows, then the project should be undertaken.
SESSION 06 APPLICATIONS OF DCF
0608
Example 5

New project
Asset costs $200,000 on the first day of a new accounting period.
Scrap value $25,000 on the last day of the next accounting period.
Operating inflows $150,000 for two years.
Tax at 33% and paid one year in arrears.
Weighted average cost of capital 10%.
Capital allowances at 25% reducing balance.
Finance options:
(1) borrowing at a post-tax cost of 7%;
(2) lease for $92,500 per year in advance for two years (lease payments
are tax allowable).
Required:
(a) Determine the operational benefit of the project.
(b) Determine how the project should be financed.
(c) Decide whether the project is worthwhile.


Solution
(a) Operational value

Time Cash flow Narrative DF @ 10% PV
$ $





Present value

________

________



SESSION 06 APPLICATIONS OF DCF
0609
(b) Financing decision
(1) Borrow and buy flows
Time Cash flow Narrative DF @ 7% PV
$ $









________


________

(W) WDAs
Time Tax effect
at 33%
Time
$ $











(2) Leasing flows
Time Cash flow Narrative DF @ 7% PV
$ $





PV of leasing

________


________



(c) Final decision
$
PV of operating flows
PV of cheaper finance



NPV
________


________


SESSION 06 APPLICATIONS OF DCF
0610

Key points

With capital rationing it is essential to identify the nature of the projects
i.e. divisible or non-divisible, mutually exclusive or not.
With asset replacement decisions, the key is the use of Annual Equivalent
Cost to compare cycles of different lengths.
With lease vs. buy decisions, the key is to separate the financing decision
from the investment decision and analyse each at a discount rate reflecting
the risk of the cash flows. Also remember all lease payments are tax
deductible expenses in the UK.



FOCUS
You should now be able to:

distinguish between hard and soft capital rationing;
apply profitability index techniques for single period divisible projects;
use DCF to analyse asset replacement decisions;
apply DCF methods to projects involving lease or buy problems.
SESSION 06 APPLICATIONS OF DCF
0611
EXAMPLE SOLUTIONS
Solution 1 Divisible projects
Projects A B C D
$000 $000 $000 $000
NPV 100 (50) 84 45
Cash flow at t
0
(50) (10) (10) (15)

Investment
NPV

50
100

10
) 50 (

10
84

15
45


Cost benefit ratio = 2 Reject = 8.4 = 3

Rank 3 1 2

Plan: CASH NPV

___

___

AVAILABLE 50
C (10) 84

___

40
D (15) 45

___

25
50% A (25) 50

___

_____

$179

_____


Solution 2 Non-divisible
Combinations NPV
$000
A only
C + D
100
129

.
.
. Choose C + D.
Solution 3 Mutually exclusive
Group 1 Group 2
$000 $000
A B C A B D
NPV
$
100
50
(50)
10
84
10
100
50
(50)
10
45
15

Index
___
2
___

___
(5)
___

___
8.4
___

___
2
___

___
(5)
___

___
3
___

Rank 2 Reject 1 2 Reject 1
SESSION 06 APPLICATIONS OF DCF
0612

Plan
NPV Capital NPV Capital
50 50
Accept C 84 (10) Accept D 45 (15)

___

___

Accept 0.8 A 80 (40) Accept 0.7 A 70 (35)

___

___

___

___

164 115

___

___


.
.
. Accept C and 0.8A.
Solution 4 Machine replacement
Replace every year
Time Cash flow Discount factor PV
0 Purchase (20,000) 1 (20,000)
1 Running costs (5,000) 0.909 (4,545)
1 Scrap proceeds 16,000 0.909 14,544

______
NPV = (10,001)

______


Annual equivalent cost =
factor annuity
year 1
NPV
= 11,002 $
909 . 0
001 , 10
=
Now repeat the above procedure, assuming the machine is replaced every two years.
Time Narrative Cash flow
@ 10%
Discount factor
value
Present
0
1
2
2
Purchase
Running costs
Running costs
Scrap proceeds
(20,000)
(5,000)
(5,500)
13,000
1
0.909
0.826
0.826
(20,000)
(4,545)
(4,543)
10,738

______
NPV = (18,350)
Annual equivalent = 570 , 10 $
736 . 1
350 , 18
AF 10% year 2
350 , 18
= =
Conclusion. Replace every two years.
SESSION 06 APPLICATIONS OF DCF
0613
Solution 5 Lease or Buy
(a) Operational value

Time Cash flow Narrative DF @ 10% PV
$ $
12
23
150,000
(49,500)
Project returns
Tax on above
1.736
1.578
260,400
(78,111)

Present value

_______

182,289
_______


(b) Financing decision
(1) Borrow and buy flows
Time Cash flow Narrative DF @ 7% PV
$ $
0
2
2
3
(200,000)
25,000
16,500
41,250
Purchase cost
Sale proceeds
(W)
(W)
1
0.873
0.873
0.816
(200,000)
21,825
14,405
33,660

________

(130,110)
________

(W) WDAs
Time Tax effect
at 33%
Time
$ $
0
1
Purchase
WDA at 25%
200,000
(50,000)

16,500

2

________



WDV b/f
Sale
150,000
25,000


2

Balancing allowance
________

125,000
________


41,250

3
(2) Leasing flows
Time Cash flow Narrative DF @ 7% PV
$ $
01
23
(92,500)
30,525
Lease payments
Tax relief thereon
1.935
0.873 + 0.816
= 1.689
(178,988)
51,557

PV of leasing flows

________

(127,431)
________

Conclusion: The cheapest method of finance is to lease.
SESSION 06 APPLICATIONS OF DCF
0614
(c) Final decision
$
PV of operating flows
PV of leasing flows (cheaper finance see (b))
182,289
(127,431)

NPV
________

54,858
________

The asset should be acquired using a lease.