W7 - Specific Investment (Lease or Buy) - 240227 - 172849

Financial Management
BAC 5006
Week 7 – Lecture 1 & 2

Lecturer: DR. Le Quynh Lien
Financial Management
Specific investment
decisions
Specific investment decisions
Lease VS. Buy Asset Replacement

decisions Capital rationing
Divisible projects Indivisible projects
Sensitivity: Internal
Lease or Buy
Leasing – a contract between a lessor and a lessee for
hire of a specific asset selected.
 Lessor – has ownership of the asset;

 Lessee – has possession and use of the asset on payment of specific
rentals over a period.
start end
Operating Finance
lease lease
Types of Lease
Operating lease
 1. Leases that minimize risk to the lease
 Short term rental
 Lessor is responsible for servicing and maintaining
 Risk is minimized
Finance lease
 2. Leases that are purely a source of finance

 Long term
 Rented for most of its life
 Lessee is responsible
Benefits of any type of lease
Availability
Avoiding tax exhaustion
Avoiding loan covenants
Slide 6
Asset replacement
Issues
How frequently Is it worth paying more

should an asset for an asset which has
be replaced? a longer expected life?
Slide 11
 Shorter replacement cycle
 Lower operating cost
 H igher residual value when the asset is disposed of
 Increased capital expenditure
 Longer replacement
 Reduce capital expenditure
 But as the asset get older, it may cost more to operate,
and residual value will be lower
Asset Replacement
Equivalent annual cost method
 When an asset is being replaced with an identical
asset, the equivalent annual cost method can be used
to calculate an optimum replace cycle.
 Steps to do:
1. Calculate PV of costs for each replacement cycle
2. Turn PV of costs for each replacement cycle into
EAC= PV over one replacement cycle
Annuity factor (AF)
 The optimum replacement policy is the one with

the lowest equivalent annual cost.
Example 1: R eplacement of an
identical asset
Solution (Example 1 continue)
Asset Replacement
Example 2
A company uses machinery which has the following cost and
resale values over three-year life.
Purchase cost = £25,000, cost of capital = 10%.
Year1 Year2 Year3
Running cost (7,500) (11,000) (12,500)
Resale value 15,000 10,000 7,500
Three organization's cost of capital is 10%
Required:
Identify how frequently the asset should be replaced
Asset Replacement
 Step 1:Calculate PV of costs for each replacement cycle
R eplace every R eplace every 2 R eplace every 3

year years years
Y Discount CF PV CF PV CF PV
factor@ 10%
0 1 (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)
15,000 13,635
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
PV (18,183) (32,644) (44,659)
Asset Replacement
Step 2: Calculate the equivalent annual cost (EAC)
EAC= PV over one replacement cycle
Annuity factor (AF)
a) Replace every year,
EAC= £(18,183)/0.909 = (£20,003)
b) Replace every 2 years,
EAC = £(32,644)/1.736 = (£18,804)
c) Replace every 3years,
EAC = £(44,659)/2.487 = (£17,957)
Therefore, replacing every 3 years offers the lowest EAC.
Asset Replacement
 Equivalent annual benefit (EAB)

 EAB expresses the N PV from a project as an
annuity, i.e. a constant cash flow per year.
EAB= N PV of project
Annuity factor
Example
Project A has an N PV of £8.22m and an expected life of six
years. With a Discount rate of 12%, the Annuity factor for
six years at 12% is 4.111, what will be the Equivalent
annual annuity of Project A?
EAB=8.22/4.111=2.00
Project B has an N PV of £8.90m and and expected life of

seven years. With annuity factor of 12% (4.564) what is
the equivalent annual annuity of the project?
 EAB=8.90/4.564=1.95
 Project A w ill be accepted despite the fact that it has a

low er N PV
Capital rationing
• Hard
• Soft
Techniques
Indivisible
Divisible - examine NPV of
- use NPV / $ invested affordable combinations
Slid
e
25
Reasons for Capital Rationing
Is where a company has a limited amount of

money to invest and investments have to be
compared in order to allocate monies most
effectively.
1. Soft capital rationing (Internal factors)

 Reluctance to cede control
 Wish only to use retain earnings
 Reluctance to dilute EPS
 Reluctance to pay more interest
 Capital expenditure budgets
2. H ard capital rationing (External factors)
 Depressed stock market

 Restrictions on bank lending
 Conservative lending policies
 Issue costs
Techniques of Capital rationing
D ivisible projects
Divisible projects are project that can be
scaled down and executed in parts
Investment funds are limiting factor so
maximize its use by selecting projects with
highest return on PV of inflows measured as
follows:
Profitability index = Pvcash-inflow/ £
invested
A ssumptions of Profitability Index
Opportunity to undertake project lost if not
taken during capital rationing period
Compare uncertainty about project outcomes
Projects are divisible
Ignore strategic value
Ignore cash flow patterns
Ignore project sizes
Suppose that H TC plc is considering four projects, W, X, Y
and Z. the following are the relevant details:
Projec C apital PV of N PV PI N PV PI
t outlay C ashflow s R anking R anking
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 N PV from investing in the optimal combination
of projects if only £60,000 was available for capital
investment.
Profitability Index approach
Project Project O utlay £
W 1st 10,000
Z 2nd 40,000
Y(balance) 3rd 10,000 (1/3 of

£30,000)
60,000
Total N PV Choosing projects

W. 1,240 according to PI with
Z 3,801 £60,000, the N PV is
Y(balance) 743 £5784
5,783
N on-divisible projects
These are projects that can be undertaken

completely or not at all.
This cannot be scaled down.
H ere examine N PV of affordable combinations
Select the project combination with the
highest N PV
Example
 STC plc has capital of £95,000 available for investment
in the forthcoming period. The directors are
considering P, Q, and R only. They wish to invest only
in whole projects.
Project Investment PV of C ash
required inflow s
P 40,000 56,500
Q 50,000 67,000
R 30,000 48,800
Required
Which combination of projects will produce the highest N OV at a cost
of capital of 20%
The N PV of each affordable combination of projects is
calculated as the total PV of inflows from each project minus
the required investment for each project
Project R equired PV of Inflow s N PV from

Investment projects
P and Q 90,000 123,500 33,500
P and R 70,000 105,300 35,300
Q and R 80,000 115,800 35,800
The highest N PV will be achieved by undertaking projects Q and R
End of
lecture 7!

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Financial Management

Week 7 – Lecture 1 & 2

Lease VS. Buy Asset Replacement

Divisible projects Indivisible projects

 Lessor – has ownership of the asset;

 2. Leases that are purely a source of finance

How frequently Is it worth paying more

 The optimum replacement policy is the one with

R eplace every R eplace every 2 R eplace every 3

Therefore, replacing every 3 years offers the lowest EAC.

 Equivalent annual benefit (EAB)

Project B has an N PV of £8.90m and and expected life of

 Project A w ill be accepted despite the fact that it has a

Is where a company has a limited amount of

1. Soft capital rationing (Internal factors)

 Depressed stock market

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

Y(balance) 3rd 10,000 (1/3 of

Total N PV Choosing projects

These are projects that can be undertaken

Project R equired PV of Inflow s N PV from

The highest N PV will be achieved by undertaking projects Q and R

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