Chapter 5 – Asset investment decisions

and capital rationing

Chapter agenda

Lease or buy
Investment
decisions Asset
replacement
Chapter 5
Divisible
Capital projects
rationing Indivisible
projects

Lease or Buy
In the last 3 chapters, the focus was on evaluating the viability (profitability) of
projects/machinery. Once the company decides to embark on a project, they need to decide
how to finance the project.

1. Outright purchase of asset (using a bank loan)

2. Obtain the asset on a lease

Leasing Outright purchase

The asset is not owned by the company The asset is owned by the company
No tax-allowable depreciation Tax-allowable depreciation
Lease payment & tax relief on lease Purchase cost, disposal value, tax- allowable
payments are the relevant cash flows depreciation are the relevant cashflows

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Discount rate/Cost of capital
When it comes to leasing or buying evaluations, the discount rate to be used in the
calculation is estimated as follows. (This is known as the post-tax cost of borrowing)

Post-tax cost of borrowing = Cost of borrowing X (1-Tax rate)

This is because
• Both leasing and buying involve a borrowing
• Interest on borrowing carries a tax benefit

Example – Lease

A company is considering obtaining a lease to finance a viable project.

Lease rental is expected to be $40,000 per annum, payable at the start of each year. Tax is
payable at 25%, one year in arrears. Post-tax cost of borrowing is 10%.

Calculate the net present value of the leasing option

Example – Lease Vs Buy

A firm has decided to acquire a new machine for a project. The machine costs $7 million and
would have an economic life of five years. Tax-allowable depreciation is 25% per annum
based on the reducing balance method. A tax of 30% is payable one year in arrears.

The firm has two financing options for the machine.

1. 5-year bank loan at a fixed interest rate (pre-tax) of 11% per annum, with principal
repayable in the 5th year

2. A leasing option where lease rental per annum is $1.7 million payable in advance.

Assume there is no scrap value for the machine under both options.

Which is the best financing method for the firm?

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Replacement decisions
Sometimes, in a long-life project undertaking, the company may have to replace the assets
used periodically.

In that, there could be different replacement assets available to the company which will
have different costs and different life spans.

In evaluating these different replacement strategies Equivalent Annual Cost (EAC) method
is used.

Equivalent Annual Cost (EAC)

EAC is calculated as follows.

𝑃𝑉 𝑜𝑓 𝑐𝑜𝑠𝑡𝑠
𝐸𝐴𝐶 =
𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑓𝑎𝑐𝑡𝑜𝑟

EAC is used specifically to deal with time scale differences between the replacement
options.

The best option will have the lowest EAC.

EAC indicates the optimum replacement period (sometimes referred to as the optimum
replacement cycle).

However, the company needs to consider other quantitative and non-quantitative factors
when making the final decision

Steps in calculating the EAC

Step 1: Calculate the NPV of the replacement strategy

Step 2: Calculate the EAC for each strategy

Step 3: Choose the strategy with the lowest EAC

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Example – EAC

A company needs to decide on the replacement policy for its lorries. A lorry costs
$24,000 and the following additional information applies:

Lorry sold in (end of Trade in allowance Asset held for Maintenance cost
year) ($) per annum
Year 1 18,000 1 year 0
Year 2 15,000 2 years 3000 in the 1st year
Year 3 14,000 3 years 3400 in the 2nd year

The lorry is only maintained at the end of the year if it is to be kept for a further year

There are no maintenance costs in the year of replacement.

Ignore taxation and inflation

Calculate the optimal replacement policy at a cost of capital of 15%.

Equivalent Annual Benefits (EAB)

When comparing projects with unequal lives equivalent annual benefits can be calculated
(Similar to the logic of EAC)

𝑁𝑃𝑉 𝑜𝑓 𝑝𝑟𝑜𝑗𝑒𝑐𝑡
𝐸𝐴𝐶 =
𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑓𝑎𝑐𝑡𝑜𝑟

The project with the highest EAB is selected.

Capital rationing
In its simplest capital rationing refers to a situation where the company has several positive
NPV-generating projects but limited funds to undertake them.

There are two main reasons why capital is limited.

1. Soft capital rationing – Limits on capital imposed by internal factors such as lack of
managerial skills, not having a presence in share and bond markets etc
2. Hard capital rationing – Limits on capital imposed by external factors such as
depressed capital markets, investors are too risk averse

When capital is rationed, the objective is to maximise the NPV per $1 invested.

Capital rationing is tested in FM with divisible and indivisible projects

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Divisible projects
When projects are divisible, even a fraction of a project can be undertaken and hence a
proportionate return can be generated.

In ranking the projects, the profitability index is calculated.

!"#
𝑃𝐼 =
$%&'()*'%)

Steps

Step 1: Calculate PI for each project

Step 2: Rank the projects based on PI
Step 3: Allocate funds to the projects based on the ranking until they are used up in full.

Example – Divisible projects

E.g., A company has $500m and needs to invest in some projects. The company has the
following divisible projects

Project Funds ($ million) Requirement NPV

A 210 35
B 250 45
C 230 40
D 300 60

Help the company in the right selection of projects.

Indivisible projects
When projects are indivisible, they must be undertaken in full. It is not possible to invest in
part of a project. In such a scenario, optimal combinations of projects must be found using a
trial-and-error approach.

Example – Indivisible projects

A company has $200,000 to invest and has identified the following 4 indivisible projects.
Determine the optimal project selection

Project Investment NPV

($000)
A 80 40
B 200 70
C 100 48
D 120 36

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Mutually exclusive projects
The term ‘mutually exclusive means that undertaking a project involves having to let go of
some other projects.

Example – Mutually exclusive projects

A company has $200,000 to invest and has identified the following 4 indivisible projects.
Assume projects C & D are mutually exclusive. Determine the optimal project selection

Project Investment NPV

($000)
A 80 40
B 200 70
C 100 48
D 120 36

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