Corporate Financial Management Lecturer’s Guide

CFML_A01v3. QXD 8/6/08 351 PM paginate 1 reviewers reap Corpo calculate fiscal focussing quaternary version Glen Arnold For further lecturer material please visit www. pears atomic number 53d. co. uk/arnold ISBN 978-0-273-71064-6 Pearson culture extra two hundred8 Lecturers adopting the main textbook ar permitted to d causeload and copy this guide as required. CFML_A01v3. QXD 8/6/08 351 PM summon 2 Pearson reproduction express mail Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies around the world Visit us on the World Wide Web at www. pears matchlessd. co. uk First publish under the Financial TimesPitman Publishing low in 1998 Second form published 2002 Third edition published 2005 Fourth edition published 2008 Financial Times Professional Limited 1998 Pearson preparation Limited 2002, 2005, 2008 The right of Glen Arnold to be identified as author of this Work has been asserted by him in accordance with the Copyright, Designs and Patents Act 1988. ISBN-978-0-273-71064-6 All rights reserved. Permission is hereby give for the material in this publication to be reproduced for OHP transparencies and student handouts, without express permission of the Publishers, for educational purposes only.In tot everyy some other cases, no part of this publication whitethorn be reproduced, stored in a retrieval system, or transmitted in either form or by any means, electronic, mechanical, photocopying, recording, or otherwise without either the prior written permission of the Publishers or a licence permitting restricted copying in the unify Kingdom issued by the Copyright Licensing Agency Ltd. , Saffron House, 6-10 Kirby Street, London EC1N 8TS. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published, without the prior consent of the Publishers.CFML_A01v3. QXD 8/5/08 416 PM foliate 3 CONTENTS Preface Location of answers to ques tions and problems SUPPLEMENTARY signifi rout outt FOR CHAPTERS Chapter 1 The monetary world Chapter 2 barf judgement Net collapse quantify and inside measure of return Chapter 3 Project estimation Cash escape rate and applications Chapter 4 The finis-making process for investing assessment Chapter 5 Project appraisal Capital rationing, taxation and inflation Chapter 6 Risk and find appraisal Chapter 7 Portfolio guess Chapter 8 The capital asset pricing model and multi-factor models Chapter 9 seam markets Chapter 10 Raising equity capitalChapter 11 Long-term debt finance Chapter 12 Short-term and medium-term finance Chapter 13 Treasury and running(a) capital management Chapter 14 Stock market efficiency Chapter 15 protect management Chapter 16 Strategy and grade Chapter 17 Value-creation metrics Chapter 18 Entire firm value measurement Chapter 19 The terms of capital Chapter 20 Valuing shares Chapter 21 Capital structure Chapter 22 Dividend insurance policy Cha pter 23 Mergers Chapter 24 Derivatives Chapter 25 Managing exchange-rate venture Pearson pedagogics Limited 2008 5 6 7 10 14 20 24 29 33 38 40 43 47 51 54 58 59 64 66 72 74 77 81 84 86 91 96 3 CFML_A01v3.QXD 8/5/08 416 PM Page 4 Supporting resources Visit www. pearsoned. co. uk/arnold to find valu commensurate online resources retainer Website for students ? Learning objectives for each chapter ? Multiple-choice questions with wink feedback to help test your learning ? Web link ups to relevant, specific Internet resources to facilitate in-depth independent research ? A huge selection of FT articles, additional to those found in the book, to provide real-world examples of pecuniary decision making in practice ? Interactive online flashcards that tolerate the contributor to check definitions against the key terms during revision Search equal online glossary For instructors ? Complete, downloadable instructors Manual including answers for all question material in the book ? A brand sore set of over 800 PowerPoint slides that can be downloaded and used as OHTs Also The regularly maintained Companion Website provides the following features ? Search tool to help locate specific items of content ? E-mail results and profile tools to unhorse results of quizzes to instructors ? Online help and support to assist with website usage and troubleshooting For more information please contact your local Pearson Education sales re bountyative or visit www. earsoned. co. uk/arnold CFML_A01v3. QXD 8/5/08 416 PM Page 5 PREFACE This Guide is designed to assist lecturers and tutors employ Corporate Financial vigilance quartern edition. Supplementary material for chapters For each chapter The learning moments are outlined. Key points and concepts are listed. Solutions to selected numerical problems (those marked with an whizz in the main book) are provided. Note that in that location is often more than one possible lay out solution to a problem. Different answe rs, which nevertheless follow the logic of the argument presented in the text, may be let inable.Overhead sickor transparency masters Also available on the website in PowerPoint for downloading are over 800 selected figures, tables and key points reproduced in a form suitable for creating overhead hearor transparency masters. These are arranged in the order in which they appear in Corporate Financial focussing. The learning objectives and summary points from the chapters are also included. Glen Arnold Pearson Education Limited 2008 5 CFML_A01v3. QXD 8/5/08 416 PM Page 6 LOCATION OF ANSWERS TO QUESTIONS AND PROBLEMS (No answers given to those in concluding column)Chapter No Answered in Appendix VII Answered in Lecturers Guide 1 Essay answer required (see text) All (see note in Appendix VII) 2 1, 2, 4, 5, 6 3, 7 3 1, 2, 3, 6, 9, 11, 13, 15 4, 5, 7, 8, 10, 12, 14 4 1, 2, 4, 5 3 5 1, 2, 3, 5, 6, 9, 10 4, 7, 8 6 1, 4, 5, 6, 7, 8, 9, 10, 11 2, 3, 12 7 1, 2, 3, 7, 8, 9, 10, 11, 12, 1 3, 15 4, 5, 6, 14a, b, c 8 1, 3, 4, 5, 7, 8, 9, 10 6, 7, 8, 9 14d 2, 6, 11 9 111 10 12 8 17, 911, 1319 11 1, 2, 3, 4, 5, 6, 10, 11, 13, 16 7 8, 9, 12, 14, 15, 1720 12 1, 2, 4, 9, 10, 11 5, 12 3, 6, 7, 8, 13, 14, 15 13 1, 4, 5, 7, 9, 10 3a, 6, 8, 23, 25a , 3b, 11, 12, 1322, 24, 25b, 25c 14 2 15 8, 9 1, 317 7, 10 16 16 14 17 1, 5, 6, 7 18 1, 2 19 2, 3 1 20 3, 4, 5, 6, 7, 9 8, 10 1, 2 21 2, 3, 6a, 9 1 4, 5, 6b, 7, 8 22 4, 5, 8 23 6 1, 3, 4, 5 2, 7, 8, 9 24 1, 2, 3, 4, 5, 7, 10 6, 8, 9 11, 12, 13 25 1, 2, 7, 8a, 10, 11 4, 9 3, 4b, 5, 6, 8b 6 2, 3, 4, 4a 8 1, 2, 3, 4, 7 Pearson Education Limited 2008 CFML_CH01v3. QXD 29/7/08 1725 Page 7 SUPPLEMENTARY MATERIAL FOR CHAPTERS Chapter 1 THE FINANCIAL WORLD L EARNING OUTCOMES It is no good learning mathematical techniques and theory if you lack an overview of what finance is about.At the end of this chapter the reader will own a balanced perspective on the purpose and value of the finance function, at both the integrated and national level. More specifically, the reader should be able to describe alternative views on the purpose of the line and show the importance to any organisation of clarity on this point describe the impact of the divide of corporate ownership from day-to-day managerial control explain the role of the financial manager expand the value of financial intermediaries show an appreciation of the function of the major financial institutions and markets. K EY POINTS AND CONCEPTS Firms should clearly decide the objective of the enterprise to provide a focus for decision making. Sound financial management is inevitable for the achievement of all stakeholder goals. Some stakeholders will have their returns satisfied given just enough to beat their contribution. One (or more) group(s) will have their returns maximised given any purposeless after all others have been satisfied. The delusive objective of the firm for finance is to maximise shareholder wealth. Reasons practical, a single obje ctive leads to clearer decisions the contractual theory survival in a competitive world it is better for society counters the tendency of managers to pursue goals for their own benefit they own the firm. Maximising shareholder wealth is maximizing purchasing power or maximising the attend of discounted bills flow to shareholders over a long snip horizon. Profit maximisation is not the same as shareholder wealth maximisation. Some factors a profit comparison does not allow for are future prospects risk accounting problems Pearson Education Limited 2008 7 CFML_CH01v3. QXD 29/7/08 1725 Page 8 Glen Arnold, Corporate Financial Management Lecturers Guide, 4th edition communication additional capital. Corporate governance. Large corporations usually have a separation of ownership and control. This may lead to managerialism where the agent (the managers) take decisions primarily with their interests in mind rather than those of the principals (the shareholders). This is a pri ncipal-agent problem. Some solutions link managerial rewards to shareholder wealth improvement sackings parcel outing shares and the takeover threat corporate governance principle improve information flow. The efficiency of production and the well-being of consumers can be improved with the introduction of coin to a barter economy. Financial institutions and markets encourage growth and progress by mobilising savings and encouraging coronation. Financial managers contribute to firms success primarily through investment and finance decisions. Their knowledge of financial markets, investment appraisal methods, treasury and risk management techniques are vital for company growth and stability. Financial institutions encourage the flow of saving into investment by acting as brokers and asset transformers, thus alleviating the conflict of preferences between the simple investors (households) and the ultimate borrowers (firms). Asset transformation is the creation of an inte rmediate security with characteristics appealing to the primary investor to attract finances, which are then made available to the ultimate borrower in a form appropriate to them. Types of asset transformation risk transformation maturity transformation volume transformation. Intermediaries are able to transform assets and encourage the flow of funds because of their economies of scale vis-a-vis the individual investor efficiencies in gathering information risk spreading execution comprise. The secondary markets in financial securities encourage investment by enabling investor liquidity (being able to sell quickly and cheaply to another investor) while providing the firm with long-term funds. The financial services sector has braggy to be of great economic significance in the UK. Reasons high income elasticity international comparative advantage. The financial sector has shown remarkable dynamism, innovation and adaptability over the last three decades. Deregulation, n ew technology, globalisation and the rapid growing of new financial products have characterised this sector. Banking sector Retail banks high-volume and low-value business. Wholesale banks low-volume and high-value business. Mostly fee based. International banks more often than not Eurocurrency transactions. Building societies still primarily small deposits aggregated for mortgage lending. Finance houses hire purchase, leasing, factoring. 8 Pearson Education Limited 2008 CFML_CH01v3. QXD 29/7/08 1725 Page 9 Glen Arnold, Corporate Financial Management Lecturers Guide, 4th edition Long-term savings institutions Pension funds major investors in financial assets. Insurance funds life assurance and endowment policies provide large investment funds. The risk spreaders Unit trusts genuine trusts which are open-ended investment vehicles. Investment trusts companies which invest in other companies financial securities, particularly shares. Open-ended investment compani es (OEICs) a hybrid between unit and investment trusts. The risk takers nonpublic equity funds invest in companies not quoted on a stock exchange. Hedge funds wide variety of investment or speculative strategies outside regulators control. The markets The money markets are short-term sell lending and/or borrowing markets. The bond markets deal in long-term bond debt issued by corporations, governments, local authorities and so on, and usually have a secondary market. The foreign exchange market one currency is exchanged for another. The share market primary and secondary trading in companies shares takes place on the Official List of the London Stock Exchange, techMARK and the Alternative Investment Market. The derivatives market LIFFE (Euronext. liffe) dominates the exchange-traded derivatives market in options and futures.However there is a flourishing over-the-counter market. There are no numerical questions in this chapter answers may be found from reading the te xt. Pearson Education Limited 2008 9 CFML_CH02v3. QXD 29/7/08 1726 Page 10 Chapter 2 PROJECT APPRAISAL NET PRESENT VALUE AND INTERNAL RATE OF call up L EARNING OUTCOMES By the end of the chapter the student should be able to demonstrate an understanding of the fundamental hypothetical justifications for using discounted money flow techniques in analysing major investment decisions, based on the concepts of the clock clock clock time value of money and the opportunity cost of capital.More specifically the student should be able to calculate net present value and upcountry rate of return show an appreciation of the relationship between net present value and internal rate of return describe and explain at least two electric potential problems that can arise with internal rate of return in specific circumstances demonstrate cognisance of the propensity for management to favour a percentage measure of investment performance and be able to use the modified internal rate of r eturn. KEY POINTS AND CONCEPTS Time value of money has three fraction parts each requiring compensation for a delay in the receipt of cash the pure time value, or impatience to consume, inflation, risk. Opportunity cost of capital is the yield forgone on the best available investment alternative the risk level of the alternative being the same as for the project under consideration. winning account of the time value of money and opportunity cost of capital in project appraisal leads to discounted cash flow analysis (DCF). Net present value (NPV) is the present value of the future cash flows after netting out the initial cash flow. Present values are achieved by discounting at the opportunity cost of capital.NPV = CF0 + (1 + k)2 + CFn (1 + k)n 0 accept 0 carry off CF1 1+r + CF2 (1 + r)2 + CFn (1 + r)n =0 The internal rate of return decision rule is IRR IRR 10 CF2 Internal rate of return (IRR) is the discount rate which, when applied to the cash flows of a project, result s in a zero net present value. It is an r which results in the following formula being true CF0 + 1+k + The net present value decision rules are NPV NPV CF1 opportunity cost of capital accept opportunity cost of capital reject Pearson Education Limited 2008 CFML_CH02v3. QXD 29/7/08 1726 Page 11Glen Arnold, Corporate Financial Management Lecturers Guide, 4th edition IRR is poor at handling situations of unconventional cash flows. Multiple solutions can be the result. There are circumstances when IRR ranks one project higher than another, whereas NPV ranks the projects in the opposite order. This be problem becomes an important issue in situations of mutual exclusivity. The IRR decision rule is reversed for financing-type decisions. NPV measures in imperative amounts of money. IRR is a percentage measure. IRR assumes that intra-project cash flows can be invested at a rate of return equalise to the IRR.This biases the IRR calculation. If a percentage measure is required, perhaps for communication within an organisation, then the modified internal rate of return (MIRR) is to be preferred to the IRR. ANSWERS TO SELECTED QUESTIONS 3 Confused plc a Project C IRRs at 12. 1% and 286%. See Fig. 2. 1. NPV + 12. 1 286 Discount rate Fig. 2. 1 Project D No solution using IRR. See Fig. 2. 2. + NPV Discount rate Fig. 2. 2 b This problem illustrates two disadvantages of the IRR method. In the case of project C multiple solutions are possible, given the non-conventional cash flow.In the case of project D there is no solution, no IRR where NPV = 0. c NPV Project C +? 646 Project D ? 200 Using NPV the accept/reject decision is straightforward. Project C is accepted and Project D is rejected. Pearson Education Limited 2008 11 CFML_CH02v3. QXD 29/7/08 1726 Page 12 Glen Arnold, Corporate Financial Management Lecturers Guide, 4th edition 7 Seddet International a Project A At 20% 5,266 + 2, calciferol ? 2. 1065 = 0, ? IRR = 20% Project B At 7% 8,000 + 10,000 ? 0. 8163 = +163 At 8% 8,000 + 10,000 ? 0. 7938 = 62 IRR = 7 + 163 163 + 62 (8 7) = 7. 7% Project CAt 22% 2,100 + 200 ? 0. 8197 + 2,900 ? 0. 6719 = +12. 45 At 23% 2,100 + 200 ? 0. 8130 + 2,900 ? 0. 6610 = 20. 5 IRR = 22 + 12. 45 12. 45 + 20. 5 (23 22) = 22. 4% Project D At 16% 1,975 + 1,600 ? 0. 8621 + 800 ? 0. 7432 = 1 ? IRR is about under 16%. The IRR exceeds the hurdle rate of 16% in the case of A and C. Therefore if all projects can be accepted these two should be undertaken. b rank under IRR Project Project Project Project C A D B IRR 22. 4% 20% 16% 7. 7% best project c Project A 5,266 + 2,500 ? 2. 2459 = 349 Project B 8,000 + 10,000 ? 0. 6407 = 1,593 Project C 2,100 + 200 + 0. 8621 + 2,900 ? 0. 7432 = 228 Project D 1,975 + 1,600 ? 0. 8621 + 800 ? 0. 7432 = 1 12 Pearson Education Limited 2008 CFML_CH02v3. QXD 29/7/08 1726 Page 13 Glen Arnold, Corporate Financial Management Lecturers Guide, 4th edition Ranking Project A Project C Project D Project B NPV 349 best project 228 1 1,593 P roject A ranks higher than project C using NPV because it generates a larger surplus (value) over the required rate of return. NPV measures in absolute amounts of money and because project A is twice the sizing of project C it creates a greater NPV despite a lower IRR. This report should comment on the meaning of a positive or negative NPV expressed in everyday language. It should mention the time value of money and opportunity cost of capital and explain their meanings. Also the drawbacks of IRR should be discussed multiple solutions be problem link with the contrast of a percentage-based measure and an absolute moneybased measure additivity not possible the reinvestment assurance is flawed. Pearson Education Limited 2008 13 CFML_CH03v3. QXD 29/7/08 1726 Page 14 Chapter 3 PROJECT APPRAISAL CASH FLOW AND APPLICATIONS LEARNING OUTCOMESBy the end of this chapter the reader will be able to identify and apply relevant and incremental cash flows in net present value calculations. The reader will also be able to recognise and deal with sunk costs, incidental costs and allocated overheads and be able to employ this knowledge to the following the replacing decision/the replacement cycle the calculation of twelvemonthbook equivalent annuities the make or buy decision optimal timing of investment displace railroad siding situations. KEY POINTS AND CONCEPTS Raw data have to be checked for accuracy, reliability, timeliness, expense of collection, etc. Depreciation is not a cash flow and should be excluded. Profit is a poor substitute for cash flow. For example, working capital try-ons may be needed to modify the profit figures for NPV analysis. Analyse on the basis of incremental cash flows. That is, the difference between the cash flows arising if the project is implemented and the cash flows if the project is not implemented opportunity costs associated with, say, using an asset which has an alternative employment are relevant incidental effects, that is, cash flow effects throughout the organisation, should be considered along with the obvious direct effects sunk costs costs which will not change regardless of the decision to proceed are clearly unlike allocated overhead is a non-incremental cost and is irrelevant interest should not be double counted by both including interest as a cash flow and including it as an element in the discount rate. The replacement decision is an example of the application of incremental cash flow analysis. Annual equivalent annuities (AEA) can be employed to estimate the optimal replacement cycle for an asset under certain restrictive assumptions. The low common multiple (LCM) method is sometimes employed for short-lived assets. Whether to repair the old machine or sell it and buy a new machine is a very common business dilemma. incremental cash flow analysis helps us to solve these types of problems. different applications include the timing of projects, the issue of fluctuating output and the make or buy decision. 14 Pearson Education Limited 2008 CFML_CH03v3. QXD 29/7/08 1726 Page 15 Glen Arnold, Corporate Financial Management Lecturers Guide, 4th edition A NSWERS TO SELECTED QUESTIONS 4 Mercia plc a Proposal 1 Consultants fee sunk cost Central overhead irrelevant Depreciation irrelevant Time ( geezerhood) ?000s 0Earthmoving Construction Ticket sales operating(a) costs Council Senior management Opportunity cost Cash flows 1,650 3? 2 100 1,650 Discounted Cash flows 1 one hundred fifty 1,400 200 +600 100 100 50 +600 100 50 +150 0 +450 150 (1. 1)2 450/0. 1 (1. 1)2 + NPV = + ? 2. 193m Proposal 2 Central overhead (? 70,000) irrelevant Consultants fees (? 50,000) sunk cost Time (years) ?000s 0 1 2 3 100 5,000 4,000 400 100 5,000 4,000 400 100 Design & phase Revenue Operating costs Equipment Executive Opportunity cost Sale of club 9,000 Cash flow 9,100 100 Discounted cash flow 9,100 100 1. 1 100 +11,000 500 + 500 (1. 1)2 +11,500 + 11,500 (1. 1)3 NPV = ? 137,56 6 Recommendation accept marriage offer 1 IRR Proposal 1 20. 2% Proposal 2 9. 4% Pearson Education Limited 2008 15 CFML_CH03v3. QXD 29/7/08 1726 Page 16 Glen Arnold, Corporate Financial Management Lecturers Guide, 4th edition 5 Mines International plc a Survey sunk cost Time (years) ?m Profit (loss) Add depreciation Capital equipment Survey 0 1 2 3 4 5 0 0 4. 75 2. 1 0 4. 75 0. 30 3. 9 2. 0 4. 7 2. 0 4. 7 2. 0 2. 9 2. 0 1. 5 0 0 0 2. 0 2. 0 2. 0 2. 25 0. 25 2. 25 2. 25 0 2. 25 1. 75 +0. 50 1. 75 0 +1. 75 0. one hundred twenty-five 0. 125 0. 125 0. 10 0 0. 25 0. 10 0 0. 10 Debtor adjustment Opening debtors Closing debtors Creditor adjustment Opening creditors Closing creditors 0 0. 15 +0. 15 Overheads Hire cost Cash reserves administration refund Cash flow Discounted cash flow 0. 2 0. 15 0. 10 0. 10 0. 125 0. 05 +0. 025 0. 2 0. 2 0. 1 0. 2 1. 0 5. 125 0. 2 +1. 0 +0. 2 5. 75 5. 75 6. 20 4. 05 6. 575 6. 9 8. 075 1. 85 6. 20 + 4. 05 + 6. 575 + 6. 9 + 8. 075 + 1. 85 1. 12 (1. 12)2 (1 . 12)3 (1. 12)4 (1. 12)5 (1. 12)5. 125 = 5. 75 5. 536 + 3. 229 + 4. 680 + 4. 385 + 4. 582 + 1. 035 = ? 6. 625m The maximum which MI should bid in the auction is ? . 625m. This additional cash outflow at time zero would result in a return of 12% being obtained. (Some students may time the final debtor and creditor payments at time 5. 25 as time 6. ) b IRR = 29. 4%. c Points to be covered Time value of money. Opportunity cost of money for a given risk class. drop cost. Treatment of depreciation. Allocated overhead treatment. Cash injections. Hire cost opportunity cost. Comparison of NPV with other project appraisal methods Advantages over IRR measures in absolute amounts of money ranking problem multiple solution problem. 16 Pearson Education Limited 2008 CFML_CH03v3. QXD 29/7/08 1726 Page 17 Glen Arnold, Corporate Financial Management Lecturers Guide, 4th edition Advantages over requital time value of money allowed for all cash flows considered cash flows within pay back period considered properly. Advantages over ARR firm theoretical base, time value of money defined decision criteria. 7 Reds plc One-year cycle Time (years) 0 1 10,000 12,000 8,000 4,000 NPV = 10,000 4,000 ? 0. 9009 = 13,604 AEA = 13,604 0. 9009 = ? 15,100 Two-year cycle Time (years) 0 1 2 10,000 12,000 13,000 ,500 6,500 NPV = 10,000 12,000 ? 0. 9009 6,500 ? 0. 8116 = 26,086 AEA = 26,086 1. 7125 = ? 15,233 Three-year cycle Time (years) 0 1 2 3 10,000 12,000 13,000 14,000 3,500 10,500 NPV = 10,000 12,000 ? 0. 9009 13,000 ? 0. 8116 10,500 ? 0. 7312 = 39,039 AEA = 39,039 2. 4437 = ? 15,975 Reds should replace the machinery on a one-year cycle. Pearson Education Limited 2008 17 CFML_CH03v3. QXD 29/7/08 1726 Page 18 Glen Arnold, Corporate Financial Management Lecturers Guide, 4th edition 8 Immediate replacement Time (years) 0 1? +4,000 15,100 +4,000 15,100 0. 11 = ? 133,273Replacement after one year Time 0 + 2? 2,000 2,000 1 3,000 15,100 0. 9009 15,100/0. 11 1. 11 3,000 ? = ? 122,966 Replacement after two years Time 0 1 2 3? 2,000 1,000 +1,500 15,100 2,000 1,000 ? 0. 9009 + 1,500 ? 0. 8116 15,100/0. 11 (1. 11)2 = ? 113,097 Recommendation Commence replacement cycle after two years. 10 Curt plc Incremental cash flows Time (years) 0 70,000 28,000 28,000 37,000 47,100 68,410 ? ? ? ? ? 0. 8621 0. 7432 0. 6407 0. 5523 0. 4761 2 3 4 5 0 70,000 100,000 80,000 48,000 110,000 82,000 121,000 84,000 133,100 86,000 146,410 88,000 10,000 70,000 Current cash flows refreshful plan 1 28,000 28,000 37,000 47,100 68,410 = = = = = = 70,000 24,139 20,810 23,706 26,013 32,570 8,960 The positive incremental NPV indicates that acceptance of the proposal to manufacture in-house would add to shareholder wealth. 18 Pearson Education Limited 2008 CFML_CH03v3. QXD 29/7/08 1726 Page 19 Glen Arnold, Corporate Financial Management Lecturers Guide, 4th edition Other factors some possibilities The relative bargaining strength of Curt and its supplier. Perhaps a search for anothe r supplier would be wise. Perhaps it would be possible to negotiate a multi-year price agreement.Are there some other incidental effects Curt has not considered, e. g. factory space usage? 12 Netq plc yield per year 1,000 ? 0. 3333 ? 2 1,000 ? 0. 3333 ? 0. 75 ? 2 1,000 ? 0. 3333 ? 0. 5 ? 2 = 667 500 333 1,500 Cost of annual output 1,500 ? ?4 = ? 6,000 PV = 6,000/0. 13 = ? 46,154 Both machines replaced Annual costs 1,500 ? ?1. 80 = ? 2,700 PV = 14,000 + 2,700 0. 13 = ? 34,769 One machine is replaced Old Output first third of year second third of year last third of year New 333. 3 166. 7 0 500 333. 3 333. 3 333. 3 1,000 Annual costs 500 ? 4 + 1,000 ? 1. 8 = ? 3,800 PV = 7,000 + 3,800 = ? 6,231 0. 13 The lowest cost option is to replace both machines. 14 Opti plc be One-year replacement PV = 20,000 6,000/1. 1 = 14,545 AEA = 14,545/0. 9091 = 16,000 Two-year replacement PV = 20,000 + 6,000/1. 1 1,000/(1. 1)2 = 24,629 AEA = 24,629/1. 7355 = 14,191 Three-year replacement PV = 20,000 + 6 ,000/1. 1 + 8,000/(1. 1)2 + 4,000/(1. 1)3 = 35,072 AEA = 35,072/2. 4869 = 14,103 Four-year replacement PV = 20,000 + 6,000/1. 1 + 8,000/(1. 1)2 + 10,000/(1. 1)3 + 10,000/(1. 1)4 = 46,410 AEA = 46,410/3. 1699 = 14,641 The optimal replacement cycle is 3 years. Pearson Education Limited 2008 9 CFML_CH04v3. QXD 29/7/08 1727 Page 20 Chapter 4 THE DECISION-MAKING PROCESS FOR INVESTMENT APPRAISAL LEARNING OUTCOMES The main outcome expected from this chapter is that the reader is aware of both traditional and discounted cash flow investment appraisal techniques and the boundary of their use. The reader should also be aware that these techniques are a small part of the overall capital-allocation plan process. The student is expected to gain knowledge of the empirical evidence on techniques used the calculation of payback, discounted payback and accounting rate of return (ARR)