ACCA FM · Chapter 8
Asset replacement, capital rationing and lease or buy MCQs with Answers
10 multiple-choice questions on Asset replacement, capital rationing and lease or buy for ACCA FM Financial Management. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
A machine costs $60,000. Running costs are $10,000 in year 1, $14,000 in year 2 and $18,000 in year 3. Its resale value is $30,000 after 2 years or $20,000 after 3 years. The cost of capital is 10% (DFs 0.909, 0.826, 0.751; annuity factors 1.736 for 2 years and 2.487 for 3 years). Which replacement cycle minimises cost, and what is its equivalent annual cost (EAC)?
- A) Replace every 2 years; EAC $32,185
- B) Replace every 3 years; EAC $79,152
- C) Replace every 2 years; EAC $55,874
- D) Replace every 3 years; EAC $31,826
Show answer & explanation
Answer: D) Replace every 3 years; EAC $31,826
2-year cycle: PV of costs = 60,000 + 10,000 x 0.909 + 14,000 x 0.826 - 30,000 x 0.826 = $55,874; EAC = $55,874 / 1.736 = $32,185. 3-year cycle: PV = 60,000 + 9,090 + 11,564 + 18,000 x 0.751 - 20,000 x 0.751 = $79,152; EAC = $79,152 / 2.487 = $31,826. The 3-year cycle has the lower EAC (rounded to the nearest $). Comparing total PVs is wrong because the cycles are of different lengths.
Question 2
Why is the equivalent annual cost (EAC) method used when deciding how often to replace an asset?
- A) It ignores resale values, which are uncertain
- B) It allows replacement cycles of different lengths to be compared on a like-for-like annual basis
- C) It always favours the shortest replacement cycle
- D) It avoids the need to discount cash flows
Show answer & explanation
Answer: B) It allows replacement cycles of different lengths to be compared on a like-for-like annual basis
Replacement cycles of different lengths cannot be compared by their total PV of costs because a longer cycle naturally has a higher total. Dividing the PV of each cycle by the annuity factor for its length converts it into an equivalent constant annual cost, assuming the cycle is repeated indefinitely. The cycle with the lowest EAC is chosen.
Question 3
The present value of the costs of owning a vehicle over a 4-year replacement cycle is $84,000. The cost of capital is 9%, and the 4-year annuity factor at 9% is 3.240. What is the equivalent annual cost (to the nearest $)?
- A) $21,000
- B) $25,926
- C) $28,259
- D) $33,188
Show answer & explanation
Answer: B) $25,926
EAC = PV of costs / annuity factor = 84,000 / 3.240 = $25,926 (nearest $). Dividing by the number of years ($21,000) ignores the time value of money.
Question 4
A company has $500k available for investment now and capital is not available later. Four divisible, independent projects are available ($000): P outlay 200, NPV 60; Q outlay 150, NPV 54; R outlay 250, NPV 70; S outlay 100, NPV 25. What is the maximum total NPV that can be achieved?
- A) $139k
- B) $148k
- C) $149k
- D) $156k
Show answer & explanation
Answer: D) $156k
Profitability indices (NPV / outlay): P 0.30, Q 0.36, R 0.28, S 0.25. Ranking by PI: Q (150, NPV 54), then P (200, NPV 60), leaving 150 for R, i.e. 150/250 = 60% of R giving NPV 42. Total NPV = 54 + 60 + 42 = 156 ($000). Ranking by absolute NPV gives only 148, and 149 is the best result if the projects were indivisible.
Question 5
A company has $300k of capital available. The following independent projects are indivisible ($000): A outlay 120, NPV 30; B outlay 180, NPV 40; C outlay 150, NPV 39; D outlay 100, NPV 20. Which combination of projects should be undertaken?
- A) Projects A and B, total NPV $70k
- B) Projects B and D, total NPV $60k
- C) Projects C and D, total NPV $59k
- D) Projects A and C, total NPV $69k
Show answer & explanation
Answer: A) Projects A and B, total NPV $70k
With indivisible projects, every feasible combination must be tested. Feasible pairs within $300k: A+B (300, NPV 70), A+C (270, NPV 69), A+D (220, NPV 50), B+D (280, NPV 60), C+D (250, NPV 59); no three projects fit. A+B gives the highest NPV of $70k. Ranking by profitability index (C 0.26, A 0.25) would select A and C, leaving $30k unused and giving only $69k.
Question 6
What is the difference between hard and soft capital rationing?
- A) Hard rationing is imposed by management, while soft rationing is imposed by the capital markets
- B) Hard rationing lasts one period, while soft rationing lasts several periods
- C) Hard rationing is imposed by external factors such as lenders, while soft rationing is imposed internally by the company's own management
- D) Hard rationing applies to divisible projects, while soft rationing applies to indivisible projects
Show answer & explanation
Answer: C) Hard rationing is imposed by external factors such as lenders, while soft rationing is imposed internally by the company's own management
Hard capital rationing arises from external constraints, for example banks being unwilling to lend more. Soft capital rationing is self-imposed, for example management setting a divisional budget limit or not wishing to dilute control by issuing new shares. The distinction does not depend on project divisibility or the number of periods.
Question 7
In a lease versus buy decision, which discount rate should normally be used to discount the financing cash flows?
- A) The company's weighted average cost of capital
- B) The cost of equity
- C) The pre-tax cost of borrowing
- D) The after-tax cost of borrowing
Show answer & explanation
Answer: D) The after-tax cost of borrowing
Once the investment decision has been made, the lease versus buy decision is a financing decision comparing leasing with borrowing to buy. The relevant cash flows (purchase cost, tax savings on depreciation, lease payments and tax relief on them) are therefore discounted at the after-tax cost of borrowing.
Question 8
A company can buy a machine for $100,000 at the start of year 1 (time 0) (4-year life, no residual value) or lease it for $28,000 a year payable at the end of each of years 1 to 4. Tax is 25%, with tax effects arising in the same year as the related cash flow. If bought, tax-allowable depreciation of 25% reducing balance is available from year 1, with a balancing allowance in year 4. The company can borrow at 8% before tax. Using exact (unrounded) discount factors, which option has the lower present value of cost, and by how much (to the nearest $)?
- A) Lease, by $5,859
- B) Lease, by $2,977
- C) Lease, by $10,096
- D) Buy, by $5,859
Show answer & explanation
Answer: A) Lease, by $5,859
Discount at the after-tax cost of borrowing: 8% x (1 - 0.25) = 6%. Buy: 100,000 less PV of tax savings on TAD (25,000, 18,750, 14,062.5 and balancing allowance 42,187.5, each x 25%) = $78,626. Lease: 28,000 x 0.75 = 21,000 a year x 4-year annuity factor at 6% (3.4651) = $72,767. Leasing is cheaper by $5,859 (exact discount factors, rounded to the nearest $). Tax relief on the lease payments and the TAD tax savings both arise in years 1 to 4, as tax is stated to be paid in the same year. Discounting both options at the pre-tax rate of 8% gives a difference of $10,096.
Question 9
A project requires an initial investment of $180,000 and the present value of its future net cash inflows is $225,000. Defining the profitability index as the NPV per $1 of capital invested, what is the project's profitability index?
- A) 0.20
- B) 0.25
- C) 0.80
- D) 1.25
Show answer & explanation
Answer: B) 0.25
NPV = 225,000 - 180,000 = 45,000. Profitability index = NPV / capital invested = 45,000 / 180,000 = 0.25. The figure of 1.25 is the ratio of PV of inflows to outlay, which is a different definition from the one stated in the question.
Question 10
Capital is expected to be limited in more than one future period. Which technique is most appropriate for selecting projects to maximise NPV?
- A) Ranking projects by profitability index
- B) Calculating the equivalent annual cost
- C) Ranking projects by payback period
- D) Linear programming
Show answer & explanation
Answer: D) Linear programming
Ranking by profitability index works only when capital is limited in a single period. When there are constraints in several periods, each project uses a different amount of the scarce resource in each period, so a mathematical programming approach such as linear programming is needed. EAC is used for replacement decisions.