31.1: Capital Allocation Principles Flashcards
The required rate of return is?
The discount rate that the issuer’s suppliers of capital require given the riskiness of the project. This discount rate is frequently called the “opportunity cost of funds” or the “cost of capital.”
A company’s weighted average cost of capital (WACC) is?
Is its cost of capital at the enterprise level, based on its average-risk investment and capital sources used to finance its assets.
Important capital allocation principles include the following?
Sunk cost;
An incremental cash flow;
An externality;
Cannibalisation;
A conventional cash flow pattern;
A non-conventional cash flow pattern.
Sunk cost is?
A cost that has already been incurred.
**One cannot change a sunk cost. Management’s decisions should be based on current and future cash flows and should not be affected by prior, or sunk, costs.
An incremental cash flow is?
The cash flow that is realized because of an investment decision: the cash flow with a decision minus the cash flow without that decision.
**Only incremental cash flows are relevant for capital allocation.
In terms of capital allocation, what is an externality?
An externality is the effect of an investment on things other than the investment itself.
**Frequently, an investment affects the cash flows of other parts of the company, and these externalities can be positive or negative.
In terms of capital allocation, cannibalisation?
It occurs when an investment takes customers and sales away from another part of the company.
In terms of capital allocation, what is a conventional cash flow pattern?
One with an initial outflow followed by a series of inflows.
In terms of capital allocation, what is a non-conventional cash flow pattern?
The initial outflow is not followed by inflows only, but the cash flows can flip from being positive (inflows) to negative (outflows) again or possibly change signs several times.
