Book 2_Corp_CAPITAL INVESTMENTS AND CAPITAL ALLOCATION Flashcards
Capital investments
- going concern projects to maintain a business or to reduce costs
- required regulatory/compliance projects
- expansion projects
- other projects that increase the size and scope of a company
Capital allocation
the process of evaluating capital projects (i.e., projects with cash flows over a period longer than one year).
Steps of the capital allocation process
(1) generate investment ideas
(2) analyze project ideas
(3) create a firm-wide capital budget
(4) monitor decisions and conduct a post-audit
a post-audit
- improve cash flow forecasts
- and stimulate management to improve operations and bring results into line with forecasts.
NPV
the sum of the present values of a project’s expected cash flows and represents the change in firm value from undertaking a project
IRR
the discount rate at which the present values of a project’s expected cash inflows and cash outflows are equal (i.e., the discount rate for which the NPV of a project is zero)
Return on invested capital
be compared to a company’s required rate of return to indicate whether the company has increased or decreased firm value over time.
ROIC = Net operating profit after tax/ Average invested capital
- NOPAT: After tax, before interest
- Invested capital: include equity and debt
Capital allocation decisions
- based on after-tax cash flows,
- ignore sunk costs,
- and capture any spillover effects on other parts of the business
Common mistakes in the capital allocation process
Cognitive Errors
- Poor forecasting
- Not considering the cost of internal funds
- Incorrectly accounting for inflation
Behavioral Biases
- Pet projects of senior management
- Inertia in setting the entire capital budget
- Basing investment decisions on EPS or ROE
- Failure to generate alternative investment ideas
Real options
allow managers to make future decisions that change the value of capital allocation decisions made today
Timing options
allow a company to delay making an investment.
Abandonment options
allow management to abandon a project if the present value of the incremental cash flows from exiting a project exceeds the present value of the incremental cash flows from continuing a project.
Expansion options
allow a company to make additional investments in a project if doing so creates value.
Flexibility options
- give managers choices regarding the operational aspects of a project.
- The two main forms are price-setting and production-flexibility options.
Fundamental options
Projects that are options themselves because the payoffs depend on the price of an underlying asset.
