Capital Investment And Capital allocation Flashcards
Match funding
Financing projects with capital sources matching on consistent with the life of the project.
Different types of capital investments
There are four different type of capital investments: going concern project, regulatory compliance project, growth / expansionprojects, other projects.
Going concern project
Projects that may be needed to maintain the ongoing business and to reduce costs. To improve efficiency, it may involve determining on deciding it an equipment is obsolete but still usable are should it be replaced,
Regulator/compliance projects
Projects that may be required to carried by government Or insurance company to involve safety related on environs concerns. These projects typically generate little or no revenue
Expansion projects
These projects are carried on grow business by either forecasting future demand and can involve entering new markets on introducing new products within the samemarket.
Other projects
It may involve entering into a new line of business which entails a complex decision making
Capital allocation process
It is the process to identify and evaluate capital projects
Capital projects
Projects the bring cash to flowers the firm for over a period longer than a year
When a capital allocation process can be used
It can be used to identify any project and evaluate the same.using this process one can examine any corporate decision that will have an impact on futureearnings.
Capital allocation process administrative steps
- Generation of near idea
2.analyzing the proposals
3.create the firm wide project - Monitoring and conducting audit of the decision.
NPV
Net present value - all expected inflows are ‘ converted intopresent value and initial outflow on investment is reduced if the NPV is positive the project is accepted. Formulae for NPR is [ ( 1- 1/ R)^t/ R ]a
What does positive NPV signify?
It signifies expected value addition to thefirm/shareholder
Is npv/irr method based on accounting or cash flows
Cash flows
Which is better- accounting or cash flows
Cash flows as accounts can be easily manipulated.
IRR
Internal rate of return is the discounting rate at which present value of expected cash inflows will be equal to the initial investment ie NPV is equal to zero.
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When, a project be accepted according to the IRR method
When IRR is greater than expected rate of return ie cost of capital accept the proposal
What is hurdle rate
Sometimes the analyst set the expected rate return of below on above the firm’s cost of capital to adjust the project’s risk, this rate is called the hurdle rate
Why NPV is superior than IRR methods
- Possibility of multiple irr’s in case of unconventional cash flow.
2.NPR assumes cash how’s are reinvested on the basis of required date of return whereas IRS assumes it is reinvested@irr. The former is more realistic.
ROIC
Return on invested capital - nopat/average book value of total capital
NOPAT
Net operating profit after tax-EBIT(1-tax rate)
Average book value of total capital
Avg total capital = long term assets + long term liabilities /2
Why only long terms assets a labilities are considered
Because short term keeps on coming in a out of the business
Features/concerns of ROIC
- Backward looking
- Accounting based hence prone to errors and difference in accounting standards used.
3.it is used to analyze whole company & not just a single project.
Principals of capital allocation
Principles considered while performing the capital allocation process are:
1. Decisions are based on cash flows and not on accounting income as accounting is on accrual basis and hence do not consider turning of cash flows.,
2. Incremental cash flow- only those costs the happen if the project is pursued are to be considered. Leg. Sunk cost should not be considered.
3. Timing of cash flow is important- sooner the cash received, its better
Sunk cost
Costs that has to be borne even if the project. Is rejected.
Cannabilization
When introduction of new product kills the sites of other product its called cannabilization.
What common errors are made by managers while performing the capital allocation process:
Two types of errors:
1. Cognitive errors - errors that happen even after knowing about it.
2. Behaviour biases - It happens due to personal preferences
Cognitive errors
Calculation errors:
1. Poor forecasting
2. Not considering the cost of internal funds.
3.incorrectly accounting for inflation.
Behavioral biases
Judgement errors:
1. Pet project of management
2. resistance in setting capital budget- manager return Or increase capital in case of budget negative or positive NPV respectively. If not, and it stagnant or o capital budget is observed, chances are behavioral bias is there.
3.investment decision based-on EPS on roe - it may avoid projects that are supposed to generate positive NPV in later time.
4. Failure to generate new/alternative business ideas
Timing options
This option give management to decide to delay making an investment
Abandonment option
It a firm is getter better option than investing in continuing the project as the present value of cash flows from exiting a project exceeds the present value of the increment al cash how’s from continuing the project.
Expansion option
Allows company to make additional investment in future projects if it decides the project will create value.
Flexibility option
It gives managers choices regarding the operational aspect of a project,- two available options are:
1. Price setting option
2. Production flexibility option
Fundmental option
Option to start the project when only feasible ie pay off depends on the price off an underlying assets
