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Corporate issuer > Capital investments > Flashcards

Capital investments Flashcards

1
Q

What are the 2 reasons to make a capital investments?

A
  • To maintain the existing business
  • To grow the current business
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2
Q

What are the 2 types of business maintenance projects? Describe them

A
  • Going concern: projects necessary to continue current operations and maintain the existing size of the business or to improve business efficiencies.
  • Regulatory/Compliance: projects typically required by a third party such as the government regulatory body to meet specified safety and compliance with standards.
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3
Q

What are examples of going concern projects?

A

PP&E replacement, or IT modernization.

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4
Q

What are examples of regulatory/Compliance projects?

A

Factory pollution control installation, performance bond posting to guarantee satisfactory project completion.

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5
Q

What are the 2 types of business growth projects? Describe them.

A
  • Expansion: projects that expand the business size and typically involve greater degrees of risk and uncertainty than going concern projects.
  • Other: projects that should include high-risk investments and new growth initiatives outside the company’s conventional business lines.
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6
Q

What are examples of expansion projects?

A

New product or service development, M&A activities.

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7
Q

What are examples of other projects?

A

Exploration of invention into a new innovation, business model, or idea.

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8
Q

What are the steps in the capital allocation process? Describe them.

A
  • Idea generation: ideas can come from anywhere within the organization or from outside.
  • Investment analysis: forecasting CF and evaluating the investment’s profitability.
  • Capital allocation planning: organizing profitable proposals to best fit the company’s strategy, considering the relevant constraints.
  • Monitoring and post-audit: comparing actual results to those that were forecast.
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9
Q

What is the IFAM abbreviation?

A
  • Idea
  • Forecasting
  • Allocation
  • Monitoring
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10
Q

What is capital allocation?

A

It is the process of the issuer’s management making capital investment decisions. It is one of the most important tasks of management.

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11
Q

What are the 6 principles of capital allocation?

A
  • Decisions are based on CF.
  • Measure incremental CF.
  • Timing of CF is crucial.
  • CF is analyzed on an after-tax basis.
  • CF is not accounting for NI or operating income.
  • Financing costs are ignored.
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12
Q

On what would be based the decisions to or not to invest?

A

It should be made on discounted CF, given that all projects involve risk.

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13
Q

What is a sunk cost?

A
  • Cost that has already been incurred.
  • Decision take sunk cost out of the process.
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14
Q

What is incremental CF?

A

CF with the decision minus CF without the decision.

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15
Q

What is an externality?

A

It is the effect of an investment on things other than the investment itself.

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16
Q

What are positive vs negative externality?

A
  • Positive: cost synergies or revenue synergies.
  • Negative: cannibalization, where the investment takes customers and sales away from another part of the company.
17
Q

What is a conventional CF pattern?

A

An initial outflow is followed by a series of inflows.

18
Q

What is a nonconventional CF pattern?

A
  • The initial outflow is followed not only by inflows.
  • They are common among projects that need heavy maintenance.
19
Q

What are independent projects?

A
  • CF independent of each other.
  • Require little management effort.
20
Q

What are mutually exclusive projects?

A
  • They compete directly with each other.
  • They create significant organizational disruption that limits the company’s ability to take on additional projects.
21
Q

What is project sequencing?

A

Many capital projects are sequenced over time.

22
Q

What are fail-fast and minimum-viable products?

A

They are examples of management breaking up a large project into smaller successive projects and then performing something similar to project sequencing for these intermediate projects.

23
Q

What is the net present value?

A

It is the present value of the future after-tax CF minus the investment outlay.

24
Q

What is the internal rate of return?

A

It is the discount rate that makes the present value of future after-tax CF equal to the investment outlay.

25
Q

What is the decision to invest with IRR?

A

If the IRR> hurdle rate, we take the project.

26
Q

What is the hurdle rate?

A

It is the required rate of return for a capital investment.

27
Q

Which project would be taken between 2 projects with different NPVs?

A

You invest in the project with the greater NPV.

28
Q

Why do we use IRR and NPV?

A
  • IRR: it helps the audience understand the decision.
  • NPV: Used to make the investment decision.
29
Q

What are the most common capital allocation pitfalls?

A
  • Inertia: anchoring the capital investment budgets to prior amounts.
  • Source of capital bias: all capital has opportunity costs, regardless of source, and the capital allocation process should be used for all capital investments.
  • Falling to consider investment alternatives or alternative states.
  • Pushing pet projects.
  • Basing investment decisions on EPS, NI, or ROE.
  • Internal forecasting errors.
  • Failing to incorporate market responses into the analysis of planned investment.
30
Q

What is the return on invested capital (ROIC)?

A

It is a measure of the profitability of a company or business segment relative to the amount of capital invested by the equity and debtholders.

31
Q

What happens when the ROIC is higher than the cost of capital?

A

The company is increasing the firm’s value for shareholders.

32
Q

How does inflation affect capital allocation?

A
  • It reduces the value of depreciation tax savings, effectively increasing real taxes.
  • It is captured in the DCF analysis.
  • Inflation shifts wealth from the taxpayer to the government.
  • Analysts can perform corporate valuation using real CF combined with a real discount rate or nominal CF, which must be combined with a nominal discount rate.
33
Q

What are the timing options?

A

A company can delay an investment instead if investing now.

34
Q

What are the types of sizing options? Describe them.

A
  • Abandonment option: it allows a company to abandon the investment after it is undertaken.
  • A growth option: it allows a company to make additional investments when future financial results are strong.
35
Q

What are flexibility options?

A

It can be, for example, a price-setting option that allows for future margin increases.

36
Q

What are fundamental options?

A

The entire project is essentially an option.

37
Q

What are approaches to evaluate capital investment with real options?

A
  • DCF analysis without considering options: Project NPV= NPV (based on DCF) - the cost of options + the value of options
  • Decision trees and option pricing models.

Corporate issuer (8 decks)

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