Capital Investments Flashcards
Describe the 4 steps of the capital allocation process
Step 1:
Idea generation. The most important step in the capital allocation process is generating good project ideas. Ideas can come from a number of sources, including senior management, functional divisions, employees, or sources outside the company.
Step 2:
Analyzing project proposals. Because the decision to accept or reject a capital project is based on the project’s expected future cash flows, a cash flow forecast must be made for each project to determine its expected profitability.
Step 3:
Create the firm-wide capital budget. Firms must prioritize profitable projects according to the timing of the project’s cash flows, available company resources, and the company’s overall strategic plan. Many projects that are attractive individually may not make sense strategically.
Step 4:
Monitoring decisions and conducting a post-audit. It is important to follow up on all capital allocation decisions. An analyst should compare the actual results to the projected results, and project managers should explain why projections did or did not match actual performance. Because the capital allocation process is only as good as the estimates of the inputs into the model used to forecast cash flows, a post-audit should be used to identify systematic errors in the forecasting process and improve company operations.
Describe the principles of capital allocation
Decisions are based on cash flows, not accounting income. The relevant cash flows to consider as part of the capital allocation process are incremental cash flows, the changes in cash flows that will occur if the project is undertaken.
Cash flows are based on opportunity costs. Opportunity costs are cash flows that a firm will lose by undertaking the project under analysis. These are cash flows generated by an asset the firm already owns that would be forgone if the project under consideration is undertaken.
Opportunity costs should be included in project costs. For example, when building a plant, even if the firm already owns the land, the cost of the land should be charged to the project because it could be sold if not used.
The timing of cash flows is important. Capital allocation decisions account for the time value of money, which means that cash flows received earlier are worth more than cash flows to be received later.
Cash flows are analyzed on an after-tax basis. The impact of taxes must be considered when analyzing all capital allocation projects. Firm value is based on cash flows they get to keep, not those they send to the government.
Financing costs are reflected in the project’s required rate of return. Do not consider financing costs specific to the project when estimating incremental cash flows. The discount rate used in the capital allocation analysis takes account of the firm’s cost of capital. Only projects that are expected to return more than the cost of the capital needed to fund them will increase the value of the firm.
What are Externalities?
Externalities are the effects the acceptance of a project may have on other firm cash flows. The primary one is a negative externality called cannibalization, which occurs when a new project takes sales from an existing product.
Define independent and mutually exclusive projects
Independent projects are projects that can be evaluated solely on their own profitability. For example, if projects A and B are independent, and both projects are profitable, then the firm could accept both projects.
Multiple projects are mutually exclusive if only one of them can be accepted so that profitability must be evaluated among the projects. If Projects A and B are mutually exclusive, either Project A or Project B can be accepted, but not both. Making a capital allocation decision to select one of two different stamping machines, each with different costs and outputs, is an example of ranking two mutually exclusive projects.
What do you use to calculate IRR and NPV?
What other process can you use
CF buttons
TVM buttons
When comparing project profitability, should you use NPV or IRR as the key factor
When comparing two mutually exclusive projects, one project may have a higher IRR, but a lower NPV. The NPV criterion is theoretically sound, accurately reflecting the goal of maximizing shareholder wealth, and should be used to choose between two projects that are both acceptable.
Advantage / Disadvantage of NPV
A key advantage of NPV is that it is a direct measure of the expected increase in the value of the firm. NPV is theoretically the best method.
Its main weakness is that it does not include any consideration of the size of the project. For example, an NPV of $100 is great for a project costing $100 but not so great for a project costing $1 million
Advantage / Disadvantage of IRR
A key advantage of IRR is that it measures profitability as a percentage, showing the return on each dollar invested. The IRR provides information on the margin of safety that the NPV does not. From the IRR, we can tell how much below the IRR (estimated return) the actual project return could fall, in percentage terms, before the project becomes uneconomic (has a negative NPV).
The disadvantages of the IRR method are (1)the possibility of producing rankings of mutually exclusive projects different from those from NPV analysis and (2) the possibility that a project has multiple IRRs or no IRR.
Describe common capital allocation pitfalls.
Failing to incorporate economic responses into the analysis.
Misusing standardized templates.
Pet projects of senior management.
Basing investment decisions on EPS or ROE.
Using the IRR criterion for project decisions. When comparing two mutually exclusive projects, one project may have a higher IRR, but a lower NPV. The NPV criterion is theoretically sound, accurately reflecting the goal of maximizing shareholder wealth, and should be used to choose between two projects that are both acceptable.
Poor cash flow estimation.
Misestimating overhead costs.
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Using the incorrect discount rate.
Politics involved with spending the entire capital budget.
Failure to generate alternative investment ideas.
Improper handling of sunk and opportunity costs.
Calculate Return on Invested Capital
After tax net profit or net op profit after tax
/
average book value of total capital
What is a real option?
describe some real options
Real options are future actions that a firm can take, given that they invest in a project today. Real options are similar to financial options (put and call options) in that they give the option holder the right, but not the obligation, to take a future action. The value of real options should be included in the calculation of project’s NPV. Options never have negative values because if, in the future, the specified action will have a negative value, the option holder will not take the action.
Types of real options include the following:
Timing options allow a company to delay making an investment because they expect to have better information in the future.
Abandonment options are similar to put options (the option to sell an asset at a given price in the future). They 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 the project.
Expansion options are similar to call options (the option to buy an asset at a given price in the future). Expansion options allow a company to make additional investments in future projects if the company decides they will create value.
Flexibility options give managers choices regarding the operational aspects of a project. The two main forms are price-setting and production flexibility options.
Price-setting options allow the company to change the price of a product. For example, the company may raise prices if demand for a product is high, in order to benefit from that demand without increasing production.
Production-flexibility options may include paying workers overtime, using different materials as inputs, or producing a different variety of product.
Fundamental options are projects that are options themselves because the payoffs depend on the price of an underlying asset. For example, the payoff for a copper mine is dependent on the market price for copper. If copper prices are low, it may not make sense to open a copper mine, but if copper prices are high, opening the copper mine could be very profitable. The operator has the option to close the mine when prices are low and open it when prices are high.
