Ch 11 - Investing Decisions

Question 1

What is capital allocation/budgeting?

Answer 1

the process of determining how to use and invest a company’s cash to maximize shareholder

Question 2

What is the capital allocation process for companies?

Answer 2

1. Must first determine if they have sufficient working capital
2. Then, decide if they want to keep it within the business or return it to shareholders via dividends (investing vs financing)

Question 3

What are examples of investing decisions?

Answer 3

• R&D
• Expanding capacity
• Replacing an asset

Question 4

What is considered when making investing decisions?

Answer 4

Consider ONLY cash flows and not net income.

Only incremental cash inflows and outflows that result from purchasing equipment or assets are considered to make an investing decision
- Therefore existing products should not be considered

Question 5

What is the Weighted-average cost of capital (WACC)? What is it expressed as?

Answer 5

The company’s cost of obtaining cash from lenders and shareholders, expressed as a percentage.

A company will only make a return, if it invests in projects that produce a return that is HIGHER THAN the company’s cost to obtain cash.

Question 6

What is up-front investment?

Answer 6

The initial cash required TODAY to purchase equipment or assets that will generate future cash flows, deliver and install equipment and any other ONE-TIME upfront cash flows necessary.

Question 7

How is NPV of an investment calculated?

Answer 7

1. Identify all relevant cash flows and categorize them as up-front or future cash flows
2. Separate relevant cash flows into cash inflows and cash outflows
   - Inflows are expressed as positive numbers, and
   - Outflows are expressed as negative numbers
3. Identify the timing of the cash inflows and outflows (i.e., which year will they occur? Are they one-time or recurring every year?)
4. Discount the net cash flows using the present value formula
5. Sum all discounted net cash flows to obtain the net present value

Question 8

What is the NPV decision rule?

Answer 8

• If NPV > $0, means the project will deliver a return greater than the weighted average cost of capital, therefore proceed from a quantitative perspective
• If NPV < $0, means the project will deliver a return less than the weighted average cost of capital, therefore don’t proceed from a qualitative perspective
• The greater the NPV, the more attractive the investment.

Question 9

How do you create a future cash flow projection for an investment (to determine if should invest in ___)

Answer 9

1. Set up a time-line of the investment (may be useful life)
2. Calculate upfront costs at time 0
3. Calculate ongoing incremental revenue and costs
   - Revenue will be positive
   - Relevant costs will be a negative
4. Calculate increase/decrease in cash flows for the whole timeline (including time 0, which is just upfront costs)
5. Calculate NPV (PV formula, with the WACC as the rate)
6. Calculate total cash flows and total NPV
7. Make a decision - if NPV > 0, then surpasses rate of return