Chapter 11 - investing decisions Flashcards
define capital allocation (capital budgeting)
the process of determining how to use and invest a company’s cash to maximize shareholder value - this process is relevant to both private = public companies, however it’s typically more formal + structured in pubic companies
process is usually part of the company’s budget process
what must the company must understand before allocating capital?
they must understand if they have sufficient cash to manage their day-to-day business (working capital), make investments for the future and return money to shareholders (dividends)
many companies have limited financial resources - first step is to understand if the company has enough cash from operating activities, if it doesn’t it must first make a financing decision (borrow or raise equity) before proceeding with the capital allocation process)
what decisions should public companies be striving to make
they should make decision that maximize shareholder value
what’s the goal of capital allocation
to invest cash available in the best projects to maximize return
what are the types of investing decision
- R&D
- Expanding capacity
- Replacing an asset
what’s the importance of investing decisions
important for the long-term success of a company
company that make investing decision which maximize their future return and are on strategy are likely to gain a competitive advantage
what’s considered in a qualitative analysis
pros + cons of an investment
important to understand a company’s strategy, goals, and objectives and assessing whether the investment is consistent with this strategy
define net present value (NPV)
the difference between the present value of cash inflows and the present value of cash outflows over a period of time
why is NPV important in investing decisions?
use NPV of an investment to analyze whether the investment will provide a future return for the company
define time value of money
receiving a dollar today is worth more than receiving a dollar a year from now
are projects that deliver returns earlier in time more preferable to those that have the majority of returns later in time
yes
define a weight-average cost of capital
company’s cost of obtaining cash from lenders + shareholders expressed as a percentage
usually used as the discount rate to obtain the present value fo future cash flows
what’s the formula to present value?
cashflows/(1+discount rate)^number of periods
are investing decision those that involve spending cash today to generate future cash flows?
yes
how to calculate future net cash flows
cash inflows - cash outflows
define an up-front investment - initial cash flow
initial cash required today to purchase equipment or assets that will generate future cash flows
one-time upfront cash flows
what’s included in an up-front cash investment
all cash flows to deliver + install the equipment or asset
when we make investing decision do we consider cash flows and net income?
no only consider cash flows not net income
only incremental cash inflows and outflows that result from purchasing equipment or assets are considered to make an investing decision
what do we with depreciation in terms of cash flows
depreciation = non cash expense that’s included in the calculation of net income
depreciation = cost of an asset amortized over its useful life
what are the steps to calculate NPV
- identify all relevant cash flows + categorize them as up-front cash flows
- separate relevant cash flows into cash inflows and cash outflows - inflows are positive number, outflows are negative numbers
3.identify the timing of cash inflows + outflows (which year will they occur? are they recurring or one-time?) - discount the net cash flows using the present value formula
- sum all discounted net cash flows to obtain the net present values
what’s an assumption in NPV
NPV analysis assumes that all cash flows other than the initial investment and additional working capital occur at the end of the periods
what’s the results of an NPV analysis
if NPV > 0, means project will deliver a return greater than the WACC - proceed from a quantitative perspective
if NPV < 0, means project will deliver a return less than WACC, no do not proceed from a quantitative perspective
