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AFM 182 > Chapter 11: Investing Decisions > Flashcards

Chapter 11: Investing Decisions Flashcards

1
Q

what is capital allocation (capital budgeting)

A

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

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2
Q

what process is capital allocation done as a part of

A

Capital allocation is done as part of the budgeting process, estimating how much cash is available to spend for the next fiscal year, and make a capital budget to see how they plan to use the cash

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2
Q

what does a company need to know before allocating capital

A
  • Before allocating capital, a company needs to know if they have enough working capital (cash used in their day-to-day business), and make investment for the future and return money to shareholders (ex. dividends)
  • need to understand if the company has enough cash from operating activities
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3
Q

who does capital allocation

A
  • Process is done by both private and public companies
  • Usually more formal and structured in public companies
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4
Q

what can companies do with their extra cash

A

they can reinvest it into the business, repurchase shares, or pay out dividends

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4
Q

what does companies need enough of for their operations

A

need to have enough working capital for their operations

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4
Q

what do companies do if they don’t have enough cash from operating activities

A

they need to find a way to finance (through equity or debt) before proceeding to the capital allocation process

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4
Q

what do public companies need to make decisions based on

A

make decisions that maximize shareholder value

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5
Q

what is the goal of the capital allocation process

A

to invest available cash in projects that will maximize return

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5
Q

how can companies allocate money to maximize shareholder return

A

make an operating decision:
- purchase more inventory

make investing decisions:
- invest in new assets to grow the business
- invest in ESG initiatives to reach net-zero targets
- purchase another company (acquisition)

make a financing decision:
- repurchase shares
- pay dividends

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5
Q

if a business doesn’t have a lot of cash from operating activities, what do they do

A
  • raise capital first (obtain cash)
  • make a financing decision to get cash through debt or equity
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6
Q

if a business has a lot of cash from operating activities, what do they do

A

allocate money to maximize shareholder return

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6
Q

what happens after a company raises capital

A
  • they allocate capital to maximize shareholder return by making an operating, investing, or financing decision
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7
Q

what is an investing decision

A

spending cash today (investing cash today) to produce future multi-year cash flows

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8
Q

what are examples of investing decisions

A
  • Research & Development (R&D); To improve existing products and develop new ones
  • Expanding capacity; To purchase new or expand manufacturing plants as product demand increases
  • Replacing an asset; Replacing assets once their useful life is fulfilled
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9
Q

what are investing decisions important for

A

Investing decisions are important for the long-term success of a company

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10
Q

what is qualitative analysis

A
  • Qualitative analysis considers the pros and cons of the investment
  • Make sure to understand the company’s strategy, goals, and objectives, and see if the investment follows them
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11
Q

what investing decisions will make a company have a competitive advantage

A

Investing decisions companies made to maximize future return and on strategy are likely to gain competitive advantage

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11
Q

what are cons of qualitative analysis

A

If the investment doesn’t meet strategic goals and objectives, they would be cons

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12
Q

what are pros of qualitative analysis

A

If the investment does help meet strategic goals and objectives, they would be pros

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13
Q

what are some other qualitative advantages and disadvantages to be considered

A
  • Customer satisfaction
  • Brand reputation
  • Employee satisfaction
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14
Q

what is net present value (NPV) & what does it help do

A
  • The difference between the present value of cash inflows and the present value of cash outflows over a period of time
  • Helps understand if an investment will which will generate future cash flows should be made today
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15
Q

in terms of time value of money, what does capital budgeting decisions that involve future cash flows need to be done

A

When capital budgeting decisions are made that involve future cash flows, they must be discounted to consider the time value of money

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15
Q

what is time value of money

A

Considers the fact that a dollar today is worth more than a dollar a year from now

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16
Q

in terms of returns, which kind of projects are preferred

A

Projects that give returns earlier in time are preferred compared to those that have majority of returns later in time

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16
Q

what is weighted-average cost of capital

A

The cost of obtaining cash from lenders and shareholders, expressed as a percentage

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16
Q

when do companies actually make a return on their investments

A
  • A company will only make a return if they invest in projects that produce a return that is higher than the cost to obtain cash
  • Ex. if the cost to obtain cash (WACC) is 10%, then a company needs to invest in projects then generate a return > 10% to actually make a return
17
Q

how do you discount capital budgeting decisions that involve future cash flows

A

Done by calculating present value of future cash flows using a discount rate to understand how much future cash flow is worth today

18
Q

what is usually the discount rate used to calculate the present value of future cash flows

A

usually WACC

19
Q

what is the formula for future net cash flows

A

Future net cash flows = cash inflows - cash outflows

20
Q

what is a good way to know if you are dealing with an investing decisions

A

Good way to know if you are dealing with an investing decision is to understand if there is an up-front investment (cash outflow) required

21
Q

when analyzing investing decisions, what do we look at

A

only look at relevant costs and benefits

21
Q

what is an up-front investment

A

Initial cash outflow; initial cash required today to purchase equipment or assets that will generate future cash flows

22
Q

what are future cash flows

A

Recurring or one-time cash inflows and outflows that occur after the investment is made

22
Q

what are the types of recurring inflows and outflows

A
  • relevant revenues
  • relevant cost of sales
  • relevant operating cash flows
23
Q

what are relevant revenues

A

Incremental cash inflows from sales revenue produced by the new asset or equipment

23
Q

are relevant revenues an inflow or an outflow

A

Recurring Inflow

23
Q

what is an example of relevant revenues

A

If a manufacturer purchases equipment to develop a new product, incremental cash inflows result from new product sales

24
Q

what are relevant cost of sales

A

Incremental cash outflows to manufacture a product or deliver a service

25
Q

what is an example of relevant cost of sales

A

Additional labour & material result in incremental cash outflows to manufacture the new product

26
Q

are relevant cost of sales an inflow or an outflow

A

Recurring Outflow

27
Q

what are relevant operating cash flows

A

Incremental cash outflows to operate the business

27
Q

what is an example of relevant operating cash flows

A

The manufacturer will require incremental administrative & marketing cash outflows related to operate & advertise the new product

28
Q

what are relevant One-Time Upfront Costs

A

Incremental one-time upfront costs that are incurred along with the initial investment

28
Q

are relevant operating cash flows an inflow or an outflow

A

Recurring Outflow

29
Q

what are the types of one-time inflows and outflows

A
  • Relevant One-Time Upfront Costs
  • Relevant Working Capital
  • Release of Working Capital
  • Relevant Repair & Maintenance
  • Salvage Value
29
Q

what is an example of relevant One-Time Upfront Costs

A

The manufacturer needs to pay for staff & training costs required to operate the new equipment

30
Q

what is relevant Working Capital

A

Incremental working capital or cash tied up to operate a business on a day-to-day basis

30
Q

are relevant One-Time Upfront Costs an inflow or an outflow

A

One-Time Outflow at the Start of Business Operation

30
Q

what is an example of relevant Working Capital

A

The manufacturer keeps a certain level of inventory of the new product on hand; would be incremental working capital related to the new product

31
Q

is relevant Working Capital an inflow or an outflow

A

One-Time Outflow at the Start of Business Operation

32
Q

what is an example of Release of Working Capital

A

Once the asset is fully utilized (ex. Reached the end of its useful life) & the manufacturer no longer produces new product inventory, all incremental working capital would be released

32
Q

what is Release of Working Capital

A

Incremental working capital is released at the end of business operations

33
Q

what is relevant Repair & Maintenance

A

Incremental cash outflows to maintain & repair the equipment or assets purchased

33
Q

is Release of Working Capital an inflow or an outflow

A

One-Time Inflow at the End of Business Operations

34
Q

what is an example of relevant Repair & Maintenance

A

The manufacturer will maintain the equipment purchase every 2 years, resulting in incremental one-time cash outflow every 2 years

34
Q

is relevant Repair & Maintenance an inflow or an outflow

A

One-Time Cash Outflow as Required

34
Q

what is Salvage Value

A

Cash received from the sale of the equipment or asset at the end of its useful life

35
Q

what is an example of Salvage Value

A

The manufacturer plans to sell the equipment at the end of its useful life, resulting in an incremental one-time cash inflow at the end of the asset’s useful life

35
Q

is Salvage Value an inflow or an outflow

A

One-Time Inflow at the End of Asset Useful Life

36
Q

what is an important note about making investing decisions

A
  • When making investing decisions, we only consider cash inflows and NOT net income
  • Only incremental cash inflows and outflows that result from purchasing equipment or assets are considered to make an investing decision
36
Q

what are the steps to calculate the net present value of an investment

A
  1. Identify all relevant cash flows and categorize them as up-front or future cash flows (recurring or one-time)
    - If there is no upfront investment, then its likely you aren’t making an investing decision
  2. Separate relevant cash flows into cash inflows and cash outflows
    - Inflows are expressed as positive numbers
    - Outflows are expressed as negative numbers
  3. Identify the time of the cash inflows and outflows (ex. 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
37
Q

what does net present value analysis assume

A

Net present value analysis assumes that all cash flows other than the initial investment and additional working capital occur at the end of the period

38
Q

what is the npv decision rule for if NPV > $0

A
  • Means the project will deliver a return greater than the WACC
  • Yes, proceed from a quantitative perspective
39
Q

what is the npv decision rule for if NPV < $0

A
  • Means the project will deliver a return less than the WACC
  • No, don’t proceed from a quantitative perspective
40
Q

the greater the NPV…

A

the more attractive the investment

41
Q

what projects do companies choose & what is the outcome

A

Companies that choose projects with high NPV and are aligned with strategy and other qualitative advantages are more likely to achieve a competitive advantage

AFM 182 (11 decks)

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