Chapter 11: Investing Decisions Flashcards
what is capital allocation (capital budgeting)
The process of determining how to use and invest a company’s cash to maximize shareholder value
what process is capital allocation done as a part of
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
what does a company need to know before allocating capital
- 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
who does capital allocation
- Process is done by both private and public companies
- Usually more formal and structured in public companies
what can companies do with their extra cash
they can reinvest it into the business, repurchase shares, or pay out dividends
what does companies need enough of for their operations
need to have enough working capital for their operations
what do companies do if they don’t have enough cash from operating activities
they need to find a way to finance (through equity or debt) before proceeding to the capital allocation process
what do public companies need to make decisions based on
make decisions that maximize shareholder value
what is the goal of the capital allocation process
to invest available cash in projects that will maximize return
how can companies allocate money to maximize shareholder return
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
if a business doesn’t have a lot of cash from operating activities, what do they do
- raise capital first (obtain cash)
- make a financing decision to get cash through debt or equity
if a business has a lot of cash from operating activities, what do they do
allocate money to maximize shareholder return
what happens after a company raises capital
- they allocate capital to maximize shareholder return by making an operating, investing, or financing decision
what is an investing decision
spending cash today (investing cash today) to produce future multi-year cash flows
what are examples of investing decisions
- 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
what are investing decisions important for
Investing decisions are important for the long-term success of a company
what is qualitative analysis
- 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
what investing decisions will make a company have a competitive advantage
Investing decisions companies made to maximize future return and on strategy are likely to gain competitive advantage
what are cons of qualitative analysis
If the investment doesn’t meet strategic goals and objectives, they would be cons
what are pros of qualitative analysis
If the investment does help meet strategic goals and objectives, they would be pros
what are some other qualitative advantages and disadvantages to be considered
- Customer satisfaction
- Brand reputation
- Employee satisfaction
what is net present value (NPV) & what does it help do
- 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
in terms of time value of money, what does capital budgeting decisions that involve future cash flows need to be done
When capital budgeting decisions are made that involve future cash flows, they must be discounted to consider the time value of money
what is time value of money
Considers the fact that a dollar today is worth more than a dollar a year from now
in terms of returns, which kind of projects are preferred
Projects that give returns earlier in time are preferred compared to those that have majority of returns later in time
what is weighted-average cost of capital
The cost of obtaining cash from lenders and shareholders, expressed as a percentage
when do companies actually make a return on their investments
- 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
how do you discount capital budgeting decisions that involve future cash flows
Done by calculating present value of future cash flows using a discount rate to understand how much future cash flow is worth today
what is usually the discount rate used to calculate the present value of future cash flows
usually WACC
what is the formula for future net cash flows
Future net cash flows = cash inflows - cash outflows
what is a good way to know if you are dealing with an investing decisions
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
when analyzing investing decisions, what do we look at
only look at relevant costs and benefits
what is an up-front investment
Initial cash outflow; initial cash required today to purchase equipment or assets that will generate future cash flows
what are future cash flows
Recurring or one-time cash inflows and outflows that occur after the investment is made
what are the types of recurring inflows and outflows
- relevant revenues
- relevant cost of sales
- relevant operating cash flows
what are relevant revenues
Incremental cash inflows from sales revenue produced by the new asset or equipment
are relevant revenues an inflow or an outflow
Recurring Inflow
what is an example of relevant revenues
If a manufacturer purchases equipment to develop a new product, incremental cash inflows result from new product sales
what are relevant cost of sales
Incremental cash outflows to manufacture a product or deliver a service
what is an example of relevant cost of sales
Additional labour & material result in incremental cash outflows to manufacture the new product
are relevant cost of sales an inflow or an outflow
Recurring Outflow
what are relevant operating cash flows
Incremental cash outflows to operate the business
what is an example of relevant operating cash flows
The manufacturer will require incremental administrative & marketing cash outflows related to operate & advertise the new product
what are relevant One-Time Upfront Costs
Incremental one-time upfront costs that are incurred along with the initial investment
are relevant operating cash flows an inflow or an outflow
Recurring Outflow
what are the types of one-time inflows and outflows
- Relevant One-Time Upfront Costs
- Relevant Working Capital
- Release of Working Capital
- Relevant Repair & Maintenance
- Salvage Value
what is an example of relevant One-Time Upfront Costs
The manufacturer needs to pay for staff & training costs required to operate the new equipment
what is relevant Working Capital
Incremental working capital or cash tied up to operate a business on a day-to-day basis
are relevant One-Time Upfront Costs an inflow or an outflow
One-Time Outflow at the Start of Business Operation
what is an example of relevant Working Capital
The manufacturer keeps a certain level of inventory of the new product on hand; would be incremental working capital related to the new product
is relevant Working Capital an inflow or an outflow
One-Time Outflow at the Start of Business Operation
what is an example of Release of Working Capital
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
what is Release of Working Capital
Incremental working capital is released at the end of business operations
what is relevant Repair & Maintenance
Incremental cash outflows to maintain & repair the equipment or assets purchased
is Release of Working Capital an inflow or an outflow
One-Time Inflow at the End of Business Operations
what is an example of relevant Repair & Maintenance
The manufacturer will maintain the equipment purchase every 2 years, resulting in incremental one-time cash outflow every 2 years
is relevant Repair & Maintenance an inflow or an outflow
One-Time Cash Outflow as Required
what is Salvage Value
Cash received from the sale of the equipment or asset at the end of its useful life
what is an example of Salvage Value
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
is Salvage Value an inflow or an outflow
One-Time Inflow at the End of Asset Useful Life
what is an important note about making investing decisions
- 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
what are the steps to calculate the net present value of an investment
- 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 - Separate relevant cash flows into cash inflows and cash outflows
- Inflows are expressed as positive numbers
- Outflows are expressed as negative numbers - Identify the time of the cash inflows and outflows (ex. Which year will they occur? Are they one-time or recurring every year?)
- Discount the net cash flows using the present value formula
- Sum all discounted net cash flows to obtain the net present value
what does net present value analysis assume
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
what is the npv decision rule for if NPV > $0
- Means the project will deliver a return greater than the WACC
- Yes, proceed from a quantitative perspective
what is the npv decision rule for if NPV < $0
- Means the project will deliver a return less than the WACC
- No, don’t proceed from a quantitative perspective
the greater the NPV…
the more attractive the investment
what projects do companies choose & what is the outcome
Companies that choose projects with high NPV and are aligned with strategy and other qualitative advantages are more likely to achieve a competitive advantage
