CHAPTER 5: CAPITAL INVESTMENTS & CAPITAL ALLOCATION Flashcards
Capital Investments
Investments with a life of one year or more.
Purpose: Generate value for shareholders.
Capital Allocation
Process of making capital investment decisions.
Importance: Impacts a company’s future
Accounting for Capital Investments
Balance Sheet: Shown as long-term assets.
Income Statement: Cost recorded as non-cash depreciation/amortization over the asset’s life.
Net Value: Initial cost minus accumulated depreciation; declines to zero or salvage value at end of life.
Types of Capital Projects
Reasons for Investment:
- Maintain Business: Keep current operations running smoothly.
- Grow Business: Expand the company’s size and capabilities.
Projects to Maintain Business
- Going Concern Projects:
Purpose: Continue current operations, improve efficiency.
Example: Machine replacement, infrastructure improvement.
- Regulatory/Compliance Projects:
Purpose: Meet safety and compliance standards required by third parties.
Example: Factory pollution control, performance bond posting.
Going Concern Projects
Purpose: Continue current operations, maintain business size, improve efficiencies.
- Common Projects: Replacing assets at end of useful life, maintaining IT hardware/software.
- Revenue Impact: Typically do not increase revenues but can save costs.
- Evaluation: Easier to evaluate compared to other projects.
- Funding: Match financing with asset lifespan (e.g., 20-year bond for a 20-year asset).
- Long-term assets with short-term financing: Rollover risk (short-term costs may rise). AGGRESSIVE.
- Short-term assets with long- term financing: Risk of overpaying in financing costs. CONSERVATIVE.
- Capital Spending Estimate: Look at depreciation and amortization expense on the income statement.
Projects to Expand Business
- Expansion Projects:
Purpose: Increase business size, involve higher risk.
Example: New product development, mergers, acquisitions.
- Other Projects:
Purpose: High-risk investments outside conventional business lines.
Example: Exploration of new innovations, business models, or ideas.
Regulatory Compliance Projects
Purpose: Meet safety and compliance standards required by third parties (e.g., government).
- Revenue Impact: Unlikely to increase revenue; may increase compliance costs.
- Industry Protection: Can act as barriers to entry, protecting profitability.
- Evaluation: Determine if business remains profitable after compliance costs.
- Cost Management: Often passed to customers; high costs might lead to ceasing operations or shutting down affected parts.
Expansion of Existing Business
Purpose: Expand business size, higher risk and uncertainty than going concern projects.
- High-Spending Industries: Pharmaceuticals, oil, and gas (over 10% of revenues).
- Acquisitions: Pursued if internal expansion opportunities are limited.
- Risks: Overpaying and integration difficulties.
Steps in Capital Allocation Process
- Idea Generation
Importance: Most crucial step.
Sources: Can come from within the organization or external sources (customers, vendors).
Goal: Identify projects that add long-term value.
- Investment Analysis
Purpose: Gather information to forecast cash flows and compute project profitability.
Output: List of profitable projects.
- Planning and Prioritization
Fit with Strategy: Ensure profitable projects align with the company’s long-term strategy.
Timing: Consider appropriateness of project timing.
Scheduling/Prioritizing: Important for project success.
New Lines of Business and Other Projects
Purpose: High-risk investments, new growth initiatives outside conventional business lines.
- Common in: Privately held companies or public companies under founding owner/significant shareholder control.
- Venture Capital Element: Potential for complete investment loss; high profitability if successful.
Capital Allocation
Process used by management to make capital investment decisions.
Net Present Value (NPV)
Definition: Present value of future after-tax cash flows minus the investment outlay.
NPV= -inv + CF1/(1+r)^1 + CF2/(1+r)^2 + CF3/(1+r)^3
r: Discount rate
Decision Rule:
- Independent Projects:
If NPV > 0: Accept
If NPV < 0: Reject
- Mutually Exclusive Projects:
Accept the project with the higher and positive NPV
Fivestar Industries is one of the largest food companies in Pakistan, manufacturing a wide range of confectionery, biscuits, snacks and packaging films. Its products are exported to more than 30 countries around the globe. Which of the following capital investment projects being considered by the company will be most likely classified as an “other” project?
A Investment to develop customized confectionery products for new customers in Africa.
B Funding of an extensive research on edible food packaging. Similar efforts by several other companies have been not been successful to date.
C Investment to modify production process to comply with recently issued regulatory guidelines regarding emissions reduction.
MAINTAIN OR GROW
A= MAINTAIN
C= GROW
THUS, B.
B is correct. The funding of an extensive study on edible food packaging appears to be a project that is likely to be classified as an “other” project. Other Projects include high-risk investments and new growth initiatives, that are outside the company’s conventional business lines. These projects tend to have a venture capital element to them. There will probably be a complete loss of investment, but if successful the project could be highly profitable.
A is not correct. Investment to develop new customized confectionery products for new customers in Africa would be classified an expansion project. These are projects that increase business size, usually by investing in the development of new products or services and/or by the acquisition of other companies.
C is not correct. Investment to modify production process to comply with recently issued regulatory guidelines regarding emissions reduction would be classified as regulatory/compliance project. These are projects typically required by a third party, such as the government regulatory body, to meet specified safety and compliance standards.
Which of the following statements is least accurate about capital investments?
A These are investments with a life of one year or more.
B Companies make capital investments to generate value for their shareholders.
C Working capital and capital structure describe a company’s prospects better than its capital investments.
C is correct.
Capital investments describe a company’s future prospects better than its working capital or capital structure, which are often similar for companies.
They provide insight into the quality of management’s decisions and how the company is creating value for stakeholders.
Which of the following will most likely be classified as an ‘expansion project’?
A Investment by a cement manufacturer to replace aging factory machinery with similar but more efficient equipment.
B Investment by an oil and gas company to discover energy reserves.
C Investment to modify production process to comply with recently issued regulatory guidelines regarding emissions reduction.
MAINTAIN OR GROW.
A= MAINTAIN
C= MAINTAIN
THUS, B= GROW. CORRECT.
B is correct. Investment by an oil and gas company to discover energy reserves is an example of an expansion project. These are projects that expand business size and typically involve greater degrees of risk and uncertainty than going concern projects.
A is an example of a going concern project which are necessary to continue current operations and maintain existing size of the business or to improve business efficiencies.
C is an example of a regulatory/compliance project.
Compute the NPV for Projects A and B given the following data:
Cost of capital = 10%
Expected Net after Tax cash flows:
Project A: Initial investment = $-1,000
Year 1 = $500,
Year 2 = $400,
Year 3 = $300,
Year 4 = $100
Project B: Initial investment = $-1,000,
Year 1 = $100,
Year 2 = $300,
Year 3 = $400,
Year 4 = $600
NPV (A)= -1000 + 500/1.1 + 400/1.1^2 + 300/1.1^3 + 100/1.1^4= 78.82
NPV (B)= -1000 + 100/1.1 + 300/1.1^2 + 400/1.1^3 + 600/1.1^4= 49.18
A IS BETTER.
Net Present Value (NPV
Excel Functions:
NPV: =NPV(rate, values)
XNPV: =XNPV(rate, values, dates)
Parameters:
rate: Discount rate
values: Cash flows
dates: Dates of each cash flow (for XNPV)
Internal Rate of Return (IRR)
Discount rate that makes the present value of future cash flows equal to the investment outlay.
Discount rate which makes NPV equal to 0.
0 = CF1/(1+R)^1 + CF2/(1+R)^2
IF R>r= accept; else, reject
- ASSUMES REINVESTMENT OF CFs
- Not Useful for projects with Unconventional CFs (1st CF is not negative)= in this case, there are more than 1 discount rates that will produce NPV= 0
- NPV is also a DIRECT measure of expected increase in firm value
Decision Rule for IRR
A. Independent Projects:
- Accept: If IRR > required rate of return (cost of capital adjusted for project riskiness)
- Reject: If IRR < required rate of return
Required Rate of Return: Also called ‘hurdle rate’
B. Mutually Exclusive Projects:
Accept: Project with higher IRR (if IRR > cost of capital)
Compute IRR for projects A and B given the following data:
Cost of Capital: 10%
Expected Net After Tax Cash Flows:
Project A:
Year 0: -1,000
Year 1: 500
Year 2: 400
Year 3: 300
Year 4: 100
Project B:
Year 0: -1,000
Year 1: 100
Year 2: 300
Year 3: 400
Year 4: 600
A= 14.49% (this is >10%) so good
B= 11.79 (this is >10%) so also good
A>B so better.
Done using BA2+
Why do we assume NPV= 0 in IRR
When NPV, is zero it means that the investment earns a rate of return equal to the discount rate.
This makes understanding IRR much easier because an investment that uses a 10% discount rate that returns an NPV of zero indicates the investment would yield a 10% return.
Internal Rate of Return (IRR): Calculation Methods in Excel
IRR or =IRR(values, guess)
XIRR or =XIRR(values, dates, guess)
Ranking Conflicts between NPV and IRR:
- For single projects, no conflict exists between NPV and IRR.
- Mutually exclusive projects can show conflicting results due to cash flow patterns and project scale.
