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Corporate Issuers > LM 5: Capital Investments & Capital Allocation > Flashcards

LM 5: Capital Investments & Capital Allocation Flashcards

1
Q

What are capital investments/projects?

A

investments that last longer than one year, and make up long term asset portion of a company’s balance sheet

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2
Q

What are 2 primary purposes of capital investments?

A
  1. business maintenance
  2. business growth
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3
Q

What are the 2 types of capital projects under business maintenance?

A
  1. going concern
  2. regulatory/compliance
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4
Q

What are the 2 types of capital projects under business growth?

A
  1. expansion
  2. new lines of business/ other
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5
Q

What are stranded assets?

A

assets that have been abandoned or stranded

assets that have suffered from unanticipated or premature write-downs, devaluations or conversion to liabilities

Stranded assets are assets that are at risk of losing their economic value due to potential regulatory changes.

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6
Q

What is going concern projects?

A

projects undertaken to continue operating at current scale.

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7
Q

What are expansion projects?

A

Expansion projects increase the size of a company’s operations, but they are riskier than replacement projects.

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8
Q

What is capital allocation?

A

distributing & investing a companys resources

process that a company’s managers follow when making decisions about which capital projects should be undertaken

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9
Q

What are the 4 steps in the capital allocation process? IICM

A
  1. Idea Generation (idea originate inside or outside of company)
  2. Investment Analysis (Collect information to forecast investment’s expected cash flows & profitability)
  3. Capital Allocation Planning (Select/prioritize profitable investment opportunities that best fit the company’s strategy)
  4. Monitoring and Post-Audit (compared actual results to forecasted)
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10
Q

What are the 3 basic principles of capital allocation? DCT

A
  1. decisions based on cash flows
  2. cash flows based on opportunity cost
  3. timing of cash flows is crucial
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10
Q

What is the required rate of return?

A

discount rate that investors should require given the riskiness of the project

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11
Q

What is sunk cost?

A

cost that has already been incurred

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12
Q

What is opportunity cost?

A

resources worth and its next best use aka required rate of return

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13
Q

What is incremental cash flow?

A

cash flow that a company acquires when it takes on a new project

reflect the cash flows realized from a particular decision net of what they would have been without that decision.

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14
Q

What is externalities?

A

a negative or positive outcome that affects a third party.

a side effect or consequence of an industrial or commercial activity that affects other parties without this being reflected in the cost of the goods or services involved

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15
Q

What is the difference between conventional cash flows and non-conventional cash flows?

A

conventional cash flows have one outflow then consistent inflow

non-conventional cash flows has outflow, inflow, then outflow, then inflow, then outflow, then inflow throughout project

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16
Q

What is the difference between independent projects and mutually exclusive cash flow projects?

A

Independent projects have cash flows that are independent of each other

mutually exclusive projects have cash flows that compete directly with each other.

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17
Q

What is project sequencing?

A

when value of certain projects depends on the successful completion of earlier projects.

18
Q

What is NPV formula with a unconventional cash flow structure?

A

NPV = (CF t / (1 + r)^t)

CF t = after tax cash flow at time t
r= required rate of return for investment/ opportunity cost
Outlay = investment cash flow at time 0

19
Q

What is NPV and the formula with a conventional cash flow structure?

A

value is the discounted present value of its expected future cash flows

NPV = (CF t / (1 + r)^t) - outlay

CF t = after tax cash flow at time t
r= required rate of return for investment/ opportunity cost
Outlay = investment cash flow at time 0

20
Q

When should you invest in a project given NPV?

A

Invest if NPV>0

Do not invest if NPV<0

21
Q

What is IRR and formula?

A

IRR is the discount rate that makes a project’s NPV equal to zero

NPV = (CF t / (1 + IRR)^t) - outlay = 0

22
Q

When should you invest in a project given IRR?

A

Invest if IRR>R

Do not invest if IRR<R

23
Q

If IRR and NPV given different investment results since they are mutually exclusive which investment should you choose?

A

Choose the project with higher NPV

24
Q

What are 6 common capital allocation pitfalls? ISFPBI

A
  1. Inertia
  2. Source of capital bias
  3. Failing to consider alternatives
  4. Pet projects
  5. Basing decisions on earnings metrics
  6. Internal forecasting errors
25
Q

Describe intertia and source of capital bias in capital allocation pitfalls.

A
  1. Inertia: Allocating capital based on how it was allocated previously.
  2. Source of capital bias: Treating internally generated funds as often treated as “free” capital with a 0% required return, while seeing debt and equity as more expensive rather than thinking in terms of WACC.
26
Q

Describe failing to consider alternatives and pet projects in capital allocation pitfalls.

A
  1. Failing to consider alternatives: Getting fixated on specific projects, even when funds may be better allocated elsewhere.
  2. Pet projects: Approving projects, often outside the capital allocation process or based on overly-optimistic assumptions, because they are championed by influential managers.
27
Q

Describe basing decisions on earnings metrics and internal forecasting errors in capital allocation pitfalls.

A
  1. Basing decisions on earnings metrics: This pitfall is more likely to be observed in companies where executive compensation is based on accounting metrics, such as earnings per share, net income, or ROE.
  2. Internal forecasting errors: Committing methodological errors (e.g., including sunk costs, using an inappropriate discount rate).
28
Q

What does return on invested capital (ROIC) measure?

A

measure return as percentage of capital invested by equity holders & debt holders.

how well company converts capital into profits

29
Q

What is ROIC formula?

A

ROIC=After-Tax Net Profit / Average Book Value of Invested Capital

30
Q

What does a greater ROIC than COC mean, and what does a less ROIC than COC mean?

A

ROIC > COC = company is increasing firm value for shareholders

ROIC < COC = company is decreasing firm value for shareholders

31
Q

What 2 components make up the value of a company?

A

value of company = value of the company’s existing investments + NPV of all future investments

32
Q

What is nominal return vs real return?

A

nominal return includes the effect of inflation, real doesnt

33
Q

What are real options in capital investment?

A

Real options are options that allow firms to make decisions in the future

that change the value of capital investment decisions made today.

34
Q

What are 4 types of real options? TSFF

A
  1. Timing options
  2. Sizing options
  3. Flexibility options
  4. Fundamental options
35
Q

What is timing options?

A

allow the company to delay investments until hopefully more information is available.

36
Q

What is sizing options and the 2 types of sizing options, describe them?

A

Sizing options allow the company to walk away from a project if the financial results are poor (abandonment option) or make additional investments if the results are positive (growth option).

37
Q

What are flexibility options?

A

Flexibility options grant the ability to adjust a project’s operations.

38
Q

What are the 2 types of flexibility options, describe them.

A

Price-setting options allow the company to change prices.

Production-flexibility options allow for changes in output levels.

39
Q

What is fundamental options?

A

Fundamental options treat the entire investment as an option.

40
Q

What are real options contingent on?

A

future events

41
Q

What is the formula for project NPV with options?

A

Project NPV =
NPV without real options
- cost of options
+ value of options

42
Q

How is shareholder wealth maximized?

A

maximized by focusing on NPV rather than EPS or ROE.

Corporate Issuers (6 decks)

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