Part 2. Uses of Capital

Question 1

Capital investments

Answer 1

These are investments with a life of 1 year or longer, and make up the long-term asset portion of the balance sheet.

They also describe a company’s future prospects better than its working capital or capital structure, which are intangible and often similar for companies.

Question 2

Capital allocation process

Answer 2

A company to make capital investment decisions depends on factors specific to the company, such as management tenure and experience, the size and complexity of capital investment being evaluated, and size of the organisation.

Question 3

Importance of monitoring and post-audit:

Answer 3

1. Help monitor the forecasts and analysis that underlie the capital allocation process - systematic error become apparent.
2. Help improve business operations, if sales/costs out of line, the process will focus attention on bringing performance closer to expectations if at all possible.
3. This will produce concrete ideas for future investments - with managers deciding to invest more heavily in profitable areas, and scale down or cancel investments in disappointing areas.

Question 4

Sunk cost

Answer 4

A cost that has already been incurred, and cannot be changed.

Decision is made today, but should be based on current and future cash flows, not affected by prior or sunk costs.

Question 5

Opportunity cost

Answer 5

This is what a resources is worth in the next best use.

Question 6

Incremental cash flow

Answer 6

The cash flow that is realised because of an investment decision; the cash flow with a decision minus the cash flow without that decision.

Question 7

Externality

Answer 7

The effect of an investment on things other than the investment itself.

positive - expected synergies with existing projects or business activities result from making the investment.

cannibalisation - a negative externality occurring within a company.

• when an investment takes customers and sales away from another part of the company.
• overall, an investment may benefit (or harm) other companies or society at large, and yet the company is not compensated for these benefits (or charged for the costs).

Question 8

Conventional cash flow

Answer 8

One with an initial outflow followed by a series of inflows.

If cash flows changes signs once.

Question 9

Unconventional cash flow

Answer 9

The initial outflow is not followed by inflows only, but the cash flows can flip from being positive (inflows) to negative (outflows) again, or possibly change sign several times.

If cashflow change signs two or more times.

Question 10

Challenges to incremental cash flow analysis:

Answer 10

1. Independent projects vs mutually exclusive projects
   - I are capital investments whose cash flows are independent of each other, whereas ME compete directly with each other.
2. Project sequencing - capital projects sequenced over time, so investing in projects creates option to invest in future projects.
3. Unlimited funds vs capital rationing - assumes company can raise funds it wants for all profitable projects by simply paying required rate of return.
   - CR exists when company has fixed amount of funds to invest.
   - if there is more profitable projects than it has funds for, it must allocate funds to achieve max. shareholder value subject to funding constraints.

Question 11

The 2 comprehensive measures to assess profitability in investment:

Answer 11

1. Net present value - the PV of future after-tax cash flows minus the investment outlay.
2. Internal rate of return - the discount rate that makes PV of future after-tax cash flows equal that investment outlay.

Question 12

Return on invested capital (ROIC)

Answer 12

The measure of the profitability of a company relative to the amount of capital invested by the equity and debtholders.

Reflects how effectively a company’s management is able to convert capital into profits.

Ratio is calculated by dividing after-tax net profit by average book value of invested capital.

Question 13

ROIC vs cost of capital (COC):

Answer 13

ROIC > COC - company is generating a higher return for investors compared with required return, increasing firms value for shareholders.

Question 14

Effect of inflation on cashflows:

Answer 14

• Nominal cash flows are discounted at nominal rate, and real cashflows discounted at real rate.
• Reduces value of depreciation tax savings to company, effectively increasing its real taxes.
• Inflation shifts wealth from taxpayer to government.
• Lower than expected inflation reduces real taxes for company; resulting in higher than expected profitability for investment, and corresponding wealth increase for company.
• Complicates capital allocation process as after tax cashflows can be better or worse depending on sales of outputs or cost of inputs affected.

Question 15

Real options

Answer 15

Options that allow companies to make decisions in the future that alter value of capital investment decisions made today.

Instead of making all decisions now at t=0, a company can wait and make add. decisions at future dates, contingent on future economic events or information.

Max company value = combo of optimal current and future decisions.

Question 16

4 types of real options:

Answer 16

1. Timing options

• The company can delay investing, basing decision on improved info you may have in the future.
• This may improve NPV of projects selected.

2. Sizing options

• Abandonment option - if results are disappointing; abandon > PV of cash flow to continue investment.
• Opposite is a growth option.

3. Flexibility options

• price setting option - increasing price company can benefit from excess demand.
• production flexibility options - offer operational flexibility to alter production when demand varies from what is forecast; profit from overtime or adding shifts.

4. Fundamental options - the payoffs from investment are contingent on an underlying asset.

Question 17

Common sense options by management to real option analysis:

Answer 17

1. Use DCF without considering options - NPV positive without considering real option will add more value.
2. NPV = NPV (based on DCF alone) - cost of option + value of options; then add value associated with real options less their incremental cost.
3. Use decision trees; capturing the essence of many sequential decision making problems.
4. Use option pricing models.

Question 18

Common capital allocation mistakes:

Answer 18

• Not incorporating economic responses to investment analysis.
• Misusing capital allocation templates.
• Pushing pet projects - selected at co. without undergoing normal CA analysis; or over optimistic projections inflate profitability.
• Basing investment decisions on EPS, net income or ROE - allowing co. to choose investments not in LR economic interests of shareholders.
• Using IRR to make investment decisions - for mutually exclusive investment opportunities can result in suboptimal investment decisions.
• Incorrectly accounting for cash flows - omit relevant cash flows, double count cash flows and mishandle taxes.
• Over or underestimating overhead costs
• Not using the appropriate risk-adjusted discount rate.
• Overspending and underspending the capital allocation.
• Failing to consider investment alternatives or alternative states.
• Incorrectly handling sunk costs and opportunity costs.