unit 11 | investing decisions

Question 1

Capital Allocation (capital budgeting)

Answer 1

The process of determining how to use & invest a company’s cash to maximize shareholder value
- Part of budgeting process
- Company estimates how much cash to spend before fiscal year starts & comes up with a capital budget which outlines how they plan to use the cash in the upcoming fiscal year

Question 2

(capital allocation) Company needs to understand if:

Answer 2

1. They have sufficient cash to manage day-to-day business (working capital)/from operating activities → make financing decision if not
2. Make investments for the future & return money to shareholders (dividends)

Question 3

3 Examples of Investing Decisions

Answer 3

1. Invest in new assets to continue to grow business profitably
2. Invest in R&D to grow business
3. Purchase another company (acquisition)

Question 4

Important of Investing decisions

Answer 4

Important for long-term success → maximize future returns & competitive advantage

Question 5

Qualitative Analysis of Investing Decision

Answer 5

• Pros & Cons of investment
• Important to understand a company’s strategy, goals, & objectives
  
  • Assess whether the investment is consistent with strategy
  • Examples:
    
    • Customer satisfaction
    • Brand reputation
    • Employee satisfaction

Question 6

Net Present Value (NPV)

Answer 6

Difference between the present value of cash inflows & outflows over a period of time

Question 7

Calculating the NPV of an Investment

Answer 7

1. Identify all relevant cash flows & categorize as up-front or future cash flows
2. Separate relevant cash flows into cash inflows & outflows
   a) Inflows are expressed as positive numbers
   b) Outflows are expressed as negative numbers
3. Identify the timing of the cash inflows & outflows (i.e., 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

Question 8

NPV Decision Rule

Answer 8

The greater the NPV, the more attractive the investment

Question 9

NPV > $0…

Answer 9

The project will deliver a return greater than the WACC

Yes → proceed from a quantitative perspective

Question 10

NPV < $0…

Answer 10

The project will deliver a return less than the WACC

No → do not proceed from a quantitative perspective

Question 11

Time Value of Money

Answer 11

Considers the fact that receiving a dollar today is worth more than receiving a dollar a year from now
- Discount future cash flows

Question 12

Weighted-average cost of capital (WACC)

Answer 12

A company’s cost of obtaining cash from lenders & shareholders, expressed as a percentage
- A company will only make a return if it invests in projects that product a return higher than the company’s cost to obtain cash
- If not → not meeting expectations of shareholders & external stakeholders
- Usually used as the discount rate to obtain the present value of future cash flows

Question 13

Calculating PV of Future Cash Flows

Answer 13

PV of future cash flow = amt of cash flow / (1+r)^n
r = discount rate (WACC)
n = # of periods (ie. years) from today

Question 14

Up-Front Investment (initial cash outflow)

Answer 14

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

Question 15

Future Cash Flows

Answer 15

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