M5: Capital Investments and Capital Allocation

What are the four broad types of capital investments?

Going concern (maintenance) projects; regulatory and compliance projects; expansion of existing business; new lines of business and other projects.

How do the four capital investment categories generally rank from lowest to highest risk?

Going concern → Regulatory/compliance → Expansion of existing business → New lines of business.

What is a going concern (maintenance) project?

An investment required to maintain existing operations at their current scale.

What is the typical risk level of a going concern project?

Low risk because it generally replicates or maintains operations the company already understands.

How are going concern projects often financed?

Using match funding, where debt maturity is matched to the useful life of the asset.

★ EXAM: What can analysts use as a proxy for maintenance capex when it is not separately disclosed?

Annual depreciation and amortisation (D&A) expense.

★ EXAM: Is D&A exactly equal to maintenance capex?

No. D&A is often used as a proxy because maintenance capex is rarely separately disclosed.

What is match funding?

Matching the maturity of financing to the life or duration of the assets being financed.

★ EXAM: How does match funding relate to working capital management?

Under the moderate/matched approach, permanent assets are funded long-term and variable current assets are funded short-term.

What is a regulatory and compliance project?

An investment required by laws, regulators, or industry standards to continue operating or avoid penalties.

Why can regulatory/compliance projects reduce profitability?

They often increase costs without directly generating additional revenue.

How can firms reduce the economic impact of compliance investments?

If they have sufficient pricing power, they may pass some or all of the additional costs to customers.

How can regulatory requirements benefit established industry incumbents?

High compliance costs can create barriers to entry for potential competitors.

★ EXAM: Which capital investment category may be undertaken even if its NPV is negative?

Regulatory and compliance projects because they may be necessary to continue operating or avoid penalties.

★ EXAM: What is the key NPV exception for compliance projects?

A compliance project may have negative NPV and still be undertaken because the alternative may be inability to continue operating or regulatory penalties.

What is an expansion project?

An investment that increases the scale of existing operations or extends existing products/services into adjacent markets or regions.

What are important risks of expansion projects?

Input sourcing problems, distribution bottlenecks, higher-than-expected customer acquisition costs, execution risk, and larger capital commitments.

How may a successful expansion track record affect financing?

Established firms with successful expansion records can generally use more debt financing; firms without such a record may rely more on equity.

What is a new-line-of-business project?

An investment in a business or activity substantially different from the firm's existing operations.

Which capital investment category generally has the highest risk?

New lines of business and other substantially unfamiliar projects.

★ EXAM: What are the two principal risks of entering a new line of business?

Unfamiliar business dynamics and overpaying for an acquired business.

Why are new-line-of-business projects particularly risky?

The firm has less experience with the market and operations, and management may underestimate execution difficulty or overpay for acquisitions.

★ EXAM: How should the analytical hurdle generally change as project risk increases?

Higher-risk projects should face a higher required return/hurdle rate.

★ EXAM: How does the analytical bar differ across project categories?

Going-concern projects mainly sustain existing cash flows; compliance projects may be mandatory despite negative NPV; expansion and new-business projects should clear higher return hurdles because of greater risk.

What is capital allocation?

The process through which management and the board decide which investment projects to pursue and how much capital to return to shareholders.

What are the four steps of the capital allocation process?

1. Idea generation; 2. Investment analysis; 3. Planning and prioritisation; 4. Monitoring and post-investment review.

★ EXAM: What is the memory sequence for the capital allocation process?

Idea → Analyse → Prioritise → Monitor.

What occurs during idea generation?

Potential investment opportunities are identified from sources such as operating managers, R&D, market analysis, and external consultants.

What occurs during investment analysis?

The timing, amount, duration, and volatility of expected project cash flows are forecast and evaluated, principally using NPV and IRR.

What occurs during planning and prioritisation?

Management selects the combination of projects expected to maximise risk-adjusted value subject to capital and operational constraints.

Why can planning and prioritisation differ from simply accepting every individually attractive project?

Capital and operational constraints may prevent undertaking every project, and interactions between projects may change their attractiveness.

What occurs during monitoring and post-investment review?

Actual performance is compared with forecasts, forecasting biases are identified, and management may modify investment levels as new information arrives.

What common forecasting bias can post-investment reviews identify?

Optimism bias, where projected cash flows systematically exceed realised cash flows.

What should a firm generally do when all value-creating investment opportunities have been exhausted?

Return remaining capital to shareholders so they can redeploy it.

What is net present value (NPV)?

The present value of all expected future after-tax project cash flows minus the initial investment.

What is the NPV formula?

NPV = Σ[CFt ÷ (1 + r)^t], from t = 0 to T.

What does CFt represent in the NPV formula?

The project's after-tax cash flow at time t; CF0 is typically the negative initial investment.

What does r represent in the NPV formula?

The required rate of return or opportunity cost of capital for an investment with similar risk.

What is the NPV decision rule?

Accept if NPV ≥ 0; reject if NPV < 0.

What does a positive NPV mean economically?

The project is expected to increase shareholder wealth by the amount of its NPV.

What does NPV = 0 mean?

The project is expected to earn exactly its required rate of return, creating no additional value above that required return.

★ EXAM: Should the hurdle rate automatically equal the firm's WACC?

No. The hurdle rate should reflect the risk of the PROJECT'S cash flows, which may differ from the firm's overall risk.

★ EXAM: What happens to the appropriate hurdle rate as project risk increases?

Higher project risk → Higher required return/hurdle rate.

When is the firm's WACC potentially appropriate as a project discount rate?

When the project's risk is similar to the risk of the firm's existing operations.

★ EXAM: Does NPV remain valid with unconventional cash flows?

Yes. NPV remains valid even when cash flows change signs multiple times.

What is IRR?

The discount rate that sets a project's NPV equal to zero.

What equation defines IRR?

0 = Σ[CFt ÷ (1 + IRR)^t], from t = 0 to T.

What is the IRR decision rule?

Accept if IRR ≥ required return; reject if IRR < required return.

What is another name for the required return used in capital allocation?

Hurdle rate.

For a conventional independent project, how do NPV and IRR decisions generally relate?

They generally produce the same accept/reject decision.

What reinvestment assumption is associated with IRR?

For IRR to equal the realised project return, interim cash flows must be reinvested at the IRR.

What reinvestment assumption is associated with NPV?

Interim cash flows are effectively assumed to be reinvested at the required rate of return.

Why is the NPV reinvestment assumption generally more realistic than the IRR assumption?

The firm's opportunity cost of capital is generally a more realistic reinvestment rate than a project's potentially very high IRR.

What causes the multiple-IRR problem?

Unconventional cash flows with more than one change in cash-flow sign can produce multiple discount rates that set NPV equal to zero.

★ EXAM: What should you suspect if cash flows change signs more than once?

Multiple IRRs may exist, making IRR unreliable; use NPV at the appropriate required return.

★ EXAM: What should be used when IRR produces multiple solutions?

NPV.

What is IRR's scale problem?

IRR measures a percentage return and may rank a smaller high-percentage project above a larger project that creates more absolute shareholder wealth.

What problem can arise when NPV and IRR rank mutually exclusive projects differently?

One project may have the higher IRR while another has the higher NPV.

⚠ WATCH FOR: Two mutually exclusive projects conflict: Project A has higher IRR and Project B has higher NPV. Which should be chosen?

Project B. For mutually exclusive projects, choose the project with the higher NPV.

★ EXAM: Why does NPV take priority over IRR for mutually exclusive projects?

NPV directly measures the amount of shareholder wealth created, whereas IRR can be distorted by project scale and cash-flow timing.

What is ROIC?

Return on invested capital, a company-wide accounting measure of profitability relative to the capital invested in the business.

What is the ROIC formula?

ROIC = After-tax operating profit ÷ Average invested capital.

What is an alternative expression for the ROIC numerator?

After-tax operating profit = (1 − Tax rate) × Operating profit.

What is average invested capital generally based on?

The average capital invested over the period, typically including equity plus long-term debt and potentially other long-term financing items depending on the analyst's definition.

What is the key requirement when choosing a definition of invested capital?

Apply the definition consistently across time and across comparable firms.

What is the key ROIC decision comparison?

Compare ROIC with the firm's cost of capital/WACC.

What does ROIC > WACC indicate?

The firm is creating value in aggregate across its portfolio of investments.

What does ROIC < WACC indicate?

The firm is destroying value in aggregate.

★ EXAM: Is ROIC a project-level capital budgeting measure?

No. ROIC is generally a firm- or segment-level accounting measure.

Why can an outside analyst calculate ROIC but generally not project NPV or IRR?

ROIC uses reported financial statement information; NPV and IRR require project-specific forecast cash flows that outside analysts generally do not have.

Is ROIC forward-looking or backward-looking?

Primarily backward-looking because it is calculated from historical reported financial statements.

What is a major accounting limitation of ROIC?

It depends on accounting choices such as depreciation, capitalisation policies, and write-downs.

What is the aggregation limitation of ROIC?

It combines high-return and low-return projects, potentially hiding poor investments within the overall company result.

How can balance-sheet management distort ROIC?

Actions such as off-balance-sheet financing or share repurchases that reduce reported invested capital can alter the ratio without necessarily improving underlying economics.

★ EXAM: NPV versus IRR versus ROIC — what does each report?

NPV = project value in currency; IRR = project return as a rate; ROIC = historical firm/segment return as a rate.

★ EXAM: Which measures are forward-looking and project-specific?

NPV and IRR.

★ EXAM: Which measure is generally historical and company/segment-wide?

ROIC.

What is the first major principle of capital allocation?

Use after-tax cash flows rather than accounting earnings.

Why are cash flows preferred to accounting earnings in capital allocation?

Cash flows reflect actual economic resources moving into and out of the firm, while earnings contain accruals and non-cash items.

What are incremental cash flows?

Cash flows that occur or change specifically because the project is undertaken.

★ EXAM: What is the basic test for whether a cash flow belongs in project analysis?

Ask: "Does this cash flow change because of the project?" If yes, it is incremental and should generally be included.

What is a sunk cost?

A cost that has already been incurred and cannot be changed by the current project decision.

★ EXAM: How should sunk costs be treated in NPV analysis?

EXCLUDE them.

★ EXAM: What wording often identifies a sunk cost?

"Already spent," "previously incurred," or "past expenditure."

Why are sunk costs excluded from capital allocation decisions?

They will not change regardless of whether the project is accepted or rejected, so they are not incremental.

What is an opportunity cost?

The value of the best alternative use sacrificed when a project uses a resource.

★ EXAM: How should opportunity costs be treated in NPV analysis?

INCLUDE them.

Why is an opportunity cost relevant even when no explicit cash payment occurs?

Using the resource for the project prevents the firm from receiving the value available from its best alternative use.

★ EXAM: What is the critical sunk-cost versus opportunity-cost rule?

Sunk cost = EXCLUDE; Opportunity cost = INCLUDE.

What is an externality in capital allocation?

An effect that a proposed project has on the cash flows of the firm's other operations.

How should externalities be treated in project analysis?

Both positive and negative externalities should be included because they are incremental cash flows caused by the project.

What is cannibalisation?

A negative externality where a new project reduces sales or cash flows from an existing product or business.

★ EXAM: How should cannibalisation be treated?

INCLUDE it as a negative incremental effect on project cash flows.

What is a positive externality?

A benefit the project creates elsewhere in the firm, such as reducing costs or increasing sales of another product.

★ EXAM: Are positive externalities included in project cash flows?

Yes. Both positive and negative externalities are included.

★ EXAM: What is a frequent externality mistake?

Forgetting to include lost cash flows from cannibalisation.

What discount rate should be used for a capital project?

A required return appropriate for the risk of the project's cash flows.

★ EXAM: What is wrong with applying one corporate WACC to every project?

Projects can have different risk levels, so using the same rate may cause the firm to accept excessively risky projects or reject relatively safe projects.

What is the double-counting principle in capital allocation?

Each economic effect should be included only once.

★ EXAM: Why shouldn't financing costs also be deducted from project operating cash flows?

Financing costs are already reflected through the required return/discount rate; subtracting them again would double-count financing.