Reading 24: Capital Investments and Capital Allocation

Book 1: Corporate Issuers

Types of Capital Investments and general idea behind them

Going Concern Projects —> maintenance

Regulatory or Compliance Projects —> finding alternatives to conduct the same operations

Expansion Projects —> value creation

Other Projects —> branching out from core businesses

Examples of Going Concern Projects

Replacing obsolete equipment

Maintaining business operations

Reducing costs

Match Funding

financing projects with capital sources that are consistent with the project life

Examples of Other Projects

buying out an existing company

expanding into a new industry

Steps to the Capital Allocation Process

1.) Idea Generation

2.) Analyzing project proposals

3.) Creating the budget

4.) Monitoring decisions and conducting post-audit

Advantages of NPV

Direct measure of the expected increase in the value of a firm

A positive NPV project should cause a ________________ in stock price.

proportionate increase

Disadvantage of NPV

doesn’t give an idea for margin of safety

Internal Rate of Return def

the discount rate that makes the PV of cash inflows = to the PV of cash outflows of a project

Hurdle Rate

the required rate of return adjusted for the level a incremental risk a project adds to a firm’s total risk

Conventional Cash Flow Pattern

only one sign change in a project’s cash flows

Unconventional Cash Flow Pattern

has more than one sign change or a change in time intervals of cash flows

Advantages of IRR

measures profitability as a percentage

provides information on the margin of safety

Disadvantages of IRR

assumes the cash flows are reinvested at the IRR

MIRR is hard to calculate

What is the appropriate metric to reinvest cash flows at?

the required rate of return; not the IRR

What is the Operating Margin After-Tax?

(NOPAT/Sales)

What is the Capital Turnover?

(Sales/Invested Capital)

What do analysts compare the ROIC to?

Required rate of return

Advantages of ROIC?

based on the firm as a whole through public accounting information and not company-specific

Disadvantages of ROIC?

accounting treatments are different for every firm, hard to compare

ROIC is backward-looking

Profitable projects may be masking unprofitable projects as analysts are the looking at the aggregate of returns

Principles of Capital Allocation

Decisions are made on after-tax cash flows, not earnings

Incremental cash flows only

The timing of cash flows is important

What costs should be considered in an capital allocation decisions? Which shouldn’t?

Cannibalization costs.

Sunk Costs

Errors management makes when making capital allocation decisions

Cognitive Errors (calculation errors)

Behavioral Biases (errors of judgment)

Types of Cognitive Errors

Poor forecasting

Not considering the cost of internal funds (dividends)

Incorrectly accounting for inflation

Types of Behavioral Biases

Pet projects of senior management

Inertia in setting the capital budget

• Not assessing opportunities every year and just using the same budget as last year

Basing investment decisions on EPS or ROE

Failure to generate alternative investment ideas

Real Options

the opportunity cost of a project

How do you consider real options in capital allocation decisions?

NPV + Real Option - Cost of Acquiring Real Option

Timing Options

allow a company to delay making an investment because it expects to have better information in the future

Abandonment Options

When the cost of abandoning a project is more lucrative than continuing it, a company can stop pursuing a project

Expansion Options

a company can make additional investments in future projects if they will create value

Flexibility Options

Price-Settling Options – ability to change price

Production-Flexibility Options – ability to alter operations

• paying overtime

  • using different raw materials

Fundamental Options

projects that are options themselves

• Copper Mine

  • Won’t pursue project when copper price is low

  • Pursue when copper is high