4.5 capital investments and capital allocation Flashcards
Capital allocation
the process that a company’s managers follow when making decisions about which capital projects should be undertaken
The typical steps in the capital allocation process are:
- Idea Generation: This can originate from within the company or from outside the company.
- Investment Analysis: Collect information to forecast the investment’s expected cash flows and profitability.
- Planning and Prioritization: Select and prioritize profitable investment opportunities that together best fit the company’s strategy.
- Monitoring and Post-Investment Review:
–> Compare actual results to forecasted results to (i) monitor forecasts and analysis that underlie the capital allocation process, (ii) improve business operations, and (iii) plan for the future. This part of the process can be complicated due to challenges in accurately measuring expected and actual results.
When the choice is between two mutually exclusive projects and the NPV and IRR measures provide different rankings, decisions should be made based on NPV. There are two key reasons to prefer this measure:
- NPV represents the amount by which a project increases a company’s overall valuation.
- NPV assumes that all interim cash flows can be reinvested at the required rate of return, while the IRR assumes reinvestment at the IRR. The reinvestment assumption of the NPV is a more economically realistic measure of a company’s cost of capital.
Return on invested capital (ROIC), also known as return on capital employed (ROCE)
measures a company’s profitability relative to the amount of capital that has been invested by lenders and equity owners
ROIC reflects the effectiveness of a company’s management in converting capital into profits, regardless of what type of capital is used (e.g., debt, equity). The ratio is calculated as:
Some key advantages of the ROIC measure include:
It is calculated using easily-accessible data (unlike NPV and IRR).
It improves on profit margin measures because it can be broken into components representing after-tax operating profitability and asset turnover
ROIC allows outside analysts to assess a company’s ability to create value from capital budgeting decisions at an aggregate level rather than at the level of individual projects.
Investors can compare ROIC to the rate of return that they require as compensation. Companies create value for investors by generating an ROIC in excess of their cost of capital. However, it is important to use a blended cost of capital rather than a required return on debt or equity in isolation.
ROIC’s limitations include:
It is accounting-based, not cash-based like NPV and IRR. Operating profit can be manipulated with choices regarding depreciation, capital expenditures, and recognition of revenues and expenses. Analysts may make further adjustments to the invested capital items such as pension obligations, deferred tax liabilities, and leases.
It is a backward-looking measure that can be highly volatile, which makes it difficult for analysts to identify trend rates.
It is an aggregate measure that can mask differences in profitability among various capital projects.
Real options
opportunities for a firm to delay a decision about a capital project or to amend the project after deciding to pursue it
Like financial options, real options are valuable because they grant the right to defer the timing of a decision until more information has been accumulated.
Real options can be classified based on which type of decision-making flexibility that they offer.
timing options
sizing options
flexibility options
fundamental options
timing options
allow a company to delay its initial decision about whether to pursue an investment.
For example, projects may be sequenced in a way that defers the need to decide about one project until the company has been able to evaluate the initial success of a related project.
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).
flexibility options
go beyond abandonment or expansion by granting management the ability to make adjustments based on subsequent market conditions
For example, price-setting options allow the company to change prices based on the observed level of demand.
Production-flexibility options allow for changes in the level of output through arrangements with employees and suppliers.
fundamental options
treat an entire investment as an option because its value depends on factors that are beyond the firm’s control.
For example, an oil exploration company may choose not to drill any new wells if oil prices fall below a certain threshold.
Research and development projects are often viewed as fundamental options.
Evaluating Capital Investments with Real Options
There are three approaches that are commonly used to estimate the value of the decision-making flexibility provided by real options:
- Use the discounted cash flow (DCF) analysis without considering options. If the NPV without options is positive, then the NPV with options will also be positive. The project can be undertaken without calculating the value of the real options.
- Adjust the stand-alone DCF analysis by including the present value of the expected costs and benefits from the real options:
Project NPV = NPV (based on DCF alone) - Cost of options + Value of options
- Decision trees and option pricing models can be used to calculate the probability-weighted expected value of a sequence of decisions.
