Capital Investment And Capital allocation

Question 1

Match funding

Answer 1

Financing projects with capital sources matching on consistent with the life of the project.

Question 2

Different types of capital investments

Answer 2

There are four different type of capital investments: going concern project, regulatory compliance project, growth / expansionprojects, other projects.

Question 3

Going concern project

Answer 3

Projects that may be needed to maintain the ongoing business and to reduce costs. To improve efficiency, it may involve determining on deciding it an equipment is obsolete but still usable are should it be replaced,

Question 4

Regulator/compliance projects

Answer 4

Projects that may be required to carried by government Or insurance company to involve safety related on environs concerns. These projects typically generate little or no revenue

Question 5

Expansion projects

Answer 5

These projects are carried on grow business by either forecasting future demand and can involve entering new markets on introducing new products within the samemarket.

Question 6

Other projects

Answer 6

It may involve entering into a new line of business which entails a complex decision making

Question 7

Capital allocation process

Answer 7

It is the process to identify and evaluate capital projects

Question 8

Capital projects

Answer 8

Projects the bring cash to flowers the firm for over a period longer than a year

Question 9

When a capital allocation process can be used

Answer 9

It can be used to identify any project and evaluate the same.using this process one can examine any corporate decision that will have an impact on futureearnings.

Question 10

Capital allocation process administrative steps

Answer 10

1. Generation of near idea
   2.analyzing the proposals
   3.create the firm wide project
2. Monitoring and conducting audit of the decision.

Question 11

NPV

Answer 11

Net present value - all expected inflows are ‘ converted intopresent value and initial outflow on investment is reduced if the NPV is positive the project is accepted. Formulae for NPR is [ ( 1- 1/ R)^t/ R ]a

Question 12

What does positive NPV signify?

Answer 12

It signifies expected value addition to thefirm/shareholder

Question 13

Is npv/irr method based on accounting or cash flows

Answer 13

Cash flows

Question 14

Which is better- accounting or cash flows

Answer 14

Cash flows as accounts can be easily manipulated.

Question 15

IRR

Answer 15

Internal rate of return is the discounting rate at which present value of expected cash inflows will be equal to the initial investment ie NPV is equal to zero.
‘

Question 16

When, a project be accepted according to the IRR method

Answer 16

When IRR is greater than expected rate of return ie cost of capital accept the proposal

Question 17

What is hurdle rate

Answer 17

Sometimes the analyst set the expected rate return of below on above the firm’s cost of capital to adjust the project’s risk, this rate is called the hurdle rate

Question 18

Why NPV is superior than IRR methods

Answer 18

1. Possibility of multiple irr’s in case of unconventional cash flow.
   2.NPR assumes cash how’s are reinvested on the basis of required date of return whereas IRS assumes it is reinvested@irr. The former is more realistic.

Question 19

ROIC

Answer 19

Return on invested capital - nopat/average book value of total capital

Question 20

NOPAT

Answer 20

Net operating profit after tax-EBIT(1-tax rate)

Question 21

Average book value of total capital

Answer 21

Avg total capital = long term assets + long term liabilities /2

Question 22

Why only long terms assets a labilities are considered

Answer 22

Because short term keeps on coming in a out of the business

Question 23

Features/concerns of ROIC

Answer 23

1. Backward looking
2. Accounting based hence prone to errors and difference in accounting standards used.
   3.it is used to analyze whole company & not just a single project.

Question 24

Principals of capital allocation

Answer 24

Principles considered while performing the capital allocation process are:
1. Decisions are based on cash flows and not on accounting income as accounting is on accrual basis and hence do not consider turning of cash flows.,
2. Incremental cash flow- only those costs the happen if the project is pursued are to be considered. Leg. Sunk cost should not be considered.
3. Timing of cash flow is important- sooner the cash received, its better

Question 25

Sunk cost

Answer 25

Costs that has to be borne even if the project. Is rejected.

Question 26

Cannabilization

Answer 26

When introduction of new product kills the sites of other product its called cannabilization.

Question 27

What common errors are made by managers while performing the capital allocation process:

Answer 27

Two types of errors:
1. Cognitive errors - errors that happen even after knowing about it.
2. Behaviour biases - It happens due to personal preferences

Question 28

Cognitive errors

Answer 28

Calculation errors:
1. Poor forecasting
2. Not considering the cost of internal funds.
3.incorrectly accounting for inflation.

Question 29

Behavioral biases

Answer 29

Judgement errors:
1. Pet project of management
2. resistance in setting capital budget- manager return Or increase capital in case of budget negative or positive NPV respectively. If not, and it stagnant or o capital budget is observed, chances are behavioral bias is there.
3.investment decision based-on EPS on roe - it may avoid projects that are supposed to generate positive NPV in later time.
4. Failure to generate new/alternative business ideas

Question 30

Timing options

Answer 30

This option give management to decide to delay making an investment

Question 31

Abandonment option

Answer 31

It a firm is getter better option than investing in continuing the project as the present value of cash flows from exiting a project exceeds the present value of the increment al cash how’s from continuing the project.

Question 32

Expansion option

Answer 32

Allows company to make additional investment in future projects if it decides the project will create value.

Question 33

Flexibility option

Answer 33

It gives managers choices regarding the operational aspect of a project,- two available options are:
1. Price setting option
2. Production flexibility option

Question 34

Fundmental option

Answer 34

Option to start the project when only feasible ie pay off depends on the price off an underlying assets