Chapter 11 - investing decisions

Question 1

define capital allocation (capital budgeting)

Answer 1

the process of determining how to use and invest a company’s cash to maximize shareholder value - this process is relevant to both private = public companies, however it’s typically more formal + structured in pubic companies

process is usually part of the company’s budget process

Question 2

what must the company must understand before allocating capital?

Answer 2

they must understand if they have sufficient cash to manage their day-to-day business (working capital), make investments for the future and return money to shareholders (dividends)

many companies have limited financial resources - first step is to understand if the company has enough cash from operating activities, if it doesn’t it must first make a financing decision (borrow or raise equity) before proceeding with the capital allocation process)

Question 3

what decisions should public companies be striving to make

Answer 3

they should make decision that maximize shareholder value

Question 4

what’s the goal of capital allocation

Answer 4

to invest cash available in the best projects to maximize return

Question 5

what are the types of investing decision

Answer 5

1. R&D
2. Expanding capacity
3. Replacing an asset

Question 6

what’s the importance of investing decisions

Answer 6

important for the long-term success of a company

company that make investing decision which maximize their future return and are on strategy are likely to gain a competitive advantage

Question 7

what’s considered in a qualitative analysis

Answer 7

pros + cons of an investment
important to understand a company’s strategy, goals, and objectives and assessing whether the investment is consistent with this strategy

Question 8

define net present value (NPV)

Answer 8

the difference between the present value of cash inflows and the present value of cash outflows over a period of time

Question 9

why is NPV important in investing decisions?

Answer 9

use NPV of an investment to analyze whether the investment will provide a future return for the company

Question 10

define time value of money

Answer 10

receiving a dollar today is worth more than receiving a dollar a year from now

Question 11

are projects that deliver returns earlier in time more preferable to those that have the majority of returns later in time

Answer 11

yes

Question 12

define a weight-average cost of capital

Answer 12

company’s cost of obtaining cash from lenders + shareholders expressed as a percentage

usually used as the discount rate to obtain the present value fo future cash flows

Question 13

what’s the formula to present value?

Answer 13

cashflows/(1+discount rate)^number of periods

Question 14

are investing decision those that involve spending cash today to generate future cash flows?

Answer 14

yes

Question 15

how to calculate future net cash flows

Answer 15

cash inflows - cash outflows

Question 16

define an up-front investment - initial cash flow

Answer 16

initial cash required today to purchase equipment or assets that will generate future cash flows
one-time upfront cash flows

Question 17

what’s included in an up-front cash investment

Answer 17

all cash flows to deliver + install the equipment or asset

Question 18

when we make investing decision do we consider cash flows and net income?

Answer 18

no only consider cash flows not net income

only incremental cash inflows and outflows that result from purchasing equipment or assets are considered to make an investing decision

Question 19

what do we with depreciation in terms of cash flows

Answer 19

depreciation = non cash expense that’s included in the calculation of net income
depreciation = cost of an asset amortized over its useful life

Question 20

what are the steps to calculate NPV

Answer 20

1. identify all relevant cash flows + categorize them as up-front cash flows
2. separate relevant cash flows into cash inflows and cash outflows - inflows are positive number, outflows are negative numbers
   3.identify the timing of cash inflows + outflows (which year will they occur? are they recurring or one-time?)
3. discount the net cash flows using the present value formula
4. sum all discounted net cash flows to obtain the net present values

Question 21

what’s an assumption in NPV

Answer 21

NPV analysis assumes that all cash flows other than the initial investment and additional working capital occur at the end of the periods

Question 22

what’s the results of an NPV analysis

Answer 22

if NPV > 0, means project will deliver a return greater than the WACC - proceed from a quantitative perspective

if NPV < 0, means project will deliver a return less than WACC, no do not proceed from a quantitative perspective