Los 24.b

Question 1

What is the capital allocation process, and why is it important?

Answer 1

The capital allocation process is crucial for identifying and evaluating projects that will generate long-term cash flows. It involves four steps:

Idea generation

Analyzing project proposals

Creating a firm-wide capital budget

Monitoring decisions and conducting post-audits
This process ensures that decisions align with maximizing shareholder value and long-term business success.

Question 2

How is Net Present Value (NPV) calculated?

Answer 2

NPV (Net Present Value) is a way to evaluate whether a project will be profitable by looking at the expected cash inflows and outflows over time. It takes into account the time value of money, meaning that money today is worth more than money in the future.

How is NPV calculated?

To calculate NPV, we add up the present value of each of the project’s future cash flows, minus the initial investment (the amount spent on the project). The formula is:

e.g. CF0 + (CF1 / 1+k) + (CFn / 1+K)
CF0 = innitial investment (negative)
CFn = after tax cash flow
K = required rate of return

Question 3

How do you interpret the decision rule for NPV?

Answer 3

For independent projects, the decision rule for NPV is:

Accept any project with a positive NPV.

Reject any project with a negative NPV.
If NPV equals zero, it indicates no change in shareholder wealth.

Question 4

How is the Internal Rate of Return (IRR) calculated, and what is its decision rule?

Answer 4

IRR is the discount rate that makes the NPV equal to zero. The IRR decision rule is:

Accept projects where the IRR is greater than the required rate of return.

Reject projects where the IRR is less than the required rate of return.

Question 5

What are the advantages and disadvantages of using NPV and IRR for capital allocation?

Answer 5

NPV Advantages:

Direct measure of value added to the firm.
Aligns with maximizing shareholder wealth.

IRR Advantages:

Shows profitability as a percentage.
Indicates the margin of safety before a project becomes uneconomic.

IRR Disadvantages:

Assumes reinvestment at IRR, while NPV assumes reinvestment at the required rate of return.
Multiple IRRs may exist for unconventional cash flows, making interpretation difficult.

Question 7

What is Return on Invested Capital (ROIC), and how is it calculated?

Answer 7

ROIC is a measure of how effectively a company uses its capital to generate profit. It is calculated as:

ROIC = NOPAT / AverageInvestedCapital = (NOPAT / Sales) * (Sales / Average Invested Capital)

Where NOPAT is the net operating profit after tax, and invested capital includes both debt and equity. ROIC can also be broken down into operating margin after tax and capital turnover.

NOPAT / S

Question 8

What is the importance of comparing ROIC to the required rate of return?

Answer 8

Comparing ROIC to the required rate of return helps determine if the company is adding value for shareholders. If ROIC exceeds the required rate, the firm is generating value. If it falls short, the firm is not meeting its cost of capital.