Los 24.c

Question 1

What are the Key Principles of Capital Allocation?

Answer 1

After-Tax Cash Flows
Capital decisions should be based on after-tax cash flows, not accounting income, which doesn’t consider cash timing or taxes. Include tax savings from non-cash deductions like depreciation.

Incremental Cash Flows Only
Only consider incremental cash flows that change if the project is undertaken. Sunk costs (costs already incurred) should not be included. Cannibalization (negative impact on existing products) and positive externalities (benefits to other products) must be considered.

Timing of Cash Flows
Capital decisions account for the time value of money. Cash flows received earlier are more valuable than later ones, requiring discounting for NPV calculations

Question 2

What are common Cognitive biases in capital allocation?

Answer 2

Poor Forecasting:
Mistakes in overhead allocation or underestimating competitors’ reactions.

Ignoring Internal Funds’ Cost:
Not considering the cost of retained earnings as equivalent to the cost of equity.

Inflation Mismanagement:
Not matching real cash flows with a real discount rate in the analysis