Library/CFA (Chartered Financial Analyst)/SchweserNotes 2022 Level I CFA Book 3: Corporate Issuers and Equity Investments/Reading 28: Uses of Capital

Reading 28: Uses of Capital

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Capital Allocation Process and Principles5 min

The capital allocation process involves identifying and evaluating projects with long-term cash flow implications. The four steps are idea generation, analyzing proposals, creating the firm-wide capital budget, and monitoring/post-audit. Key principles dictate that analysis uses incremental after-tax cash flows. Sunk costs (unavoidable past costs) are ignored, while opportunity costs (value of foregone alternatives) and externalities (effects on other firm cash flows, like cannibalization) are included. Financing costs are handled through the discount rate, not cash flow deductions.

Key Points

Idea generation is the most important step.
Post-audits identify systematic errors and improve operations.
Cash flows are incremental and after-tax.
Sunk costs are ignored; opportunity costs are included.
Externalities like cannibalization must be deducted.
Financing costs are reflected in the required rate of return.

Evaluation Methods: NPV and IRR5 min

Net Present Value (NPV) and Internal Rate of Return (IRR) are the primary tools for project evaluation. NPV calculates the potential increase in shareholder wealth by discounting future cash flows at the required rate of return. A positive NPV implies the project should be accepted. IRR is the discount rate that makes NPV zero. While IRR provides a return percentage, NPV is theoretically superior for mutually exclusive projects because it measures absolute value creation. Conflicts can arise between NPV and IRR rankings due to cash flow timing or size differences.

Key Points

NPV > 0 increases shareholder wealth.
IRR is the discount rate where inflows equal outflows (NPV = 0).
Accept independent projects if IRR > cost of capital.
NPV is preferred for mutually exclusive projects.
IRR assumes reinvestment at the IRR; NPV assumes reinvestment at the cost of capital.
NPV profiles show sensitivity of NPV to discount rates.

Real Options and Pitfalls5 min

Real options represent future flexibility embedded in projects, such as the option to expand, abandon, or delay investment. These options add value to a project beyond standard DCF analysis. Common pitfalls in capital allocation can lead to poor decisions. These include ignoring competitor responses, focusing on short-term accounting metrics like EPS instead of long-term value, using the wrong discount rate, and letting office politics dictate spending.

Key Points

Real options (timing, abandonment, expansion) increase project NPV.
Flexibility options relate to price-setting and production inputs.
Pitfalls include failing to account for economic responses and misusing templates.
Managers may wrongly focus on EPS/ROE rather than NPV.
Sunk costs and opportunity costs are often handled improperly.
Using the firm's WACC for all projects without risk adjustment is a common error.

Questions

Question 1

Which step in the capital allocation process is considered the most important?

Reading 28: Uses of Capital

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