Library/CFA (Chartered Financial Analyst)/JuiceNotes 2024: Corporate Issuers - CFA Level I/Capital Investments and Capital Allocation

Capital Investments and Capital Allocation

51 questions available

Take a quiz Listen to a podcast

Capital Budgeting Process and Principles6 min

The capital budgeting process is structured into four steps: idea generation, analysis of proposals, budget creation, and monitoring/post-audit. Decisions are based on incremental cash flows, not accounting income. It is crucial to consider opportunity costs—benefits lost by choosing one option over another—and externalities, such as the cannibalization of existing product sales. Sunk costs, which are incurred regardless of the decision, are ignored. Financing costs are also excluded from cash flow calculations because they are accounted for in the discount rate (WACC). Projects are classified by purpose, ranging from mandatory compliance projects to expansionary ventures requiring detailed analysis.

Key Points

Steps: Idea generation, Analyzing proposals, Firm-wide budget, Monitoring/Post-audit.
Focus on cash flows, not accounting income.
Ignore sunk costs; include opportunity costs and externalities (cannibalization).
Exclude financing costs from cash flows (handle via discount rate).
Categories: Replacement, Expansion, Mandatory, Other.

Investment Evaluation Criteria8 min

Several methods exist to evaluate projects. NPV is the gold standard, representing the potential increase in shareholder wealth. The IRR is the rate where NPV equals zero; if IRR exceeds the cost of capital, the project is acceptable. The Payback Period measures how quickly the initial investment is recovered but ignores the time value of money and cash flows after the payback point. The Discounted Payback Period addresses the time value of money but still ignores later cash flows. The Profitability Index (PI) measures the value created per unit of investment. For independent projects, NPV and IRR usually agree. For mutually exclusive projects, NPV is the superior decision criterion.

Key Points

NPV: PV of Inflows - PV of Outflows; accept if > 0.
IRR: Discount rate where NPV = 0; accept if > Cost of Capital.
Payback Period: Measure of liquidity; ignores TVM and terminal flows.
Profitability Index: PV of Inflows / PV of Outflows; accept if > 1.
For mutually exclusive projects, choose the highest NPV.

Real Options and Pitfalls6 min

Real options allow management to adjust operational decisions over time. Timing options allow delaying investment; abandonment options limit losses; expansion options capitalize on success; flexibility options relate to pricing or production inputs; and fundamental options treat the entire investment as an option (e.g., natural resources). Analysts must also be aware of pitfalls in capital allocation, such as 'pet projects' driven by senior management, excessive focus on short-term accounting metrics (EPS/ROE) rather than long-term value, and failure to account for inflation or alternative investment opportunities properly.

Key Points

Real Options: Timing, Abandonment, Expansion, Flexibility, Fundamental.
Inflation: Match nominal cash flows with nominal rates.
Pitfalls: Pet projects, short-termism, sunk cost errors, template misuse.
Capital Rationing: Limited funds require selecting the bundle of projects with max NPV.

Questions

Question 1

Which of the following is the first step in the capital budgeting process?

Capital Investments and Capital Allocation

Questions

Other chapters