fbpixelCapital Budgeting | IFT World
IFT Notes for Level I CFA® Program

R28 Uses of Capital

Part 1


1. Introduction

Capital allocation is the process that companies use for decision-making on capital investments i.e., investments with a life of a year or more.

Capital allocation is important because it helps decide the future of many corporations. Most capital investments require huge investments that are not easy to reverse.

The valuation principles used in capital budgeting are also used in security valuation and portfolio management. These principles deal with projecting and then discounting cash flows to determine if the project adds value.

This reading covers:

  • A typical capital allocation process – steps, assumptions, and types of projects
  • Basic investment decision criteria – NPV and IRR
  • Real options – timing, sizing, flexibility, and fundamental options
  • Common capital allocation pitfalls

2. The Capital Allocation Process

Steps in Capital Allocation Process

The steps in the capital allocation process are as follows:

Step 1 – Idea generation: Most important step in the process. Investment ideas can come from anywhere within the organization, or outside (customers, vendors, etc.). What projects can add value to the company in the long term?

Step 2 – Investment analysis: Gathering information to forecast cash flows for each project and then computing the project’s profitability. Output of this step: A list of profitable projects.

Step 3 – Capital allocation planning: Do the profitable projects fit in with the company’s long-term strategy? Is the timing appropriate? Some projects may be profitable in isolation but not so much when considered along with the other projects. Scheduling and prioritizing of projects are important.

Step 4 – Monitoring and post-audit: Post-audit helps in assessing how effective the capital budgeting process was. How do the actual revenues, expenses, and cash flows compare against the predictions? Post-auditing is useful in three ways:

  • If the predictions were optimistic or too conservative, then it becomes evident here.
  • Helps improve business operations. Puts the focus on out-of-line sales and costs.
  • Helps in identifying profitable areas for fresh investments in the future, or scale down in non-profitable ones.

Types of Capital Projects

Capital allocation projects may be divided into the following categories:

  • Replacement projects: Analyzing whether the replacement of existing equipment would be profitable.
  • Expansion projects: Constructing a new plant or expanding capacity of the existing one.
  • New products and services: Diversifying current business operations to maintain a competitive edge.
  • Regulatory, safety, and environmental projects: Regulatory safety and environmental laws, mandated by a governmental agency or an insurance company.
  • Other projects: Pet projects of senior management or high-uncertainty projects like R&D projects that are difficult to analyze using the traditional methods.

Capital Allocation Assumptions

The following are the six key principles of capital allocation:

  1. Decisions are based on cash flows:
  • Use incremental cash flows: Cash flow with the decision minus the cash flow without the decision.
  • Exclude sunk costs: For example, already incurred costs like preliminary consulting fees should not be included in the analysis.
  • Include externalities – Both positive/negative externalities should be considered in the analysis. For example, negative impact of a new diet soda product launch on the sales of existing soda products.
  • A project has conventional cash flows if the sign of cash flows changes only once during the life of the project, while an unconventional cash flow project has more than one sign change.
  1. Cash flows are not accounting net income or operating income: Decisions are not based on accounting concepts like net income or operating income because these measures are accrual based and exclude non-cash expenses such as depreciation.
  2. Cash flows are based on opportunity cost: For example, if you plan to use an existing office space rather than renting it out, then rental income from an office space is an opportunity cost.
  1. Cash flows are analyzed on an after-tax basis: Shareholder value increases only on the cash that they have earned. Hence, any tax expenses must be deducted from the cash flows.
  1. Timing of cash flows is vital: Due to the time value of money, cash flows received earlier are more valuable than cash flows received later.
  1. Financial costs are ignored: Financial costs are already included in the cost of capital (discount rates) used to discount cash flows to arrive at the present value. Hence, to avoid double counting, they must not be deducted from the cash flows.

Independent projects vs. mutually exclusive projects: Independent projects are unrelated projects that can be analyzed separately, while mutually exclusive projects compete with each other. Two independent projects can both be executed if they individually meet the criteria. If two projects are mutually exclusive, then either of the two can be undertaken, not both.

Project sequencing: Certain projects are linked through time, i.e. completion of one project creates an opportunity to invest in another project later based on its profitability.

Unlimited funds vs. capital rationing: A firm can undertake all profitable projects if it has access to unlimited funds. A company having limited capital however, must prioritize and allocate funds to projects that maximize shareholder value.