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LM Categories Characteristics and Compensation Structures of Alternative Investments

LM01 Categories, Characteristics, and Compensation Structures of Alternative Investments

LM Corporate Structures and Ownership

LM01 Corporate Structures and Ownership

LM Derivative Instrument and Derivative Market Features

LM01 Derivative Instrument and Derivative Market Features

LM Ethics and Trust in the Investment Profession

LM01 Ethics and Trust in the Investment Profession

LM Fixed Income Securities Defining Elements

LM01 Fixed-Income Securities: Defining Elements

LM Introduction to Financial Statement Analysis

LM01 Introduction to Financial Statement Analysis

LM Market Organization and Structure

LM01 Market Organization and Structure

LM Portfolio Management Overview

LM01 Portfolio Management Overview

LM Time Value of Money

LM01 Time Value of Money

LM Topics in Demand and Supply Analysis

LM01 Topics in Demand and Supply Analysis

LM Code of Ethics and Standards of Professional Conduct Profession

LM02 Code of Ethics and Standards of Professional Conduct Profession

LM Financial Reporting Standards

LM02 Financial Reporting Standards

LM Fixed Income Markets Issuance Trading and Funding

LM02 Fixed Income Markets - Issuance Trading and Funding

LM Forward Commitment and Contingent Claim Features and Instruments

LM02 Forward Commitment and Contingent Claim Features and Instruments

LM Introduction to Corporate Governance and Other ESG Considerations

LM02 Introduction to Corporate Governance and Other ESG Considerations

LM Organizing Visualizing and Describing Data

LM02 Organizing, Visualizing, and Describing Data

LM Performance Calculation and Appraisal of Alternative Investments

LM02 Performance Calculation and Appraisal of Alternative Investments

LM Portfolio Risk and Return Part I

LM02 Portfolio Risk and Return Part I

LM Security Market Indexes

LM02 Security Market Indexes

LM The Firm and Market Structures

LM02 The Firm and Market Structures

LM Aggregate Output Prices and Economic Growth

LM03 Aggregate Output, Prices and Economic Growth

LM Business Models amp Risks

LM03 Business Models & Risks

LM Derivative Benefits Risks and Issuer and Investor Uses

LM03 Derivative Benefits, Risks, and Issuer and Investor Uses

LM Guidance for Standards I VII

LM03 Guidance for Standards I-VII

LM Introduction to Fixed Income Valuation

LM03 Introduction to Fixed Income Valuation

LM Market Efficiency

LM03 Market Efficiency

LM Portfolio Risk and Return Part II

LM03 Portfolio Risk and Return Part II

LM Private Capital Real Estate Infrastructure Natural Resources and Hedge Funds

LM03 Private Capital, Real Estate, Infrastructure, Natural Resources, and Hedge Funds

LM Probability Concepts

LM03 Probability Concepts

LM Understanding Income Statements

LM03 Understanding Income Statements

LM An Introduction to Asset Backed Securities

LM04 An Introduction to Asset-Backed Securities

LM Arbitrage Replication and the Cost of Carry in Pricing Derivatives

LM04 Arbitrage, Replication, and the Cost of Carry in Pricing Derivatives

LM Basics of Portfolio Planning and Construction

LM04 Basics of Portfolio Planning and Construction

LM Capital Investments

LM04 Capital Investments

LM Common Probability Distributions

LM04 Common Probability Distributions

LM Introduction to the Global Investment Performance Standards GIPS

LM04 Introduction to the Global Investment Performance Standards (GIPS)

LM Overview of Equity Securities

LM04 Overview of Equity Securities

LM Understanding Balance Sheets

LM04 Understanding Balance Sheets

LM Understanding Business Cycles

LM04 Understanding Business Cycles

LM Introduction to Industry and Company Analysis

LM05 Introduction to Industry and Company Analysis

LM Monetary and Fiscal Policy

LM05 Monetary and Fiscal Policy

LM Pricing and Valuation of Forward Contracts and for an Underlying with Varying Maturities

LM05 Pricing and Valuation of Forward Contracts and for an Underlying with Varying Maturities

LM Sampling and Estimation

LM05 Sampling and Estimation

LM The Behavioral Biases of Individuals

LM05 The Behavioral Biases of Individuals

LM Understanding Cash Flow Statements

LM05 Understanding Cash Flow Statements

LM Understanding Fixed Income Risk and Return

LM05 Understanding Fixed-Income Risk and Return

LM Working Capital amp Liquidity

LM05 Working Capital & Liquidity

LM Cost of Capital Foundational Topics

LM06 Cost of Capital-Foundational Topics

LM Equity Valuation Concepts and Basic Tools

LM06 Equity Valuation: Concepts and Basic Tools

LM Financial Analysis Techniques

LM06 Financial Analysis Techniques

LM Fundamentals of Credit Analysis

LM06 Fundamentals of Credit Analysis

LM Hypothesis Testing

LM06 Hypothesis Testing

LM Introduction to Geopolitics

LM06 Introduction to Geopolitics

LM Introduction to Risk Management

LM06 Introduction to Risk Management

LM Pricing and Valuation of Futures Contracts

LM06 Pricing and Valuation of Futures Contracts

LM Capital Structure

LM07 Capital Structure

LM International Trade and Capital Flows

LM07 International Trade and Capital Flows

LM Introduction to Linear Regression

LM07 Introduction to Linear Regression

LM Inventories

LM07 Inventories

LM Pricing and Valuation of Interest Rates and Other Swaps

LM07 Pricing and Valuation of Interest Rates and Other Swaps

LM Technical Analysis

LM07 Technical Analysis

LM Currency Exchange Rates

LM08 Currency Exchange Rates

LM Fintech in Investment Management

LM08 Fintech in Investment Management

LM Long Lived Assets

LM08 Long Lived Assets

LM Measures of Leverage

LM08 Measures of Leverage

LM Pricing and Valuation of Options

LM08 Pricing and Valuation of Options

LM Income Taxes

LM09 Income Taxes

LM Option Replication Using Put Call Parity

LM09 Option Replication Using Put–Call Parity

LM Non current Long Term Liabilities

LM10 Non-current (Long-Term) Liabilities

LM Valuing a Derivative Using a One Period Binomial Model

LM10 Valuing a Derivative Using a One-Period Binomial Model

LM Financial Reporting Quality

LM11 Financial Reporting Quality

LM Applications of Financial Statement Analysis

LM12 Applications of Financial Statement Analysis

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IFT Notes for Level I CFA^® Program

LM04 Capital Investments

Part 2

3. The Capital Allocation Process

Capital allocation is the process used by an issuer’s management to make capital investment decisions.

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.

Capital Allocation Principles

The following are the six key principles of capital allocation:

Decisions are based on cash flows: Decisions are not based on an accounting/accrual basis (net income or operating income) which subtract non-cash charges such as depreciation.

Measure incremental cash flows: What incremental cash flows occur with the investment as compared to without it?
Timing of cash flows is crucial: Due to the time value of money, cash flows received earlier are more valuable than cash flows received later.

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.

Cash flows are not accounting net income or operating income: Cash flows should not reflect non-cash charges. Economic income (cash inflows plus change in company’s market value),unlike accounting income, does not reflect non-cash charges.)
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.

Other important points to consider:

Exclude sunk costs: A sunk cost is one that has already been incurred and cannot be changed. For example, already incurred costs like preliminary consulting fees should not be included in the analysis.
Use incremental cash flows: Cash flow with the decision minus the cash flow without the decision.
Include externalities: Both positive/negative externalities should be considered in the analysis. Cannibalization is an example of a negative externality. For example, negative impact of a new diet soda product launch on the sales of existing soda products.
Conventional cash flow pattern vs. nonconventional cash flow pattern: 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.

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.

4. Investment Decision Criteria

Net Present Value

Net present value is the present value of the future after tax cash flows minus the investment outlay.

$NPV=CF0\ +\ \left[\frac{CF1}{{\left(1+r\right)}^1}\right]+\ \left[\frac{CF2}{{\left(1+r\right)}^2}\right]+\ \left[\frac{CF3}{{\left(1+\ r\right)}^3}\right]$

Decision rule:

For independent projects:

If NPV > 0, accept.

If NPV < 0, reject.

For mutually exclusive projects:

Accept the project with higher and positive NPV.

Example

Compute NPV for projects A and B given the following data:

Cost of capital = 10%
Expected Net after Tax cash flows
Year	Project A (in $)	Project B (in $)
0	-1,000	-1,000
1	500	100
2	400	300
3	300	400
4	100	600

Solution:

Project A:

NPV = $-1000 + \frac{500}{1.1} + \frac{400}{{1.1}^2} + \frac{300}{{1.1}^3} + \frac{100}{{1.1}^4}$ = 78.82$

On the exam, you can save time by using the calculator to solve for NPV instead of using the above formula. The key strokes are given below:

Key strokes	Display
[CF][2^nd][CLR WORK]	CF0 = 0
1000 [+\|-] [ENTER]	CF0 = -1000
[↓] 500 [ENTER]	C01 = 500
[↓]	F01 = 1
[↓] 400 [ENTER]	C02 = 400
[↓]	F02 = 1
[↓] 300 [ENTER]	C03 = 300
[↓]	F03 = 1
[↓] 100 [ENTER]	C04 = 100
[↓]	F04 = 1
[NPV] 10 [ENTER]	I = 10
[↓] CPT	NPV = 78.82

Project B:

NPV = $-1000 + \frac{100}{1.1} + \frac{300}{{1.1}^2} + \frac{400}{{1.1}^3} + \frac{600}{{1.1}^4}$ =49.18

Microsoft Excel functions can also be used to solve for the NPV. The two functions available are:

NPV or =NPV(rate, values) and
XNPV or =XNPV(rate, values, dates),

where “rate” is the discount rate, “values” are the cash flows, and “dates” are the dates of each of the cash flows.

Internal Rate of Return

IRR is the discount rate that makes the present value of future cash flows equal to the investment outlay. We can also say that IRR is the discount rate which makes NPV equal to 0.

Decision rule:

For independent projects:

If IRR > required rate of return (usually firms cost of capital adjusted for projects riskiness), accept the project.

If IRR < required rate of return, reject the project.

The required rate of return is also called hurdle rate.

For mutually exclusive projects:

Accept the project with higher IRR (as long as IRR > cost of capital).

Example

Compute IRR for projects A and B given the following data.

Cost of Capital = 10%; Expected Net After Tax Cash Flows
Year	Project A (in $)	Project B (in $)
0	-1,000	-1,000
1	500	100
2	400	300
3	300	400
4	100	600

Solution:

Project A:

A very tedious method is to set up the equation below and solve for r using trial and error.

$1000 = \frac{500}{1\ +\ r} + \frac{400}{{\left(1\ +\ r\right)}^2} + \frac{300}{{\left(1\ +\ r\right)}^3}\ + \frac{100}{{\left(1\ +\ r\right)}^4}$ r = 14.49%

A much faster method is to use the calculator:

Key strokes	Display
[CF][2^nd][CLR WORK]	CF0 = 0
1000[+\|-] [ENTER]	CF0 = -1000
[↓] 500 [ENTER]	C01 = 500
[↓]	F01 = 1
[↓] 400 [ENTER]	C02 = 400
[↓]	F02 = 1
[↓] 300 [ENTER]	C03 = 300
[↓]	F03 = 1
[↓] 100 [ENTER]	C04 = 100
[↓]	F04 = 1
[IRR][CPT]	14.49

Project B:

$1000 = \frac{100}{1\ +\ r} + \frac{300}{{\left(1\ +\ r\right)}^2} + \frac{400}{{\left(1\ +\ r\right)}^3} + \frac{600}{{\left(1\ +\ r\right)}^4}$

r = 11.79%

Microsoft Excel functions can also be used to solve for the IRR. The two functions available are:

IRR or =IRR(values, guess)
XIRR or =XIRR(values, dates, guess)

where “values” are the cash flows, “guess” is an optional user-specified guess that defaults to 10%, and “dates” are the dates of each cash flow.

Ranking conflicts between NPV and IRR

For single and independent projects with conventional cash flows, there is no conflict between NPV and IRR decision rules. However, for mutually exclusive projects the two criteria may give conflicting results. The reason for conflict is due to differences in cash flow patterns and differences in project scale.

For example, consider two projects one with an initial outlay of $1 million and another project with an initial outlay of $1 billion. It is possible that the smaller project has a higher IRR, but the increase in firm value (NPV) is small as compared to the increase in firm value (NPV) of the larger project.

In case of a conflict, we should always go with the NPV criterion because:

The NPV is a direct measure of expected increase in value of the firm.
The NPV assumes reinvestment of cash flows at the required rate of return (more realistic), whereas the IRR assumes reinvestment of cash flows at the IRR rate (less realistic).
IRR is not useful for projects with non-conventional cash flows as such projects can have multiple IRRs , i.e., there are more than one discount rates that will produce an NPV equal to zero.

Comparison between NPV and IRR

NPV	IRR
Advantages	Advantages
Direct measure of expected increase in value of the firm.	Shows the return on each dollar invested.
Theoretically the best method.	Allows us to compare return with the required rate.
Disadvantages	Disadvantages
Does not consider project size.	Incorrectly assumes that cash flows are reinvested at IRR rate. The correct assumption is that intermediate cash flows are reinvested at the required rate.
	Might conflict with NPV analysis.
	Possibility of multiple IRRs.

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