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

# Part 3

## 5. Common Capital Allocation Pitfalls

Common mistakes that companies make when analyzing capital allocation projects are:

• Inertia: The amount of capital investment in a business segment/unit for a year is highly correlated to the amount spent in the previous year. Ideally, the amount should vary based on the number and scale of opportunities available each year.
• Source of capital bias: Many managers consider internally generated capital to be “free” and allocate it according to a budget that is heavily correlated with prior period amounts. Externally raised capital, on the other hand, is regarded as “expensive” and is used sparingly, typically only for large investments. Ideally, managers should view all capital as having an opportunity cost, regardless of source.
• Failing to consider investment alternatives or alternative states: During the ‘idea generation’ step, many good alternatives are never even considered at some companies. Many companies also fail to consider differing states of the world, which should ideally be incorporated through breakeven, scenario, and simulation analyses.
• Pushing “pet” projects: Pet projects are projects backed by senior management. They may contain overly optimistic projections that overstate the project’s profitability.
• Basing investment decisions on EPS, net income, or return on equity: The compensation of managers is sometimes tied to EPS, net income, or ROE. They may therefore reject even strong positive NPV projects that reduce these accounting numbers in the short run.
• Internal forecasting errors: Companies may make errors in their internal forecasts. The errors could be related to incorrect costs or discount rate inputs. For example, overhead costs such as management time, IT support, and financial systems can be difficult to estimate. Also, companies may incorrectly treat sunk costs and missed opportunity costs; and incorrectly use the company’s overall cost of capital, cost of debt, or cost of equity rather than the investment’s required rate of return in their analysis.

## 6. Corporate Use of Capital Allocation

Analysts and corporate managers should understand the logic and practicalities of different capital allocation methods.

If a company can invest in a project that earns more than its opportunity costs of funds, then the investment creates value and will increase shareholder wealth. Conversely, if the project earns less than the company’s opportunity cost of funds, then the investment decreases value and will reduce shareholder wealth. The return on invested capital (ROIC) is a measure that is often used to make these comparisons.

ROIC = After-Tax Operating Profit/Average Book Value of Invested Capital

ROIC reflects how effectively a company’s management is able to convert capital into after-tax operating profits. Note that the numerator excludes interest expense because it represents a source of return to providers of debt capital, and the denominator includes sources of capital from all providers.

If the ROIC measure is higher than the cost of capital (COC), the company is generating a higher return for investors compared with the required return, thereby increasing the firm’s value. We can also say that projects with positive NPV will have a ROIC that is greater than the COC.

Relationship between NPV and Stock Price

• The value of a company can be measured as the existing value plus the present value of its future investments. NPV is a direct measure of the expected change in the firm’s value from undertaking a capital project.
• Theoretically, a positive NPV project should cause a proportionate increase in a company’s stock price. But, if the project’s profitability is less than expectations, then the stock price may be negatively impacted.
• However, in reality, there are many other factors that can affect the stock price, and the relationship between NPV and stock price is not perfect.

Example

A company is undertaking a project with an NPV of $500 million. The company currently has 100 million shares outstanding and each share has a price of$50. What is the likely impact of the project on the stock price?

Solution:

NPV of the project = $500 million. The overall value of company should increase by$500 million because of the project. Since there are 100 million shares outstanding, each share should go up by 500/100 = $5. The share price should increase from$50 to \$55.

Effects of Inflation on Capital Allocation process

Capital allocation analysis can be done either in ‘nominal’ terms or ‘real’ terms. Nominal cash flows include the effects of inflation. Whereas, real cash flows are adjusted downward to remove the effect of inflation. Nominal cash flows should be discounted at a nominal discount rate, and real cash flows should be discounted at a real rate. In general, the relationship between real and nominal rates is:

(1 + Nominal rate) = (1 + Real rate) (1 + Inflation rate).

Inflation reduces the value of depreciation tax savings. This is because the depreciation charge is based on the asset’s original purchase price and it is not adjusted to match the current inflated price. Higher-than-expected inflation increases the corporation’s real taxes and shifts wealth from the corporation to the government.

Inflation does not affect all revenues and costs uniformly. The company’s after-tax cash flows will be better or worse than expected depending on how particular sales outputs or cost inputs are affected.

Inflation complicates the capital allocation process.

## 7. Real Options

Real options are options that allow managers to make decisions in the future that change the value of capital investment decisions made today. As with financial options, real options are contingent on future events. The difference is that real options deal with real assets.

Types of real options include:

• Timing options: A company can delay investing until it has better information.
• Sizing options: If a company can invest in a project and then abandon it if its financial results are weak, it has an abandonment option. Conversely, if the company can make additional investments when financial results are strong, it has a growth option.
• Flexibility options: Once an investment is made, operational flexibilities such as changing the price (price setting option), or increasing production (production flexibility option) may be available.
• Fundamental options: In this case, the whole investment is an option. For example, the value of an oil well or refinery depends on the price of oil. If oil prices are low, a company may not drill a well. If oil prices are high, the company may pursue drilling.

There are several approaches to evaluating capital allocation projects with real options.

1. Use DCF analysis without considering options. If the NPV of the project without considering options is positive, then we can go ahead and make the investment. The presence of real options will simply add even more value. Therefore, it is not necessary to determine the value of the options separately.
2. If NPV is negative without considering options, then calculate project NPV as: Project NPV = NPV (based on DCF alone) – Cost of options + Value of options. Check if the project NPV turns positive after the options are considered.
3. Use decision trees and option pricing models. They can help in many sequential decision-making problems.

Example: Production-flexibility option

(This is Example 7 from the curriculum.)

Auvergne AquaFarms has estimated the NPV of the expected cash flows from a new processing plant to be –EUR0.40 million. Auvergne is evaluating an incremental investment of EUR0.30 million that would give management the flexibility to switch between coal, natural gas, and oil as an energy source. The original plant relied only on coal. The option to switch to cheaper sources of energy when they are available has an estimated value of EUR1.20 million. What is the value of the new processing plant including this real option to use alternative energy sources?

Solution:

NPV, including the real option = NPV based on DCF alone – Cost of options + Value of options

= -0.40 million – 0.30 million + 1.20 million = 0.50 million.

Without the flexibility offered by the real option, the plant is unprofitable. The real option to adapt to cheaper energy sources adds enough to the value of this investment to give it a positive NPV.

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