Basic Principles of Capital Allocation (2024)

As we dive a little deeper into the principles of capital allocation, we’ll provide you with more details to enhance your understanding.

Conventions and Significance in Capital Allocation

Remember, consistency is crucial when using conventions in capital allocation. For instance, if a firm is considering buying a vending machine for $500, the initial cash outflow is -$500. Projected cash inflows of $300 per year for the following three years are denoted as arrows away from the timeline, with a positive sign.

Five Key Principles in Capital Allocation Process

1. Cash flows, not accounting income: Cash flows reflect the actual money exchanged during transactions, while accounting income, like net income, might include non-cash items like depreciation expense and amortization. Stick to cash flows for capital allocation decisions.
2. Opportunity costs: Account for opportunity costs by calculating the cash flows that would occur if the project wasn’t undertaken, and subtracting it from the projected cash flows if the project was undertaken. The result represents the incremental cash flows.
3. Timing of cash flows: Be precise with the timing of each cash flow, as earlier cash flows are worth more due to the time value of money. As an analyst, it’s crucial to make an effort in accurately estimating the timing of each cash flow.
4. After-tax basis: Taxes reduce the value a project brings to the firm, so cash flows should be analyzed after accounting for taxes. This ensures a more realistic assessment of a project’s impact on the firm’s value.
5. Ignore financing costs: Although it might seem counterintuitive, ignore financing costs, as the discount rate used in the capital allocation process already accounts for the firm’s cost of capital. The cost of capital will be covered in the next topic.

Terms Used In Capital Allocation

Sunk Costs: Sunk costs are expenses that have already been incurred and cannot be avoided or recovered, regardless of whether the project proceeds or not. These costs should not be included in project evaluation since they don’t impact the decision-making process. For example, if a firm has already paid $50 to a consultant for a project assessment, this cost is considered sunk and should not influence the project’s evaluation.

Externalities: Externalities refer to the indirect effects a project might have on other aspects of the firm’s operations. Negative externalities, such as cannibalization, occur when a new project reduces sales from existing products. On the other hand, positive externalities may arise when a new project complements and boosts the sales of existing products. As an analyst, it’s crucial to account for both positive and negative externalities when evaluating a new project.

Basic Concepts in Evaluating Capital Projects

As we explore the fundamental concepts involved in evaluating capital projects, we’ll provide you with additional details to help you better understand the intricacies of project evaluation.

Independent vs. Mutually Exclusive Projects

When it comes to choosing projects, understanding the difference between independent and mutually exclusive projects is vital. Independent projects don’t directly compete, so a firm can choose multiple profitable projects simultaneously. In contrast, mutually exclusive projects require the firm to select just one option, generally the most profitable among the group. If there are several profitable mutually exclusive projects, a firm can still only choose one.

Project Sequencing

Some projects are interconnected and must be undertaken in a specific order, which makes project sequencing an important factor to consider. For instance, investing in Project A today might create the opportunity to invest in Project B in the future. If Project B is unprofitable, the firm might not invest in Project C. Thus, understanding the interdependencies between projects and their sequence is critical when assessing their overall impact on a firm’s long-term profitability.

Unlimited Funds vs. Capital Rationing

While it would be ideal for a firm to have unlimited access to capital and undertake all profitable projects, the reality is often different. Firms typically face constraints on the amount of capital they can raise, leading to capital rationing. In such scenarios, firms must prioritize their project selection to maximize shareholder value within the available funding constraints. This might involve using techniques such as the internal rate of return (IRR) or net present value (NPV) to compare projects and choose those with the highest potential returns.

Now equipped with a more comprehensive understanding of the basic concepts in evaluating capital projects, you’re better prepared for analyzing the profitability and impact of various projects.