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Corporate IssuersModule 5 of 7

Capital Investments and Capital Allocation

6

Concepts

4

Formulas

1

Decisions

4

Quiz Questions

Key Concepts

6 concepts covered in this module.

Net Present Value (NPV)

Sum of PV of all cash flows (including initial investment). Accept if NPV > 0. The theoretically best capital budgeting method.

Internal Rate of Return (IRR)

Discount rate that makes NPV = 0. Accept if IRR > required return. May conflict with NPV for mutually exclusive projects.

Payback Period

Time to recover initial investment. Simple but ignores TVM and cash flows after payback.

Return on Invested Capital (ROIC)

NOPAT / Invested Capital. Measures how efficiently capital is deployed. Create value when ROIC > WACC.

Real Options

Options embedded in capital projects: option to delay, expand, abandon, or switch. Add value beyond NPV.

Capital Allocation Pitfalls

Sunk cost fallacy, pet projects, failure to consider opportunity costs, optimism bias, anchoring.

Formulas

4 essential formulas for this module.

NPV

NPV = Σ CFt/(1+r)t - Initial Investment

Where: r = required return (WACC for firm projects)

IRR

NPV = 0 = Σ CFt/(1+IRR)t

Where: IRR = rate where NPV equals zero

Payback Period

Payback = Years before full recovery + (Unrecovered amount / CF in recovery year)

Where: Simpler but ignores TVM

ROIC

ROIC = NOPAT / Invested Capital

Where: NOPAT = Net Operating Profit After Tax

Decision Frameworks

1 decision frameworks to guide your analysis.

NPV vs IRR: which to follow?

  • NPV: always correct ranking for mutually exclusive projects
  • IRR: useful for communication (percentage return is intuitive)

Mind Map

Visual overview of how concepts connect in this module.

Capital Allocation
NPV
PV of all CFs minus cost
Accept if NPV > 0
Best theoretical method
Assumes reinvestment at WACC
IRR
Rate where NPV = 0
Accept if IRR > WACC
May conflict with NPV
Multiple IRR problem
Other Methods
Payback period
Discounted payback
Profitability index
ROIC
Real Options
Delay
Expand
Abandon
Switch
Add value to NPV
Pitfalls
Sunk cost fallacy
Optimism bias
Pet projects
Ignoring opportunity costs
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Net Present Value (NPV)

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Answer
Sum of PV of all cash flows (including initial investment). Accept if NPV > 0. The theoretically best capital budgeting method.
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