Refresher Reading
Capital Investments
2023 Curriculum CFA Program Level I Corporate Finance
Introduction
Capital investments, also referred to as capital projects, are investments with a life of one year or longer made by corporate issuers. Issuers make capital investments to generate value for their stakeholders by returning long-term benefits and future cash flows greater than the associated funding cost of the capital invested. How companies allocate capital between competing priorities and the resulting capital investment portfolio are central to a company’s success and together constitute a fundamental area for analysts to understand. Given that corporate disclosure of capital investments typically is given at a very high level and often lacks specifics, the evaluation of a company’s capital investments is often challenging for analysts.
Capital investments describe a company’s future prospects better than its working capital or capital structure, which are often similar for companies, and provide insight into the quality of management’s decisions and how the company is creating value for stakeholders. Although the focus of this coverage is on capital investments, companies also make other investments in increased working capital, information technology (IT), and human resources projects. These investments might not be capitalized and therefore affect near-term operating profit, but they are made for similar long-term benefit as capital investments.
Learning Outcomes
The member should be able to:
- describe types of capital investments made by companies;
- describe the capital allocation process and basic principles of capital allocation;
- demonstrate the use of net present value (NPV) and internal rate of return (IRR) in allocating capital and describe the advantages and disadvantages of each method;
- describe common capital allocation pitfalls;
- describe expected relations among a company’s investments, company value, and share price; and
- describe types of real options relevant to capital investment.
Summary
Capital investments—those investments with a life of one year or longer—are key in determining whether a company is profitable and generating value for its shareholders. Capital allocation is the process companies use to decide their capital investment activity. This reading introduces capital investments, basic principles underlying the capital allocation model, and the use of NPV and IRR decision criteria.
- Companies invest for two reasons: to maintain their existing businesses and to grow them. Projects undertaken by companies to maintain a business including operating efficiencies are (1) going concern projects and (2) regulatory/compliance projects, while (3) expansion projects and (4) other projects are undertaken by companies to strategically expand or grow their operations.
- Capital allocation supports the most critical investments for many corporations—their investments in long-term assets. The principles of capital allocation are also relevant and can be applied to other corporate investing and financing decisions and to security analysis and portfolio management.
- The typical steps companies take in the capital allocation process are (1) idea generation, (2) investment analysis, (3) capital allocation planning, and (4) postaudit and monitoring.
Companies should base their capital allocation decisions on the investment project’s incremental after-tax cash flows discounted at the opportunity cost of funds. In addition, companies should ignore financing costs because both the cost of debt and the cost of other capital are captured in the discount rate used in the analysis. - The NPV of an investment project is the present value of its after-tax cash flows (or the present value of its after-tax cash inflows minus the present value of its after-tax outflows) or
NPV = Σ t=0 n CF t _ (1 + r) t,
where the investment outlays are negative cash flows included in CFt, and r is the required rate of return for the investment. - Microsoft Excel functions to solve for the NPV for both conventional and unconventional cash flow patterns 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. - The IRR is the discount rate that makes the present value of all future cash flows of the project sum to zero. This equation can be solved for the IRR:
Σ t=0 n CF t _ (1 + IRR) t = 0. - Using Microsoft Excel functions to solve for IRR, the functions are
- IRR or = IRR (values, guess), and
- 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.
- Companies should invest in a project if the NPV > 0 or if the IRR > r.
- For mutually exclusive investments that are ranked differently by the NPV and IRR, the NPV criterion is the more economically sound approach that companies should use.
- The fact that projects with positive NPVs theoretically increase the value of the company and the value of its stock could explain the use and popularity of the NPV method by companies.
- Real options allow companies to make future decisions contingent on future economic information or events that change the value of capital investment decisions the company has made today. These can be classified as (1) timing options; (2) sizing options, which can be abandonment options or growth (expansion) options; (3) flexibility options, which can be price-setting options or production-flexibility options; and (4) fundamental options.