Capital Investments and Capital Allocation
Refresher reading access
Overview
The previous learning module described issuers’ short-term investments and financing activities. In this module and the next, we turn our attention to issuers’ long-term investment and financing activities. First, we explore the various forms of capital investment and their purposes. We then discuss the investment decision-making process and compare analytical approaches employed in that process. In the third lesson, we describe principles of capital allocation and common pitfalls. While the goals of both capital allocation and estimating expected investment returns are to select the best choice among investment alternatives, a firm’s decision today may influence future investment decisions, resulting in so-called real options, which are discussed in the final lesson.
- Companies make capital investments to maintain or expand operations. Capital investments can be grouped into four categories based on their risk and return characteristics: (1) going concern projects, (2) regulatory/compliance projects, (3) expansion projects, and (4) other.
- Capital allocation is a process undertaken by issuers’ management and board for evaluating investment opportunities based on their expected contribution to shareholder value, as well as other considerations, such as environmental, social, and governance (ESG) factors. Although 1 © 2024 CFA Institute. All rights reserved.2 Capital Investments and Capital Allocation some projects might look profitable on an accounting or standalone basis, they might be uneconomical compared to alternatives or from an overall strategic perspective. Such projects should not be pursued, and capital should instead be returned to shareholders.
- Net present value (NPV) and internal rate of return (IRR) are two tools used to evaluate individual investment projects. NPV estimates the increase in firm value from a project, while IRR is an estimate of the rate of return on a project, subject to certain assumptions, which can be compared to a hurdle rate.
- Unlike NPV and IRR, return on invested capital (ROIC) is a company-wide measure and can be calculated using data available to independent analysts. ROIC is the rate of return an issuer earns over a period across all investments and can be compared to an investor’s required rate of return. Like NPV and IRR, ROIC is subject to limitations and assumptions.
- Before investment projects are appraised on a quantitative basis, they should be modeled in accordance with certain principles, including measurement of cash flows on an after-tax basis, avoiding double counting, and including a project’s impact on the rest of the firm. Impacts can be positive, such as cost savings, or negative, such as the loss of sales from existing products.
- Apart from deviations from these principles, capital allocation is additionally prone to behavioral biases and cognitive errors. These pitfalls can be detected by a thorough analysis of a company’s financials on a historical and comparative basis, as well as an examination of corporate governance and management renumeration policies.
- Real options are like financial options in that they provide a right, not an obligation, for management to alter different aspects of capital projects in the future. Those aspects include timing and size of a project, as well as flexibility with regard to future pricing policies or operating capacity.
- The most common approach to evaluating projects with real options is to compare a project’s NPV before and after inclusion of an option’s value less the option’s cost. More advanced methods include decision trees and option pricing models, which require assumptions about the probability of future events.
Learning outcomes
The candidate should be able to:
- describe types of capital investments;
- describe the capital allocation process, calculate net present value (NPV), internal rate of return (IRR), and return on invested capital (ROIC) and contrast their use in capital allocation;
- describe principles of capital allocation and common capital allocation pitfalls;
- describe types of real options relevant to capital investments.
1.25 PL Credit
If you are a CFA Institute member don’t forget to record Professional Learning (PL) credit from reading this article.