Capital Allocation Assumptions

Capital allocation decisions are based on incremental after-tax cash flows discounted at the opportunity cost of capital. Assumptions are:

• Capital budgeting decisions must be based on cash flows, not accounting income.
  Accounting profits only measure the return on the invested capital. Accounting income calculations reflect non-cash items and ignore the time value of money. They are important for some purposes, but for capital allocation process, cash flows are what are relevant.
  Economic income is an investment's after-tax cash flow plus the change in the market value. Financing costs are ignored in computing economic income.

• The opportunity cost should be charged against a project. Remember that just because something is on hand does not mean it's free. See below for the definition of opportunity cost.

• Expected future cash flows must be measured on an after-tax basis. The firm's wealth depends on its usable after-tax funds.

• Cash flow timing is critical because money is worth more the sooner you get it. Also, firms must have adequate cash flow to meet maturing obligations.

• Ignore how the project is financed. Interest payments should not be included in the estimated cash flows since the effects of debt financing are reflected in the cost of capital used to discount the cash flows. The existence of a project depends on business factors, not financing.

Important Capital Allocation Concepts

A sunk cost is a cash outlay that has already been incurred and which cannot be recovered regardless of whether a project is accepted or rejected. Since sunk costs are not increment costs, they should not be included in the capital budgeting analysis.

For example, a small bookstore is considering opening a coffee shop within its store, which will generate an annual net cash outflow of $10,000 from selling coffee. That is, the coffee shop will always be losing money. In the previous year, the bookstore spent $5,000 to hire a consultant to perform an analysis. This $5,000 consulting fee is a sunk cost; whether the coffee shop is opened or not, the $5,000 is spent.

An opportunity cost is the return on the best alternative use of an asset or the highest return that will not be earned if funds are invested in a particular project. For example, to continue with the bookstore example, the space to be occupied by the coffee shop is an opportunity cost - it could be used to sell books and generate a $5,000 annual net cash inflow.

An incremental cash flow is the net cash flow attributable to an investment project. It represents the change in the firm's total cash flow that occurs as a direct result of accepting the project.

• Forget sunk costs.
• Subtract opportunity costs.
• Consider side effects on other parts of the firm: externalities and cannibalization.
• Recognize the investment and recovery of net working capital.

Project Interactions

Independent projects versus mutually exclusive projects. Mutually exclusive projects are investments that compete in some way for a company's resources - a firm can select one or another but not both. Independent projects, on the other hand, do not compete for the firm's resources. A company can select one or the other or both, so long as minimum profitability thresholds are met.

Common Capital Allocation Pitfalls

Here are some of the common capital allocation mistakes that managers make:

Internal forecasting errors: Companies may make internal forecasting errors that are hard, if not impossible, for outside analysts to spot, which might lead to unsuccessful investment results. The required rate of return for a project should be based on its risk, not the cost of debt, equity or weighted average of capitals involved. The longer a project's life, the bigger the impact of the discount rate errors on a project.

Source of capital bias: The capital allocation process should be used for all capital investments, whether made using internally produced cash, debt, or equity. Management teams should consider all capital as having an opportunity cost, independent of its source. Some management teams may plan for internally generated cash differently and as if it is "free" from externally raised capital like equity or debt.

Inconsistent treatment of inflation: Projected cash flows should be discounted at the matching rate (nominal or real). Nominal cash flows should be discounted at a nominal discount rate, and real cash flows should be discounted at a real discount rate. Inflation does not affect all revenues and costs uniformly. Certain costs may rise faster or more slowly than revenues.

Inertia: By comparing the current capital investment to the amount from the previous year and the return on investment, analysts can determine the presence of inertia. The analyst should evaluate the issuer's justification for its capital investment and if management should contemplate alternate uses if capital spending each year is stagnant or rising despite declining returns on investment.

Basing investment decisions on accounting measures (e.g. EPS): Even for those with a high NPV, many investments do not increase earnings per share (EPS), net income, or return on equity (ROE) in the short run. Since many managers sometimes have short-term incentives, they may choose projects that do not align with the company's long-term interests.

Pushing pet projects: Pet projects are projects that influential managers want the corporation to invest in. They should undergo normal capital budgeting analysis. However, sometimes insufficient analysis is performed or overly optimistic projections are used to inflate the profitability of a pet project.

Failing to consider investment alternatives or the alternative states: The most basic phase in the capital allocation process is to generate solid investment ideas, yet many good alternatives are never even explored in some organizations. Furthermore, many businesses overlook different world conditions, which should be considered through breakeven, scenario, and simulation analyses.