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2025 R24 Module 24.2

The document outlines principles of capital allocation, emphasizing the importance of incremental cash flows, timing, and avoiding sunk costs. It highlights common cognitive and behavioral mistakes in capital allocation decisions, such as poor forecasting and reliance on senior management's pet projects. Additionally, it discusses real options that provide firms with flexibility in investment decisions, including timing, abandonment, and expansion options.

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7 views3 pages

2025 R24 Module 24.2

The document outlines principles of capital allocation, emphasizing the importance of incremental cash flows, timing, and avoiding sunk costs. It highlights common cognitive and behavioral mistakes in capital allocation decisions, such as poor forecasting and reliance on senior management's pet projects. Additionally, it discusses real options that provide firms with flexibility in investment decisions, including timing, abandonment, and expansion options.

Uploaded by

ahmedmohamed889889
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Corporate Issuers

Capital Allocation Principles


and Real Options

Capital Allocation Principles


and Real Options

Principles of Capital Allocation


 Decisions are made based on changes in after-tax cash flows
 Only consider incremental cash flows
 Do not consider sunk costs
 Consider cash opportunity costs
 Consider externalities—cannibalization
 Timing of cash flows is important
 Do not consider project-specific financing costs

© Kaplan, Inc. 1

1
Capital Allocation Principles
and Real Options

Common Mistakes
Cognitive (calculation) errors
 Poor forecasting: allocation of overhead expenses,
neglecting competitor response
 Incorrect accounting for inflation: real (nominal) cash flows to
be discounted at real (nominal) rates.
 Not considering cost of internal funds: retained earnings are
not free!

© Kaplan, Inc. 2

Capital Allocation Principles


and Real Options

Common Mistakes
Behavioral (judgment) errors
 Pet projects of senior management
 Inertia in setting initial capital budget
 Basing investment decisions on EPS and ROE
 Failure to generate alternative ideas

© Kaplan, Inc. 3

2
Capital Allocation Principles
and Real Options

Real Options
 There are future actions a firm can take if they invest in a
project today:
 Timing option: delay investment until firm has more information
 Abandonment option: stop project if PV of doing so > PV of
continuing
 Expansion or growth option: invest in additional projects

© Kaplan, Inc. 4

Capital Allocation Principles


and Real Options

Real Options
Flexibility options
 Price-setting: increase product price if demand is high
(without increasing production)
 Production flexibility: inputs (materials, overtime) or variety
of product
 Fundamental option: project payoffs depend on price of an
underlying asset (e.g., copper mine)
 Project NPV (without option) > 0, accept; otherwise, add option
value (net of cost) and recheck if > 0

© Kaplan, Inc. 5

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