A factory expansion, a software replacement, an environmental retrofit, and a new product line all compete for the same pool of capital. Capital allocation decides which wins, and the math matters more than the slide deck.
Capital investments are long-lived outlays whose cash returns spread across many years. Analysts describe four standard types of capital investment:
- Going concern (maintenance) projects. Replace worn equipment, upgrade IT, sustain current operations. Lowest risk because the cash baseline is well known.
- Regulatory, safety, and environmental. Mandated by law or regulator. Often produce no measurable revenue. Failure to invest means losing the license to operate.
- Expansion of existing business. Scale current products or geographies. Risk is moderate. The cash-flow model rests on familiar products.
- New lines of business and other. Greenfield products, R&D, pet projects. Highest uncertainty. This is where bias and politics show up.
KEY: Forecast uncertainty climbs from going-concern (lowest) to new business (highest). Required returns and scrutiny should rise with the category.
Common mistakes
- Including sunk costs. R&D already spent on a product is irrelevant to the go/no-go decision. Trap: subtracting $2,000,000 of prior research from the project's incremental cash flows.
- Picking IRR over NPV for mutually exclusive projects. A small project at 30% IRR creates less dollar value than a large project at 18% IRR. Trap: choosing the smaller project because the percentage looks better.
- Double-counting financing. WACC already reflects the cost of debt and equity. Subtracting interest expense in the cash-flow line understates project value. Trap: deducting interest and also discounting at WACC.
Bottom line
- Four investment types: going concern (maintenance), regulatory/compliance, expansion of existing business, and new lines of business, climbing in risk and required return
- NPV rule: accept if NPV > 0. IRR rule: accept if IRR > required return. ROIC rule: value created if ROIC > WACC, where ROIC is NOPAT over invested capital
- When NPV and IRR conflict on mutually exclusive projects, follow NPV
- IRR's three weaknesses: multiple roots when signs flip, scale insensitivity, and an unrealistic reinvestment assumption at the IRR
Exam shortcut
When NPV and IRR conflict on mutually exclusive projects, always pick NPV. The IRR's reinvestment assumption is the trap. For pitfalls, scan for the three classics: sunk costs included, financing inside cash flows, externalities ignored. For real options, memorize TSFF: Timing, Sizing, Flexibility, Fundamental. If static NPV is near zero, the correct exam answer often hinges on identifying an embedded real option.
The full lesson (about 2,191 words, 15 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- capital investments and capital allocation
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