Lesson 6 of 8 · All lessons in this module
- Types of capital investments
- The capital allocation process and NPVVideo lesson
- IRR, and choosing between IRR and NPVVideo lesson
- Return on invested capital (ROIC)Video lesson
- Integrated case: three projects against a ROIC target
- Principles of capital allocation
- Capital allocation pitfalls
- Real optionsVideo lesson
Lesson 6 of 8 · 12 min
Principles of capital allocation
Analyse projects on after-tax, incremental cash flows, judged broadly across the whole firm, with careful attention to when the cash arrives.
In short
- Use after-tax cash flows, not accounting profit; include the tax saving from non-cash deductions such as depreciation.
- Include only incremental cash flows: what changes if the project goes ahead versus if it does not.
- Ignore sunk costs, money already spent or committed regardless of the decision.
- Include effects on the rest of the firm: cost savings elsewhere (positive) and lost sales of existing products (negative).
- Timing matters: delaying the same cash flows lowers both NPV and IRR.
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