Capital Allocation: The Four-Step Process

The investment analysis step of the capital allocation process is deemed very difficult because:

Correct. The ability to accurately estimate future cash flow size and timing can be extremely difficult. Typically, the effort involves sales forecasts, engineering analysis, inflation and tax estimates, and project variable costs. Before a project is deemed financially acceptable, a company often uses multiple evaluation methods, and each method is fully developed through sensitivity analysis on the forecasted data.

Incorrect. A company often uses the weighted average cost of capital to aid in evaluating capital project proposals. This cost can be slightly raised if it appears that the project imposes more risk than normal.

Incorrect. The information on initial investment is generally known or can be readily computed, and the present value can be determined. For example, the cost to purchase and install equipment can be estimated through experienced company procurement and construction personnel or through using standard installation estimates.

cash flows are estimated.

the cost of capital is unknown.

the project's initial investment can span over one time period.