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Investment Decisions CMA Part 2
Section E – Investment Decisions

Introduction to Investment Decisions
The Investment Decisions section accounts for 15% of the CMA Part 2 exam. The whole exam will contain 100
multiple-choice questions and 2 essay questions. Topics within an examination part and the subject areas
within topics may be combined in individual questions. Therefore, it is difficult to predict how many multiple-
choice questions will come from this section or if there will be any essay questions from this section on any
given exam. The best approach to preparing for this exam is to know and understand the concepts well and
be ready for anything.
Investment Decisions focuses on capital budgeting, which refers to a group of methods to evaluate possible
capital projects in which to invest. Capital budgeting is used to make long-term planning decisions, which
usually involve large sums of money and extended time commitments. Therefore, it is critical to the
company’s success that its management makes correct decisions in these matters.
Note: The process of financing capital investments is covered in Raising Capital (Section B in Volume 1 of
this book) and is not discussed in this section.
To succeed in this section of the exam, it is important to be competent in the following areas:
• Calculating the cash flows for all of the years of a project, including the cash flows resulting from
disposal of the assets at the end of the project.
• Calculating the Depreciation Tax Shield.
• Calculating the Net Present Value.
• Calculating the Internal Rate of Return.
• Determining which project or projects to invest in.
• Calculating and using other covered methods, such as the Payback Method and the Accounting Rate
of Return.
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Section E Investment Decisions
Capital Budgeting Process Overview

Capital—whether debt, equity, or retained earnings—is a limited resource, and a company must carefully
manage its capital, protect it, and make it grow through identifying and taking advantage of investment
opportunities as they arise. However, a company’s management needs a method to decide whether or not a
particular project under consideration will contribute to profits and thus to the value of the firm’s equity and
the wealth of its shareholders. Furthermore, if several projects are under consideration, management needs
to be able to identify which ones are the most profitable. A new plant, new product line, a new business under
consideration, or other similar long-term investments are projects that might be evaluated using capital
budgeting techniques.
Through capital budgeting, management can evaluate different investment opportunities and identify those
that will contribute the most to profits and thus to the value or wealth of the firm and its owners, the
shareholders. As an important decision-making tool, most of the capital budgeting methods focus on the
expected value of net cash flow (as opposed to net income) throughout the entire life of the project,
including all expected cash inflows, expected cash outflows, and expected cash savings (such as tax savings
resulting from the depreciation of the purchased assets). Thus, capital budgeting is a “life-cycle” or “cradle-
to-grave” approach to selecting, implementing, and monitoring the results of long-term investments.
Capital budgeting uses the incremental approach to determine the expected cash inflows, outflows, and
cost savings of a potential investment. With the incremental approach, the only cash flows relevant to the
analysis are those that would be additional as a result of the activity. On the other hand, if the decision
calls for a choice between two or more alternatives, the differential approach is used, in which the only cash
flows relevant to the analysis are those that would differ between or among the alternatives.
Note: The terms “incremental” and “differential” are sometimes used interchangeably; however, they are
not the same.
• Incremental cash flows are cash flows that would be additional as the result of a potential activity.
• Differential cash flows are cash flows that differ between or among two or more potential alterna-
tives.
Five capital budgeting techniques—four primary methods and one secondary method—are used, offering
different ways to analyze a project.
• The Net Present Value Method and the Internal Rate of Return Method use the time value of
money.43 The time value of money recognizes the fact that a $1,000,000 net cash inflow received
next year is worth more than a $1,000,000 net cash inflow received five years from now. Therefore,
to make the analysis meaningful, the expected net cash flows for each of the years over the entire
life of the project are discounted to their present values at the beginning of the project’s life using
the firm’s required rate of return.
• In a third method, the Payback Method, the future net expected cash inflows are compared with
the net initial investment (cash outflow) to determine the time required to recoup the net initial in-
vestment, without considering the time value of money.
• A variation of the Payback Method, the Discounted Payback Method, also uses the time value of
money. It uses the present value of the expected cash flows to calculate the payback period instead
of the undiscounted expected cash flows.
• The final method, the Accrual Accounting Rate of Return Method, is the only method that uses
net income rather than net cash flow. It is calculated by dividing an accounting measure of net in-
come for the project by an accounting measure of investment for the project to calculate an annual
average accounting rate of return on the investment.
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Time value of money concepts are covered in Appendix A to this volume. The time value of money is a very important
concept in capital budgeting.
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The Stages in Capital Budgeting

The process of making capital investment decisions includes six stages:
1) Identification Stage: In this initial phase, management identifies which capital expenditure pro-
jects are necessary to accomplish its objectives such as expanding into a new market or reducing
expenses.
2) Search Stage: The company explores a variety of capital investments that will achieve the organi-
zational objectives.
3) Information-Acquisition Stage: The company determines the expected costs and benefits, both
quantitative and qualitative, of the different capital investments.
There are four main steps for determining net cash flows for each potential project:
a. Determine the net investment and initial-cost cash outflow, which are the net cash outflows as-
sociated with the increase in long-term assets needed for the project or projects under
consideration, as well as the initial cash outflows for activities such as advertising, employee
training, and research and development.
b. Determine the additional net working capital requirement, which is the increase in net current
assets (that is, current assets minus current liabilities) that will result from the investment deci-
sion. The additional net working capital that is required must be treated as an investment
because it represents short-term assets unavailable for other purposes.
c. Determine the estimated subsequent net operating cash flows for each future period in which
the acquired assets will be used. Reliable estimates of revenues, expenses, and also tax savings
due to tax-deductible depreciation expense on the assets are essential for this process.
d. Determine all the net cash flows at the project’s conclusion related to the disposal of the long-
term assets and release of the working capital.
Note: All amounts used in the Information-Acquisition Stage are net amounts, that is, cash in-
flows minus cash outflows.
4) Selection Stage: On the basis of financial analysis and nonfinancial considerations, the company
chooses the project or projects to implement.
5) Financing Stage: The company obtains the necessary project funding.
6) Implementation and Control Stage: The project is implemented and monitored over time.
Note: A post-completion audit (or post-audit) of a capital budgeting project compares the actual
benefits and costs of the project with the original estimates. Post-completion audits should be done for all
large projects and for all strategically important projects, regardless of size. They should also be done for a
sample of smaller projects.
A post-audit lets management know how closely the actual results of the project matched the original
estimates. The feedback from a post-audit helps management learn where its forecasts may have been
inaccurate and to understand which important factors may have been omitted from its capital budgeting
analysis. The information gained from a post-audit can help to improve future capital budgeting analyses.
Although each of the six stages is important, the following discussion will focus on the Information-Acquisition
Stage and the Selection Stage, examining potential investments from a purely financial viewpoint.
However, in real-world analysis of potential projects, it is important to realize that there may be non-financial
considerations that may prompt a company to select an investment that may not be the most financially
rewarding. For example, the company might invest in a project that has low or negative net cash flows but
which would benefit the local community and raise the company’s philanthropic profile.
Terms Used in Capital Budgeting

A number of different forms of cash flows, revenues, and costs are used in capital budgeting. Relevant cash
flows must be included and cash flows that are not relevant must be excluded from the decision-making
process.
Avoidable Cost A cost that can be avoided or eliminated either by deciding not to invest or ceasing to
invest. Because these costs may be different between or among options, they are
relevant costs.
Committed Cost A specific cost that a company has agreed to assume, even if the delivery or invoicing
has not yet taken place, such as a signed contract to purchase goods or services. A
committed cost cannot be changed even though the money has not yet been paid.
Committed costs must be covered. If a committed cost cannot be changed by any
current decision, then it is not relevant to a decision-making process because the cost
will be the same no matter which alternative is ultimately selected.
Common Cost Cost of operating a business that cannot be allocated to any specific user or users on
any cause-and-effect basis, and it may be allocated to all the users on some other
basis. The cost will be the same in total regardless of which option is selected, so it is
not relevant.
Cost of Capital The weighted average cost of interest on debt, net of tax, and the implicit and explicit
costs of equity capital. The cost of capital is the minimum required rate of return for a
project in order to not dilute (or reduce) shareholders’ interests. The cost of capital is
often used as the discount rate in net present value calculations.
Deferrable Cost A cost that can be deferred to future periods without creating a significant impact in
(or Discretionary the current period.
Cost)
Differential The difference in revenue, cost, or cash flow between two alternatives. Differential
Revenue, Cost, or revenues, costs, and cash flows result from choosing one option over another option,
Cash Flow and they are relevant factors in decision-making. Differential revenues, costs, and
cash flows are not the same as incremental revenues, costs, and cash flows (see
below).
Fixed Cost A cost that remains constant over a specified range of activity (or the relevant
range).
Imputed Cost The benefit of the “next best option” that is surrendered as a result of using company
resources elsewhere. It is a cost that is not explicitly stated but which must be
calculated. An imputed cost is a form of opportunity cost (see below).
Incremental The additional revenue, cost, or cash flow that result from choosing an activity over not
Revenue, Cost, or choosing any activity. Incremental revenues, costs, and cash flows are relevant factors in
Cash Flow decision-making.
Opportunity Cost The benefit that could have been gained from an alternative use of the same resource.
An opportunity cost is the contribution to income that is lost when a limited resource is
not used in its best alternative use, or the next highest valued alternative use, that
was given up in order to achieve a specific objective.
Relevant Relevant revenues, costs, or cash flows vary with one course of action over another.
Revenue, Cost, or These are important factors in a decision because all other revenues, costs, and cash
Cash Flow flows are the same for all options. Relevant revenues, costs, or cash flows may be
either incremental or differential.
Sunk Cost A cost that has already been incurred and therefore is not relevant since any new
decision will not change these costs.
Note: “Differential” and “incremental” are different terms with different meanings, although the distinction
between them is very narrow. On the exam they may be used interchangeably. The precise definitions of
“differential” and “incremental” and the difference between them are discussed in more detail in Marginal
Analysis in Section C in this volume, Decision Analysis.
Identifying and Calculating the Relevant Cash Flows

To correctly perform the different capital budgeting methods, it is important to be able to recognize the
relevant cash flows in each of the years of a given project because almost all capital budgeting analyses will
be based upon individual cash flow analyses. Four of the five capital budgeting methods under discussion
here—Net Present Value, Internal Rate of Return, Payback Method, and Discounted Payback
Method—rely on the relevant expected cash inflows and outflows, whereas one—Accrual Accounting Rate
of Return Method—utilizes relevant accounting incomes and expenses.
Note: Each individual cash flow is discussed first without reference to the tax effect of the cash flow. After
the cash flow is discussed, the tax implications, if there are any, are then covered. It is important to know
which cash flows have an associated tax implication and which do not.
“Relevant Cash Flows” Defined

Relevant cash flows are expected future cash flows that differ between alternatives. Relevant cash flows
can be either differential or incremental.
• Differential cash flows are those that differ between two alternatives.
• Incremental cash flows are those that are received or incurred additionally as a result of an
activity.
Cash flows that are the same for all the options under consideration are not relevant because they will be
the same no matter which option is selected.
“Expected Cash Flow” Defined

The annual expected cash flow in a capital budgeting analysis for a given year is the expected value of
the forecasted cash flows for that year.
Note: “Expected value” has a very specific meaning. It does not mean “forecasted value” or “anticipated
value” or “budgeted value.”
The expected value of a discrete random variable is the weighted average of all the possible
outcomes using the probabilities of each of the outcomes as the weights.
The expected value of the forecasted cash flows for a given year is the weighted average of all of the possible
cash flows, with the probabilities of each cash flow occurring serving as the weights. Thus, several possible
cash flows will be projected for each year of a project’s life and probabilities will be determined for each
possible cash flow for each year so that the expected value of the cash flows for each year can be calculated.
When Do Cash Flows Take Place?

• The initial cash outflows that represent the investment in the capital project take place at the very
beginning of the first year of the project.
• In any capital budgeting analysis that uses time value of money concepts,44 all expected cash flows
are treated as though they will take place at the end of the year in which they are expected to oc-
cur, even though they will probably take place throughout the year. The year-end assumption makes
the use of present value concepts possible, and any error introduced by that assumption is not ma-
terial enough to change the decision.
Therefore, if an exam question says that a particular cash flow is received at the beginning of a
year, for capital budgeting purposes it must be treated as if it were received at the end of the previ-
ous year.
• However, expected cash flows used in the Payback Method (not a method that uses time value of
money concepts) are treated as though they will take place evenly throughout each year following
the initial cash outflow at the beginning of the project.
Expected Cash Flows at the Beginning of the Project (Year 0)

All expected cash flows at the beginning of a project relate to the net initial investment. In capital budgeting
analysis, the date of the initial investment may be referred to as either “Year 0” or “Time 0.” Cash flows, both
inflows and outflows, that occur at the beginning of a project take place one year before the end of Year 1.
These Year 0 cash flows consist of three components:
1) Initial investment. The initial investment is the cash outflow necessary to get the project operat-
ing, such as purchase or construction of assets, transportation costs to have the assets shipped to
the location where they will be used, installation and setup, testing, and other related costs.
Tax Effect: There is no immediate tax effect with respect to the initial investment. However, be-
ginning with the first full year of operation, tax benefits will arise over the life of the project as
the capital assets are depreciated. The tax benefit received from the depreciation, called the de-
preciation tax shield, is covered later as an annual cash flow over the life of the project.
2) Initial working capital investment. Working capital, also known as net working capital, is
total current assets minus total current liabilities. An expected increase in working capital means that
accounts receivable and inventory are expected to increase due to the project under consideration.
Cash will be required to purchase the inventory and to support the increase in receivables. The in-
crease in accounts receivable represents goods supplied or services rendered for which the company
has incurred costs but for which it has not yet received payment.
On the liability side of the balance sheet, accounts payable related to the purchased inventory will
also increase. However, the increase in accounts payable will not be as great as the increase in ac-
counts receivable and inventory.
Thus, net working capital will increase by the amount of the increase in current assets minus the
amount of the increase in current liabilities related to the project. This increase in working capital is
a cash outflow at the beginning of the project.
For example, if a new, higher-capacity machine replaces an older one resulting in higher production
and higher sales, the initial working capital investment will be the difference between the working
capital investment required for the new machine and the working capital investment required for the
old machine. In this case, the initial working capital investment is an incremental amount.
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Present Value, Internal Rate of Return, and the Discounted Payback Method use time value of money concepts. Time
value of money concepts are covered in Appendix A in this volume.
Tax Effect: There is no tax effect related to working capital. Therefore, the amount that needs to
be included in the capital budgeting analysis is the actual amount of the increase in working capi-
tal that the company expects to occur.
3) Cash received from the disposal of old or outdated assets. In the process of beginning a
project, assets might need to be liquidated. For example, a new project might require the company
to purchase a new machine to replace an older machine. Since the older machine is now obsolete,
the company might wish to maximize a cash return for the older machine (perhaps through a heavily
discounted resale or a tax-deductible, charitable contribution) rather than throw it away. Cash re-
ceived from the disposal of old or outdated assets is a cash inflow and therefore reduces the initial
investment for the newer assets.
Tax Effect: When an old asset is sold, there is an income tax effect related to the gain or loss on
the sale. The amount of the gain or loss is the difference between the cash received from the sale
and the tax basis of the asset (that is, its book value for tax purposes).
Any gain on the sale is taxed, and the amount of the income tax constitutes a reduction in the
net cash inflow from the sale.
Any loss on the sale constitutes a reduction of net taxable income, which lowers the company’s
total income tax burden. The amount of the tax savings that results increases the net cash inflow
received from the sale of the asset for the purposes of the capital budgeting analysis. Therefore, a
loss on the disposal of the old assets creates an increase to net cash flow in the form of lower
income taxes. If an old asset is donated to a qualified charitable organization, the tax savings re-
ceived as a result of the tax deduction for the donation is a cash inflow from the disposal.
However, under U.S. tax law, capital losses are allowed on the tax return only as a reduction of
capital gains from other transactions. If gains during the year are not adequate to offset the
loss, a net capital loss can be carried back up to three years and forward up to five years as a
short-term capital loss. For exam purposes, unless a question states otherwise, assume that the
company has other capital gains equal to or greater than any capital loss and thus is able to use
the capital loss on its tax return to reduce both those gains and its income tax paid.
Note: The calculation of the taxable gain or loss should be performed using the tax basis of the
asset. The tax basis is the asset’s book value for tax reporting purposes, which may be different
from the asset’s book value for financial reporting purposes. In some questions on the exam, both
the book value and the tax basis will be given. However, on other questions, only the book value
of the asset may be given. If only the book value is given, then use the book value to calculate
the gain or loss. But if both the book value and the tax basis are given, use the tax basis.
A problem may indicate that the company’s tax rate for capital gains is different from its tax rate
for cash flows from operations. If this occurs, use the tax rate given for capital gains to calculate
the tax effect of the gain or loss.
Note regarding timing of the tax effect: The tax effect of either a gain or a loss on the disposal of
an old asset affects the same year’s cash flow as is affected by the cash flow from the disposal
because in the U.S., businesses pay estimated taxes quarterly. Since quarterly estimated taxes
are paid throughout the year, tax effects occur virtually immediately. Unless an exam question
specifically states that the tax effect will take place at a different time from the cash flow from the
disposal, assume the tax effect occurs at the same time as the cash flow from the disposal.
Annual Net Cash Flows

Annual net cash flows after the project begins include net operating cash flows, cash outflows for follow-up
investments, and the depreciation tax shield, a cash inflow.
Operating Cash Flows

After a project begins, the company will have annual net cash flows from operations that will either remain
constant for each year of the project or else fluctuate. The operating cash inflows may result from one or both
of two sources:
1) Increased sales. If all goes well, the investment will lead to an increase in sales and cash flows.
The cash inflow for capital budgeting purposes is the amount of the increased net operating cash
flows (that is, cash inflows minus cash outflows) that result each year from the investment.
2) Decreased operating expenses. Improvements in worker and equipment efficiency may reduce
operating expenses. The amount of the decreased operating expenses constitutes a cash inflow for
capital budgeting purposes.
Tax Effect: The company will need to pay income taxes as a result of either increased sales and
profits or decreased operating costs. Therefore, the cash flows related to these items need to be
reduced for the resulting taxes.
Depreciation is not included in operating cash flows because it is not a cash expense.
Cash Outflows for Follow-Up Investments

The company may have cash outflows after the initial investment is made. Two potential sources of cash
outflows in subsequent years are:
1) Another capital investment. A follow-up capital investment may be needed to maintain the
equipment after a certain number of years. This would be treated as a cash outflow for the amount
expected to be paid in the year it is to be paid.
Tax Effect: The tax effect of a subsequent investment is treated in the same manner as the orig-
inal investment. Beginning with the year in which the additional investment is made, a benefit is
received in the form of tax savings resulting from the subsequent depreciation of the additional
investment, covered in the topic on the depreciation tax shield.
2) Subsequent working capital investment. The company may need another increase in its working
capital later in the project’s life. This additional increase is treated in the same manner as the in-
crease in working capital at the beginning of the project, except that, of course, it occurs in a later
year.
Tax Effect: As is the case with the original investment in working capital, any increase in working
capital in subsequent periods has no tax effect.
Depreciation Tax Shield – A Cash Inflow

The most difficult recurring cash flow over the life of the asset is the cash flow that arises from the
depreciation tax shield. As previously discussed, the tax effect of an asset is received as it is depreciated.
Depreciation is a tax-deductible expense, so it increases expenses and decreases net taxable income on the
firm’s tax return. The tax benefit is received in the form of reduced taxes due to the decreased taxable
income.
The amount of depreciation that is deductible for tax purposes depends on the depreciation method used for
tax purposes. In the U.S., the method of tax depreciation is calculated for most assets using the Modified
Accelerated Cost Recovery System (MACRS), which is based on the double declining balance method (or
the 200% declining balance method) of depreciation. However, depreciation for tax purposes can be
calculated in other ways, such as straight-line. In fact, an exam problem could say that any method of
depreciation is being used for tax purposes.
For tax purposes, the annual depreciation amount is always calculated using a cost basis equal to the full
cost of the asset.
• If MACRS depreciation is being used, the annual depreciation amount is the full cost of the asset
multiplied by the MACRS depreciation rate for each year the depreciation is taken. The depreciation
rate is a different rate for each year and depends on the number of years over which a property is
depreciated. The relevant annual rates will be given in the exam problem.
• If straight-line depreciation is being used for tax purposes, the annual depreciation amount is the full
cost of the asset divided by the number of years of useful life. No residual or salvage value is
used in straight-line depreciation when it is used for tax purposes.
It is important to remember that in capital budgeting, the full cost of the asset is always used to
calculate the annual depreciation to be expensed for tax purposes. The full cost of the asset includes
the purchase price plus all other costs required to transport the asset to its location and make it ready for
use.
Exam Tip: Salvage (or residual) value is not taken into account when calculating the depreciation for
the depreciation tax shield in capital budgeting, regardless of which depreciation method is being used
(even straight-line depreciation). The depreciable base for tax purposes is always 100% of the
asset’s cost, according to U.S. tax regulations, no matter which method of depreciation is being used.
Since depreciation expense is a tax-deductible expense, the calculated amount of tax-deductible depreciation
reduces the company’s taxable income, thereby reducing the amount of tax that will be due. This tax
reduction is not an actual cash inflow, but it does reduce the cash outflow for tax payments. Therefore, the
amount of tax savings that occurs as a result of the depreciation expense is treated as a cash inflow for
capital budgeting purposes. The amount of tax savings that results from the depreciation is called the
depreciation tax shield.
The depreciation tax shield is calculated as follows for each year of an asset’s life:
Depreciation Tax Shield = Full Cost of Asset × Annual Depreciation Rate × Tax Rate
If the new asset is replacing an older asset that still is usable and not yet fully depreciated, the only
relevant depreciation amount to use in calculating the depreciation tax shield is the amount of
difference in each year’s depreciation expense between the new asset and the asset it replaced. The amount
of difference in the annual depreciation expense may change radically at some point during the project term,
since the depreciation on the old asset, if kept, might end before the useful life of the new asset ends.
Exam Tips: The following information represents important exam-related insights and strategies.
The exam will indicate the method of depreciation for tax purposes. Be sure to read the problem
carefully to identify the method and then calculate the tax depreciation and the depreciation tax shield
using this method. If the problem gives one depreciation method for book purposes and another method
for tax purposes, always use the method used for tax purposes.
It is particularly important to note that, for tax purposes, the entire cost of an asset is always depreciated
over its depreciable life. Therefore, do not subtract any salvage value from the cost to calculate the
depreciable base, regardless of which method of depreciation is being used for tax purposes.
If straight-line depreciation is used for tax purposes, do not subtract the salvage value from the
cost to calculate the depreciable base, even though straight-line depreciation for book purposes
requires the subtraction of the salvage value. Under U.S. tax laws, 100% of an asset’s cost is always
depreciated on the tax return, so that is the standard for depreciation calculations for capital budgeting.
HOCK has verified with the ICMA that salvage (or residual) value is not subtracted from the cost to
calculate the depreciable base for purposes of calculating depreciation and the depreciation tax
shield in capital budgeting. It appears, however, that other study guides (not HOCK-related) do not
consistently teach this rule correctly, which has led to some confusion. Do not be concerned about this
discrepancy. Rest assured that HOCK has presented the correct information.
Cash Flows at the Disposal or Completion of the Project

The termination of a project creates a number of potential cash flows:
1) Cash received from the disposal of equipment. Cash received from the sale of related assets
(equipment, machines or the investment project itself) is a cash inflow in the project’s final year.
Tax Effect: If the sale of the assets results in either a gain or a loss, there will be a tax effect.
The gain or loss is calculated by subtracting the tax basis (or book value, if the tax basis is not
given) from the cash received and multiplying the result by the tax rate. Remember that the tax
basis is the full cost of the asset minus accumulated tax depreciation on the sale date.
If there is a gain, reduce the cash inflow by the taxes paid on the gain. If there is a loss, it will be
tax deductible and will result in tax savings. Add the tax savings to the cash received from the
sale to calculate the cash inflow. This tax treatment is calculated in the same way as the calcula-
tion of the gain or loss on the sale of old assets at the beginning of the project.
As with the sale of old assets, in the event of a loss it must be assumed that the company has
other capital gains from which it can deduct the loss and thus is able to use the loss to lower its
tax bill.
A problem may indicate that the company’s tax rate for capital gains is different from its tax rate
for cash flows from operations. If this occurs, use the tax rate for capital gains to calculate the tax
due on the gain.
2) Recovery of working capital. The initial incremental investment in working capital and any subse-
quent investments in working capital are usually fully recouped at the end of the project. The final
accounts receivable will be collected and not replaced with other accounts receivable for this project.
The inventory associated with the project will have been used in production and the finished goods
will have been sold. All the related accounts payable will have been paid. It is also possible for an in-
vestment in working capital to be recovered before the end of the project. Whenever working capital
is recovered, it is a cash inflow in the year of recovery.
Tax Effect: There is no tax effect related to working capital because working capital is neither an
income nor an expense. Therefore, the amount that needs to be included in the capital budgeting
analysis is the actual amount of the working capital that is recovered at the end of the project.
Note: It is very common on the exam for a question to ask only for the cash flows in the final year of the
project. Remember that there are usually two events in this type of question: 1) the sale of the assets
themselves and 2) the release of working capital. Of these, only the gain or loss on the sale of the
asset generates a tax effect. The release of working capital is not a taxable event.
In addition, there may be after-tax operating cash flows and/or a depreciation tax shield for the final year
of operations. Whether to use these or not in the answer depends on what the question asks for and what
information is given. For example, if the equipment will be fully depreciated before the final year, there will
be no depreciation tax shield in the final year. And even though there may be cash flow from operations
and depreciation in the final year, the question may ask only for the cash flows related to the disposition of
the equipment.
Question 79: Which one of the following procedures would most likely help managers identify errors in
their capital budgeting decisions?
a) Value engineering
b) Scenario analysis
c) Post-audits
d) Monte Carlo simulations.
(ICMA Adapted)
Question 80: Which one of the following items is least likely to directly impact an equipment replacement
capital expenditure decision?
a) The net present value of the equipment that is being replaced.
b) The depreciation rate that will be used for tax purposes on the new asset.
c) The amount of additional accounts receivable that will be generated from increased production and
sales.
d) The sales value of the asset that is being replaced.
(ICMA 2010)
Depreciation for Income Tax Purposes

The tax basis of an asset is its book value for income tax purposes. In the U.S., many companies use a
method of calculating depreciation on their tax return that differs from the method they use for book
purposes. Different methods are used because of varying requirements in laws and regulations. For example,
the tax laws say that depreciation must be calculated a certain way on the tax return, whereas U.S. GAAP
says it must be calculated in a different way for financial reporting. In capital budgeting, it is important to
identify the effect that the depreciation reported on the tax return will have on cash. Even though
depreciation itself is a non-cash expense, it has an effect on the amount of tax that is due because the
depreciation expense reduces net taxable income. The amount of tax due is based on net taxable income, and
taxes paid affect cash. Therefore, use the type of depreciation that will be used on the tax return to
calculate the depreciation tax shield in the capital budgeting analysis. Furthermore, when the asset is sold,
use the asset’s tax basis (that is, its book value for tax purposes) to calculate the amount of gain or loss on
its sale and the tax effect of the gain or loss.
MACRS Depreciation for Tax Purposes

MACRS, or Modified Accelerated Cost Recovery System, is the most common type of depreciation required by
the U.S. tax laws, although it is not the only acceptable method a company can use on its tax return.
Remember that the depreciable base for tax purposes, regardless of what method of depreciation is
being used, is always 100% of the cost of the asset and the other costs required to make it ready for
use. Therefore, any anticipated salvage value at the end of the asset’s life is never subtracted from
the original cost when calculating depreciation for tax purposes or when calculating the tax basis (book
value for tax purposes) when the asset is sold.
There is an important consideration to be aware of with respect to depreciation for tax purposes. U.S. tax
laws require that a portion of a year’s depreciation be taken in the year the asset is acquired and a portion of
a year’s depreciation be taken in the year the asset is disposed of. The most common portion used is one-half
year’s depreciation in both the first and the last year, regardless of the actual date the asset was purchased.
Assuming one-half year’s depreciation in the first and last year is called the half-year convention.
Therefore, a three-year asset is depreciated over a three-year period, but that three-year period begins in the
middle of the fiscal year in which the asset is acquired (July 1 if the company is using a calendar year as its
fiscal year) and it ends in the middle of the year in which the asset is completely depreciated and/or disposed
of. For example, a three-year asset purchased in 20X1 when the company’s fiscal year is the same as the
calendar year will be depreciated over four calendar years as follows:
20X1 ½ of one year’s depreciation

20X2 1 year’s depreciation
20X3 1 year’s depreciation
20X4 ½ of one year’s depreciation
Note that the above depreciation schedule works out to three full years of depreciation, but the depreciation
is taken over a period of four tax years.
The U.S. Internal Revenue Service (IRS) provides MACRS tables that give the percentage of the original cost
to be depreciated each year. There are several tables, each incorporating a given convention, and the half-
year convention is the most commonly used. The percentages for the first and last year in the half-year
convention table have already been adjusted to reflect one-half year’s depreciation in those years. Therefore,
when calculating annual depreciation amounts using the MACRS tables, the percentages should be used as
given.
For example, for an asset that is being depreciated over three years using MACRS and the half-year
convention, here are the percentages given in the tables:
Year 1 33.33%
Year 2 44.45%
Year 3 14.81%
Year 4 7.41%
Total 100.0%
The first year’s depreciation in the schedule above is 33.33% of the asset’s total cost. If one full year’s
depreciation were recorded in the first year, the full year amount would be 66.67% of the asset’s total cost.
One-half of that is 33.33%. The final year’s depreciation is adjusted similarly.
Exam Tip: Knowledge of these percentages are not necessary for the exam. If MACRS is to be
used on the exam, the percentages will be given in the question.
Example: The amount of depreciation to be taken for each year for an asset with an original cost of
$90,000 that is being depreciated as three-year property using MACRS and the half-year convention will be
as follows:
Year 1 33.33% $29,997
Year 2 44.45% 40,005
Year 3 14.81% 13,329
Year 4 7.41% 6,669
Totals 100.0% $90,000
Straight-Line Depreciation When Used for Tax Purposes

The method of calculating straight-line depreciation for tax purposes generally requires that assets be
depreciated on a monthly basis. If a question asks for straight-line depreciation for tax purposes, it will
usually state that the asset was purchased on either January 1 or on June 30/July 1.
1) If the asset was purchased on January 1, take a full year of depreciation in the year acquired. A
three-year asset will be depreciated over only three tax years, not four tax years.
2) If the asset was purchased on June 30 or July 1, take one-half year of the annual straight-line
depreciation amount in the year acquired and leave one-half year of depreciation for the final year. A
three-year asset will be depreciated over four tax years.
3) If the asset was purchased on any date other than June 30 or July 1, calculate the monthly straight-
line depreciation for the first year and the final year of the asset’s life as needed. The asset will be
depreciated over one tax year more than its life. For example, a three-year asset that was purchased
on October 1 will be depreciated for three months in the first tax year it is owned and for nine
months in the fourth tax year.
Remember that if straight-line depreciation is used for tax purposes, do not the subtract the salvage value to
determine the depreciable base, even though for financial reporting under U.S. GAAP the salvage value would
be subtracted. The depreciable base for tax purposes is always 100% of the asset’s cost, and tax depreciation
is what must be used in capital budgeting.
Other Tax Considerations

When management makes an investment decision, numerous tax considerations are involved. In addition to
income taxes, management needs to consider the effect the investment will have on the company’s state and
local taxes, many of which are property taxes. Management will need to consider available tax concessions
or relief offered by local taxing authorities as an incentive for taking on a particular project. A tax concession
is a reduction in the local tax rate and a relief is a period of time during which taxes do not need to be paid.
Tax concessions and reliefs can quickly become complicated issues when a company has investments in
different countries or tax jurisdictions in the U.S.
For example, it is common for a city, state, or county to grant property or other tax concessions to persuade
a company to build an office or production facility within that region. A local government can grant
concessions or relief only for taxes that it levies, such as local income taxes or local property taxes. A local
government does not have the authority to provide federal tax concessions or relief.
It is important only to be aware that these considerations do exist, in case they are mentioned in an exam
question. For the purposes of these study materials, only income taxes will be considered in capital budgeting
analyses.
Irrelevant Cash Flows

Some cash flows are not relevant to a capital budgeting analysis and should be disregarded. Irrelevant cash
flows include the following.
Sunk Costs and Allocated Common Costs

Sunk costs such as the amount paid historically or the current book value of existing assets that will
continue to be used are irrelevant because they will not change as a result of any capital budgeting project
decision made.
The allocation of common costs to a particular segment may increase due to a capital budgeting project if
the common costs are allocated based on assets or sales and if those increase as a result of the capital
budgeting project. However, this increase is irrelevant unless the total common costs for the company
as a whole will change as a result of the project. If the total overhead costs will change, the only
relevant cash flow related to them is the increase in total common costs that the project generates. If the
common costs do not change in total but are allocated differently as a result of the project and this particular
segment receives a greater allocation, then other segments will receive less. As long as the total common
costs incurred do not change as a result of the project, there is no relevant increase in costs for the company
as a whole.
Financing Cash Flows

Financing cash flows associated with the project—principal and interest payments on new debt or dividends
on new stock issued—are irrelevant and are not a part of any capital budgeting analysis. The cost of the
financing is captured in the discount rate, or hurdle rate,45 used to discount the future cash flows for
discounted cash flow methods (which will be explained later). To include the cash flows for financing in the
analysis would be to double count them. If financing can be obtained on a more favorable basis than
anticipated, it could add value to the project; however, the financing cash flows are never included in the
capital budgeting analysis that is used to decide whether or not to accept a proposed capital budgeting
project.
Example of Calculation of After-Tax Relevant Cash Flows

CMA Products, Inc. is considering the purchase of a new piece of equipment to introduce a new product line.
The equipment will cost $125,000 including setup costs, installation, and testing. The estimated before-tax
annual cash flow from operations is $50,000, and the investment will require an initial investment in working
capital of $25,000. The estimated salvage value at the end of Year 9 is $10,000. CMA has an effective income
tax rate of 30%.
45
The hurdle rate is the minimum rate of return on a project or investment required by company management or an
investor. The company’s cost of capital is usually the hurdle rate for a capital budgeting project. However, if management
perceives unusual risk in an investment, it should set the hurdle rate higher than the cost of capital to compensate for the
additional risk it is taking.
The equipment will have an economic life of nine years but will be depreciated for tax purposes over seven
years using MACRS. The MACRS depreciation rates for each of the eight years (using the half-year
convention) are:
Year 1 14.29%
Year 2 24.49%
Year 3 17.49%
Year 4 12.49%
Year 5 8.93%
Year 6 8.92%
Year 7 8.93%
Year 8 4.46%
The relevant after-tax cash flows are:
1) Net Initial Investment:

Initial investment in equipment $(125,000) cash outflow
Initial investment in working capital (25,000) cash outflow
Disposal of old equipment 0.00
Net Initial Investment $(150,000)
2) After-Tax Cash Flow from Operations (excluding depreciation effect):
$50,000 before-tax CF × (1 − 0.30) = $35,000 net cash inflow per year
3) Depreciation Tax Shield (30% of depreciation; varies due to varying MACRS depreciation
rates):
Year 1 $125,000 × 0.1429 × 0.30 = $5,359

Year 2 $125,000 × 0.2449 × 0.30 = $9,184
Year 3 $125,000 × 0.1749 × 0.30 = $6,559
Year 4 $125,000 × 0.1249 × 0.30 = $4,684
Year 5 $125,000 × 0.0893 × 0.30 = $3,349
Year 6 $125,000 × 0.0892 × 0.30 = $3,345
Year 7 $125,000 × 0.0893 × 0.30 = $3,349
Year 8 $125,000 × 0.0446 × 0.30 = $1,671
Year 9 (Fully depreciated) 0
4) After-Tax Cash Flow from Disposal at Salvage Value:

Cash received from disposal $10,000
Gain on disposal: $10,000 − $0 tax basis = $10,000
Income tax is 30% on the gain: $10,000 × 0.30 (3,000)
After-tax cash flow from disposal, Year 9 $ 7,000
Therefore, the relevant, after-tax cash flows per year are:
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9
Initial
Investment
(125,000)
in
Equipment
Working
Capital ( 25,000) 25,000*
Increase
After-Tax
CF from 35,000 35,000 35,000 35,000 35,000 35,000 35,000 35,000 35,000
Operations
Depreciation
5,359 9,184 6,559 4,684 3,349 3,345 3,349 1,671 -0-
Tax Shield
After-Tax
CF from 7,000
Disposal
Total After
Tax Cash (150,000) 40,359 44,184 41,559 39,684 38,349 38,345 38,349 36,671 67,000
Flows
* Recovery of released working capital.
Note: Any increase in working capital that occurs during any year subsequent to Year 0 is a reduction
of the cash inflows for that period. In the preceding example, the increase in working capital came in Year
0. However, increases in working capital could occur in other years, as well.
The working capital is released in the final year of the project and becomes a cash inflow at that time.
Question 81: eGoods is an online retailer. The management of eGoods is interested in purchasing and
installing a new server for a total cost of $150,000. The controller of eGoods has asked an accountant at
eGoods to determine the incremental yearly tax savings should the new server be acquired. The server
has an estimated useable life of approximately four years and no salvage value. eGoods currently uses
straight-line depreciation and is assessed an effective income tax rate of 40%. The accountant calculated
the incremental yearly tax savings to be
a) $15,000.
b) $22,500.
c) $37,500.
d) $60,000.
(ICMA Adapted)
Question 82: Garfield, Inc. is considering a 10-year capital investment project with forecasted revenues of
$40,000 per year and forecasted cash operating expenses of $29,000 per year. The initial cost of the
equipment for the project is $23,000, and Garfield expects to sell the equipment for $9,000 at the end of
the tenth year. The equipment depreciates over 7 years. The project requires a working capital invest-
ment of $7,000 at its inception and another $5,000 at the end of year 5. Assuming a 40% marginal tax
rate, the expected net cash flow from the project in the 10th year is:
a) $32,000
b) $24,000
c) $20,000
d) $11,000
(CMA Adapted)
Question 83: Kore Industries is analyzing a capital investment proposal for new equipment to produce a
product over the next 8 years. The analyst is attempting to determine the appropriate “end-of-life” cash
flows for the analysis. At the end of 8 years, the equipment must be removed from the plant and will
have a net book value of zero, a tax basis of $75,000, a cost to remove of $40,000, and scrap salvage
value of $10,000. Kore’s effective tax rate is 40%. What is the appropriate “end-of-life” cash flow related
to these items that should be used in the analysis?
a) $45,000
b) $27,000
c) $12,000
d) $(18,000)
(CMA Adapted)
Capital Budgeting Methods

To answer capital budgeting questions, candidates must be able to make calculations related to different
investment analysis methods and also make decisions about which investment or investments a company
should pursue given a set of circumstances.
The capital budgeting methods that are covered on the CMA exam are:
1) Payback Period or Payback Method
2) Discounted Payback Period or Discounted Payback Method (Breakeven Time)
3) Net Present Value
4) Internal Rate of Return
5) Accounting (or Average) Rate of Return
The first four methods are based on the relevant after-tax cash flows as demonstrated previously. The final
method is based on accounting income and assets. Methods 2, 3, and 4 use time value of money concepts.
Time value of money concepts are covered in Appendix A in this volume.
Payback Period or Payback Method

The Payback Method is used to calculate the number of periods that must pass before the net after-tax
cash inflows from an investment will equal, or “pay back,” the initial investment cost. A company using the
payback method will choose its desired payback period. Projects with payback periods of less than the chosen
amount of time are candidates for further consideration, while projects with payback periods in excess of the
chosen amount of time are rejected.
If the expected cash inflows are constant over the life of the project, the payback period can be
calculated as follows:
Initial net investment

Payback Period =
Periodic constant expected cash inflow
If the expected cash inflows are not constant over the life of the project, the payback period is calculated
by determining the cumulative net cash flow (inflows and outflows) at the end of each year of the project’s
life (including Year 0) to find in which period the inflows will equal the outflows.
Example of the Payback Method with Unequal Annual Cash Flows

CMA Products, Inc. is considering the purchase of a new piece of equipment to introduce a new product line.
The equipment will cost $125,000 including setup costs, installation, and testing. The estimated before-tax
annual cash flow from operations is $50,000, and the investment will require an initial investment in working
capital of $25,000. The estimated salvage value at the end of Year 9 is $10,000. CMA has an effective income
tax rate of 30%.
convention) are as follows.
Year 1 14.29%
Year 2 24.49%
Year 3 17.49%
Year 4 12.49%
Year 5 8.93%
Year 6 8.92%
Year 7 8.93%
Year 8 4.46%
Because the depreciation expense and therefore the depreciation tax shield differs from year to year, the
expected net cash flows are not constant over the life of the project. Therefore, to calculate the payback
period, it is necessary to calculate the cumulative net cash flow for each year of the project’s life until the
inflows equal the outflows.
The schedule of cash flows that follows is the same one used to illustrate relevant after-tax cash flows. Years
5-8 are not shown because they occur after the cumulative net cash flows have become zero, so they are not
needed for demonstrating the calculation of the payback period.
Year 0 Year 1 Year 2 Year 3 Year 4 Years 5-8 Year 9
Initial
Investment in (125,000)
Equipment
Working
Capital (25,000) 25,000*
Increase
After-Tax Cash
Flows from 35,000 35,000 35,000 35,000 … 35,000
Operations
Depreciation
5,359 9,184 6,559 4,684 … -0-
Tax Shield
After-Tax Cash
Flows from 7,000
Disposal
Total After Tax

(150,000) 40,359 44,184 41,559 39,684 … 67,000
Cash Flows
Cumulative
(150,000) (109,641) (65,457) (23,898) 15,786
Cash flows
* Recovery of released working capital.
The cumulative cash flow from the project becomes positive sometime during Year 4. Assuming that the cash
flows occur evenly throughout the year, the exact payback period is 3.6 years, calculated as follows:
Number of the project year in the final year when cash flow is negative: 3
Plus: a fraction consisting of:
Numerator = The positive value of the negative cumulative cash inflow

amount from the final negative year 23,898
Denominator = Cash inflow for the following year 39,684
23,898
Payback Period = 3 + = 3.6 years
39,684
Benefits of the Payback Method of Capital Budgeting
• It is simple and easy to understand.
• It can be useful for preliminary screening when there are many proposals.
• It can be useful when expected cash flows in later years of the project are uncertain. Cash flow
predictions for periods far in the future are less certain than predictions for three to five years ahead.
• It is helpful for evaluating an investment when the company desires to recoup its initial investment
quickly.
• Since the Payback Method favors projects with short time horizons, it can be used to concentrate on
more liquid projects and thus avoid tying up capital for long periods of time.
• The Payback Method can help a company manage risk when evaluating the feasibility of a project in
an unstable environment, where quick profit-making is preferable.
(Limitations begin on next page)
Limitations of the Payback Method of Capital Budgeting
• It ignores all cash flows beyond the payback period and does not consider total project profitability.
Therefore, a project that has large expected cash flows in the latter years of its life could be rejected
in favor of a less profitable project that has a larger portion of its cash flows in its early years.
• The Payback Method does not incorporate the time value of money. Therefore, interest lost while the
company waits to receive money is not considered.
• It ignores the cost of capital, so the company could accept a project for which it will pay more for its
capital than the project can return.
Question 84: Fitzgerald Company is planning to acquire a $250,000 machine that will provide increased
efficiencies, thereby reducing annual operating costs by $80,000. The machine will be depreciated by the
straight-line method over a 5-year life with no salvage value at the end of 5 years. Assuming a 40%
income tax rate, the machine’s payback period is:
a) 3.13 years
b) 3.21 years
c) 3.68 years
d) 4.81 years
(CMA Adapted)
Question 85: Testra Foods is considering opening a new restaurant. The expected purchase price is
$270,000, expected annual revenues are $150,000, and expected annual costs are $90,000, including
$22,500 of depreciation. The investment has a payback period of approximately
a) 1.8 years.
b) 3.0 years.
c) 3.3 years.
d) 4.5 years.
(ICMA Adapted)
Discounted Cash Flow Methods of Capital Budgeting
Introduction to Discounted Cash Flow Methods

Discounted cash flow (DCF) methods measure all of the expected cash inflows and outflows of a project using
time value of money concepts. The premise of time value of money concepts is that money received today is
worth more than money received in any future period. In a discounted cash flow analysis, the earlier that a
project is able to generate cash inflows the better, because cash flows received earlier in a project’s life are
worth more than cash flows received later.
Note: Time value of money concepts are covered in Appendix A in this volume. Candidates who are not
familiar with time value of money concepts should read Appendix A before proceeding.
Discounted cash flow methods focus on the expected cash inflows and outflows from the project rather than
using income as the measurement basis, as in accrual accounting. The focus of discounted cash flow methods
is on the cash return that can be obtained in the future for a cash outlay now.
In discounted cash flow analysis, unless otherwise directed, always assume that all expected cash flows
occur at the end of the year. In some instances, a problem may say that a particular cash flow occurs at
the beginning of the year. If that happens, treat the cash flow occurring at the beginning of the year as
though it occurs at the end of the previous year.
Though this assumption about cash flows occurring only at the end of a year is not in line with reality, it is a
necessary assumption in order to be able to use discounted cash flow techniques to determine the present
value of the expected cash flows. The inaccuracy introduced by this assumption is not material to the analysis
and would not cause a change in the decision.
The Discounted Payback Method, the Net Present Value Method, and the Internal Rate of Return Method use
discounted cash flows.
Discounted Payback Period or Method (Breakeven Time)

The Discounted Payback Method (also called Breakeven Time) is based on the same concept as the
Payback Method, but before calculating the payback period, the expected cash flows are discounted to their
present values using an appropriate interest rate, usually the company’s cost of capital. The Discounted
Payback Method addresses the Payback Method’s limitation of not incorporating the time value of money.
Example of the Discounted Payback Method

Using the same facts as were used in calculating the Payback Method, the Discounted Payback method is
calculated as follows, using a 10% required rate of return:
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Years 6-8 Year 9
Net Initial
Investment in (125,000)
Equipment
Working Capital
(25,000) 25,000*
Increase
After-Tax Cash
Flows from 35,000 35,000 35,000 35,000 35,000 … 35,000
Operations
Depreciation
5,359 9,184 6,559 4,684 3,349 … -0-
Tax Shield
After-Tax Cash
Flows from 7,000
Disposal
Total After Tax

(150,000) 40,359 44,184 41,559 39,684 38,349 … 67,000
Cash Flows
PV of $1 Factor
1.000 0.909 0.826 0.751 0.683 0.621
for 10%
Discounted
(150,000) 36,686 36,496 31,211 27,104 23,815
Cash Flow
Cumulative
Discounted (150,000) (113,314) (76,818) (45,607) (18,503) 5,312
Cash Flows
*Recovery of released working capital
Note that each annual cash flow amount is discounted individually using the present value of $1 factor for
10% for the appropriate term. Discounting each annual cash flow individually is necessary because the cash
flows vary each year, and the present value of an annuity factor cannot be used when cash flows vary. Yet
even if the cash flows did not vary during the period of the project, each year’s cash flow would still need to
be discounted individually when the Discounted Payback Method is being used. Annual discounted cash flow
information is needed to determine the number of years until the initial investment is paid back in discounted
cash inflows. Discounting a series of cash flows as an annuity results in only one amount: the present value of
all the future expected cash flows, and that is not useful for calculating the Discounted Payback Period.
Because the Discounted Payback Method uses cumulative discounted expected cash flows instead of
cumulative undiscounted expected cash flows, the payback period is longer under the Discounted Payback
Method than it is under the Payback Method.
Calculation of the Discounted Payback Period:
Numerator = The positive value of the negative cumulative discounted

cash inflow amount from the final negative year 18,503
Denominator = Discounted cash inflow for the following year 23,815
18,503
Discounted Payback Period = 4 + = 4.8 years
23,815
The Discounted Payback Period is 4.8 years, compared with 3.6 years under the Payback Method using
undiscounted cash flows.
The benefits and limitations of the Discounted Payback Method are similar to those of the Payback Method
with one difference: because it uses discounted cash flows, the Discounted Payback Method does incorporate
the time value of money. However, it still fails to account for expected cash flows after the payback period.
Exam Tip: If a question asks for the breakeven time, it is asking for the Discounted Payback Period.
Question 86: A proposed capital budgeting project has a discounted payback period of 5 years when a
10% cost of capital is used. The project has cash flows that will be positive for years 1 through 7. The
undiscounted payback period of the project is
a) more than 7 years.
b) between 5 and 7 years.
c) less than 5 years.
d) 2 years.
(ICMA 2014)
Question 87: A proposed capital budgeting project requires an initial investment of $95,000. The
subsequent annual cash flows from the project of $40,000 are expected to last for 7 years and be received
at the end of each year. If the cost of capital is 20%, the discounted payback period of the project is
a) less than 2 years.
b) between 2 and 3 years.
c) between 3 and 4 years.
d) between 4 and 5 years.
(Note: Time value of money factor tables are in Appendix A.)

(ICMA Adapted)
Net Present Value (NPV) Method

The Net Present Value (NPV) method is based on the present value of the expected monetary gain or loss
from a project. All expected cash inflows and outflows are discounted to the beginning of the project, using
the required rate of return. The NPV of an investment or project is the difference between the present value
of all future expected cash inflows and the present value of all (initial and future) expected cash
outflows, using the required rate of return.46
Thus, a project’s NPV is the present value of its future expected cash inflows minus the present value of its
future expected cash outflows. The initial cash outflow occurs at the very beginning of the project, so that
amount is not discounted (or if it is, it is “discounted” by multiplying it by 1.0). Some projects may have other
net cash outflows (negative cash flows) in subsequent years of the project. If so, those future negative cash
flows are also discounted and the discounted cash outflow amounts are also deducted from the present value
of the project’s future expected cash inflows.
The present value of the expected cash flows is calculated using a discount rate that is the company’s
required rate of return (RRR), which is one of two options:
1) The return the company can expect to receive in the market for an investment of comparable risk
2) The minimum rate of return that the project must earn to justify investment of the resources
This required rate of return is also called the discount rate, hurdle rate, or opportunity cost of capital.
Generally, the company’s cost of capital is used as the discount rate.47 However, the required rate of return
used to discount the future expected cash flows and compute the NPV must be appropriate to the
project’s risk. Adjustment of the required rate of return to reflect risk is covered in more detail later.
Relevant expected cash flows used in the Net Present Value capital budgeting analysis include:
• Initial net cash outflows, including the cost of the asset or assets and increased working capital
requirements
• Initial cash inflow from the sale of existing assets if new assets are replacing existing assets, net
of the tax effect of any gain or loss
• Net cash outflows that may be expected to occur subsequent to the beginning of the
project, such as additional investments required during the project
• Operating cash inflows (increased revenues and reduced expenses) net of related income taxes
• Operating cash outflows (expected operating losses or increased expenses) net of the related
reduction in income taxes
• Tax savings from the depreciation tax shield
• Cash proceeds from the sale of the asset at the end of the project, net of the tax effect of any gain
or loss on the sale
• Working capital released at the end of the project
46
“Hurdle” rate, “discount rate,” “cutoff rate,” and “cost of capital” may all be used in the exam to refer to the required
rate of return.
47
Cost of capital is covered in Section B, Corporate Finance, in Volume I of this textbook.
Interpretation of an NPV Analysis

An NPV analysis is interpreted as follows:
• When a project has a positive NPV, it will be profitable because it will earn more than it will cost the
company. Shareholder wealth will increase. The project is acceptable.
• When a project has a zero NPV, the present value of its expected future cash inflows is exactly equal
to the present value of the expected cash outflows. Shareholder wealth would neither increase nor
decrease. A project with a zero NPV is questionable at best. Technically, the company would not lose
money on it, but a zero NPV does not provide any motivation to embark upon the project. Further-
more, the project would have no margin of safety. If the expected cash inflows were not achieved,
the project could quickly become unprofitable.
• When a project has a negative NPV, the project would be unprofitable because it would cost the
company more than it could earn. Shareholder wealth would decrease. The project is not acceptable.
Note: Net Present Value can be calculated with a financial calculator or calculated manually using factor
tables for the Present Value of $1 and/or the Present Value of an Annuity of $1. Four models of financial
calculators are permitted on the CMA exams:
 Texas Instruments BA II Plus (not the BA II Plus Professional),

 HP 12c, and
 HP 12c Platinum.
 The HP 10BII is also valid for use on the exam but is no longer available for purchase.
The following discussion explains the manual calculation of NPV.
Calculation of Net Present Value
Example 1: A Series of Unequal Cash Flows

Returning to the example of CMA Product’s plan to purchase a new piece of equipment: CMA Products, Inc. is
considering the purchase of a new piece of equipment to introduce a new product line. The equipment will
cost $125,000 including setup costs, installation, and testing. The estimated before-tax annual cash flow from
operations is $50,000, and the investment will require an initial investment in working capital of $25,000. The
estimated salvage value at the end of Year 9 is $10,000. CMA has an effective income tax rate of 30%.
convention) are:
Year 1 14.29%
Year 2 24.49%
Year 3 17.49%
Year 4 12.49%
Year 5 8.93%
Year 6 8.92%
Year 7 8.93%
Year 8 4.46%
The calculation of the project’s NPV follows.
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9
Net Initial
(125,000)
Investment
Working
Capital (25,000) 25,000*
Increase
After-Tax
Cash Flows
35,000 35,000 35,000 35,000 35,000 35,000 35,000 35,000 35,000
from
Operations
Deprec. Tax
5,359 9,184 6,559 4,684 3,349 3,345 3,349 1,671 -0-
Shield
After-Tax
Cash Flows 7,000
from Disposal
Total After
Tax Cash (150,000) 40,359 44,184 41,559 39,684 38,349 38,345 38,349 36,671 67,000
Flows
PV of $1
Factor for 1.000 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424
10%
Discounted
(150,000) 36,686 36,496 31,211 27,104 23,815 21,627 19,673 17,125 28,408
Cash Flow
Cumulative
Discounted (150,000) (113,314) (76,818) (45,607) (18,503) 5,312 26,939 46,612 63,737 92,145
Cash Flows
*Recovery of released working capital.
The cumulative discounted expected cash flow at the end of the project, which is its NPV, is $92,145.48
The NPV of a project is also the sum of all the discounted cash inflows and outflows from the project over its
life minus the initial investment. In this case, the sum of all the discounted cash inflows from the project over
its life is $242,145, while the net investment is $150,000. Thus, the NPV is $242,145 − $150,000 =
$92,145.
Since the NPV is positive, this project is acceptable.
If all the future expected net cash flows are positive, the Net Present Value can be calculated as:
NPV = PV of future expected net cash inflows – initial investment
If some future expected net cash flows are negative, the Net Present Value is calculated the same
way as it was in the above example, except that the negative discounted cash flows reduce the
cumulative discounted cash flows.
48
The number of decimal places in the factors used to calculate the present values of the cash flows will affect the project’s
net present value. The greater the number of decimals used in the factors, the more accurate will be the calculation of the
NPV. Factors used in examples in this book are from the factor tables provided in Appendix A in this volume. The use of
rounded factors does not impact the decision that would result from use of the resulting NPV.
Note: The cash outflows in Year 0 are multiplied by 1.000 on the “PV of $1 Factor” line in the cash flow
analysis because they are, in a sense, already discounted. They occur at the point to which all the future
cash flows are being discounted.
If additional cash outflows are planned for future periods, those additional cash outflows will need to be
included as a reduction in the future net cash flows and discounted along with them.
Example 2: A Series of Equal Cash Flows

The preceding example represents a Net Present Value analysis where the net after-tax cash flows are
different for each of the years. If the net after-tax cash inflows subsequent to Year 0, including the
depreciation tax shield, are the same during every year of the project’s life (the final year included), and
if the discount rate is the same throughout the life of the project, the present value of the expected cash
inflows can be discounted as an annuity.
The net present value of the investment is the present value of the cash inflows less the initial investment,
calculated in two steps:
1) The present value of the cash inflows is:
PV of cash inflows = PV of ordinary annuity i, n × Annual cash flow
2) The net present value of the project is:
NPV = PV of cash inflows – Initial investment
Example: Due to recent sales growth, AMC Petroleum, Inc., an oil wholesaler, plans to purchase an
additional tanker. The new truck costs $100,000. AMC estimates the after-tax cash flows from the new
truck, including the effect of the depreciation tax shield on cash, will be $20,000 per year, and the truck
will last for seven years. AMC’s required rate of return is 10%. AMC expects no salvage value. The
company’s tax rate is 40%.
Using the factor from the Present Value of an Annuity table for 10% for 7 years to discount the future cash
flows, the present value of the cash inflows is:
PV of cash inflows = PV of ordinary annuity i=10%, n=7 × $20,000
PV of cash inflows = 4.868 × $20,000 = $97,360
The NPV is:
NPV = PV of cash inflows – Initial investment
NPV = $97,360 − $100,000 = $(2,640)
Since the NPV of the new oil tanker truck is negative, this project should be rejected.
Note: The present value (PV) of an ordinary annuity (annuity in arrears) is used in the preceding and
other examples in this section, because in capital budgeting discounted cash flow methods, expected cash
flows are assumed to occur at the end of each period for the sake of convenience. The PV of an annuity
factor used in the preceding example is the factor that is given in the PV of an annuity table for the
discount rate and term of the project. For most capital budgeting purposes, use the factor from the table
because the equal cash flows will occur at the end of each year.
However, if a problem specifies that the cash flows occur at the beginning of each period, the annuity is
called an annuity due. To calculate the present value of the cash flows for an annuity due, either assume
that each cash flow occurs at the end of the previous period or adjust by using the factor for one period
less and adding 1.000 to the resulting factor.
For example, if the cash flows in the annuity above occurred at the beginning of each year instead of at
the end, the company would receive $20,000 at Year 0 (that is, the beginning of Year 1) that would not be
discounted plus 6 more annual cash inflows of $20,000 at the end of Years 1-6 (that is, at the beginning of
Years 2-7). The factor for the present value of an ordinary annuity at 10% for 6 years is 4.355. The PV of
the expected cash inflows could be calculated by adding 1.000 to the factor for the present value of an
ordinary annuity at 10% for 6 years, as follows:
$20,000 × (1.000 + 4.355) = $107,100
Alternatively, the present value of the expected cash inflows could be calculated this way:
$20,000 + ($20,000 × 4.355) = $107,100
A third way is to multiply the present value of an ordinary annuity factor by 1 + the discount rate, or 1.10
in this example. The factor for a seven-year ordinary annuity at 10% is 4.868. To use that factor to
calculate the present value of a seven-year 10% annuity due, multiply it by 1.10. The resulting factor is
5.3548.
$20,000 × 5.3548 = $107,096 (Difference due to rounding.)
With an initial investment of $100,000, the NPV if the cash flows are to be received at the beginning of
each future period is $107,100 − $100,000 = $7,100.
It is necessary to learn only one method of using a present value of an ordinary annuity factor to find the
present value of an annuity due.
Example 3: A Series of Equal Cash Flows with One Unequal Amount at the End
Many times, the final year’s cash flow will be different from the cash flows preceding it because the assets
used in the project are sold and working capital tied up in the project may be released at the end of the
project as the final inventory is sold and the final receivables are collected. The future expected cash flows
that are all the same amount can be discounted as an annuity while the future expected cash flow that is
different is discounted as a single amount.
Example using the same facts as in the previous example but adding salvage value: Due to recent
sales growth, AMC Petroleum, Inc., an oil wholesaler, plans to purchase an additional tanker. The new
truck costs $100,000. AMC estimates the after-tax cash flows from the new truck, including the effect of
the depreciation tax shield on cash, will be $20,000 per year, and the truck will last for seven years. AMC’s
required rate of return is 10%. AMC projects that at the end of seven years it will be able to sell
the truck for $30,000. The truck will be fully depreciated for tax purposes, so the full amount received
will be taxable as a gain. The company’s tax rate is 40%.
The after-tax cash inflow in the seventh year of the project will not be the same as all the other after-tax
cash inflows. It will be greater by $30,000 less tax at 40%, or by $18,000. The present value of an annuity
factor can still be used to find the present value of the six annual cash flows that are equal, and then the
present value of $1 factor can be used to find the present value of the seventh year’s cash inflow.
PV of cash inflows, Years 1-6:

PV of ordinary annuity i=10%, n=6 × $20,000 = 4.355 × $20,000 $ 87,100
Plus: PV of $1 i=10%, n=7 × ($20,000 + [$30,000 × (1 − 0.40)]) = 0.513 × $38,000 19,494
Present value of cash inflows of the project $106,594
Less: Initial investment 100,000
NPV $ 6,594
The addition of the salvage value at the termination of the project has caused the NPV to change from a
negative amount to a positive amount. This project is now acceptable.
Example 4: A Perpetual Annuity

Cash flows that go on and on without end are called a “stream of perpetual cash flows.” If the annual
amounts are all the same, the cash flow is called a “perpetual annuity.”
The present value of a stream of perpetual, equal, cash flows is called the Zero Growth Dividend Model,
which is also used for valuing preferred stock.49 Calculation of the net present value of a perpetual annuity is
a two-step process:
1) The present value of the annual cash inflows is:
Annual cash flow

PV =
Required rate of return
2) The net present value of the project is the present value calculated in Step 1 minus the initial
investment:
NPV = PV – Initial investment
49
See Vol. 1 of this textbook, Section B, Long-Term Financial Management, for information on valuing preferred stock.
Example: Perpetua Enterprises plans to invest $40,000 in a project expected to generate after-tax cash
flow of $5,000 each year, beginning with Year 1 and continuing indefinitely. Perpetua’s required rate of
return is 10%. What is the NPV of the project?
1) The present value of a perpetual stream of $5,000 after-tax cash flows, discounted at 10%, is:
Annual cash flow

PV =
Required rate of return
$5,000
PV = = $50,000
0.10
2) The net present value (NPV) of the project is the $50,000 present value of the cash inflows minus
the initial investment of $40,000.
NPV = $50,000 − $40,000
NPV = $10,000
Example 5: A Perpetual Growing Annuity

If the perpetual cash flow is expected to grow at a steady rate, the present value of the cash flow is the next
annual cash flow amount (or the cash flow at the end of the first year) divided by the required rate of return
minus the expected growth rate. That present value minus the initial investment is the net present value.
1) The present value of a perpetual growing annuity is:
Annual cash flow, end of first year

PV =
Required rate of return − Growth rate
2) The net present value of the project is the present value minus the initial investment:
The formula for the present value of a growing annuity is the same as the formula for the Constant Growth
Dividend Model, which is used for valuing common stock when the dividends are growing.50 The Constant
Growth Dividend Model is:
Next annual dividend (expected next period)

P0 =
Investors’ required rate of return – the annual future growth rate of the dividend
The dividend used in the Constant Growth Dividend model needs to be the next annual dividend. So, when
using this model to calculate the present value of a growing stream of perpetual cash flows, make sure to use
the cash flow amount expected at the end of the first year.
50
For information on valuing common stock, see Vol. 1 of this textbook, Section B, Long-Term Financial Management.
Example: Perpetua Enterprises plans to invest $40,000 in a project. Perpetua Enterprises expects the net
after-tax cash flow at the end of the first year to be $5,000, but it expects the cash flow to grow by
5% each subsequent year in perpetuity. Perpetua’s required rate of return is 10%. What is the NPV?
1) The present value of this growing, perpetual stream of after-tax cash flows is
$5,000
PV = = $100,000
0.10 – 0.05
2) The net present value (NPV) of the project is the $100,000 present value of the cash inflows minus
the initial investment of $40,000:
NPV = $100,000 − $40,000
NPV = $60,000
The Importance of the Discount Rate Choice

Choice of the proper discount rate (or required rate of return or hurdle rate) to calculate the NPV is critical to
the success of a project. A company should invest money in a project only if the project provides a return
higher than the required rate of return. Doing so will increase the value of the firm and stockholder wealth.
The usual measure of the required rate of return is a firm’s weighted average cost of capital (WACC).
However, it is appropriate to use the weighted average cost of capital only when the risk of the project is the
same as the risk of the overall business. If the project is either more risky or less risky than the company’s
other business, the rate should be adjusted to reflect the increased or decreased risk.
• Cash inflows for a riskier project should be discounted using a higher hurdle rate, while a hurdle
rate of less than the firm’s weighted average cost of capital may be used for a project that is judged
to be safer than the company’s other business. The hurdle rate may also be adjusted for different
levels of inflation.
• If a capital project will have only net cash outflows, for example a construction project for internal
use, the adjustment to the discount rate to incorporate risk is done inversely. A high-risk project’s
net cash outflows should be discounted at a rate lower than the firm’s weighted average cost of
capital. Because the project has only net cash outflows during its life, the project’s NPV will be a
negative amount. Using a lower discount rate will result in an NPV that is a higher negative
amount, thus incorporating the greater risk of the project appropriately. A low-risk project with only
net cash outflows should be discounted at a rate that is higher than the firm’s WACC, because that
will result in an NPV that is a smaller negative amount.
Weighted Average Cost of Capital (WACC)

To determine the appropriate discount rate to use, start with the optimal capital structure. “Capital
structure” refers to the funding structure or the composition of a company’s long-term debt, common equity,
and preferred stock. The optimal capital structure is the unique capital structure that minimizes the
company’s composite cost of long-term capital and therefore maximizes its value. The proportion of each
capital component in the optimal capital structure is multiplied by its cost to the company and the result is its
Weighted Average Cost of Capital (WACC).51
The WACC is the opportunity cost of capital for the company’s existing assets. The weighted average cost
of capital is the appropriate discount rate for capital budgeting decisions and NPV calculations as long as the
riskiness of the project is the same as the riskiness of existing projects. For the risk premium to
remain unchanged as a result of the capital expansion project, the following conditions must be met:
• New assets financed by the new capital must not substantially change the operating environment.
51
The weighted average cost of capital is covered in Volume 1 of this textbook, Section B, Corporate Finance, Long-Term
Financial Management, Cost of Capital.
• The new capital must be raised in the same proportions as the existing capital, so that the firm’s
capital structure and financial risk remain the same.
The optimal mix of the various sources of capital (such as debt, preferred stock, and common stock) is a
controversial issue in finance. Even so, by raising new capital in the same proportions as existing capital, the
firm should leave its financial risk unchanged. Assuming the above conditions are met, a company’s current
weighted average cost of capital can be used as the required rate of return.
Using NPV
In general, any project with a positive NPV should be accepted, since these projects will increase shareholder
wealth. Conversely, any project with a negative NPV should be rejected. However, perhaps due to limited
funds or certain nonfinancial factors, not all projects with positive NPVs will be chosen. Therefore, a more
accurate statement is that any project with a positive NPV is a candidate for further consideration.
When a firm has limited funds to invest, NPV enables management to rank the various projects according
to the amount that each one is expected to return.
Exam questions about NPV can become fairly detailed and include a lot of information. It is best to focus on
the present value of the cash flows, both cash in and cash out, associated with the project.
In working with the cash flows, remember that even though depreciation is a non-cash expense, it does
have a cash flow impact through reduction of the income taxes paid.
Problems With NPV

Several problems inherent in the use of Net Present Value are discussed below.
Reinvestment Assumption
The Net Present Value method incorporates an assumption that all cash inflows from the project will be
reinvested at the required rate of return, which may not be the case. The project’s cash inflows probably
cannot be reinvested in the same project because that project will most likely not need more money invested.
Furthermore, even if the cash flows could be reinvested in the same project, there is no reason to believe that
additional investment would increase cash inflows. Since a project’s cash flows probably cannot earn a return
from the same capital project, they would need to be invested elsewhere. The alternative investment of the
cash inflows may or may not generate as high a rate of return as the initial capital project. The assumption
that the cash inflows from a project can be reinvested at the same rate used in the NPV calculation may lead
to an incorrect evaluation of the project’s true worth.
NPV Expressed as a Monetary Amount

Since the NPV is expressed as a monetary amount, it does not provide an expected rate of return on the
investment. The NPV can indicate whether a project’s rate of return is higher or lower than the required rate
of return, but it cannot provide the project’s actual rate of return.
Incorrect Assumptions Affect Validity

Assumptions made in the calculation of the NPV may be incorrect, and the incorrect assumptions can affect
the validity of the results. The risk can be mitigated by using a higher than usual required rate of return,
which causes the resulting NPV to be lower. A lower NPV increases the probability that the project will be
judged unacceptable.
The Discount Rate Used Affects the Results

The discount rate used may be very different from the firm’s actual cost of capital due to market fluctuations.
Over the term of a project, the actual change in shareholders’ value can vary significantly from the initial
estimates.
Cash Flows Beyond the Project’s Term

A project may provide cash flows beyond its initial expected lifetime, which can provide additional shareholder
value; but those additional cash flows are not recognized in the NPV analysis.
The Effect of the Discount Rate on NPV and the NPV Profile
The discount rate used has an important effect on the final NPV. The higher the discount rate, the lower the
NPV; and the lower the discount rate, the higher the NPV.
Below is an example of a project and the NPVs that result from various hurdle rates used to discount its cash
flows:52
Project Y
Hurdle Rate Project NPV
25% $(50,368)
20% 2,500
15% 54,200
10% 116,800
5% 193,200
0% 287,000
A graph that shows the relationship between a project’s net present values at various discount rates is called
the project’s NPV Profile. Following is the NPV Profile of the project above:
$350,000
NPV Profile
$300,000 Project Y
$250,000
$200,000
NPV
$150,000
$100,000
$50,000
$0
0% 5% 10% 15% 20% 25%
-$50,000
-$100,000 Discount Rate
52
The NPVs in this chart cannot be recalculated because the backup information for them is not provided.
The NPV profile line crosses the x-axis at a discount rate of a little more than 20%. The table showing Project
Y’s various possible hurdle rates and the resulting NPVs at each rate shows that at a discount rate of 20%,
the NPV is closest to zero, and at a discount rate of 25%, the NPV profile line is in negative territory, or
$(50,368) on the graph above.
The NPV Profile graph will be used in the next topic, Internal Rate of Return.
Benefits of the Net Present Value Method of Capital Budgeting
• It provides an estimate of the profitability of a project and the amount of change in shareholder
wealth that should take place if the project is undertaken.
• It takes into consideration the time value of money.
• It can be used to manage risk in a project by adjusting the required rate of return used as the
discount rate to compensate for projects with higher or lower risk than the company’s current
projects.
• NPV enables ranking of potential projects according to their expected returns, which is useful when a
firm has limited funds for capital projects.
• It can incorporate a fluctuating required rate of return during the life of the project.
Limitations of the Net Present Value Method of Capital Budgeting
• NPV incorporates an assumption that all cash inflows from the project will be reinvested at the
required rate of return, which may not be the case and which may lead to an incorrect evaluation of
the project’s true worth.
• Since the NPV is expressed as a monetary amount, it does not provide an expected rate of return on
the investment.
• There is the risk of incorrect assumptions, which can affect the validity of the results.
• The firm’s actual cost of capital may vary significantly from the discount rate used in the NPV analysis
due to market fluctuations, which can cause the actual change in shareholders’ value to be different
from the initial estimates.
• Cash flows beyond the initial expected lifetime of the project are not recognized in an NPV analysis but
can provide additional shareholder value.
Question 88: The Keego Company is planning a $200,000 investment that has an estimated 5-year life
and no salvage value. The company has projected the following cash flows for the investment:
Year Projected Cash Inflows Present Value of $1

1 $120,000 0.91
2 60,000 0.76
3 40,000 0.63
4 40,000 0.53
5 40,000 0.44
The net present value of the investment is:
a) $18,800
b) $218,800
c) $196,200
d) $91,743
(CMA Adapted)
Question 89: McLean is considering the purchase of a new machine that will cost $160,000. The machine
has an estimated useful life of 3 years. Assume that 30% of the depreciable base will depreciate in the
first year, 40% in the second year and 30% in the third year. The new machine will have a $10,000
resale value, which is equal to residual value at the end of its useful life. The machine is expected to save
the company $85,000 in operating expenses each year. McLean uses a 40% estimated tax rate and a
16% hurdle rate to evaluate capital projects.
The discount rates for 16% are as follows:
PV of $1 PV of a $1 Annuity
Year 1 0.862 0.862
Year 2 0.743 1.605
Year 3 0.641 2.246
What is the net present value of this project?
a) $3,278
b) $6,270
c) $5,842
d) $30,910
(CMA Adapted)
Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) for a project is the interest rate (that is, the discount rate) at which the
present value of its expected cash inflows equals the present value of its expected cash outflows. In other
words, the IRR is the interest (discount) rate at which the NPV is equal to zero. To evaluate a project’s
IRR, compare it with the firm’s required rate of return for the project. If the IRR is higher than the project’s
required rate of return, the investment is acceptable. If its IRR is lower than the required rate of return, the
investment should not be made.
Calculating the IRR

If annual cash flows are the same for every year of a project’s life, its IRR can be found by applying
the following steps:
1) Divide the net initial investment by the annual cash flow. The result will be a factor that represents
the present value of an annuity.
2) Consult a Present Value of an Annuity factor table. Begin with the line indicating the number of years
of the project’s life, and locate the factor on that line closest to the one calculated in Step 1. Follow
that column up to the rate shown at the top, and that rate will be the rate of return closest to the
project’s internal rate of return.
3) If necessary, interpolate a more accurate rate using the procedure described in Appendix B.
When annual cash flows are not the same for every year of the project’s life, the IRR can be found by
calculating the NPV using different rates and interpolating until finding the rate where the NPV is zero.
Appendix B in this volume contains a detailed example of this calculation.
The IRR can also be calculated using a financial calculator.53
NPV Profile and the IRR

Below are the various hurdle rates and the NPVs of each for Project Y again:
Project Y
Hurdle Rate Project NPV
25% $(50,368)
20% 2,500
15% 54,200
10% 116,800
5% 193,200
0% 287,000
On the following graph of Project Y’s NPV Profile (the graph of the above chart), the NPV profile line crosses
the horizontal axis where the NPV is zero, at approximately 20%.
53
Financial calculators can be used to determine an IRR on the CMA exam. From the ICMA’s calculator policy in the
Candidate Handbook: “Candidates are allowed to bring a small battery or solar powered electronic calculator restricted to a
maximum of six functions—addition, subtraction, multiplication, division, square root, and percentage. The calculator must
not be programmable and must not use any type of tape. Candidates can also use the Texas Instrument’s BA II Plus,
HP 12c, or HP 12c Platinum calculators when taking the exams. The Hewlett-Packard 10BII is valid, but no
longer available to purchase. Candidates will not be allowed to use calculators that do not comply with these
restrictions.” HOCK Note: The Texas Instruments BA II Plus Professional is not allowed.
The point where the NPV profile line crosses the horizontal axis—where the NPV is zero—is the project’s IRR.
This project’s IRR is approximately 20%, because that is the discount rate at which the project’s NPV
becomes zero.
$350,000
NPV Profile
$300,000 Project Y
$250,000
$200,000
NPV
$150,000
$100,000
$50,000
$0
0% 5% 10% 15% 20% 25%
-$50,000
-$100,000 Discount Rate
Evaluating IRR
If the IRR is higher than the required rate of return management has established for the project (or the
hurdle rate), the project is acceptable. If the IRR is lower than the required rate of return, the project is not
acceptable and should not be considered further.
Remember that the IRR is a rate, in contrast to NPV, which is a monetary amount.
Note: The IRR calculation incorporates an assumption that the cash inflows from the project can be
reinvested at the project’s Internal Rate of Return; however, the cash inflows from the project may
not be able to be reinvested at the assumed rate. If the cash inflows cannot be reinvested at the Internal
Rate of Return, then the IRR will not represent a project’s true rate of return.
The modified IRR attempts to deal with this problem. The modified IRR incorporates an assumption that
the cash flows received from the project are reinvested at the company’s cost of capital rate, rather
than the IRR rate.
Example: The following facts relate to a proposed capital budgeting project.
• The initial investment is $150,000.

• The project life is 5 years.
• The hurdle rate is 8%.
• The annual after-tax cash flow is $39,000.
What is the Internal Rate of Return?
Solution: Divide $150,000 by the annual cash flow amount of $39,000. The result is 3.846. Consult a
Present Value of an Annuity factor table. Moving across the line for 5 periods, locate a factor or factors
close to 3.846. Under 9% is a factor of 3.890 and under 10% is a factor of 3.791; 3.846 is about halfway
between those two numbers. Therefore, the IRR of this project is approximately 9.5%, halfway between
9% and 10%. Since 9.5% is higher than the hurdle rate of 8%, this project is acceptable.
If the NPV were calculated using an 8% discount rate, the NPV would be the net of the present value of the
positive annual cash flows of $39,000 (using the PV of an annuity factor for 8% for 5 years, which is
3.993) minus the initial investment amount of $150,000:
NPV = ($39,000 × 3.993) − $150,000 = $5,727
The NPV is positive, so the project is acceptable according to NPV analysis, as well. That evaluation is
consistent with the evaluation of the project’s IRR, which is that the project is acceptable because its IRR
of 9.5% is higher than its hurdle rate of 8%.
Problems With IRR

Several problems are associated with IRR, and they are discussed below.
Reinvestment Assumption
In the IRR calculation, cash inflows from the project are assumed to be reinvested at the Internal Rate of
Return. However, cash inflows may not be able to be reinvested at the assumed rate. If the cash inflows
cannot be reinvested at the IRR, then the calculated IRR will not represent the project’s true rate of return.
Multiple IRRs for Nonconventional Projects

A conventional project begins with a cash outflow followed by several cash inflows. In other words, the
direction of the cash flow changes just once, from negative in Year 0 to positive in Year 1, and remains
positive throughout the remainder of the project’s life. However, not all projects follow this conventional
pattern. Cash flows might change in different directions over the course of many years, alternating between
positive and negative.
If a project has a negative expected cash flow or flows after Year 0, for instance if an additional investment is
required during a subsequent year, the project is called a nonconventional project. A nonconventional
project may have more than one IRR because more than one discount rate will cause the project’s NPV to be
zero. The number of IRRs will be equal to the number of sign changes in the cash flows, including the sign
change following the initial investment in Year 0. In other words, a conventional project will have only one
IRR because it has only one sign change: the change from a negative cash flow in Year 0 to a positive cash
flow in Year 1. But a nonconventional project that has a sign change after the initial investment because of a
negative cash flow in a subsequent year will actually have three sign changes and three IRRs: the first sign
change when the negative cash flow in Year 0 becomes a positive cash flow in Year 1, and then two more sign
changes. One of the additional sign changes takes place when the cash flow becomes negative in the
subsequent year and the other additional sign change takes place when the cash flow again becomes positive
during a later year.
Multiple IRRs are usually not a problem, since generally only one of the IRRs will fall within reasonable
parameters, while the other IRRs can vary widely, such as 500% or −50%, or even as high as 10,000%.
However, if the multiple solutions cause a financial calculator to return an error message, then the IRR cannot
be calculated on the financial calculator.
Thus, if a project has more than one change in annual cash flow direction, it is better to evaluate it on the
basis of its NPV rather than on its IRR.
Mutually Exclusive Projects

Sometimes project options are mutually exclusive; that is, a company can choose only one project to the
exclusion of all others. When projects are mutually exclusive, they frequently are of different sizes or have
different cash flow patterns, and the information provided by the IRR is not very useful for decision making.
Different Size Projects

When the sizes of the initial investment opportunities are different, the IRR can be misleading. Since the IRR
is a rate of return, a project with a smaller initial investment can show a higher IRR than a project requiring a
larger initial investment, even though the project with the larger initial investment has a higher NPV.
For example, a company could build a plant for $250,000 to manufacture plastic molds or it could build a
plant for $2,000,000 to manufacture solar cells. Solar cells would be more profitable but would require a
much larger investment in the plant, technology, and equipment than would the plastic molds.
Following are the expected cash flows, NPVs (using a required rate of return of 15%), and the IRRs for both
projects:
Solar Cell Mold

Manufacturing Manufacturing
Plant Plant
Year 0 (2,000,000) (250,000)
Year 1 150,000 60,000
Year 2 250,000 70,000
Year 3 350,000 80,000
Year 4 450,000 90,000
Year 5 550,000 100,000
Year 6 650,000 110,000
Year 7 750,000 120,000
Year 8 850,000 130,000
Year 9 950,000 140,000
Year 10 1,050,000 150,000
NPV @ 15% 391,968 192,105
IRR 19.11% 31.74%
Each project has a positive NPV and an IRR that is above the hurdle rate. If the company bases its decision on
the IRRs alone, it would choose to manufacture molds because that IRR is 31.74% versus 19.11% for the
solar cells. However, solar cells are more profitable by $199,863 ($391,968 − $192,105). Therefore, the solar
cell plant is the more lucrative choice, even though its IRR is less than that of the plastic mold plant.
The IRR is not reliable for selecting between mutually exclusive projects of different sizes. NPV is more
reliable.
Different Cash Flow Patterns

IRR is not reliable for evaluating mutually exclusive projects when the cash flows have different patterns.
The following example shows two projects, both requiring the same amount of investment and for the same
length of time but with very different cash flow patterns. Project P’s cash flows are received early, whereas
Project Q’s cash flows come later. Over the lives of the two projects, Project Q’s net discounted cash flow is
significantly greater than that of Project P (Q = $545,000, P = $287,000). However, the IRR for Project P
(20.3%) is higher than that of Project Q (14.2%). This difference in the IRRs is due to Project P’s cash flows
being received earlier than Project Q’s cash flows.
Discounted Cash Flows Project P Project Q
Year 0 (1,000,000) (1,000,000)

Year 1 800,000 70,000
Year 2 475,000 150,000
Year 3 7,000 525,000
Year 4 5,000 800,000
Net Discounted Cash Flow 287,000 545,000
IRR 20.3% 14.2%
Below is a table showing the two projects’ NPVs at various required rates of return (or hurdle rates):
Project P Project Q
Hurdle Rate NPV NPV
25% ( 50,368) (251,520)
20% 2,500 (123,200)
15% 54,200 ( 20,100)
10% 116,800 116,800
5% 193,200 299,400
0% 287,000 545,000
The table shows a number of significant facts:
1) At the hurdle rate of 10%, the NPVs of the two projects are identical: $116,800. Therefore, for these
two projects, 10% is the crossover rate.
2) The hurdle rate used determines which of the two projects has a higher NPV, and the dividing point
is the crossover rate.
• When discounted at hurdle rates higher than the crossover rate, the NPVs and the IRRs give the
same result: Project P is the better project.
• When discounted at hurdle rates lower than the crossover rate, NPV and IRR give different re-
sults. Project Q is the more attractive project according to the NPVs, though Project P has the
higher IRR.
When the timing of cash flows for mutually exclusive projects is different, the IRR can give varying results
depending on the hurdle rate used. NPV is more reliable because its results show amounts of profit instead of
rates of return for the two projects.
Benefits of the Internal Rate of Return Method of Capital Budgeting
• As a discounted cash flow method, the IRR accounts for the time value of money.
• The IRR can be compared with a required rate of return that is based on market return rates for
similar investments or another hurdle rate chosen by management.
• It is easier for managers to understand and interpret than net present value.
Limitations of the Internal Rate of Return Method of Capital Budgeting
• The IRR incorporates an assumption that the cash inflows from the project will be reinvested at the
Internal Rate of Return. If that is not a valid assumption, the calculated IRR will not represent the
project’s true rate of return.
• If a project is nonconventional (has a negative cash flow or flows after Year 0), it will have more than
one IRR, or the IRR may not be able to be calculated.
• When investments are mutually exclusive and are of different sizes or have different cash flow
patterns, the information provided by the IRR may not be useful for decision making.
Question 90: If an investment project has a negative net present value (NPV), which one of the following
statements about the internal rate of return (IRR) of this project must be true?
a) The IRR is negative.
b) The IRR is less than the company’s weighted average cost of capital.
c) The IRR is equal to zero.
d) The IRR is greater than the company’s weighted average cost of capital.
(ICMA 2014)
Question 91: Cora Lewis is performing an analysis to determine if her firm should invest in new equip-
ment to produce a product recently developed by her firm. The other option would be to abandon the
product. She uses the net present value (NPV) method and discounts at the firm’s cost of capital. Lewis
is contemplating how to handle the following items.
I. The book value of warehouse space currently used by another division.
II. Interest payments on debt to finance the equipment.
III. Increased levels of accounts payable and inventory.
IV. R&D spent in prior years and treated as a deferred asset for book and tax purposes.
Which of the above items are relevant for Lewis to consider in determining the cash flows for her NPV
calculation?
a) I, II, III and IV.
b) II and III only.
c) III only.
d) IV only.
(ICMA 2010)
Question 92: Tendulkar Inc. has a project that requires a $40,000,000 initial investment and is expected
to generate annual after-tax cash flows of $6,000,000 for 12 years. Tendulkar’s weighted average cost of
capital is 14%. This project’s net present value (NPV) and the approximate internal rate of return (IRR)
are
NPV IRR
a) $(6,040,000) 10%
b) $(6,040,000) 12%
c) $( 232,000) 10%
d) $( 232,000) 12%
(ICMA 2010-QA)
NPV Profiles and the Crossover Rate

The charts showing the expected cash flows, the IRRs, and the NPVs at various hurdle rates for Projects P and
Q are repeated below.
Expected Cash Flows and IRRs, Projects P and Q
Project P Project Q
Year 0 (1,000,000) (1,000,000)
Year 1 800,000 70,000
Year 2 475,000 150,000
Year 3 7,000 525,000
Year 4 5,000 800,000
IRR 20.3% 14.2%
NPVs at Various Hurdle Rates, Projects P and Q
Project P Project Q
Hurdle Rate NPV NPV
25% ( 50,368) (251,520)
20% 2,500 (123,200)
15% 54,200 ( 20,100)
10% 116,800 116,800
5% 193,200 299,400
0% 287,000 545,000
Following are the NPV profiles for Project P and Project Q. Notice that Project P’s NPV Profile line crosses the
horizontal axis at approximately 20%. Project P’s IRR is actually 20.3%. Project Q’s NPV Profile line crosses
the horizontal axis at a little below 15% and its IRR is 14.2%.
$600,000
NPV Profiles, Projects P and Q
$500,000
$400,000 Project P
CROSSOVER RATE
$300,000 10%, $116,800
Project Q
NPV
$200,000
$100,000
$0
0% 5% 10% 15% 20% 25%
-$100,000
-$200,000
Discount Rate
-$300,000
-$400,000
Finding the Crossover Rate

The crossover rate is an important indicator when comparing two projects, either with similar or different cash
flow patterns. The crossover rate is the discount rate at which a manager might be indifferent to two projects
because their NPVs are the same.
It is easier to demonstrate how to find the crossover rate than to describe it, so an example follows.
Example: The following shows the calculation of the crossover rate for two projects when they both have
level cash flows.
A company is considering two projects, A and B. Each requires the purchase of a new machine, but the
company can accept only one project because it has factory space for only one new machine.
Project A Project B
Investment $ 50,000 $150,000
Annual Cash Flow 15,000 44,000
Project Term 5 Years 5 Years
At which discount rate would the company be indifferent (that is, the point at which the choice of project
does not matter financially to the company)? In other words, what is the single discount rate that would
result in the same NPV for both projects?
A project’s NPV is the PV of its future cash inflows minus its initial investment. Also, the PV of an annuity is
the annual cash flow amount multiplied by the factor for the PV of an annuity at the specified rate and for
the specified number of periods.
The objective is to identify one Present Value of an Annuity factor that will cause the NPVs of both projects
to be the same. Once that factor has been found, the related discount rate is easy to locate on a PV of
Annuity factor table.
Two equations are needed, one representing the NPV of Project A and one representing the NPV of Project
B. In these formulas, X represents the unknown discount factor. Since the unknown discount factor is the
same for both projects, both equations will use X to represent the factor for a PV of an annuity of 5 years
that leads to the discount rate for both projects that will cause their NPVs to be the same.
15,000X – 50,000 = NPV of Project A.
44,000X – 150,000 = NPV of Project B.
Since both NPVs must be the same, the two left sides of the equations are set equal to one another and
then solved for X:
15,000X – 50,000 = 44,000X – 150,000
To solve for X, first add 150,000 to both sides and subtract 15,000X from both sides:
100,000 = 29,000X
Divide both sides by 29,000 to find the value of X:

X = 3.448
3.448 is the factor for the discount rate for a five-year annuity that will cause the NPVs to be the same for
both projects.
Consult the Present Value of an Annuity table along the five-year line and locate 3.448, which falls
between 12% (the factor for 12% is 3.605) and 14% (the factor for 14% is 3.433). Since 3.448 is close to
the factor for 14%, the crossover rate is just below 14%.
Note that this method will work only when the following conditions are met:
 The cash flows of both projects are the same for each year of each project’s life.
 Both projects are the same length.
Both projects do not need to have the same cash flows, but each project’s cash flows throughout the life of
the project need to be the same.
The following information is for the next two questions.
A firm with an 18% cost of capital is considering the following projects on January 1, Year 1:
January 1, Year 1 December 31, Year 5 Project Internal

Cash Outflow Cash Inflow Rate of Return
Project A $3,500,000 $7,400,000 16%
Project B $4,000,000 $9,950,000 ?
Present Value of $1 due at the End of "N" Periods
N 12% 14% 15% 16% 18% 20% 22%

4 0.6355 0.5921 0.5718 0.5523 0.5158 0.4823 0.4230
5 0.5674 0.5194 0.4972 0.4761 0.4371 0.4019 0.3411
6 0.5066 0.4556 0.4323 0.4104 0.3704 0.3349 0.2751
Question 93: Using the net-present-value (NPV) method, project A’s net present value is:
a) $316,920
b) $23,140
c) $(265,460)
d) $(316,920)
Question 94: Project B’s internal rate of return is closest to:
a) 15%
b) 16%
c) 18%
d) 20%
(CIA Adapted)
Question 95: The net present value (NPV) and the internal rate of return (IRR) capital budgeting methods
make assumptions about the reinvestment rate of cash inflows over the life of the project. Which one of
the following statements is correct with respect to this reinvestment rate of cash inflows?
a) Under both NPV and IRR the reinvestment rate is the risk-free rate of return.
b) Under NPV and IRR the reinvestment rates are the cost of capital rate and the risk-free rate of
return, respectively.
c) Under NPV and IRR the reinvestment rates are the cost of capital rate and the internal rate of
return, respectively.
d) Under NPV and IRR the reinvestment rates are the cost of capital rate and the asset risk premium
rate, respectively.
(ICMA Adapted)
Question 96: Gro-well Inc., which has a cost of capital of 12%, invested in a project with an internal rate
of return of 14%. The project is expected to have a useful life of four years and will produce net cash
inflows as follows:
Year Net Cash Inflows
1 $10,000
2 20,000
3 40,000
4 40,000
The initial investment in this project was
a) $125,000.
b) $116,000.
c) $96,470.
d) $74,830.
(ICMA Adapted)
Question 97: Which one of the following statements is correct regarding the Net Present Value (NPV) and
the Internal Rate of Return (IRR) approaches to capital budgeting?
a) If the IRR of a project is equal to the company’s cost of capital, the NPV of the project must be 0.
b) Both approaches always provide the same ranking of alternative projects.
c) If the NPV of a project is negative, the IRR must be greater than the company’s cost of capital.
d) Both approaches fail to consider the timing of the project's cash flows.
(ICMA Adapted)
The Accounting (or Average) Rate of Return

The accounting rate of return (ARR) is a ratio of the amount of the expected increase in annual average
accounting income as a result of the project relative to the required investment. It is calculated as:
Accounting Rate Increase in Expected Annual Average After-Tax Accounting Net Income
=
of Return (ARR) Net Initial Investment
Since the ARR method uses accrual accounting income, the numerator includes depreciation.
The accounting rate of return method does not include any consideration of the time value of money, and
therefore it is also called the unadjusted rate of return model.
Note: Sometimes the average investment is used in the denominator rather than the net initial
investment. The average investment is usually calculated as the initial investment divided by 2, because
the investment will have a book value of zero at the end of the project. Dividing the initial investment
balance by 2 produces the same result as calculating the average balance by summing the beginning and
ending balances and dividing the sum by 2.
When management evaluates a project using the ARR method, it first determines a required accounting rate
of return for the project. Management then compares its calculated accounting rate of return for the project
with its required rate of return. Projects with returns that exceed the required rate are considered acceptable.
Example: AMC Petroleum, Inc., an oil wholesaler, plans to purchase an oil tanker that will cost $120,000
and will last for six years. AMC’s estimates for cash flows and annual net income are shown in the chart
below. The company’s tax rate is 35%, and it uses straight-line depreciation for both book and tax
purposes. AMC anticipates no salvage value at the end of six years.
Book Value at Before Tax Annual Before-Tax Annual After-Tax Annual
Beg. of Ea. Year Cash Flow Depreciation Net Acctg. Income Net Acctg. Income
$120,000 $60,000 $20,000 $40,000 $ 26,000
100,000 55,000 20,000 35,000 22,750
80,000 50,000 20,000 30,000 19,500
60,000 45,000 20,000 25,000 16,250
40,000 40,000 20,000 20,000 13,000
20,000 35,000 20,000 15,000 9,750
Total $ 107,250
Average Income (Total ÷ 6) $ 17,875
Accounting rate of return calculated using the initial investment in the denominator:
$17,875
ARR = = 0.149 or 14.9%
$120,000
Accounting rate of return calculated using the average investment in the denominator:
$17,875
ARR = = 0.298 or 29.8%
$60,000
Both the ARR and the IRR produce a rate of return. However, ARR bases the calculation of this rate of return
on accrual net income, not cash flow, and does not consider the time value of money. IRR, on the
other hand, bases the calculation on cash flow and the time value of money. For capital budgeting
purposes, IRR provides better information.
Benefits of the Accounting Rate of Return Method of Capital Budgeting
• Since ARR focuses on operating income, the computations are easy to do and understand.
• When the Accounting Rate of Return method is being used to evaluate management, it is convenient
to also use it to evaluate projects.
Limitations of the Accounting Rate of Return Method of Capital Budgeting
• The results of the ARR are affected by the method of depreciation used.
• The ARR does not use cash flow.
• The ARR does not incorporate the time value of money. Therefore, interest lost while the company
waits to receive money is not considered.
Question 98: Doria Chung, controller of Nanjing Manufacturing, is evaluating two projects and wishes to
do a cash flow analysis of each of the projects. Both projects have positive cash inflows starting in year 1
and have similar initial investments. The cost of capital is expected to fluctuate during the life of the
projects, and Chung has selected the net present value method for her analysis. Did Chung select the
most appropriate method for her analysis?
a) Yes, the net present value method is the most appropriate method because it can properly consider
the fluctuating cost of capital.
b) No, she should have selected the payback method to properly consider the initial investments and
time value of money.
c) No, she should have selected the accounting rate of return since it will properly consider the time
value of money.
d) No, she should have selected the internal rate of return method to properly consider the fluctuating
cost of capital.
(ICMA 2014)
Advanced Capital Budgeting Topics
Theoretical Impact of a Project on Market Share Price

The value of a share of stock is the present value of its future cash flows. If the present value of the future
cash flows increases as a result of a new project, in theory the stock’s market value should also increase. The
net present value of the project divided by the number of common shares outstanding should provide an
estimate of the amount by which the market share price should increase, assuming the expected cash flows
are achieved.
Example: Lands Inc., a publicly-traded manufacturing company, is planning an expansion. The net
present value of the project is $15 million. Lands has 5,000,000 shares outstanding and the current
market price of the shares is $10. Assuming the expected cash flows from the project are realized, what
would be the theoretical impact of the project on Lands’ share price?
The NPV of the project is $15 million. With 5,000,000 shares outstanding, if the targeted cash flows are
achieved, the present value of the company’s future cash flows should increase by $15 million. Theoretical-
ly, the market price of the company’s shares should increase by $3 ($15,000,000 ÷ 5,000,000 shares), to
$13 per share.
However, in reality the price of a common share of any publicly-traded company is determined by a great
many factors. One of the most important drivers of share price is the market’s expectations about the
company’s future value-creation abilities, or the investors’ expectations regarding the ability of the firm to
identify positive NPV projects in the future. The higher investors judge the company’s potential for future
value creation to be, the higher will be the share price relative to the capital invested. Thus, any actual future
increase (or decrease) in the market share price may be very different from the theoretical impact of the
project on the share price.
Incremental Analysis: A New Asset Replacing an Old Asset

An incremental capital budgeting analysis can help a company decide whether to continue using an old asset
or replace it with a newer asset. In essence, the company needs to calculate the difference in cash flows
between keeping or replacing the older asset.
The relevant cash flows are:
1) The after-tax salvage value of the old asset if and when the new asset is purchased
2) The after-tax salvage value of the new asset at the end of its useful life.
3) The difference between the depreciation tax shield for the new asset and the depreciation tax shield
for the old asset during the period when the old asset, if kept, would have been depreciated.
4) If the old asset would have had a salvage value at the end of its life if not replaced, the loss of the
after-tax salvage value at the end of the old asset’s life if it is sold now and the new asset is pur-
chased.
5) Any difference in after-tax operating cash flow that would result from the purchase of the new asset.
In the following example, note that the company’s effective tax rate for operating income is different from its
capital gains tax rate. On the exam there may be a capital budgeting question with separate tax rates for
operating income and capital gains. This kind of question is handled the same way as any other capital
budgeting question, except one tax rate is used for calculating the tax on capital gains and losses and a
different tax rate is used for calculating tax on operating income.
Example of an Incremental Analysis

Wannabe Company is considering replacing an old, manually-controlled plastic extrusion machine with a
computer-controlled extrusion machine. Management estimates output could be increased and labor costs
would be reduced with the new machine so that before-tax operating cash flow would increase by $90,000
per year. Wannabe’s cost of capital is 12%. Its effective tax rate on operating income is 40%, and its capital
gains tax rate is 30%.
Existing New
Machine Machine
Original cost $80,000 $150,000
Installation costs 2,000 10,000
Freight and insurance on shipment 3,000 5,000
Expected salvage value at end of expected useful life 2,000 10,000
Depreciation method Straight Line Straight Line
Expected useful life when purchased 10 years 5 years
The existing machine’s expected useful life at the time of its purchase was 10 years, and it has been in
service for seven years. It could be sold now for $5,000. However, if the older machine is kept, assume that it
will not be sold at the end of its expected useful life, which would occur in Year 3 of the incremental capital
budgeting analysis. Instead, assume the old machine would continue to be used for current production
through Year 5 of the incremental capital budgeting analysis. Assume that at the end of Year 5 the old
machine could be sold for $500.
If the new machine is purchased, what will be the net present value of the new machine?
1) The old machine can be sold for $5,000 now. The machine has been in service for 7 years and the
straight-line depreciation has been $8,500 per year ($85,000 ÷ 10), so $59,500 has been depreciat-
ed. The original cost was $85,000, so the tax basis (book value for tax purposes) is $85,000 −
$59,500, or $25,500. The capital loss on the sale would thus be $20,500 ($5,000 − $25,500), and at
a 30% capital gain tax rate, tax savings due to the loss would be $6,150. Thus, the net after-tax
cash flow from the sale, if it were to take place now, would be $11,150 ($5,000 + $6,150).
2) The depreciation on the old machine, if kept, would be $8,500 per year during Years 1, 2, and 3; and
afterward, it would be fully depreciated. Since it would continue to be used through Years 4 and 5,
depreciation on the old machine would be zero during Years 4 and 5. Annual depreciation on the new
machine would be $165,000 ÷ 5, or $33,000 for each of Years 1 through 5. So, the difference in
the annual depreciation if the new machine is purchased would be $33,000 minus $8,500, or
$24,500, in Years 1, 2, and 3 and the full $33,000 in Years 4 and 5. Thus, the difference in the de-
preciation tax shield would be $24,500 × 0.40, or $9,800, in Years 1, 2, and 3 and $33,000 × 0.40,
or $13,200, in Years 4 and 5.
3) The salvage value of the old machine, if it were kept and used and sold at the end of Year 5, would
be $500. The old machine would be fully depreciated for tax purposes and its tax basis (book value
for tax purposes) would be zero, so the gain on the sale would be the full $500. At a 30% capital
gain tax rate, tax on the gain would be $150. The net after-tax cash that would be received from the
sale would be $500 minus $150, or $350. This $350 will be a negative cash flow in Year 5 of the in-
cremental analysis, because it represents a cash flow that would not be received in Year 5 if the new
machine is purchased. The expected salvage value at the end of the old machine’s expected useful
life in Year 3 ($2,000) is irrelevant to this analysis because the old machine would not be sold at the
end of Year 3 regardless of which option is chosen. (The old machine would be sold in Year 0 if the
new machine is purchased or in Year 5 if the new machine is not purchased.)
4) The increase in annual after-tax operating cash flow is $90,000 × (1 − 0.40), or $54,000.
5) The new machine can be sold for $10,000 at the end of its life in Year 5. At that point, its tax basis
will be zero, so the amount of the gain will be the full $10,000. At a 30% capital gain tax rate, tax
on the gain would be $3,000. Thus, the net after-tax cash received from the sale would be $7,000.
Below are the incremental cash flows and the calculation of the incremental NPV:
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Investment (165,000)
After-Tax Cash
Flow from Sale of 11,150
Old Machine
Difference in
Depreciation Tax 9,800 9,800 9,800 13,200 13,200
Shield
Increase in
Annual After-Tax
54,000 54,000 54,000 54,000 54,000
Operating Cash
Flow
After-Tax Cash
Flow Not Received
(350)
from Sale of Old
Machine
After-Tax Cash
Flow from Sale of 7,000
New Machine
Net Cash Flows (153,850) 63,800 63,800 63,800 67,200 73,850
PV of $1 Factor @
1.000 0.893 0.797 0.712 0.636 0.567
12%
Discounted Cash
(153,850) 56,973 50,849 45,426 42,739 41,873
Flows
NPV = $56,973 + $50,849 + $45,426 + $42,739 + $41,873 − $153,850 = $84,010
Therefore, Wannabe Company should purchase the new machine because the net advantage is $84,010. In
other words, Wannabe Company’s net present value will increase by $84,010 if it purchases the new
machine.
The same result could be obtained by creating two separate capital budgeting analyses, one for keeping the
old machine and one for replacing it, and then subtracting the NPV for keeping the old machine from the NPV
for replacing it. The time required to prepare the analysis is much less when a single incremental analysis
such as the one above is prepared.
The detail for the two separate capital budgeting analyses can be found in Appendix C in this volume.
Additional Investment Made During the Project

Sometimes, a project is planned with an additional investment to be made midway through, either in
equipment or working capital or both. The cash flow and capital budgeting analysis for this kind of
arrangement is similar to an analysis when the only investment is made at the beginning. However, if the
additional investment is an investment in depreciable assets, the depreciation and depreciation tax shield will
change in the year the new equipment is purchased. Furthermore, if the new investment causes cash flow to
be negative in the year the investment is made, an IRR for the project cannot be calculated. Whenever a
project has a negative cash flow in any year after Year 0, it can have more than one IRR; the number of IRRs
will equal the number of sign changes in the cash flows.
Example of a Capital Budgeting Project with an Additional Investment

The following information will be used to calculate the Payback Period and the NPV for a project.
The IRR for this project is not calculated. Whenever a project has a negative cash flow or flows in any
subsequent year after Year 0, it can have more than one IRR, because more than one discount rate will cause
the project’s NPV to be zero. The number of IRRs will be equal to the number of sign changes in the cash
flows. This project has three sign changes: from Year 0 to Year 1 (negative to positive), from Year 2 to Year 3
(positive to negative), and from Year 3 to Year 4 (from negative to positive). Therefore, the IRR is not
meaningful.
1) The project is a six-year project.
2) The initial investment is $150,000; an additional $60,000 investment is made in equipment in Year
3.
3) The initial working capital increase is $25,000; additional working capital increase in Year 3 is
$10,000.
4) The tax rate is 40%.
5) The operating cash flow before tax is $75,000 per year, Years 1-6.
6) Straight-line depreciation is used for tax purposes.
7) The initial investment is purchased on June 30, Year 0, and depreciates over a five-year life; the
additional investment is purchased on June 30, Year 3, and depreciates over a three-year life. A half-
year of depreciation is taken in the year acquired and in the year of disposal for both investments.
8) The salvage value of both pieces of equipment (combined) in Year 6 is $50,000. The equipment will
be sold at year end when it is fully depreciated, so 100% of the salvage value is taxable capital gain.
9) The required rate of return (discount rate) is 10%.
The Depreciation Tax Shield is calculated as follows using a tax rate of 40%:
$150,000 initial investment: Straight-line depreciation on $150,000 initial investment, 5-year life beginning
with Year 1. $30,000 depreciation expense per year, one-half year of depreciation taken in Years 1 and 6.
$60,000 additional investment in Year 3: Straight-line depreciation on $60,000 investment with a 3-year life
beginning with Year 3. $20,000 depreciation expense per year, one-half year of depreciation taken in Years 3
and 6.
Depreciation Depreciation Depreciation

Initial Additional Total Tax Shield - 40% of
Investment Investment Depreciation Total Depreciation
Year 1 $15,000 $15,000 $ 6,000
Year 2 30,000 30,000 12,000
Year 3 30,000 $10,000 40,000 16,000
Year 4 30,000 20,000 50,000 20,000
Year 5 30,000 20,000 50,000 20,000
Year 6 15,000 10,000 25,000 10,000
Below are the cash flows:
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Investment
(150,000) (60,000)
in Equipment
Working
(25,000) (10,000) 35,000
Capital
After-Tax
Cash Flows
45,000 45,000 45,000 45,000 45,000 45,000
from
Operations
Depreciation
6,000 12,000 16,000 20,000 20,000 10,000
Tax Shield
After-Tax
Cash Flows
30,000
from
Disposal
Total After-
Tax Cash (175,000) 51,000 57,000 (9,000) 65,000 65,000 120,000
Flows
Cumulative
(175,000) (124,000) (67,000) (76,000) (11,000) 54,000 174,000
Cash Flows
Payback Method with a Subsequent Investment

Numerator = The positive value of the negative cumulative cash inflow

amount from the final negative year 11,000
Denominator = Cash inflow for the following year 65,000
11,000
Payback Period = 4 + = 4.17 years
65,000
The initial and subsequent investments will be recouped after 4.17 years.
Net Present Value with a Subsequent Investment

The following chart repeats the cash flow information from the example and adds a row for the PV of $1 factor
for 10% for each year and a row for the calculation of the discounted cash flow for each year. The cumulative
discounted cash flows and the NPV can then be calculated.
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Investment
(150,000) (60,000)
in Equipment
Working
(25,000) (10,000) 35,000
Capital
After-Tax
Cash Flows
45,000 45,000 45,000 45,000 45,000 45,000
from
Operations
Depreciation
6,000 12,000 16,000 20,000 20,000 10,000
Tax Shield
After-Tax
Cash Flows
30,000
from
Disposal
Total After-
Tax Cash (175,000) 51,000 57,000 (9,000) 65,000 65,000 120,000
Flows
PV of $1
Factor for 1.000 0.909 0.826 0.751 0.683 0.621 0.564
10%
Discounted
(175,000) 46,359 47,082 (6,759) 44,395 40,365 67,680
Cash Flow
Cumulative
Discounted (175,000) (128,641) (81,559) (88,318) (43,923) (3,558) 64,122
Cash Flows
The NPV, which is the cumulative discounted cash flow at the end of the project, is $64,122.
Because this project has a positive NPV, it is technically acceptable. However, the cumulative discounted cash
flows are negative until the final year of the project, and the Payback Period as calculated above is over four
years. Therefore, if the overall nature of the project is uncertain, management may reject it because of the
long payback period and the long delay before the cumulative discounted cash flow becomes positive.
Internal Rate of Return with a Subsequent Investment

The IRR for this project is not calculated because it has a negative cash flow in a subsequent year, Year 3.
Whenever a project has a negative cash flow or flows in any subsequent year(s) after Year 0, it can have
more than one IRR. The number of IRRs will be equal to the number of sign changes in the cash flows. This
project has 3 sign changes: from Year 0 to Year 1 (negative to positive), from Year 2 to Year 3 (positive to
negative), and from Year 3 to Year 4 (from negative to positive).
Interpretation of the Capital Budgeting Analyses with a Subsequent Investment

This project has a positive NPV, so it is technically an acceptable project. However, the cumulative cash flows
are negative until the final year of the project. The Payback Period is over 4 years. If the project is a risky
project, the company’s management may find it unacceptable because of the long payback period and the
long delay until the cash flow becomes positive.
Difficulties with the Different Capital Budgeting Methods

A project that begins with a net cash outflow followed by several years of cash inflows is considered a
conventional project. When analyzing an independent project that is also a conventional project, the
discounted cash flow methods of capital budgeting (both NPV and IRR) will lead to the same accept-or-reject
decision. However, not all projects are conventional projects, and an unconventional project can affect capital
budgeting analysis results.
• An unconventional project may start out with a cash inflow followed by cash outflows.
For example, Project A starts out with a cash inflow, followed by cash outflows. Project B starts
out with a cash outflow followed by inflows. The effective result of the first project is that money is
borrowed instead of invested. To compare these two projects, rely on their NPVs.
• Alternatively, an unconventional project may start out with a cash outflow but instead of the outflow
being followed by several years of cash inflows, it may be followed by some years of cash inflows
and some years of cash outflows.
If a project starts out with a cash outflow and is followed by some years of cash inflows and
some years of cash outflows, it may have more than one IRR. Multiple IRRs occur when the
sign of the cash flow changes more than once during a project’s life. Whether or not multiple sign
changes actually do cause more than one IRR depends on the size of the cash flows. However,
whenever a project is not conventional, there could be more than one IRR. If this situation occurs,
rely on the NPV instead of the IRR.
Other considerations that can affect the interpretation of capital budgeting results are:
• A project may not be independent. An independent project does not depend on the acceptance of
any other project or projects. However, an interdependent (or contingent) project does depend
upon the acceptance of one or more other projects; therefore, none of the interdependent projects
can be considered in isolation.
If a project is not independent—meaning that if it is accepted, then one or more other projects must
be accepted also—then all the interdependent projects must be evaluated together and either
all accepted or all rejected.
• Two or more projects may be mutually exclusive and have different characteristics. If projects
are mutually exclusive, accepting one of them means not accepting the others. It is critical to deter-
mine which project is preferable. If mutually exclusive projects are ranked differently using IRR and
NPV, the conflict in rankings will be caused by one of the following differences:
o Scale differences. The initial investment amounts are different. For example, if a company has
two mutually exclusive projects, one that involves an investment of $100,000 and one that in-
volves an investment of $1,000,000, the IRR of the smaller project could be higher than that of
the larger project, while the NPV of the larger project would probably be higher than that of the
smaller project.
The conflict between the NPV and the IRR occurs because the IRR ignores the size of the invest-
ment. The IRR is expressed as a rate or percentage, and therefore the size of the investment is
not considered. Yet even if the small project’s IRR is very high, because of its small size, its NPV
will probably be lower than the NPV of a larger project with a lower IRR.
The project with the higher NPV will maximize shareholder wealth. On the other hand, the pro-
ject with the higher IRR will maximize the rate of return on investments, even though the
absolute amount of increase in shareholder wealth may be lower. Management’s choice will be
determined by whether its goal is to maximize shareholder wealth or to maximize the rate of re-
turn on its investments.
o Cash flow timing differences. An example of a cash flow timing difference is one project with
cash flows that are high in Year 1 and decrease over the term of the project while another pro-
ject has cash flows that are low in Year 1 but increase over the term of the project. Cash flow
timing differences can cause the NPV and the IRR to give different rankings of the projects.
When two projects under consideration have cash flow timing differences, the result of each cap-
ital budgeting method is a function of the hurdle rate used as the discount rate for the NPV
calculations and as the rate against which the IRRs are compared. Using a different discount rate
for both the NPV calculations and as a comparison for the IRRs may give different rankings.
The unique discount rate where the NPVs of both projects are the same is the crossover rate
(also called Fisher’s rate of intersection). The crossover rate is important, because if a hurdle
rate of less than the crossover rate is used, the NPV ranking will conflict with the IRR ranking. If
a hurdle rate of greater than the crossover rate is used, the NPV and IRR rankings will agree.
When cash flow timing differences cause these conflicts, the NPVs should be used as the deci-
sion criteria.
o Different assumptions regarding reinvestment rates. The NPV incorporates an assumption

that the cash flows from the project can be reinvested at the hurdle rate. The IRR incorporates
an assumption that the cash flows from a project can be reinvested at the IRR. Thus, when
comparing the IRRs of two projects, assume that each will have a different rate of return on re-
investment of its cash flows. NPV is a better indicator in a comparison because, assuming the
same discount rate applies to both projects, the same rate of reinvestment for the returns will be
used for both projects so the projects are more comparable.
o Variations in lives of projects. If two mutually exclusive projects have different lengths of
useful lives, their NPVs and IRRs could return conflicting results. In this case, the NPV gives the
proper ranking.
Note: Any of the above situations can cause the IRR and the NPV to present conflicting information about
the best project to undertake. Ultimately, it is best to rely on the NPV when dealing with conflicting
capital budget methods, assuming that the company’s goal is to maximize shareholder wealth.
Summary of NPV Versus IRR

To summarize the NPV versus the IRR capital budgeting methods in the event of a conflict:
1) In most instances when there is a conflict between NPV and IRR, rely on the NPV.
2) When there is a scale difference because the investments are of different amounts, IRR and NPV
can return different results. The correct choice depends on whether the firm’s goal is to maximize
shareholder wealth (use NPV) or to maximize the rate of return on investments (use IRR). Short-
lived projects with smaller up-front investments may have very high IRRs but may not add much
value either to the firm or to shareholder wealth.
3) Rely on IRR instead of NPV in the case of a scale difference only if the firm’s goal is to maximize
return on investment instead of maximizing shareholder wealth.
The following information is for the next three questions.
The Moore Corporation is considering the acquisition of a new machine. The machine can be purchased for
$90,000; it will cost $6,000 to transport to Moore’s plant and $9,000 to install. It is estimated that the
machine will last 10 years, and it is expected to have an estimated salvage value of $5,000. Over its 10-
year life, the machine is expected to produce 2,000 units per year with a selling price of $500 and
combined material and labor costs of $450 per unit. Federal tax regulations permit machines of this type
to be depreciated using the straight-line method over 5 years with no estimated salvage value. Moore has
a marginal tax rate of 40%.
Question 99: What is the net cash outflow at the beginning of the first year that Moore Corporation should
use in a capital budgeting analysis?
a) $(85,000)
b) $(90,000)
c) $(96,000)
d) $(105,000)
Question 100: What is the net cash flow for the third year that Moore Corporation should use in a capital
budgeting analysis?
a) $68,400
b) $68,000
c) $64,200
d) $79,000
Question 101: What is the net cash flow for the tenth year of the project that Moore Corporation should
use in a capital budgeting analysis?
a) $100,000
b) $81,000
c) $68,400
d) $63,000
(CMA Adapted)
The following information is for the next four questions.
Yipann Corporation is reviewing an investment proposal. The initial cost and other relevant data for each
year are presented in the schedule below. All cash flows are assumed to take place at the end of the year.
The salvage value of the investment at the end of each year is equal to its net book value, and there will
be no salvage value at the end of the investment’s life.
Initial Cost Annual Net After-Tax Annual
Year and Book Value Cash Flows Net Income
0 $105,000 $ 0 $ 0
1 70,000 50,000 15,000
2 42,000 45,000 17,000
3 21,000 40,000 19,000
4 7,000 35,000 21,000
5 0 30,000 23,000
Yipann uses a 24% after-tax target rate of return for new investment proposals. The discount factors for a
24% rate of return are given below.
Present Value of Present Value of an Annuity
$1.00 Received at of $1.00 Received at the End
Year the End of Period of Each Period
1 0.81 0.81
2 0.65 1.46
3 0.52 1.98
4 0.42 2.40
5 0.34 2.74
6 0.28 3.02
7 0.22 3.24
Question 102: The average annual cash inflow at which Yipann would be indifferent to the investment
(rounded to the nearest dollar) is:
a) $21,000
b) $40,000
c) $38,321
d) $46,667
Question 103: The accounting rate of return for the investment proposal over its life using the initial value
of the investment is:
a) 36.2%
b) 18.1%
c) 28.1%
d) 38.1%
Question 104: The traditional payback period for the investment proposal is:
a) 0.875 years
b) 1.933 years
c) 2.250 years
d) Over 5 years
Question 105: The net present value of the investment proposal is:
a) $4,600
b) $10,450
c) $(55,280)
d) $115,450
(CMA Adapted)
Question 106: Capital Invest Inc. uses a 12% hurdle rate for all capital expenditures and has done the
following analysis for 4 projects for the upcoming year.
Project 1 Project 2 Project 3 Project 4

Initial capital outlay $200,000 $298,000 $248,000 $272,000
Annual net cash inflows
Year 1 $ 65,000 $100,000 $ 80,000 $ 95,000
Year 2 70,000 135,000 95,000 125,000
Year 3 80,000 90,000 90,000 90,000
Year 4 40,000 65,000 80,000 60,000
Net present value (3,798) 4,276 14,064 14,662
Internal rate of return 11% 13% 14% 15%
Which project(s) should Capital Invest Inc. undertake during the upcoming year, assuming it has no
budget restrictions?
a) All of the projects
b) Projects 1, 2 and 3
c) Projects 2, 3 and 4
d) Projects 1, 3 and 4
(CMA Adapted)
The following information is for the next four questions.

The following selected data pertain to a 4-year project being considered by Metro Industries:
• A depreciable asset that costs $1,200,000 will be acquired on January 1. The asset, which is expected
to have a $200,000 salvage value at the end of 4 years, qualifies as 3-year property under the Modi-
fied Accelerated Cost Recovery System (MACRS).
• The new asset will replace an existing asset that has a tax basis of $150,000 and can be sold on the
same January 1 date for $180,000.
• The project is expected to provide added annual sales of 30,000 units at $20. Additional cash
operating costs are: variable, $12 per unit; fixed, $90,000 per year.
• A $50,000 working capital investment, fully recoverable at the end of the fourth year, is required at
the beginning of the project.
Metro is subject to a 40% income tax rate and rounds all computations to the nearest dollar. Assume that
any gain or loss affects the taxes paid only at the end of the year in which it occurred. The company uses
the net present value method to analyze investments and will employ the following factors and rates.
Period PV of $1 at 12% PV of $1 Annuity at 12% MACRS
1 0.89 0.89 33%
2 0.80 1.69 45%
3 0.71 2.40 15%
4 0.64 3.04 7%
Question 107: The discounted cash flow for the fourth year MACRS depreciation on the new asset is:
a) $0
b) $17,920
c) $21,504
d) $26,880
Question 108: The discounted, net-of-tax amount that relates to disposal of the existing asset is:
a) $168,000
b) $169,320
c) $180,000
d) $190,680
Question 109: The expected incremental sales will provide a discounted, net-of-tax contribution margin
over 4 years of:
a) $57,600
b) $92,160
c) $273,600
d) $437,760
Question 110: The overall discounted-cash-flow impact of the working capital investment on Metro's
project is:
a) $(2,800)
b) $(18,000)
c) $(50,000)
d) $(59,200)
(CMA Adapted)
Question 111: A company is considering two investments. Both have an estimated useful life of 5 years
and require an initial cash outflow of $15,000. The cash inflow for each project is shown below.
Project A Project Z
Year 1 $7,000 $ 0
Year 2 $8,000 $ 5,000
Year 3 $9,000 $ 5,000
Year 4 $ 0 $ 5,000
Year 5 $ 0 $25,000
The company requires an 8% rate of return and uses straight-line depreciation.
Present value factors at a rate of 8% are as follows:

PV of $1 PV of Annuity
1 year 0.926 0.926
2 years 0.857 1.783
3 years 0.794 2.577
4 years 0.735 3.312
5 years 0.681 3.993
Which one of the following capital budgeting evaluation methods would result in an initial recommenda-
tion of the less profitable project as the better choice?
a) Payback period.
b) Accounting rate of return.
c) Internal rate of return.
d) Net present value.
(ICMA 2014, adapted)
Capital Budgeting and Inflation

Thus far, inflation has not been a factor in these capital budgeting discussions. However, inflation is an
important consideration when evaluating a project that will extend many years into the future because
inflation causes a decline in general purchasing power over time. For example, if inflation is 10% annually,
then what $100 can buy on January 1 will cost $110 by December 31.
The terms nominal and real are used when analyzing the effects of inflation on purchasing power.
• Nominal cash flow and nominal rate of return include inflationary increases. For a capital budgeting
project, they are the cash flow and rate of return expected in the future when an assumed rate of
future inflation is taken into consideration.
• Real cash flow and real rate of return do not include inflationary increases. For a capital budgeting
project, they represent the future cash flow and rate of return if there were no inflation during the
period of the analysis.
Normally, nominal cash flows and nominal rates of return are used in a capital budgeting analysis.
However, if a project extends into the future for many years, the nominal cash flows and nominal rates of
return, which include an adjustment for expected inflation, can be misleading. They can make a project
appear to be more profitable than it really is. For example, if the company plans to sell the same number of
units per year over a two-year period and management incorporates an expected inflation rate into the sale
price and the expected costs, both the nominal revenue and the nominal costs in Year 2 would be higher than
those of Year 1, without any increase in volume. Expected operating cash flow for Year 2 would be higher
than that of Year 1 by the expected inflation rate.
If an analyst wants to analyze the real return from the project, without taking into consideration any factor
for inflation during the period of the project, the analyst can convert the nominal cash flows and the nominal
rate of return used to real cash flows and the real rate of return for the analysis. The result will not be what is
expected in nominal terms, but it may provide a more realistic picture of the project’s real value. For
example, if the project’s net present value is calculated using real cash flows and return, the result will be the
project’s expected net present value if there were no inflation during the project period.
Converting Nominal Cash Flows and Rate of Return to Real Cash Flows and Rate of Return
To convert a nominal expected cash flow to a real expected cash flow, divide the nominal cash flow by
the inflation factor, which is (1 + Inflation Rate)n, where n is the number of years from Year 0:
Nominal Cash Flow

Real Expected Cash Flow =
(1 + Inflation Rate)n
Example: An $11,000 nominal expected cash flow to be received in one year when inflation is expected to
be 2% annually is equivalent to real cash flow received in one year of:
$11,000
Real Expected Cash Flow = = $10,784
(1.02)1
If that same $11,000 nominal expected cash flow were to be received in two years instead of one, with an
expected inflation rate of 2% annually over the two-year period, the real expected cash flow to be received
in two years is:
$11,000
Real Expected Cash Flow = = $10,573
(1.02)2
A nominal rate of return can be converted to a real rate of return as follows:
1 + Nominal Rate
Real Rate of Return = − 1
1 + Inflation Rate
Example: With a nominal rate of return of 6% and an inflation rate of 2%, convert the nominal rate of
return to a real rate of return as follows:
1 + 0.06
Real Rate of Return = − 1 = 3.92%
1 + 0.02
Converting Real Cash Flows and Rate of Return to Nominal Cash Flows and Rate of Return
Sometimes, the real expected cash flows and rate of return need to be converted to nominal expected cash
flows and rate of return for capital budgeting purposes.
For example, a company is considering investing in a product and expects to sell 1,000 units each year for
four years. Furthermore, it expects a net cash inflow of $10 per unit if there were no inflation during the
life of the project. Therefore, with no inflation, the company can expect a net cash inflow of $10,000 per year
for the life of the project ($10 per unit multiplied by 1,000 units sold each year).
However, if inflation is factored in during the sales period, the company should expect progressively higher
cash inflows in each subsequent year, even though no increase in sales volume takes place. These increased
figures are nominal expected cash flows, and they represent the transactions that will be recorded in the
accounting system. The net expected cash inflows of $10,000 assuming no inflation are the real expected
cash inflows, which are not recorded in the accounting system.
Real expected cash flows and rates of return can also be converted to nominal cash flows and rates of return.
To convert a real expected cash flow to a nominal expected cash flow, multiply the real cash flow by the
inflation factor, which is (1 + Inflation Rate)n, where n is the number of years from Year 0:
Nominal Expected Cash Flow = Real Expected Cash Flow × (1 + Inflation Rate)n
Example: The following illustrates real expected cash flows converted to nominal expected cash flows for
capital budgeting.
Assume that real expected cash inflows are $10,000 per year for four years, and expected annual inflation
is 3%:
Before-Tax Before-Tax
Expected Expected
Real Cash Cumulative Nominal Cash
Year Flows Inflation Factor Inflows
1 $10,000 × 1.031 or 1.0300 = $10,300
2 10,000 × 1.032 or 1.0609 = 10,609
3 10,000 × 1.033 or 1.0927 = 10,927
4 10,000 × 1.034 or 1.1255 = 11,255
This capital budgeting analysis can now use the nominal expected cash flows calculated for Years 1
through 4. The amount of the initial investment is not adjusted, because it is assumed to take place before
the impact of the future inflation.
Future expected cash flows and the required rate of return both need to be adjusted for inflation. In other
words, if one is adjusted, the other must also be adjusted.
The real required rate of return is the rate of return required to cover the risk inherent in an investment.
Like real cash flow, it assumes no inflation. The real rate of return includes two components:
1) The risk-free rate of return, assuming no expected inflation, which is approximated by the rate for
long-term government bonds.
2) A risk premium, which is required to compensate for the business risk foreseen.
The nominal required rate of return consists of three elements because it includes a component for
inflation:
1) The risk-free rate of return, assuming no expected inflation, which is approximated by the rate for
long-term government bonds.
2) A risk premium, which is required to compensate for the business risk foreseen.
3) An inflation element, which is a premium above the real rate that is required to offset the expected
decline in purchasing power due to inflation.
Rates of return quoted on financial markets are nominal rates, because investors demand compensation for
both the investment risk they assume and for the expected decline in their purchasing power due to inflation.
The nominal rate of return will be slightly higher than the real rate plus the inflation component, because
inflation decreases the purchasing power of both the principal and the real rate of return earned each year.
The nominal rate of return is calculated as follows:
Nominal Rate of Return = (1 + Real Rate of Return) × (1 + Inflation Rate) – 1
Example: If inflation is expected to be 3% per year, to convert a real rate of return of 5% to a nominal
rate of return, the calculation is:
Nominal Rate = (1 + 0.05) × (1 + 0.03) − 1
= (1.05 × 1.03) − 1
= 1.0815 − 1
= 0.0815 or 8.15%
When incorporating inflation into a capital budgeting analysis, adjust both the expected real cash flow and the
real required rate of return to nominal values. The nominal required rate of return, as shown above, is used
to determine the present value of each of the annual nominal expected cash flows.
The same nominal rate of return is used to discount the expected cash flow for every year of the project; it is
not adjusted upward annually.
Note: If the required rate of return used to discount the cash flows of a project includes a premium for
inflation, then expected cash flows used in the analysis must also include a premium for inflation.
Example: The following illustrates the calculation of net present value using adjustments for inflation.
• The inflation rate is 3%.

• Expected real cash inflows after taxes are $10,000 per year and will be adjusted to nominal expected
cash flows.
• The real required rate of return is 5%, and it is adjusted to a nominal required rate of return of 8.15%.
• The net initial investment is $25,000 (unadjusted).
• Depreciation for book and tax purposes is $6,250 per year.
• The tax rate is 40%.
Year 0 Year 1 Year 2 Year 3 Year 4

Real expected cash flow
(after-tax) (25,000) 10,000 10,000 10,000 10,000
Inflation factor (see Note 1) _______ 1.0300 1.0609 1.0927 1.1255
Nominal expected cash flow
(after-tax) (25,000) 10,300 10,609 10,927 11,255
PV of $1 factor for nominal rate
of 8.15% (see Note 2) 1.0000 0.92464 0.85496 0.79053 0.73096
PV of Nominal Cash Flow (25,000) 9,524 9,070 8,638 8,227
Depreciation (see Note 3) 6,250 6,250 6,250 6,250
Depreciation Tax Shield (Depr.×0.40) 2,500 2,500 2,500 2,500
PV of Depr. Tax Shield (see Note 3) 2,312 2,137 1,976 1,827
PV of Total Nominal Cash Flow (incl.
PV of Depr. Tax Shield) (25,000) 11,836 11,207 10,614 10,054
NPV = (25,000) + 11,836 + 11,207 + 10,614 + 10,054 = 18,711
Note 1: The inflation factor is calculated as (1 + inflation rate)n, where n is the number of years from Year
0.
Note 2: The nominal required rate of return is calculated as (1 + Real Rate of Return) × (1 + Inflation
Rate) – 1, as follows: (1 + 0.05) × (1 + 0.03) – 1 = 0.0815. The PV of $1 factor is calculated as 1/(1+r)n.
Note 3: The depreciation is not adjusted for inflation because the U.S. IRS allows assets to be depreciated
only on the original cost of the asset. The depreciation tax shield is the depreciation expense multiplied by
the tax rate. Therefore, the depreciation tax shield will not increase because of inflation. The depreciation
tax shield is already the nominal amount, so it is discounted at the nominal rate of return.
Summary of Real Versus Nominal Cash Flows and Rates

The following points summarize the main ideas of this topic.
• Real expected cash flow is cash flow assuming no inflation.
• Nominal expected cash flow includes an increase to reflect inflation.
• In an inflationary environment, nominal cash flow will be higher than real cash flow.
• The real rate of return is the return assuming no inflation.
• The nominal rate of return includes an inflation component.
• In an inflationary environment, nominal returns will be higher than real returns.
Summary and Review of Relevant Cash Flows
Relevant Expected Cash Flows Used for Capital Budgeting

1) Use expected cash flows, not accounting income.
2) Use operating cash flows, not financing cash flows.
3) Expected cash flows must be determined on an after-tax basis.
4) Expected cash flows should be incremental; analyze only the difference between expected cash
flows with the project and those without the project.
5) Calculation of the depreciation tax shield is always based on the type of depreciation used for tax
purposes; furthermore, 100% of the asset’s cost is always depreciated, regardless of the type
of depreciation (for example, MACRS or straight-line) is being used for tax purposes.
Determining Initial (Year 0) Cash Outflow
Cost of new asset(s)

+ Capitalized expenditures (such as shipping and installation costs)‡
± Increased (decreased) level of net working capital (change in current assets net
of change in current liabilities) related to the project
− Net before-tax proceeds from sale of old asset(s) if the project represents
replacement of assets
± Taxes (tax savings) from gain/(loss) on the sale of replaced old assets
= Initial cash outflow
‡The asset’s cost, plus any other capitalized expenditures necessary to prepare it for its
intended use, form the tax basis of the asset for depreciation for tax purposes. Under
depreciation for tax purposes, the depreciable basis is not reduced by any estimated
salvage value.
Basic Principles for Estimating Incremental Cash Flows

1) Sunk costs are ignored.
2) Opportunity costs should be included.
3) Requirements for increased net working capital (that is, project-driven increases in current
assets minus project-driven increases in current liabilities) should be considered as part of the initial
investment’s cash outflow. At the end of a project’s life, the working capital investment is returned in
the form of a cash inflow.
4) An additional increase in net working capital may be required midway through the project. If so, it is
a cash outflow in the year it takes place, and both the initial increase and the additional increase in
working capital are recovered at the end of the project.
5) If the required rate of return includes a premium for inflation, then expected cash flows must also
include an inflation component.
6) Taxable operating cash flows are adjusted to their after-tax equivalents.
7) Though depreciation is a non-cash expense, it has an income tax consequence in the form of re-
duced tax liability, which is a cash inflow called the depreciation tax shield.
Determining Incremental Net Cash Flows Per Period During the Project’s Life
Net increase (decrease) in operating revenue

∓ Net (increase) decrease in operating expenses, excluding depreciation
= Net incremental operating cash flow before taxes
∓ Net (increase) decrease in income taxes on operating cash flow
= Net incremental operating cash flow after taxes
± Depreciation tax shield: net increase (decrease) in depreciation expense for
tax purposes × tax rate
= Incremental net cash flow for the period
Determining Incremental Net Cash Flow in Final Year of the Project
Incremental net cash flow for the period (as above), not including project
termination considerations
± Proceeds from sale or (costs of disposal) of asset(s)
∓ (Taxes on gain) or tax savings on loss from disposal of asset(s)
± Recovered net working capital or (increased net working capital)
= Final year’s incremental net cash flow
Risk in Capital Budgeting

Capital budgeting always entails risk, and risk must be factored into the capital budgeting process.
The expected value of future cash flows used for each year in a capital budgeting analysis is an average of all
the possible cash flows for that year as determined by management. The expected cash flows used are
weighted averages of all of the possible cash flows, with the probabilities of each cash flow occurring serving
as the weights. Thus, several possible cash flows will be projected for each year of a project’s life and
probabilities will be determined for each possible cash flow for each year so that the expected value of the
cash flows for each year can be calculated.
An expected value is a “long-run” average value. As a result, an expected value is more reliable as a long-run
average forecast and less reliable as a forecast for the net cash flow for an individual project for a given year.
Despite not being a reliable forecast, expected value is often used to project future cash flows from individual
projects because it is the best method available for obtaining a forecast. Due to its long-run nature, though,
achievement of the expected cash flows used in a capital budgeting analysis is not a certainty. The problem
with using expected value as a forecast for a specific project is that any given project has only one
opportunity to achieve its cash flow for each of the years of its duration and then the project is complete. The
cash flow actually achieved for any project could be anywhere from its lowest possible cash flow to the
highest possible cash flow or even outside that range. Numerous factors can affect a project’s net cash flows.
The more widely that the potential investment returns are dispersed, the greater will be the potential for loss
or gain and thus the riskiness of the investment increases. In determining the various possible cash flows for
use in calculating each year’s expected cash flow, management must:
1) Determine which influences (for example economic events, labor conditions, or international condi-
tions) have affected the net cash flows of similar projects in the past
2) Determine probabilities of each influence or event occurring
3) Make assumptions about the effect or effects of each influence on the project.
After following these steps, the financial manager can estimate the impact that each assumption might have
on the various possible net cash flows in each year of the project’s life and, using the probabilities, calculate
the expected cash flows for each year of the project’s life. A project judged to be riskier may be evaluated
using a higher required rate of return in order to compensate for the increased risk.
Risk analysis can be focused narrowly on each investment opportunity or on the entire investment portfolio.
In theory, a diversified portfolio can lower the overall risk of investments because different risks may affect
different assets. Cash flows and rates of return that are higher than expected on some projects can offset
cash flows and rates of return that are lower than expected on other projects.
Example: XYZCo is comparing two capital budgeting proposals, both for one-year projects and both
requiring the same investment. Management has made several forecasts for the cash flows, as follows:
Project A Project B
Economy in a deep recession $200,000 $100,000
Economy in a mild recession 250,000 200,000
Economy stable 300,000 300,000
Economy in a minor expansion 350,000 400,000
Economy in a major expansion 400,000 500,000
The company’s economists forecast that the probability of a deep recession occurring next year is 5%, a
mild recession 10%, a stable economy 50%, a minor expansion 25%, and a major expansion 10%. Using
these probabilities, the expected values of the cash flows for both projects are as follows:
Probability Project A Project B

(P) Cash Flow CF×P Cash Flow CF×P
Economy in a deep recession 5% $200,000 $ 10,000 $100,000 $ 5,000
Economy in a mild recession 10% 250,000 25,000 200,000 20,000
Economy stable 50% 300,000 150,000 300,000 150,000
Economy in a minor recession 25% 350,000 87,500 400,000 100,000
Economy in a major expansion 10% 400,000 40,000 500,000 50,000
Expected Value $312,500 $325,000
The expected value of Project B’s cash flow is higher than the expected value of Project A’s cash flow.
However, a review of the ranges of the potential cash flows for both projects reveals that Project B’s cash
flow is riskier because the range of possible cash flows is greater. Project B’s lowest possible cash flow is
$100,000 and its highest possible cash flow is $500,000, whereas Project A’s lowest possible cash flow is
$200,000 and its highest possible cash flow is $400,000. The range of Project B’s potential cash flows is
$400,000, whereas the range of Project A’s potential cash flows is only $200,000.
This range of potential cash flows is called the dispersion of the possible cash flows about their means, or
their expected values. “Dispersion” describes how much the individual data points are scattered or spread
out around their expected value. The narrower the distribution of the data, the lower the project’s risk will
be. The wider the distribution of data, the higher the project’s risk will be. Therefore, Project B is riskier
than Project A.
The risk of each project can be inferred from the dispersion of its possible cash flows, but the risk can be
quantified by calculating the variance and standard deviation of each set of cash flows. Calculation of the
variance and standard deviation of a set of data is outside the scope of the CMA Part 2 exam and thus is
not discussed here. Variance and standard deviation are tested on the CMA Part 1 exam and are covered in
study materials for that exam.
Types of Risk
There are two main types of risk involved in capital budgeting: market risk and nonmarket risk.
Market risk (also called nondiversifiable or systematic risk) refers to the uncertainties that a company
might experience due to unplanned or unexpected changes in its business environment. A company can
prepare for market risk and attempt to manage it. However, these types of changes are wide-ranging enough
that they can affect all companies in the same marketplace, and as a result, it is difficult, if not impossible, for
a single company to have any meaningful impact on market risk. Furthermore, diversifying is not an effective
countermeasure against market risk. Finally, market risk can be difficult to measure effectively.
The following is a partial list of the kinds of market risks that could affect a project’s cash flows:
1) Interest-rate risk. The return on the investment could fluctuate over the life of the investment due
to changes in market interest rates. Thus, the longer the term of the investment, the higher the in-
terest rate risk.
2) Purchasing-power risk. A general increase in price levels means that as time goes by, money buys
less and less. For example, an item that cost $1 in Year 1 may cost $1.10 in Year 2. The threat of
this decline in purchasing power is essentially the risk of inflation that affects a buyer. Inflation must
be taken into account in capital budgeting.
3) Exchange-rate risk. Foreign currency exchange rates fluctuate, so companies that operate interna-
tionally face the risk that changes the exchange rates will negatively impact cash flows.
Nonmarket risk (also called company-specific, stand-alone, or diversifiable risk) focuses on the
uncertainties related to a specific company or a specific project. An individual company can influence, and in
some cases mitigate, this type of risk, for example through diversification. Nonmarket risk can be measured
by statistical measurements using the standard deviation and the coefficient of variation54 of the probability
distribution of the possible outcomes of the project. Furthermore, project outcomes can be determined
through such tools as decision trees, sensitivity analysis, simulation analysis, scenario analysis, and
breakeven analysis.
The following is a partial list of the kinds of nonmarket risks that could affect a project’s cash flows:
1) Portfolio risk. These are uncertainties and changes that affect an entire portfolio of investments.
Portfolio risk can be reduced through proper diversification in the management of the portfolio.
2) Liquidity risk. The risk that a capital asset cannot be sold quickly enough without discounting the
price below market value. Therefore, an asset has high liquidity risk if it would need to be sold at a
high discount in order to sell it quickly.
3) Financial risk. The financing a company pursues for a project may cause the company’s debt-to-
equity ratio to either increase or decrease, which could change the company’s financial risk and the
risk to its shareholders.
4) Business risk. The risk of changes in earnings before interest and taxes is business risk. Business
risk depends on a variety of factors, including the variability of demand, sales price, the price of in-
puts, and also the amount of the company’s operating leverage. If these variables are stable, a
company will experience less business risk.
Analysis of Risk
Risk is a constant concern for decision-makers, and therefore it is essential to have the proper skills to
analyze and calculate risk. Unfortunately, risk is volatile and unpredictable by its nature, and so risk
identification and mitigation is difficult to execute effectively. Furthermore, risk events often arise from a
diverse range of events that only converge in the future, and it can be a particular challenge to keep track of
all possible factors that might lead to a specific event. In many instances, risk analysis depends on a degree
of business intuition and creative guesswork. Even so, managers can use a number of techniques to help
them get a grasp on the scope of the risks they face and, in many instances, provide meaningful approaches
to mitigating and reducing the likelihood and effect of risk.
54
Standard deviation is covered in the HOCK CMA Part 1 textbook. Standard deviation provides information on how much
the various values are dispersed around the mean. The coefficient of variation is a measure of risk per unit of expected
return. The coefficient of variation compares the amount of the variation from the expected return with the amount of the
expected return. The coefficient of variation is calculated as follows:
Standard Deviation
Coefficient of Variation = Expected Return
The higher the coefficient of variation is, the riskier the investment is relative to its expected return.
Decision Trees
Decision trees help management choose the best course of action when it is faced with several possible
options under a condition of risk. Decision trees provide a structured way to think about choices and they help
develop and support subjective judgments critical for effective decision-making by breaking down complex
problems into a series of smaller problems or decision points. By using probabilities to determine the
expected value of a project’s payoff, a decision tree can show the natural or logical progression of events.
Depending on the decision made at each point, the probabilities of the potential payoffs can be used in order
to develop an overall expected value for the entire project. For example, in capital budgeting decision trees
can be used effectively to allocate limited resources between or among various projects.
Decision trees are depicted as a series of circles and boxes, with lines indicating relationships and connections
to pre-existing conditions and choices.
• A circle represents a probability node (or chance node), in effect any condition that exists and
cannot be controlled. At each probability node, the “tree” branches out, and the branch that is taken
is a matter of probability or chance, not a matter that management can control through a decision.
These are conditional probabilities because they are dependent upon events that may or may not
precede them.
• A box represents a decision node, the point at which a decision is to be made. At a decision node,
the branch of the tree that is taken depends on specific decisions made by an agent (such as a man-
ager).
Example of a Decision Tree

Sales Depot is considering opening a retail store in a new market. Management has census and market data
available to help it calculate probabilities of success. Also, it has obtained economic data suggesting that
there is a 60% chance that the economy will be good and a 40% chance that the economy will be weak. The
actual future state of the economy, which will most certainly influence the results of the investment, is out of
the company’s control. Therefore, the outcome of the economy is a probability node. On the other hand, the
size of the store, either large or small, is a decision that the company can control; therefore, this choice is a
decision node.
The probability decision tree for the retail store decision is illustrated in the following diagram.
Payoff (NPV):
Demand Strong $10,000,000

75%
Large Store
4
Economy Demand Weak $ 4,000,000
Strong 25%
2
60%
Demand Strong $ 7,000,000
75%
Small Store
5
Demand Weak $ 5,000,000
1 25%
25%
Large Store
6
Economy
Weak Demand Weak $(1,000,000)
3 75%
40%
25%
Small Store
7
Demand Weak $ 500,000
75%
Probability Node 1 represents the state of the economy, either strong or weak, which is not within Sales
Depot’s control, but the company estimates there is a 60% probability the economy will be strong and a 40%
probability it will be weak.
Decision Nodes 2 and 3 represent the choices between a large or a small store, given a strong or weak
economy.
Probability Nodes 4 to 7 represent the effect of different demand conditions on large and small stores.
According to the preceding diagram, either a large or a small store built during a strong economy has a 75%
probability of experiencing strong demand and a 25% probability of experiencing weak demand. Under weak
economic conditions, the probabilities reverse: either a large or a small store built during a weak economy
has a 25% probability of experiencing strong demand and a 75% probability of experiencing weak demand.
This tree includes forecasts of the net present value of each investment under each of the different scenarios.
These net present values appear on the right side of the decision tree (at the end of each of the nodes) as
payoffs.
The decision strategy incorporates a backward pass through the decision tree and follows these guidelines:
1) At a probability node, calculate the expected value by multiplying the payoff at the end of each of
the branches by its probability.
2) At a decision node, select the decision branch that results in the greatest expected value.
To determine the expected values of each of these decisions under each set of economic conditions, multiply
the probabilities by the payoffs and, in each case, sum them to calculate an expected value.
The following illustrates the decision strategy.
If the Economy is Strong

The expected value of the large store in a strong economy (Decision Node 2, Probability Node 4) is:
EV (Node 4) = (0.75 × $10,000,000) + (0.25 × $4,000,000) = $8,500,000
The expected value of the small store in a strong economy (Decision Node 2, Probability Node 5) is:
EV (Node 5) = (0.75 × $7,000,000) + (0.25 × $5,000,000) = $6,500,000
If the Economy is Weak

The expected value of the large store in a weak economy (Decision Node 3, Probability Node 6) is:
EV (Node 6) = (0.25 × $4,000,000) + [0.75 × $(1,000,000)] = $250,000
The expected value of the small store in a weak economy (Decision Node 3, Probability Node 7) is:
EV (Node 7) = (0.25 × $2,000,000) + (0.75 × $500,000) = $875,000
The decision tree has now been reduced from eight branches to four. The next step is to move back to
Decision Nodes 2 and 3 and select the alternative that leads to the best expected value of each one.
• Once the expected values of various outcomes are calculated based on the payoff amounts and the
probability of the outcome, then at each preceding decision node management can choose the alter-
native with the best expected value. At decision Node 2 (strong economy), management selects the
large store because its expected value (EV = $8,500,000) is greater than the expected value of the
small store (EV = $6,500,000).
• At decision Node 3 (weak economy), management selects the small store because its expected value
(EV = $875,000) is greater than the expected value of the large store (EV = $250,000).
The ultimate course of action depends on management’s forecast of the economy. If management believes
the economy will be strong, it will build the large store. If management believes the economy will be weak, it
will build the small store. At this point, judgments about weak or strong demand are not significant, because
those figures have already been factored into the expected values.
Management could go one more step and calculate an expected value for the overall decision, but that
expected value would not be meaningful. At this point, management has two mutually exclusive projects:
either a large store for a strong economy or a small store for a weak economy. Another option would be to
build a small store, regardless of management’s forecast for the economy and, in the event of a strong
economy, expand it to a large store. Thus, building a small store provides an option to expand later.
It should be noted here that a decision tree is merely a tool to visualize and comprehend important choices;
the tree does not make decisions. Only the decision-maker can make the final decision, based on the
information the tree illustrates. Furthermore, the probabilities associated with each of the outcomes in a
decision tree are almost always subjective, meaning they are derived from conjecture and educated
guesses. Different people could assign different sets of probabilities, which could lead them to very different
conclusions.
Benefits of Decision Trees
• Decision trees are helpful when there is a series of conditional choices.
• They show the impact of time on decisions.
• They create a model to visualize uncertainty.
• They produce quantitative results.
• They are flexible, examining the effects of predictors one at a time.
Limitations of Decision Trees
• Decision factors are quantitative. Decision trees are not well equipped to illustrate or meaningfully
express qualitative factors such as customer goodwill or community image.
• They can be difficult to develop in a group setting, with multiple opinions and perspectives on event
probabilities.
• In the case of a great number of possible outcomes, a decision tree can become extremely large,
complex, and unwieldy.
• All information developed from decision tree analysis must be subjected to the judgment of the
decision-maker.
Sensitivity Analysis
Sensitivity analysis can be used to determine how cash flows are expected to vary with changes in underlying
assumptions. Using expected cash flows, the NPV and IRR of the project are determined. Next, the key
assumptions used in making the original expected cash flow projections are identified. One assumption at a
time is then changed, leaving the other assumptions unchanged; the NPV and IRR are recalculated to
determine what effect changing one assumption would have on those measures. This process may show some
area of risk that the company had not been aware of previously and thus indicate that the investment is
riskier than originally thought.
Scenario Analysis
In scenario analysis, the NPV or IRR of a project is analyzed under a series of specific scenarios, which are
based on macroeconomics, factors specific to the industry the firm operates in, and factors specific to the
company itself. Revenues, expenses, and ratios under each of the scenarios are estimated, and the NPV and
IRR of the project under each scenario are estimated. The decision to accept or reject the project is based on
the NPVs and IRRs under all the scenarios, not just one.
Simulation Analysis
Simulation analysis allows for more than one uncertain element in the analysis. Therefore, simulation analysis
is more comprehensive than sensitivity analysis. Simulations can be used to develop possible outcomes, using
statistical methods and computing the NPV and IRR for each set of outcomes. All of the results from the
simulations are then summarized into average, variance, coefficient of variation, and so forth, for all the
statistics across all the simulation runs. The final decision is based on the summary statistics. Simulation
analysis is, however, an expensive method and will generally be used only for larger projects.
Monte Carlo Simulation and “What-If” Risk Analysis

“What-if” analysis is a type of risk analysis that uses randomly generated values for probabilistic inputs. The
goal of risk analysis is to determine the probability of a negative event (such as a loss) and the magnitude of
potential damages if it occurs. The analyst estimates ranges for the probabilistic inputs, such as labor costs or
materials costs, then “what-if” analysis is used to determine a worst-case scenario (that is, what would
happen in the worst of circumstances) and a best-case scenario (that is, what would happen in the best of
circumstances). In addition, the base-case scenario represents the most likely circumstances based on the
analyst’s estimates of the most likely probabilistic inputs. What-if analysis like this does not utilize simulation.
It can provide a variety of scenarios, but it reveals little about their probabilities.
Monte Carlo simulation can be used to develop an expected value when the situation is complex and the
values cannot be expected to behave predictably. Monte Carlo simulation uses repeated random sampling and
can develop probabilities of various scenarios coming to pass that can be used to compute a result that
approximates an expected value.
Adding a Monte Carlo simulation to the model allows analysts to assess various scenario probabilities because
they can generate random values for the probabilistic inputs based on their probability distributions. The
analyst can determine ranges for the probabilistic inputs (such as labor costs or materials costs) and also
their probability distributions, means, and standard deviations. The computer-simulation application then
generates the random values for the probabilistic inputs based on their ranges, probability distributions,
means, and standard deviations as determined by the analyst.
The values for the probabilistic inputs are used to generate multiple possible scenarios, similar to performing
statistical sampling experiments, except that it is done on a computer and over a much shorter time span
than actual statistical sampling experiments. Enough trials are conducted (indeed, hundreds or thousands)
with different values for the probabilistic inputs in order to determine a probability distribution for the
resulting scenario, which is the output. The repetition is an essential part of the simulation.
For example, if the simulation is run to evaluate the probability that a new product will be profitable, the
output may include an average profit and the probability of a loss. Furthermore, the average profit that
results should be a reasonable approximation of expected profit.
Benefits of Simulation
• Simulation is flexible and can be used for a wide variety of problems.
• It can be used for “what-if” situations, because it enables the study of the interactive effect of
variables.
• Simulation is easily understood.
• Many simulation models can be implemented without special software packages, because most
spreadsheet packages provide useable add-ins. For more complex problems, simulation applications
are available.
Limitations of Simulation
• Simulation is not an optimization technique. It is a method that can predict how a system will operate
when certain decisions are made for controllable inputs and when randomly generated values are
used for the probabilistic inputs.
• Although simulation can be effective for designing a system that will provide good performance, there
is no guarantee it will be the best performance.
• The results will be only as accurate as the model that is used. A poorly developed model or a model
that does not reflect reality will provide poor results and may even be misleading.
• There is no way to test the accuracy of assumptions and relationships until a certain amount of time
has passed.
Breakeven Analysis
Breakeven analysis, also called Cost-Volume-Profit (CVP) analysis,55 can be used to estimate the revenue
that will be needed for a project to break even, in accounting terms. At the breakeven point, fixed costs
including depreciation will be equal to revenue minus variable costs.
Fixed Costs Including Depreciation = Revenue − Variable Costs
Breakeven analysis assumes that two kinds of costs are involved in producing a product: fixed and variable.
Within the relevant range, fixed costs in total are not influenced by the level of activity, usually production or
sales volume. Variable costs are costs per unit of activity. Thus, variable costs change in total in response to
changes in the level of production or sales.
The difference between the selling price of an item and the variable costs incurred to produce and sell that
item is the unit contribution margin of the item and is calculated as follows:
Unit Contribution Margin = Selling price per unit − Variable costs per unit
The breakeven point in number of units or volume from an accounting standpoint is the point at which
operating income will be zero but all the fixed costs will be covered by the contribution margin. The
breakeven point is the fixed costs including depreciation divided by the unit contribution margin:
Fixed costs including depreciation

BEP in units =
Unit contribution margin
Once the breakeven number of units has been calculated, the breakeven number of units can be used to find
the breakeven point in revenue, because total revenue is equal to the total number of units sold multiplied
by the selling price per unit.
Note that income taxes are not a factor in true breakeven analysis when the goal is to achieve zero operating
income. When a company is operating at its breakeven point, it has no operating income and thus is assumed
to have no taxable income or income tax liability, so income taxes are not relevant.
Present Value Breakeven Analysis

Present value breakeven analysis as used in capital budgeting combines breakeven analysis with net
present value to determine the number of units a firm must sell incrementally as a result of a capital project
to achieve a net present value of zero (in other words, the breakeven NPV) for the project. The present
value breakeven analysis takes into consideration the opportunity cost of the investment. It results in the
minimum sales volume and revenue that would be required to make the project feasible from a net present
value perspective.
Present value breakeven analysis is an adaptation of breakeven analysis, described above as a technique to
estimate the sales volume and revenue that will be needed for a firm to break even from an accounting
perspective, or the point where fixed cost including depreciation is equal to revenue minus variable costs.
Present value breakeven analysis can be used to determine the number of units that need to be sold and the
amount of revenue needed to cause a capital budgeting project’s net present value to be at the breakeven
point, in other words for its net present value to be zero.
55
Breakeven analysis is covered in Section C of this volume, Decision Analysis.
Present value breakeven analysis is conceptually similar to breakeven analysis, but it differs from breakeven
analysis in several important ways:
1) Because net present value utilizes cash flow information, not accounting information, depreciation
expense is not included in the fixed costs used in present value breakeven analysis, where-
as in breakeven analysis, depreciation expense is included in fixed costs. In present value breakeven
analysis, the cost of the investment is incorporated in the cash outflow for the initial investment, not
in the depreciation expense.
2) Unlike breakeven analysis, the opportunity cost of the investment is included in a present value
breakeven analysis.
3) Taxes are not a factor in breakeven analysis due to the assumption that if the firm is operating at
the breakeven point, it will have no taxable income and no tax liability. In present value breakeven
analysis, however, the effect of income taxes is included because cash flow is used as the input in-
stead of accounting income. Income tax causes a decrease in cash flow, so it will affect the cash flow
of the project.
4) In addition, the Depreciation Tax Shield is used in present value breakeven analysis because depre-
ciation increases tax-deductible expenses and thus decreases tax liability. The decreased tax liability
is analyzed as a cash inflow in capital budgeting.
The present value breakeven point uses the concept of Equivalent Annual Cost, or EAC. EAC is calculated
and used in different ways in business, but in the context of capital budgeting and net present value, EAC is
the initial investment cost divided by the present value of an annuity factor for the required rate of return
used in the net present value analysis and the term of the project. It incorporates the annual opportunity
cost of making the investment.
Steps in calculating the present value breakeven point are as follows.
Step 1: Calculate the EAC:
Initial Investment
EAC =
PV Ordinary Annuity Factor i,n
Step 2: Calculate the Present Value Breakeven Point:
The formula to calculate the present value breakeven point in volume is:
[EAC + (FC × [1 − t])] – (Annual Depreciation × t)

Present Value Breakeven =
(Price – Variable Cost per Unit) × (1 – t)
Where:
EAC is Equivalent Annual Cost. It is the initial investment cost divided by the present value of an
annuity factor for the rate used in the net present value analysis and the term of the project. EAC is
added to cash fixed costs to incorporate the annual opportunity cost of making the investment.
FC × [1 − t] is annual cash fixed costs not including depreciation, multiplied by (1 – t) to express

it on an after-tax basis.
(Annual Depreciation × t) is the Depreciation Tax Shield. It is subtracted from EAC and annual
after-tax cash outflows for fixed costs because the depreciation tax shield results in lower taxes for
the company, thus decreasing annual cash outflow (equivalent to increasing net annual cash inflows).
(Price – Variable Cost per Unit) × (1 – t) is the unit contribution margin, multiplied by (1 – t) to
express it on an after-tax basis.
Example: EAT Pizza, Inc., a manufacturer of frozen pizza crusts, is planning to purchase an additional
pizza crust machine because of recent sales growth. The new machine will cost $100,000. EAT plans to
charge $3.00 per pizza crust, and its estimated variable costs are $1.50 per pizza crust. The new pizza
crust machine will require an estimated $15,000 of maintenance per year, a fixed cost. The new machine
will have a useful life of 5 years, and it will be depreciated on the straight-line basis for tax purposes. EAT’s
tax rate is 40%, and its required rate of return is 10%. EAT expects no salvage value for the machine at
the end of its life.
How many incremental (additional) pizza crusts must EAT sell each year to break even on the purchase of
the additional pizza crust machine on a present value basis?
Initial Investment
EAC =
PV of an ordinary annuity for 5 years at 10%
$100,000
EAC = = $26,378.26
3.791
[EAC + (FC × [1 − t])] – (Annual Depreciation × t)

Present Value Breakeven =
(Price – Variable Cost per Unit) × (1 – t)
($26,378.26 + $9,000.00 ) – $8,000.00)

Present Value Breakeven = = 30,420.29
($3.00 – $1.50) × 0.6
The present value breakeven point in incremental volume is 30,420.28, or 30,421 additional crusts must
be sold (since a partial crust cannot be sold).
Proof:
The after-tax incremental addition to cash flow per year for selling 30,421 additional crusts will be:
Contribution margin: 30,421 × $1.50 $45,632

Less: Cash fixed costs - maintenance (before tax) 15,000
Net operating cash inflow before tax $30,632
Less: tax at 40% 12,253
Net operating cash inflow after tax $18,379
Plus: Depreciation tax shield, $100,000 ÷ 5 × 0.4 8,000
Annual after-tax net operating cash inflow and depreciation tax shield $26,379
The discounted annual cash flow and the NPV are calculated as follows, using the factor from the Present
Value of an Annuity table for 10% for 5 years to discount the future cash flows:
PV of Cash Inflows = PV of ordinary annuity i=10%, n=5 × Annual after-tax cash flows
PV of Cash Inflows = 3.791 × $26,379 = $100,002
NPV = PV of Cash Inflows − Initial Investment
NPV = $100,002 − $100,000 = $2 (the $2 difference is due to rounding)
At its estimated sales price, variable costs, and fixed costs, and at its required rate of return, this project
requires a volume of 30,421 additional pizza crusts sold to achieve a breakeven net present value. The
management of EAT can use this information to evaluate its assumptions and determine whether a change
needs to be made, perhaps in the selling price or the costs, before embarking on the project.
Benefits of Present Value Breakeven Analysis
• It can give an indication of how many units need to be sold or how much revenue needs to be earned
to achieve a breakeven present value for a project while taking into consideration the opportunity cost
of the initial investment.
Limitations of Present Value Breakeven Analysis
• The life of the project and the period over which it will be depreciated for tax purposes must be the
same.
• The depreciation for tax purposes must be the same amount each year during the life of the project.
• The expected after-tax operating cash flows for the project must be the same every year during the
life of the project.
Portfolio Diversification
A diversified portfolio of investments can mitigate the company-specific, or nonmarket, risk associated with
single investment, and therefore the remaining risks are the systematic risks associated with the market. As a
result, the more sensitive an investment is to the market, the riskier that asset becomes.
The Informal Method

The informal method relies primarily on professional opinion, informed guesswork, and instinct. When a
final choice must be made and the contributing factors provide inconclusive evidence for one decision or
another, a person in a key leadership role or management may take a best-guess approach to making a final
selection.
Question 112: When simulating with the Monte Carlo technique, the average simulated demand over the
long run should approximate the
a) Actual demand.
b) Real demand.
c) Sampled demand.
d) Expected demand.
(ICMA 2010-QA)
Question 113: The modeling technique that should be used in a complex situation involving uncertainty is
a(n)
a) Expected value analysis.
b) Program evaluation review technique.
c) Monte Carlo simulation.
d) Markov process.
(ICMA 2010)
Question 114: All of the following are advantages of a simulation model except that it
a) Allows what-if type of questions.
b) Does not interfere with the real-world systems.
c) Generates optimal solutions to problems.
d) Allows the study of the interactive effect of variables.
(ICMA 2010)
Adjustments to the Discount Rate for Risk or Inflation

Risk-Adjusted Discount Rate
The company’s weighted average cost of capital (WACC) is the appropriate hurdle rate in capital budgeting
decisions and NPV calculations as long as the project’s riskiness is the same as the riskiness of the
company’s existing business. If a project has risk characteristics that differ from the risk of the company’s
existing business, the company’s WACC can be adjusted and a risk-adjusted discount rate used in the
capital budgeting analysis to reflect the amount of risk in the project.
Risk-Adjusted Discount Rate = Weighted Average Cost of Capital +/− Risk Adjustment
1) A company should increase the discount rate used in capital budgeting for investments that are
riskier or more uncertain than the company’s present portfolio of investments. A higher discount rate
requires higher expected future cash flows for the investment to be acceptable, which makes fewer
investments acceptable.
2) A company should lower the discount rate used for investments it judges to be less risky than the
company’s present portfolio of investments, which increases the probability that a given investment
will be acceptable.
When the risk adjustment is an increase to the firm’s WACC, the risk adjustment is called a risk premium.
For the WACC to be used as a hurdle rate without any risk adjustment, the following two conditions must be
met:
1) The new project must not substantially change the firm’s operating environment. If a new project
introduces significant change, risks (as discussed above) will enter into the equation and must be
accounted for.
2) The new capital must be raised in the same proportions as the existing capital, so that the compa-
ny’s financial risk remains the same.
If either of these two assumptions does not hold true, the discount rate used as the required rate of return
must be adjusted to reflect the change in the firm’s risk profile that will result from the project.
Thus, a higher risk-adjusted discount rate reflects higher risk, since with a higher discount rate, the
expected cash flows from the investment will need to be higher to create a positive NPV. If the expected cash
flows are not higher, increasing the discount rate could change a positive NPV to a negative NPV, and the
project would be more likely to be rejected. Conversely, if the project is safer than the existing business of
the firm, a discount rate that is lower than the present Weighted Average Cost of Capital should be used as
the required rate of return, increasing the chances of the project’s being accepted.
However, discount rates should not be adjusted for nonmarket risks that are unique or diversifiable, such as
the possibility that a new drug may not be approved or that a drilling project will be unsuccessful. Instead,
the expected cash flows should be adjusted to reflect those risks. If expected project cash flows give
weight to all possible outcomes, both favorable and unfavorable, they will be correct on average. In other
words, the expected cash flows for some projects will be too high and for other projects they will be too low,
but over a long period of time and several projects, the total actual cash flows should be close to the total
expected cash flows.
After adjusting cash flow forecasts for the nonmarket, or diversifiable, risks, management should then
consider whether or not systematic, or market, risks require adjustment of the discount rate.
Example 1: A company is considering a new project that involves entering a new market where
competition is stiff and the risk of failure is high. Because of these factors, the project will add significant
business risk to the company’s operating environment, and, as a result, investors will require a higher rate
of return to compensate. The firm’s weighted average cost of capital will increase, so management should
evaluate the project using a higher required rate of return.
Example 2: A company decides to use more debt to finance a new project than it has in its current capital
structure, thus raising the amount of debt in its capital structure. Up to a certain point, additional debt is
not a problem for the company or its investors. However, if the proportion of debt in the company’s capital
structure becomes too high, investors will become more nervous because of the increased possibility that
the company might not be able to service its debt and could go into default. Under such conditions,
potential investors in the new debt to be issued will require a risk premium to invest in the bond. The rate
of return the company will have to pay on its debt will increase. The cost of the firm’s equity will increase
as well because equity investors will require a higher expected rate of return to buy or hold the company’s
common stock. As a result, the company’s overall weighted average cost of capital will increase, so a
higher discount rate should be used in the capital budgeting analysis.
Example 3: A company decides to replace an old machine with a newer model. This change will probably
not alter the company’s operating environment and therefore carries little risk. Management would
probably use its weighted average cost of capital as the required rate of return for discounting the cash
flows from the new machine that is simply replacing an old machine.
However, if the company is considering a new machine to enter a new line of business, the project will
most certainly introduce uncertainty and risk. Because of the increased risk in entering a new line of
business, the company’s required rate of return would be higher for the new machine purchased for that
purpose. Management would therefore use a risk-adjusted discount rate to analyze the purchase of the
second machine.
Note: The preceding guidelines for risk-adjusting the discount rate apply only to projects with positive
net cash flows, in other words projects with cash inflows that exceed their cash outflows. If all of the
cash flows for a project are negative, for example because the project has only costs and no related
revenues or has revenues that are lower than its costs, the guidelines for risk-adjusting the discount rate
are reversed. The discount rate for a project with greater risk should be decreased, whereas the
discount rate for a project with lesser risk should be increased.
The Capital Asset Pricing Model and the Required Rate of Return for a Project
Risk analyses can be used to assign a beta to a project. Then, using the Capital Asset Pricing Model (CAPM)
with the project’s assigned beta,56 the risk-free rate of return and the expected return on the market,
management can determine the amount of the risk premium needed and the required rate of return (that is,
the risk-adjusted discount rate to be used as a discount rate).
The formula for the Capital Asset Pricing Model (CAPM) is
R = RF + β(RM − RF)
Where: R = Investors’ required rate of return

RF = Risk-free rate of return
β = Beta coefficient
RM = Market’s required rate of return
Using the CAPM, the project’s assigned beta, the risk-free rate of return, and the expected return on the
market, the required rate of return for the project can be calculated.
Example: Prospect Industries uses the Capital Asset Pricing Model to determine the required rate of return
on investment projects. The beta value it has assigned to Project Y is 1.2, the risk-free rate is 3%, and the
expected return on the market is 10.5%. The required return (R) for Project Y is
R = RF + β(RM − RF)
R = 0.03 + 1.2(0.105 – 0.03)
R= 0.12 or 12%.
Prospect Industries will use a hurdle rate of 12% to evaluate Project Y.
 If the NPV of the project is positive when using 12% as the discount rate, the project will be acceptable.
 If the calculated IRR of the project is greater than 12%, the project will be acceptable.
Net Present Value and Risk-Adjusted Discount Rates

Net Present Value as a capital budgeting method has a unique advantage over other capital budgeting
methods, because cash flows used in an NPV analysis can be discounted individually by component and by
period. The ability to assign different hurdle rates for different components and periods of a project’s life
provides a flexibility when the Net Present Value method is used that is not available with other capital
budgeting methods.
Different Rates for Different Cash Flows

Different discount rates can be used to calculate the present values of different annual cash flows throughout
a single project analysis. For example, if the cash flow from the depreciation tax shield is relatively certain but
the operating cash flows are less certain, the net after-tax operating cash flows can be discounted at a higher
rate than the rate used to discount the depreciation tax shield cash flows to reflect the greater risk in the
operating cash flows.
56
The Capital Asset Pricing Model is covered in this textbook in Section B, Volume 1, Corporate Finance. As explained
there, beta is a measurement of an investment’s systematic, or undiversifiable, risk.
Different Rates for Different Periods

If the amount of risk is expected to fluctuate throughout the life of a project, different discount rates can be
assigned to different periods. Each year’s cash flow is discounted in multiple steps, with each step utilizing
one of the discount rates in effect and the number of years it will be in effect before the receipt of that cash
flow.
Note: Net Present Value is the only capital budgeting method that can incorporate a fluctuating required
rate of return.
Example: A net cash inflow of $50,000 is expected in Year 5 of a 5-year project. The required rate of
return for Years 1, 2, and 3 is 5%. The required rate of return for Years 4 and 5 is 6%.
Begin with the final rate of return for the project and work backward.
Step 1: The $50,000 is discounted at 6% for two years to the end of Year 3. The present value of $1 factor
for 6% for two years is 0.890. The result is the present value of the $50,000 as of the end of Year 3:
PV = $50,000 × 0.890 = $44,500
Step 2: The present value of the $50,000 as of the end of Year 3 calculated in Step 1—$44,500—is
discounted at 5% for three years to Year 0. The present value of $1 factor for 5% for 3 years is 0.864. The
result is the present value of the Year 5 cash flow as of Year 0:
PV = $44,500 × 0.864 = $38,448
The present value of $38,448 incorporates the 5% discount rate for the first three years and the 6%
discount rate for the final two years.
The same thing would be done individually for each annual cash flow amount using the appropriate
discount rate for each time period.
Note: When using multiple discount rates, always begin at the end of the project and work backward in
steps to Year 0.
Inflation
In an environment of inflation, the capital budgeting process needs various adjustments.
First, the discount rate should be increased. The market requires a higher rate of return to compensate
for the increased risk of inflation, so by raising the discount rate, the present value of the future expected
cash flows decreases and the project will be less likely to have a positive NPV.
Secondly, the future expected cash flow amounts need to be increased. Inflation will cause the
currency to be worth less in the future, and the amounts of cash, both inflows and outflows, will also increase.
For example, if 5% annual inflation is expected, cash flows should also increase 5% annually, compounding
the increase each year. These adjusted cash flows are called nominal cash flows in capital budgeting.
The nominal cash flows projected in capital budgeting will be comparable to the actual cash flows ultimately
recorded in the accounting system, since actual receipts and disbursements will reflect the effect of inflation.
Question 115: Which one of the following would be the most appropriate discount rate for an investment
deemed to have moderate risk?
a) Yield on U.S. Treasury obligations.
b) Yield on investment grade bonds.
c) Projected return on S&P 500 equities.
d) Projected return on global equities.
(ICMA Adapted)
Real Options in Capital Budgeting

To analyze a proposed capital budgeting project using NPV, it is necessary to make estimates of expected
future cash flows and an appropriate discount rate. At the most basic level, management can calculate a
single NPV, decide to embark upon a project, and then wait until the project’s term runs its course—a
decidedly passive approach. However, a project’s NPV can be calculated only with information known at the
time the estimates are made, and the choice is between accepting or rejecting the project. Thus, the NPV
approach ignores the fact that other choices may be made and that the option to make those other choices
can have value.
The real options approach addresses the problem of optimizing a real asset (such as a piece of equipment,
a building, land, a project, and so forth) under conditions of uncertainty, given the available options.57 Real
options goes beyond the basic passive approach to NPV and project management. Instead, real options
provide a framework for strategic decision-making as the project goes along. In essence, real options begin
with an initial choice that is then followed by additional choices that factor in as more information becomes
available.
Wayne S. Upton, Jr. provides a comprehensive discussion of real options:
A real option is easier to describe than to define. A financial option is a contract that grants to the
holder the right but not the obligation to buy or sell an asset at a fixed price within a fixed period (or
on a fixed date). The word option in this context is consistent with its ordinary definition as “the
power, right or liberty of choosing.” Real option approaches attempt to extend the intellectual rigor of
option-pricing models to valuation of nonfinancial assets and liabilities. Instead of viewing an asset or
project as a single set of expected cash flows, the asset is viewed as a series of compound options
that, if exercised, generate another option and a cash flow. . . .
Proponents argue that the application of option pricing to nonfinancial assets overcomes the shortfalls
of traditional present value analysis, especially the subjectivity in developing risk-adjusted discount
rates. They contend that a focus on the value of flexibility provides a better measure of projects in
process that would otherwise appear uneconomical. 58
Those who employ the real options approach consider capital budgeting investment opportunities as if they
were American call options, with the exercise price as the investment amount and the underlying asset as the
project. The act of investing may create new options, such as the option to abandon a project or the option to
expand it. Having an option to abandon a capital project is similar to owning a put option, which is the right
but not the obligation to sell the project at a set price before a certain expiration date. Real options have
value, in the same way that put and call options have value.
57
The idea of “real options” was developed in 1977 by MIT professor Stewart C. Myers. Myers took the concept of financial
options—American call options in particular—and applied the concept to capital budgeting under conditions of uncertainty.
58
Wayne S. Upton, Jr., Business and Financial Reporting, Challenges from the New Economy (Norwalk, Connecticut:
Financial Accounting Standards Board, 2001), 92-93.
For example, a company might consider a project that, while attractive, has a negative NPV. Under most
conditions, the company should avoid the project. However, it is possible that, based on real options analysis,
a company might be more willing to undertake such a project because it could offer expansion opportunities
or because it could be abandoned if conditions turned unfavorable. Moreover, the company could even restart
the project later if conditions turned favorable. These types of options—the flexibility to stop, restart, or
reconsider—can have specific values assigned to them. It is possible that a negative NPV project would be
undertaken because of the value of its options.
The following is a list of a few common real options:
1) The option to make follow-on investments if the immediate investment project succeeds.
For example, suppose a company is evaluating an investment in a new $100 million plant to manu-
facture a newly developed product, but the project would require very high sales volume to result in
a positive NPV. A real option could be to build a smaller plant instead for only $10 million, then wait
to see if the new product is successful. If the product does sell well, then the $100 million plant
could be built. In this example, the cost of the option is $10 million. The company is acquiring a real
option to expand while obtaining strategic “first-mover” (that is, first into a market) advantage.
2) The option to abandon a project. If actual cash flows turn out to be much lower than forecasted,
it is helpful to have the option to cancel a project and recover the investment by selling it. If the
abandonment value of the assets is greater than the present value of the future expected cash flows
from continuing the project, the project can and ought to be abandoned. Thus, the option to aban-
don a project is comparable to a put option on a financial asset.
A project might be temporarily abandoned if actual cash flow is below forecasted cash flow and then
revived when market conditions improve and prices rebound. The project’s value may be greater
with an abandonment option than without one.
3) The option to wait and learn more before investing. A real options approach can be taken to
find the optimal timing of an investment. For example, if a project’s expected net cash flows are
high, the company may want to invest without delay in order to capture those cash flows. However,
if the forecasted cash flows are lower, managers may be more inclined to wait to invest, even if the
NPV of the project is positive. The company could wait another year to learn more about the market
for the proposed project. Therefore, if an outcome’s potential is highly variable, it may be more val-
uable to take the wait and learn option.
For example, a company owns a tract of land that it wishes to develop into a revenue-generating en-
terprise. However, once the land has been converted to a particular use, its flexibility becomes
limited and its function can be changed only after great expense. By waiting, the company can ob-
serve changes in values of developed properties in the same neighborhood to make better estimates
of expected cash flows from alternative investments. As time passes, expected cash flows from one
of the investment alternatives may emerge as being significantly higher than the others.
The greater the variability in possible outcomes is, the greater is the value of the option to wait and
learn.
4) The option to vary the inputs to the production process, the production methods, or the
firm’s output or product mix. Equipment can be designed to operate in different ways or with dif-
ferent raw materials, depending upon specific conditions. Production can be shifted from one product
to another to adapt to changing market demands. Even if this shift increases production cost, it can
result in additional cash flow if the alternative would be production of a product that is not marketa-
ble due to insufficient demand.
Upton adds the following examples:
1) Growth options. An example of a growth option is the decision to invest in entry into a new mar-
ket.
2) Flexibility options. An example of a flexibility option is the choice between building a single, cen-
trally located facility or two facilities in different locations.59
Bailout Payback and Real Options

The Bailout Payback is a variation on the Payback Period method of capital budgeting, and it is one method
of quantifying a real option. The Bailout Payback Period is calculated in the same way as the Payback Period,
but it recognizes that the project may end prematurely and the assets may be sold. The after-tax salvage
value of the project assets at various dates is added to the project’s cash inflows through the same dates.
This process essentially includes in the payback period a calculation of the cash flows that would result upon
termination of the project at various dates. The Bailout Payback method of analyzing a capital budgeting
project is one method of quantifying the abandonment option and offers a form of protection if things could
go wrong.
Although calculating the Bailout Payback Period is not required for the exam, exam takers may need to be
aware of it and its uses.
Question 116: Debrock Corporation has an option to abandon one of its capital investment projects. The
option to abandon makes Debrock the
a) Writer of a put option.
b) Owner of a put option.
c) Writer of a call option.
d) Owner of a call option
(ICMA 2010-QA)
Decision Trees and Valuing Real Options

In addition to the Bailout Payback method, decision trees can be used to quantify the real options inherent in
a project. Companies use decision trees to identify available future choices, understand the risk involved and
assign probabilities, and clarify how future decisions will affect project cash flows.
Valuing the Real Option

Because options limit the downside potential of a project, the value of a real option is increased when the
uncertainty relating to its underlying asset is greater. Thus, the greater the number of options and the greater
the uncertainty surrounding their use, the greater the worth of a project with real options.
To value a real option using a decision tree, the first step is to value the project as if it had no options
attached. Next, the various options and possible results are set up on a decision tree using the various
possible outcomes. The expected value of the option or options is determined by using the decision tree and
the probabilities of each event occurring to determine the payoffs under each possible combination of events.
Possible events may include permanent abandonment, temporary abandonment, varying inputs or outputs,
varying the production mix, and so forth.
59
Upton, Business and Financial Reporting, Challenges from the New Economy, 92, citing Martha Amram and Nalin
Kulitilaka, Real Options: Managing Strategic Investment in an Uncertain World (Boston: Harvard Business School Press,
1999), 10.
The project’s NPV with the real option is its value without the real option plus the value of the real option:
Project Worth = NPV Without the Real Option + Real Option Value
The value of a real option can also be determined by calculating the net present value of the project without
the real option, then calculating its net present value with the real option, and then finding the difference.
Real Option Value = Project Worth (NPV of project with the real option)
– NPV of Project Without the Real Option
Decision trees can become quite complex. For example, a decision tree could illustrate the results of two
different decisions under varying levels of demand, the probabilities of each of those levels of demand, the
courses of action that might be taken under each level of demand, probabilities of success for each of those
courses of action, and the payoff (the NPV) under each scenario. For a project containing several real options,
the expected cash flow is a combination of all the probabilities and all the possible cash flows, starting at the
right side of the tree and working backward.
Thus, decision trees can be used to understand and quantify the links between present day decisions and
future decisions. However, because they can be so complex, decision trees should not necessarily be
comprehensive but rather limited only to the most important links.
Monte Carlo Simulation

As an alternative to the decision tree, Monte Carlo analysis may be used to determine a project’s NPV with
the real options by building all of the possible payoffs under the real options into the Monte Carlo analysis
model. The result is an averaged approximate NPV with the real options.
A Monte Carlo simulation employs computer simulation to help decision-makers consider all possible
combinations of project outcomes. When used in capital budgeting, this simulation utilizes a model where all
the variables are defined: market size, product price, market share, unit variable cost, and fixed cost. The
probabilities of each possible outcome for each variable are specified and the effect of all the possible events
on subsequent years’ results is determined. After all relevant information is built into the model, the computer
creates random scenarios and calculates the resulting cash flows for each period. After multiple iterations, an
estimate of the probability distributions of the project’s cash flows emerges. The accuracy of the estimate will
depend upon the accuracy of the model and the interrelationships among the variables.
The probability distributions of the cash flows help an analyst calculate expected cash flows, which can then
be discounted to find their present values. Several NPVs are calculated based on the random choices of
variables, and the NPVs are averaged to get an approximate NPV for the project.
However, because a Monte Carlo simulation emphasizes expected value, its results can be less than realistic if
variables such as market growth, market share, costs, and so forth diverge from expected levels.
Other Methods of Valuing Real Options

Real options involve complex issues and trade-offs. In terms of valuing real options, each real investment
opportunity can be thought of as having a “double”; that is, a stock or a portfolio of stocks that have the
same risk as the investment project. A key assumption here is that an investor would be willing to pay the
same amount for a real option based on the project as for a traded option on the “double” investment.
Therefore, a real option can also be valued in the same way as an American call option on a stock. An
American call option gives the holder the right but not the obligation to purchase the stock at a set price at
any time before its maturity date.60 In buying a call option, the investor takes a position in the stock but
puts up less money than would be necessary to purchase it outright. An option has a higher beta and a higher
standard deviation of return than a stock, and thus an option is riskier than the underlying stock. A call
option’s risk is related to the stock’s price relative to the exercise price of the option, and the option’s risk
changes each time the stock price changes.
If the price of the underlying stock rises above the exercise price of the option, the call option is worth the
price of the stock minus the exercise price of the option. If the price of the stock falls below the exercise price
of the option, the call option is worthless, and the investor’s loss is the amount paid for the option.
The value of its real options does not show up anywhere on the balance sheet of a company. However,
investors know that they are there and include them in their valuation of the company’s stock. If a company
has valuable real options, the market value of its stock will be higher than the market value of the physical
assets on its balance sheet.
The Qualitative Factor in Capital Budgeting Decisions

Quantitative, quantifiable factors are key elements that guide management and analysts in making important
business-related decisions. However, there may also be a range of qualitative factors that could influence a
company to override the recommendation produced by quantitative methods. In other words, a company’s
decision-making process, its willingness or desire to invest in particular projects, can be guided by factors
other than a need to expand its market share, outdo its competitors, or increase its stock’s market value and
thereby increase shareholder wealth. Indeed, it is possible that certain projects under consideration could
reduce market share, a stock’s value, or lead to less capital. However, a qualitative factor such as a moral or
ethical imperative, a regulatory requirement, or the personal tastes of management or the company’s owner
may override the quantitative results.
The following is a partial list of qualitative factors that a company might consider:
• Enhancing the quality of products and services offered.
• Shortening the time required to produce products and services and deliver them.
• Addressing consumer safety concerns.
• Responding to new government regulations or emerging environmental protection concerns.
• Improving worker safety.
• Raising the company’s public relations image and prestige.
• Improving the community where the firm operates.
• Reflecting the owners’ or management’s personal wishes.
60
In contrast, a European option can be exercised only on its maturity date.

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Investment Decisions CMA Part 2

Section E – Investment Decisions

• Calculating the Depreciation Tax Shield.

• Calculating the Net Present Value.

• Calculating the Internal Rate of Return.

• Determining which project or projects to invest in.

Capital Budgeting Process Overview

The Stages in Capital Budgeting

Terms Used in Capital Budgeting

Identifying and Calculating the Relevant Cash Flows

“Relevant Cash Flows” Defined

“Expected Cash Flow” Defined

When Do Cash Flows Take Place?

Expected Cash Flows at the Beginning of the Project (Year 0)

These Year 0 cash flows consist of three components:

Annual Net Cash Flows

Operating Cash Flows

Cash Outflows for Follow-Up Investments

Depreciation Tax Shield – A Cash Inflow

Cash Flows at the Disposal or Completion of the Project

d) Monte Carlo simulations.

a) The net present value of the equipment that is being replaced.

d) The sales value of the asset that is being replaced.

Depreciation for Income Tax Purposes

MACRS Depreciation for Tax Purposes

20X1 ½ of one year’s depreciation

Straight-Line Depreciation When Used for Tax Purposes

Other Tax Considerations

Irrelevant Cash Flows

Sunk Costs and Allocated Common Costs

Financing Cash Flows

Example of Calculation of After-Tax Relevant Cash Flows

The relevant after-tax cash flows are:

1) Net Initial Investment:

2) After-Tax Cash Flow from Operations (excluding depreciation effect):

$50,000 before-tax CF × (1 − 0.30) = $35,000 net cash inflow per year

Year 1 $125,000 × 0.1429 × 0.30 = $5,359

4) After-Tax Cash Flow from Disposal at Salvage Value:

Therefore, the relevant, after-tax cash flows per year are:

* Recovery of released working capital.

Capital Budgeting Methods

1) Payback Period or Payback Method

2) Discounted Payback Period or Discounted Payback Method (Breakeven Time)

3) Net Present Value

4) Internal Rate of Return

5) Accounting (or Average) Rate of Return

Payback Period or Payback Method

Initial net investment

Example of the Payback Method with Unequal Annual Cash Flows

Year 0 Year 1 Year 2 Year 3 Year 4 Years 5-8 Year 9

Total After Tax

* Recovery of released working capital.

Numerator = The positive value of the negative cumulative cash inflow

Denominator = Cash inflow for the following year 39,684

Benefits of the Payback Method of Capital Budgeting

• It is simple and easy to understand.

Limitations of the Payback Method of Capital Budgeting