The following is a review of the Corporate Issuers (1) principles designed to address the learning outcome

statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #19.

Study Session 6

This topic review covers various methods for evaluating capital projects and builds on
the net present value (NPV) decision criterion that you learned at Level I. The irst thing
you need to know is that the relevant cash lows for evaluating a capital project are the
incremental after-tax cash lows. Pay special attention to after-tax salvage value and the
impact that depreciation has on determining cash low. Once you have the cash lows
down, it should be relatively easy to discount those cash lows and apply the proper NPV
analysis for an expansion or replacement project, or decide between two mutually
exclusive projects with different lives. Another concept to know is how various real
options give managers lexibility with capital budgeting projects. Even if you are unsure
how to handle the calculation of NPV involving real options, remember that the existence
of options will always increase NPV. Finally, familiarize yourself with alternative
concepts of calculating income, including economic income, economic pro it, residual
income, and claims analysis, and pay attention to the proper discount rate under each
method. You’ll see these concepts later in the Equity Valuation Study Sessions.

Video covering
this content is
The capital budgeting process is the process of identifying and available online.
evaluating capital projects; that is, projects where the cash low to the
irm will be received over a period longer than a year. Any corporate decisions with an
impact on future earnings can be examined using this framework. Decisions about
whether to buy a new machine, expand business in another geographic area, move the
corporate headquarters to Cleveland, or replace a delivery truck, to name a few, can be
examined using a capital budgeting analysis.

Capital budgeting projects may be divided into the following categories:

Replacement projects to maintain the business are normally made without detailed
analysis. The only issues are whether the existing operations should continue and, if
so, whether existing procedures or processes should be maintained.
Replacement projects for cost reduction determine whether equipment that is
obsolete, but still usable, should be replaced. A fairly detailed analysis is necessary
in this case.
Expansion projects are taken on to expand the business and involve a complex
decision-making process since they require an explicit forecast of future demand. A
very detailed analysis is required.

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 New product or market development also entails a complex decision-making
process that will require a detailed analysis due to the large amount of uncertainty
involved.
Mandatory projects may be required by a governmental agency or insurance
company and typically involve safety-related or environmental concerns. These
projects typically generate little to no revenue, but they accompany new revenue-
producing projects undertaken by the company.
Other projects. Some projects are not easily analyzed through the capital budgeting
process. Such projects may include a pet project of senior management
(e.g., corporate perks), or a high-risk endeavor that is dif icult to analyze with
typical capital budgeting assessment methods (e.g., research and development
projects).

The capital budgeting process involves ive key principles:

1. Decisions are based on cash lows, not accounting income. The relevant cash lows to
consider as part of the capital budgeting process are incremental cash lows, the
changes in cash lows that will occur if the project is undertaken.
Sunk costs are costs that cannot be avoided, even if the project is not undertaken.
Since these costs are not affected by the accept/reject decision, they should not be
included in the analysis. An example of a sunk cost is a consulting fee paid to a
marketing research irm to estimate demand for a new product prior to a decision
on the project.
Externalities are the effects the acceptance of a project may have on other irm
cash lows. The primary one is a negative externality called cannibalization, which
occurs when a new project takes sales from an existing product. When considering
externalities, the full implication of the new project (loss in sales of existing
products) should be taken into account. An example of cannibalization is when a
soft drink company introduces a diet version of an existing beverage. The analyst
should subtract the lost sales of the existing beverage from the expected new sales
of the diet version when estimating incremental project cash lows. A positive
externality exists when doing the project would have a positive effect on sales of a
irm’s other project lines.
2. Cash lows are based on opportunity costs. Opportunity costs are cash lows that a
irm will lose by undertaking the project under analysis. These are cash lows
generated by an asset the irm already owns that would be foregone if the project
under consideration is undertaken. Opportunity costs should be included in project
costs. For example, when building a plant, even if the irm already owns the land,
the cost of the land should be charged to the project since it could be sold or rented
to an outside party if not used.
3. The timing of cash lows is important. Capital budgeting decisions account for the
time value of money, which means that cash lows received earlier are worth more
than cash lows to be received later.
4. Cash lows are analyzed on an after-tax basis. The impact of taxes must be
considered when analyzing all capital budgeting projects. Firm value is based on
cash lows they get to keep, not those they send to the government.

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 5. Financing costs are re lected in the project’s required rate of return. The required
rate of return is a function of its risk. Ordinarily, the level of risk is measured
relative to the irm’s overall risk and the required return relative to the irm’s cost
of capital. Only projects that are expected to return more than the cost of the
capital needed to fund them will increase the value of the irm.

The choice of depreciation method has important implications for the after-tax cash
lows of a capital project. Most countries specify which depreciation methods are
acceptable to use for tax purposes. In the United States, most companies use straight-line
depreciation for inancial reporting and the modi ied accelerated cost recovery
system (MACRS) for tax purposes. For capital budgeting purposes, we should use the
same depreciation method used for tax reporting since capital budgeting analysis is
based on after-tax cash lows and not accounting income.
Under MACRS, assets are classi ied into 3-, 5-, 7-, or 10-year classes, and each year’s
depreciation is determined by the applicable recovery percentage given in Figure 19.1.

Ownership Year Class of Investment

3-Year 5-Year 7-Year 10-Year
1 33% 20% 14% 10%
2 45 32 25 18
3 15 19 17 14
4 7 12 13 12
5 11 9 9
6 6 9 7
7 9 7
8 4 7
9 7
10 6
11 3
100% 100% 100% 100%
Buildings are 39-year assets: 1.3% in years 1 and 40 and 100 / 39 = 2.6% in the other years.

You do not need to memorize the MACRS tables, but you should be prepared to use MACRS or
any other accelerated depreciation method if you need to compute incremental cash lows for
a capital budgeting project.

The half-year convention under MACRS assumes that the asset is placed in service in
the middle of the irst year. The effect of this is to extend the recovery period of a 3-year
class asset to four calendar years (33%, 45%, 15%, 7%) and a 5-year asset to six calendar
years (20%, 32%, 19%, 12%, 11%, 6%).
The depreciable basis is equal to the purchase price plus any shipping or handling and
installation costs. The basis is not adjusted for salvage value regardless of whether the
accelerated or straight-line method is used (however, the formula for computing
depreciation expense differs between straight-line and accelerated depreciation).

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LOS 19.a: Calculate the yearly cash lows of expansion and replacement capital
projects and evaluate how the choice of depreciation method affects those cash
lows.
CFA® Program Curriculum, Volume 3, page 184
Generally, we can classify incremental cash lows for capital projects as (1) initial
investment outlay, (2) operating cash low over the project’s life, and (3) terminal-year
cash low.
Initial investment outlay is the up-front costs associated with the project.
Components are price, which includes shipping and installation (FCInv) and
investment in net working capital (NWCInv).
outlay = FCInv + NWCInv
The investment in NWC must be included in the capital budgeting decision.
Whenever a irm undertakes a new operation, product, or service, additional
inventories are usually needed to support increased sales, and the increased
additional sales lead to increases in accounts receivable. Accounts payable and
accruals will probably also increase proportionally.
The investment in net working capital is de ined as the difference between the
changes in non-cash current assets and changes in non-cash current liabilities
(i.e., those other than short-term debt). Cash is excluded because it is generally
assumed not to be an operating asset.
NWCInv = Δnon-cash current assets − Δnon-debt current liabilities = ΔNWC
If NWCInv is positive, additional inancing is required and represents a cash out low
because cash must be used to fund the net investment in current assets. (If negative,
the project frees up cash, creating a cash in low.) Note that at the termination of the
project, the irm will expect to receive an end-of-project cash in low (or out low)
equal to initial NWC when the need for the additional working capital ends.
After-tax operating cash lows (CF) are the incremental cash in lows over the
capital asset’s economic life. Operating cash lows are de ined as:
CF = (S − C − D)(1 − T) + D = (S − C)(1 − T) + (TD)
where:
S = sales
C = cash operating costs
D = depreciation expense
T = marginal tax rate
Although depreciation is a non-cash operating expense, it is an important part of
determining operating cash low because it reduces the amount of taxes paid by the
irm. We can account for depreciation either by adding it back to net income from
the project (as in the irst cash low formula) or by adding the tax savings caused by
depreciation back to the project’s after-tax gross pro it (as in the second formula).
In general, a higher depreciation expense will result in greater tax savings and
higher cash lows. This means that accelerated depreciation methods will create
higher after-tax cash lows for the project earlier in the project’s life as compared
to the straight-line method, resulting in a higher net present value (NPV) for the
project.

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 Interest is not included in operating cash lows for capital budgeting purposes because it is
incorporated into the project’s cost of capital.

Terminal year after-tax non-operating cash lows (TNOCF). At the end of the
asset’s life, there are certain cash in lows that occur. These are the after-tax salvage
value and the return of the net working capital.
TNOCF = SalT + NWCInv − T (SalT − BT)
where:
SalT = pre-tax cash proceeds from sale of ixed capital
BT = book value of the ixed capital sold

The notation for this formula is somewhat confusing because T is used in two different ways:
(1) as the marginal tax rate and (2) as a time subscript indicating year T, the inal year of the
project. If T shows up in a formula, assume it refers to the marginal tax rate unless it is
subscripted.

An expansion project is an investment in a new asset to increase both the size and
earnings of a business.

Expansion project analysis

Mayco, Inc. would like to set up a new plant (expand). Currently, Mayco has an option to buy an
existing building at a cost of $24,000. Necessary equipment for the plant will cost $16,000,
including installation costs. The equipment falls into a MACRS 5-year class. The building falls into a
MACRS 39-year class. The project would also require an initial investment of $12,000 in net
working capital. The initial working capital investment will be made at the time of the purchase of
the building and equipment.
The project’s estimated economic life is four years. At the end of that time, the building is expected
to have a market value of $15,000 and a book value of $21,816, whereas the equipment is expected
to have a market value of $4,000 and a book value of $2,720.
Annual sales will be $80,000. The production department has estimated that variable
manufacturing costs will total 60% of sales and that ixed overhead costs, excluding depreciation,
will be $10,000 a year [costs: (0.60)80,000 + 10,000 = 58,000]. Depreciation expense will be
determined for the year in accordance with the MACRS rate.
Mayco’s marginal federal-plus-state tax rate is 40%; its cost of capital is 12%; and, for capital
budgeting purposes, the company’s policy is to assume that operating cash lows occur at the end
of each year. The plant will begin operations immediately after the investment is made, and the irst
operating cash lows will occur exactly one year later.
Under MACRS, the pre-tax depreciation for the building and equipment is:
Year 1 = $3,512; Year 2 = $5,744; Year 3 = $3,664; Year 4 = $2,544
Compute the initial investment outlay, operating cash low over the project’s life, and the terminal-
year cash lows for Mayco’s expansion project. Then determine whether the project should be
accepted using NPV analysis.
Answer:
Initial outlay:
initial outlay = price of building + price of equipment + NWCInv = $24,000 + $16,000 +
$12,000 = $52,000
Operating cash lows:
CF = (S − C)(1 − T) + DT

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 CF1 = [($80,000 − 58,000)(0.6)] + (3,512)(0.4) = $14,605
CF2 = 13,200 + (5,744)(0.4) = $15,498
CF3 = 13,200 + (3,664)(0.4) = $14,666
CF4 = 13,200 + (2,544)(0.4) = $14,218
Terminal year after-tax non-operating cash lows:
There are two elements to the terminal year cash low (TNOCF): (1) return of net working capital
and (2) salvage value of both the building and the equipment.
First calculate the after-tax terminal cash lows associated with the building and the equipment
separately:
CF for building = $15,000 − 0.4($15,000 − $21,816) = $17,726
CF for equipment = $4,000 − 0.4($4,000 − $2,720) = $3,488
Then include the return of NWCInv:
TNOCF = $17,726 + $3,488 + $12,000 = $33,214
Note in this example the investment in NWC was positive (a use of cash resulting in a cash out low),
so the terminal value effect will be a cash in low. Had the project freed up working capital, the
initial investment in NWC would be negative (a cash in low) and the terminal value effect would be
a cash out low. Also notice that the building was sold for less than book value. The loss on the
building reduces taxes and results in a positive incremental cash low equal to the tax savings.
Using the expansion project’s relevant after-tax cash lows and given that Mayco has a cost of
capital of 12%, the NPV for the project can be computed as:

IRR (from inancial calculator) = 21.9%

Decision: Since NPV > 0 and the IRR > 12%, Mayco should accept the expansion project.

Remember that you can use the time value functions of your calculator to quickly calculate
NPV and IRR.
The TI BA II Plus keystrokes to calculate the 21.9% IRR for Mayco’s new plant project are:
[CF] [2nd] [CLR WORK] 52000 [+/–] [ENTER] [↓] 14605 [ENTER] [↓][↓] 15498 [ENTER] [↓]
[↓] 14666 [ENTER] [↓][↓] 47432 [ENTER] [↓] [IRR] [CPT]

There are two other formats for presenting the analysis of a capital budgeting project
with which you should be familiar: (1) table format with cash lows collected by year,
and (2) table format with cash lows collected by type. Be prepared to analyze a project
when the cash lows are presented in either of these formats on the exam.
Figure 19.2 presents the analysis of the Mayco capital budgeting project with cash lows
collected by year.

Year 0 1 2 3 4
Initial outlay:
FCInv −$40,000
WCInv −$12,000

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 Year 0 1 2 3 4
−$52,000
After-tax operating CFs:
Sales $80,000 $80,000 $80,000 $80,000
Cash operating expenses 58,000 58,000 58,000 58,000
Depreciation 3,512 5,744 3,664 2,544
Oper. income before taxes 18,488 16,256 18,336 19,456
Taxes on oper. income 7,395 6,502 7,334 7,782
Oper. income after taxes 11,093 9,754 11,002 11,674
Add back: depreciation 3,512 5,744 3,664 2,544
After tax oper. CF 14,605 15,498 14,666 14,218
Terminal year after-tax non-oper. CF (TNOCF)
After-tax salvage value 21,214
Return of NWC 12,000
TNOCF 33,214
Total after-tax CF −$52,000 $14,605 $15,498 $14,666 $47,432
NPV(12%) $13,978
IRR 21.9%

Figure 19.3 presents the analysis of the Mayco capital budgeting project with cash lows
collected by type.

PV at
Time Type of CF Before-Tax CF After-Tax CF
12%
0 FCInv –$40,000 –$40,000 –$40,000
0 NWCInv –12,000 –12,000 –12,000
22,000 (1 − 0.4) =
1–4 Sales − cash expenses 22,000 40,093
13,200
Depreciation tax
1 None 3,512 (0.4) = 1,405 1,255
savings*
Depreciation tax
2 None 5,744(0.4) = 2,298 1,832
savings*
Depreciation tax
3 None 3,664(0.4) = 1,466 1,043
savings*
Depreciation tax
4 None 2,544(0.4) = 1,018 647
savings*
19,000 = 15,000 + 21,214 (from
4 After-tax salvage value 13,482
4,000 Figure 19.2)
4 Return of NWCInv 12,000 12,000 7,626
NPV = $13,978
*Note that if straight-line depreciation is used, the depreciation tax savings is an annuity and you can
calculate the present value of that annuity directly, rather than summing the present values of the
individual depreciation tax savings for each year.

Replacement project analysis occurs when a irm must decide whether to replace an
existing asset with a newer or better asset. There are two key differences in the analysis
of a replacement project versus an expansion project. In a replacement project analysis
we have to:

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1. Re lect the sale of the old asset in the calculation of the initial outlay:
outlay = FCInv + NWCInv − Sal0 + T (Sal0 − B0)
2. Calculate the incremental operating cash lows as the cash lows from the new asset
minus the cash lows from the old asset:
ΔCF = (ΔS − ΔC)(1 − T) + ΔDT
3. Compute the terminal year non-operating cash low:
TNOCF = (SalTNew − SalTOld) + NWCInv − T[(SalTNew − BTNew) − (SalTOld −
BTOld)]

Replacement project analysis

Suppose Mayco wants to replace an existing printer with a new high-speed copier. The existing
printer was purchased ten years ago at a cost of $15,000. The printer is being depreciated using
straight line basis assuming a useful life of 15 years and no salvage value (i.e., its annual
depreciation is $1,000). If the existing printer is not replaced, it will have zero market value at the
end of its useful life.
The new high-speed copier can be purchased for $24,000 (including freight and installation). Over
its 5-year life, it will reduce labor and raw materials usage suf iciently to cut annual operating costs
from $14,000 to $8,000.
It is estimated that the new copier can be sold for $4,000 at the end of ive years; this is its
estimated salvage value. The old printer’s current market value is $2,000, which is below its $5,000
book value. If the new copier is acquired, the old printer will be sold to another company.
The company’s marginal federal-plus-state tax rate is 40%, and the replacement copier is of slightly
below-average risk. Net working capital requirements will also increase by $3,000 at the time of
replacement. By an IRS ruling, the new copier falls into the 3-year MACRS class. The project’s cost
of capital is set at 11.5%.
Under the MACRS system, the pre-tax depreciation for the equipment is:
Year 1 = $7,920; Year 2 = $10,800; Year 3 = $3,600; Year 4 = $1,680; Year 5 = $0
Compute the initial investment outlay, operating cash low over the project’s life, and the terminal-
year cash lows for Mayco’s replacement project. Then determine whether the project should be
accepted using NPV analysis.
Answer:
Initial investment outlay:

Operating cash lows:

CFt = [(ΔS − ΔC) (1 − T)] + ΔDT
ΔS = 0
ΔC = –6,000
ΔDT = (MACRSD − 1,000)(0.4)
CF1 = [0 − (–6,000)](1 − 0.4) + (7,920 − 1,000)(0.4) = $6,368
CF2 = [0 − (–6,000)](1 − 0.4) + (10,800 − 1,000)(0.4) = $7,520
CF3 = [0 − (–6,000)](1 − 0.4) + (3,600 − 1,000)(0.4) = $4,640
CF4 = [0 − (–6,000)](1 − 0.4) + (1,680 − 1,000)(0.4) = $3,872
CF5 = [0 − (–6,000)](1 − 0.4) + (0 − 1,000)(0.4) = $3,200

When calculating depreciation, we need to decrease the new printer depreciation

expense by the depreciation that would have occurred with the old printer, which
was $1,000 per year.

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 Terminal year low:
Sal (new machine) = $4,000
Sal (old) = 0 (after ive more years)—this is given in the irst paragraph.
NWCInv (given) = $3,000
pro it on salvage of new = 4,000 − 0 (book value) = 4,000
pro it on salvage of old = 0
Tax on (4,000 − 0) at 40% = 1,600
TNOCF = (SalNew − SalOld) + NWCInv − T[(SalTNew − BTNew) − (SalTOld − BTOld)]
TNOCF = (4,000 − 0) + 3,000 − 0.4[(4,000 − 0) − (0)] = $5,400
Given Mayco’s incremental cash lows and a cost of capital of 11.5%, net present value (NPV) for
the project can be computed as:

Decision: Since the NPV is negative and the IRR is less than the cost of capital, Mayco should not
replace the printer with the new copier.

LOS 19.b: Explain how in lation affects capital budgeting analysis.

CFA® Program Curriculum, Volume 3, page 192

In lation is a complication that must be considered as part of the capital budgeting
process.
Analyzing nominal or real cash lows. Nominal cash lows re lect the impact of
in lation, while real cash lows are adjusted downward to remove in lation effects.
Although either type of cash low can be used in the capital budgeting process, it is
important to match the type of cash lows with the discount rate. Nominal cash
lows should be discounted at a nominal discount rate, while real cash lows should
be discounted at a real discount rate.
Changes in in lation affect project pro itability. If in lation is higher than
expected, future project cash lows are worth less, and the value of the project will
be lower than expected. The opposite is also true, however. If in lation turns out to
be lower than originally expected, future cash lows from the project will be worth
more, effectively increasing the project’s value.
In lation reduces the tax savings from depreciation. If in lation is higher than
expected, the irm’s real taxes paid to the government are effectively increased
because the depreciation tax shelter is less valuable. This is because the
depreciation charge, which is based upon the asset’s purchase price, is less than it
would be if recalculated at current (i.e., in lated) prices.
In lation decreases the value of payments to bondholders. Bondholders
receive ixed payments that are effectively worth less as in lation increases. This
means that higher than expected in lation effectively shifts wealth to issuing irms
at bondholders’ expense.
In lation may affect revenues and costs differently. If prices of goods change at
a different rate than the prices for inputs used to create those goods, the irm’s
after-tax cash lows may be better or worse than expected.

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1. Which of the following factors is a firm to consider when appropriately
evaluating a new project?
A. The depreciation expense tax shield on the new project.
B. The cost of advertising that was purchased to promote the project.
C. Upcoming expenditures associated with a market test to determine the
feasibility of the project.

Mayco, Inc. is considering the purchase of a new machine for $60,000. The
machine will reduce manufacturing costs by $5,000 annually.
Mayco will use the modified accelerated cost recovery system (MACRS)
accelerated method (5-year asset) to depreciate the machine and expects to
sell the machine at the end of its 6-year operating life for $10,000. Use the
MACRS table in Figure 1. (Remember, you don’t have to memorize the
MACRS tables!)
The firm expects to be able to reduce net working capital by $15,000 when the
machine is installed, but required working capital will return to the original
level when the machine is sold after six years.
Mayco’s marginal tax rate is 40%, and it uses a 12% cost of capital to evaluate
projects of this nature.
2. The first year’s MACRS depreciation and the initial cash outlay are to:
A. $10,000 depreciation and $60,000 initial outlay.
B. $12,000 depreciation and $45,000 initial outlay.
C. $12,000 depreciation and $60,000 initial outlay.
3. The first year’s operating cash flow and terminal year’s cash flow excluding the last
year’s operating cash flow are to:
A. $4,800 OCF and –$4,000 CF.
B. $7,800 OCF and –$4,000 CF.
C. $7,800 OCF and –$9,000 CF.
4. Suppose for this question only that the machine is depreciated to zero over six years
using the straight-line method and all other information is the same. The NPV of the
project is to:
A. –$20,780.
B. –$18,753.
C. –$17,125.
5. An analyst has collected the following information on a replacement project:
Purchase price of the new machine $8,000
Shipping and installation charge 2,000
Sale price of old machine 6,000
Book value of old machine 2,000
Inventory increase if the new machine is installed 3,000
Accounts payable increase if the new machine is installed 1,000
Marginal tax rate 25%

The initial cash flow is to:

A. –$10,000.
B. –$7,000.
C. –$3,000.
6. Michael Eastman and David Mann are part of the management team responsible for
evaluating capital projects at Anasi, Inc. The tax laws in the country where Anasi is
located allow the company to choose the depreciation method for tax purposes.
Eastman is trying to explain to Mann the importance of considering depreciation when
making capital budgeting decisions. Eastman makes the following statements:

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 : Depreciation is a non-cash expense; however, it is an important part of
determining incremental cash flows because it reduces the interest expense paid by
the firm.
: If we use the double-declining balance method of depreciation for tax
purposes, the NPV of the project we are considering should be higher than if we use
the straight-line method.
Is Eastman correct or incorrect with regards to the statements?
A. Both statements are correct.
B. Only one of the statements is correct.
C. Neither statement is correct.
7. Bruce Spang is teaching a finance class about the impact of inflation on capital
budgeting analysis. Spang makes the following statements to his class:
: Project cash flows should always be discounted at the real interest rate in
order to avoid double counting inflation in the capital budgeting analysis.
: Inflation tends to affect costs and revenues for a firm proportionally
because firms are generally able to pass price increases of inputs along to consumers
as price increases in the final product.
Is Spang correct or incorrect with regards to the statements?
A. Both statements are correct.
B. Only one of the statements is correct.
C. Neither statement is correct.

Video covering
LOS 19.c: Evaluate capital projects and determine the optimal this content is
capital project in situations of 1) mutually exclusive projects with available online.
unequal lives, using either the least common multiple of lives
approach or the equivalent annual annuity approach, and 2) capital rationing.

CFA® Program Curriculum, Volume 3, page 193

When two projects are mutually exclusive, the irm may choose one project or the other,
but not both. If mutually exclusive projects have different lives, and the projects are
expected to be replaced inde initely as they wear out, an adjustment needs to be made in
the decision-making process. There are two procedures to make this adjustment:
1. Least common multiple of lives approach.
2. Equivalent annual annuity (EAA) approach.

Projects with unequal lives

Mayco, Inc. is planning to modernize its production facilities. Mayco is considering the purchase of
either (1) a book press with a useful life of six years or (2) an offset printer, which has a useful life
of three years. The time lines presented in the following two igures show the cash lows, NPVs, and
IRRs for both of these mutually exclusive projects.
Expected Cash Flows (in dollars) for Book Press

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 Expected Cash Flows (in dollars) for the Offset Printer Project

Evaluate these projects using both the least common multiple of lives approach, and the equivalent
annual annuity approach, assuming whichever process is chosen will be repeated inde initely.
Answer:
Least common multiple of lives method
The NPVs indicate the book press should be selected:
NPVpress = $3,245.47 > NPVprinter = $2,577.44

However, the IRRs recommend the opposite decision because the IRR of the offset printer is larger
than the IRR of the book press. To make the comparison meaningful, we can ind the NPVs for the
two projects over the least common multiple of lives.
In this case, the least common multiple of lives is six years. This means that, for the printer, we will
need to buy another 3-year printer in year 3 to make it comparable to the 6-year press. Assuming
no changes in annual cash lows and a constant cost of capital of 12%, we can compute the NPV of
the two back-to-back offset printers using the process illustrated in the next igure.

A project where equipment will need to be replaced every few years is often called a
replacement chain. The key is to analyze the entire chain and not just the irst link in
the chain.
Replacement Chain for Offset Printer

Decision: The NPV of this extended printer project is $4,412, and its IRR is 25.2%.
Since the $4,412 extended NPV of two chained-together 3-year printers (six years total) is greater
than the $3,245.50 NPV of the offset press, the printer should be selected.
The next igure illustrates that the value of the cash low streams of two consecutive printers can be
summarized by two separate project NPVs: one at year 0 representing the value of the initial
project and one at year 3 representing the value of the replication project.
Replacement Chain NPVs

The present value of these two cash lows, when discounted at 12%, is $4,412, so we again come to
the conclusion that the printer should be selected.

The EAA approach is a simpler approach to evaluating mutually exclusive projects with
different lives. The EAA approach inds the sequence of equal annual payments with a

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present value that is equal to the project’s NPV. The resulting calculation is an annual
payment that allows for an “apples to apples” comparison of projects with different lives.
As demonstrated in the next example, there are three steps to the EAA approach.

EAA approach

Evaluate the offset printer and the book press from the preceding example using the EAA approach.
Answer:
Step 1: Find each project’s NPV.
NPVpress = $3,245

NPVprinter = $2,577

Step 2: Find an annuity (EAA) with a present value equal to the project’s NPV over its individual life
at the WACC.
EAApress : PV = –3,245; FV = 0; N = 6; I = 12;

compute PMT = $789

EAAprinter: PV = –2,577; FV = 0; N = 3; I = 12;

compute PMT = $1,073

Note the negative sign in front of the PV value. This is for the calculator’s sign convention and not to
signify that the NPV is negative.
Step 3: Select the project with the highest EAA. In this example, the printer should be accepted
because:
EAAprinter > EAApress

As you can see, either of the two methods will lead to the same conclusion. However, per the
LOS, you are expected to know both of them!

Ideally, irms will continue to invest in positive return NPV projects until the marginal
returns equal the marginal cost of capital. Should a irm have insuf icient capital to do
this, it must ration its capital (allocate its funds) among the best possible combination of
acceptable projects. Capital rationing is the allocation of a ixed amount of capital
among the set of available projects that will maximize shareholder wealth. A irm with
less capital than pro itable (i.e., positive NPV) projects should choose the combination of
projects it can afford to fund that has the greatest total NPV.
Note that capital rationing is not the optimal decision from the irm’s perspective. More
value would be created by investing in all positive NPV projects. Therefore, capital
rationing violates market ef iciency because society’s resources are not allocated to their
best use (i.e., to generate the highest return).
Hard capital rationing occurs when the funds allocated to managers under the capital
budget cannot be increased. Soft capital rationing occurs when managers are allowed to
increase their allocated capital budget if they can justify to senior management that the
additional funds will create shareholder value.

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 Capital rationing (1)

Mayco has a $2,000 capital budget and has the opportunity to invest in ive projects. The initial
investment and NPV of the projects are described in the next igure. Determine in which projects
Mayco should invest.
Projects Available to Mayco
Investment Outlay NPV
Project A –$800 $300
Project B –$500 $180
Project C –$400 $100
Project D –$350 $85
Project E –$300 –$50

Answer:
Projects A, B, C, and D are all pro itable. However, the cost of taking on all four projects would be
$2,050, which would exceed the capital budget. Mayco should choose Projects A, B, and C, which
have a total NPV of $580 and a total outlay of $1,700. These three projects maximize the NPV while
not exceeding the capital budget constraint of $2,000. The remaining $300 in the capital budget
could then be used elsewhere in the company. Note that Project E is not considered acceptable,
regardless of the availability of capital, because of its negative NPV.

Capital rationing (2)

Mayco has a $2,000 capital budget and has the opportunity to invest in ive different projects. The
initial investment and NPV of the projects are described in the following igure. Determine in which
projects Mayco should invest.
Projects Available to Mayco
Investment Outlay NPV
Project F –$1,200 $500
Project G –$1,000 $480
Project H –$800 $300
Project I –$450 $150
Project J –$200 $40

Answer:
All of the projects are pro itable, but with a capital budget of only $2,000, Mayco should choose
Projects G, H, and J that have a combined NPV of $820.
Note that choosing Projects G, H, and J, means that Project F, which has the highest NPV, is not
chosen. If Project F were chosen, the next best choice would be Project H, which would max out the
capital budget with a combined NPV of only $800. Remember, the goal with capital rationing is to
maximize the overall NPV within the capital budget, not necessarily to select the individual projects
with the highest NPV.

LOS 19.d: Explain how sensitivity analysis, scenario analysis, and Monte Carlo
simulation can be used to assess the stand-alone risk of a capital project.
CFA® Program Curriculum, Volume 3, page 197
Sensitivity analysis involves changing an input (independent) variable to see how
sensitive the dependent variable is to the input variable. For example, by varying sales,
we could determine how sensitive a project’s NPV is to changes in sales, assuming that

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all other factors are held constant. The key to sensitivity analysis is to only change one
variable at a time.
With sensitivity analysis, we start with the base-case scenario. Base case would be the
NPV we determined by using the project’s input estimates. Now we change one of the
selected variables by a ixed percentage point above and below the base case, noting the
effect this change has on the project’s NPV. We could do this for all the variables used in
the analysis.

Sensitivity analysis

Ferndale Inc. is analyzing a capital budgeting expansion project with the following cash low
forecasts:
3-year project
Unit sales = 1,500 per year
Price = $50.00
Variable cost = $20.00 per unit
Fixed cost = $5,000 per year
FCInv = $60,000
Depreciated straight-line over three years to book value of zero
NWCInv = $15,000
Salvage value at end of three years = $10,000
Marginal tax rate = 40%
Cost of capital = 15%
The base case NPV and IRR are $11,871 and 23.5%, respectively.
The following igure includes a sensitivity analysis of the key inputs assuming a 20% increase and
decrease in each variable, holding the others constant. (We haven’t provided the solutions here
because we want to focus on sensitivity analysis, but feel free to check our answers!)
Ferndale Inc. Sensitivity Analysis
Input Estimate Down 20% Base Case Up 20%
Unit sales NPV –$458 $11,871 $24,200
IRR 14.7% 23.5% 32.2%
Price NPV –$8,678 $11,871 $32,420
IRR 8.6% 23.5% 37.8%
Variable costs NPV $20,091 $11,871 $3,651
IRR 29.3% 23.5% 17.6%
Fixed costs NPV $13,241 $11,871 $10,501
IRR 24.5% 23.5% 22.5%
Salvage value NPV $11,083 $11,871 $12,660
IRR 23% 23.5% 24%

To which inputs are the NPV and the IRR estimates (1) most sensitive and (2) least sensitive?
Answer:
The project’s NPV and IRR are most sensitive to changes in price because when price drops by 20%
the NPV goes from positive to negative. The project is also sensitive to changes in unit sales because
a 20% drop in sales will generate a negative NPV. The project appears to be least sensitive to
changes in the estimate of salvage value and ixed costs.

Scenario analysis is a risk analysis technique that considers both the sensitivity of some
key output variable (e.g., NPV) to changes in a key input variable (e.g., sales) and the

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likely probability distribution of these variables. The key difference between scenario
analysis and sensitivity analysis is that scenario analysis allows for changes in multiple
input variables all at once. In scenario analysis, we study the different possible scenarios,
such as worst case, best case, and base case.
A scenario analysis for the Ferndale capital budgeting project is shown in Figure 19.4.
Notice that in the worst case scenario unit sales, price, and salvage value are down 20%,
while ixed and variable costs are up 20%. In the best case scenario, unit sales, price, and
salvage value are up 20%, while costs are down 20%. In fact, the worst case scenario is so
bad that the IRR is negative.

Worst Case Base Case Best Case

Unit sales Down 20% 1,500 Up 20%

Price Down 20% $50 Up 20%
Variable costs Up 20% $20 Down 20%
Fixed costs Up 20% $5,000 Down 20%
Salvage value Down 20% $10,000 Up 20%
NPV −$25,632 $11,871 $60,882
IRR −4.4% 23.5% 56.8%

Simulation analysis (or Monte Carlo simulation) results in a probability distribution

of project NPV outcomes, rather than just a limited number of outcomes as with
sensitivity or scenario analysis (e.g., base case, best case, worst case). The steps in
simulation analysis are as follows:
Step 1: Assume a speci ic probability distribution for each input variable. For example,
we might assume that unit sales are normally distributed with a mean of 100,000 and a
standard deviation of 15,000, unit prices are normally distributed with a mean of $40 and
a standard deviation of $5, and so on for each input variable. We don’t necessarily have to
assume a normal distribution for each variable, however.
Step 2: Simulate a random draw from the assumed distribution of each input variable.
That results in a single value for each of the inputs. For example, our irst draw might be
unit sales of 85,000, a unit price of $42.00, and so on.
Step 3: Given each of the inputs from Step 2, calculate the project NPV.
Step 4: Repeat Step 2 and Step 3 10,000 times.
Step 5: Calculate the mean NPV, the standard deviation of the NPV, and the correlation of
NPV with each input variable.
Step 6: Graph the resulting 10,000 NPV outcomes as a probability distribution.
For example, our NPV probability distribution for a simulation analysis of the Ferndale
expansion project might look like Figure 19.5. Notice that the probability distribution in
Figure 19.5 is not symmetrical or necessarily perfectly normal. That will typically be the
case, although with a large number of observations, the distribution is likely to be
approximately normal.

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1. Which of the following statements about capital budgeting is ?
A. The capital budgeting analysis for expansion and replacement projects is the
same.
B. If the fixed assets are sold for book value, terminal year after-tax non-operating
cash flows equal the cash proceeds from the sale of fixed capital plus the
recovery of net working capital.
C. The replacement decision involves an analysis of two independent projects where
the relevant cash flows include the initial investment, additional depreciation,
and the terminal value.
2. Mayco, Inc. wants to buy a new printer. Mayco is looking at two mutually exclusive
projects: A and B.
Printer A costs $100,000 and generates positive after-tax cash flows of
$75,000 at the end of each of the next two years.
Printer B also costs $100,000 and has positive after-tax cash flows of
$50,000 at the end of each of the next four years.
Printer A can be replaced at the end of its life with the cash inflows and
outflows remaining the same. It has no salvage value.
Both printers are expected to be replaced indefinitely with the same type at
the end of their useful lives.
Assuming a 4-year replacement chain and a 10% cost of capital, which of the following
choices is to the net present value (NPV) of Printer A and Printer B?
NPV (A) NPV (B)
A. $63,996 $56,884
B. $55,095 $58,493
C. $75,221 $3,786
3. Mayco, Inc. is evaluating two mutually exclusive investment projects. Assume both
projects can be repeated indefinitely. Printer A has an NPV of $20,000 over a 3-year
life, and Printer B has a NPV of $25,000 over a 5-year life. The project types are
equally risky, and the firm’s cost of capital is 12%. Which of the following choices is
to the equivalent annual annuity (EAA) of project A and B?
EAA (A) EAA (B)
A. $8,327 $6,935
B. $3,567 $5,326
C. $7,592 $7,592
4. Which of the following statements about replacement decisions is ?
A. Any loss on the sale of the old equipment is multiplied by the tax rate and is
treated as an initial cash outflow.
B. The present value of additional depreciation expense on the new equipment (as
compared to depreciation on the old equipment) multiplied by the tax rate is
treated as an operating inflow.
C. The present value of the after-tax benefits of a cost reduction resulting from a
new investment is treated as an operating inflow.

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 5. Elaine Smith has been given responsibility for developing General Pacific Company’s
capital budgeting policy manual. In a meeting with her team, she makes the following
statements:
: The equivalent annual annuity approach assumes continuous
replacements can and will be made each time the asset’s life ends.
: In comparing mutually exclusive projects with unequal lives, you should
always choose the project that has the highest NPV.
Is Smith correct or incorrect with regards to the statements?
A. Both statements are correct.
B. Only one of the statements is correct.
C. Neither statement is correct.
6. Which of the following statements about Monte Carlo simulation is ?
Monte Carlo simulation:
A. can be useful for estimating a project’s stand-alone risk.
B. is capable of using probability distributions for variables as input data.
C. uses best- and worst-case scenarios to determine the most likely outcome.
7. Which of the following statements is ?
A. Capital rationing is only applied to projects with a negative NPV.
B. In the absence of capital rationing, a firm should take all projects with a positive
net present value, regardless of IRR.
C. When capital is rationed, the projects with the highest IRRs should be selected,
up to the allocated capital budget.
8. Eldon Windows Inc. has an $80,000 capital budget and has the opportunity to invest in
five different projects. The initial investment and NPV of the projects is shown in the
table. In which combination of projects should Eldon Windows invest?
Investment Outlay NPV
Project 1 –$45,000 $18,000
Project 2 –$40,000 $16,000
Project 3 –$20,000 $9,000
Project 4 –$18,000 $8,000
Project 5 –$15,000 $4,000

A. Projects 1, 3, and 5.
B. Projects 2, 3, and 4.
C. Projects 1, 3, and 4.
9. Elaine Smith of General Pacific Company is analyzing a 5-year expansion project to
increase manufacturing capacity. The project requires an investment in net working
capital of $500,000 that will be recovered at the end of the project and has a cost of
capital of 10%. In her analysis, Smith assumes that the two cash flows net out to zero
over the life of the project, so she does not include a cash flow for net working capital
at the beginning or the end of the project. Assuming she correctly analyzes all the
other components of the project, Smith has :
A. overestimated the project’s cash flow by approximately $310,000.
B. underestimated the project’s net present value by approximately $310,000.
C. overestimated the project’s net present value by approximately $190,000.

Video covering
this content is
available online.
LOS 19.e: Describe types of real options and evaluate a capital
project using real options.

CFA® Program Curriculum, Volume 3, page 204

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Real options allow managers to make future decisions that change the value of capital
budgeting decisions made today. Real options are similar to inancial call and put options
in that they give the option holder the right, but not the obligation, to make a decision.
The difference is that real options are based on real assets rather than inancial assets
and are contingent on future events. Real options offer managers lexibility that can
improve the NPV estimates for individual projects.
Types of real options include the following:
Timing options allow a company to delay making an investment with the hope of
having better information in the future. A project sequencing option allows the
company to defer the decision to invest until the outcome of a current project is
known.
Abandonment options are similar to put options. They allow management to
abandon a project if the present value of the incremental cash lows from exiting a
project exceeds the present value of the incremental cash lows from continuing a
project.
Expansion options are similar to call options. Expansion options allow a company
to make additional investments in a project if doing so creates value.
Flexibility options give managers choices regarding the operational aspects of a
project. The two main forms are price-setting and production lexibility options.
Price-setting options allow the company to change the price of a product. For
example, the company may raise prices if demand for a product is high in
order to bene it from that demand without increasing production.
Production- lexibility options may include paying workers overtime, using
different materials as inputs, or producing a different variety of product.
Fundamental options are projects that are options themselves because the payoffs
depend on the price of an underlying asset. For example, the payoff for a copper
mine is dependent on the market price for copper. If copper prices are low, it may
not make sense to open a copper mine, but if copper prices are high, opening the
copper mine could be very pro itable. The operator has the option to close the mine
when prices are low and open it when prices are high.
A manager can use a number of different approaches for evaluating the pro itability of an
investment with real options. Examples of different approaches include the following:
Determine the NPV of the project without the option. A real option adds value to a
project, even if it is dif icult to determine the monetary amount of that value. If the
NPV of the project without the option is positive, the analyst knows that the
project with the option must be even more valuable, and determining a speci ic
value for the option is unnecessary.
Calculate the project NPV without the option and add the estimated value of the real
option. In equation form, this can be expressed as:
overall NPV = project NPV (based on DCF) − option cost + option value
Imagine that an analyst determines that the NPV of a project is –$100 million. If the
analyst believes that the real option value net of its cost is at least $100 million, it
makes sense to take on the project. This method effectively determines a “hurdle
value” that the option must exceed in order for the project to add value.

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Use decision trees. This method does not determine a value for the option but may
allow a manager to make a more informed choice by showing the sequence of
decisions made.
Use option pricing models. This method may require the use of complex equations
or special consultants.

Option pricing models are discussed in Study Session 13.

Production- lexibility option

Black Pearl Yachts estimated that the NPV of the expected cash lows from a new production facility
to produce Classic Yachts is negative $8 million. Black Pearl’s production manager is evaluating an
additional investment of $5 million in equipment that would give management the lexibility to
switch between Classic, Deluxe, and Elite models of yachts depending on demand. The option to
switch production among models of yachts is estimated to have a value of $15 million. Evaluate the
pro itability of the project, including the real option.
Answer:
overall NPV = project NPV − option cost + option value
overall NPV = –$8 million − $5 million + $15 million = $2 million
Without the option, the NPV of the production facility is negative. However, the real option adds
enough value to make the overall project pro itable.

Abandonment option

Recall from an earlier example the 3-year project with a project cost of capital of 14%. The initial
investment is $1,000 and the expected cash lows are $400. We determined previously that based
on this discounted cash low (DCF) analysis that the NPV was –$71.35. The appropriate decision
based on this analysis is to not undertake the project.
Suppose instead that we have more information on the expected cash lows. First, there is a 50%
probability that the cash lows will be $200 and a 50% probability that they will be $600 (i.e., the
expected cash lows are still $400). In addition, at the end of the irst year we will know whether
the project is a success (cash low is $600) or a failure ($200), and we have the option to abandon
the project at the end of the irst year and receive the salvage value of $650.
First determine the optimal abandonment strategy. Then calculate the project’s NPV and the value
of the abandonment option using that strategy.
Answer:
By abandoning the project, we receive the salvage value of $650 but give up the cash lows in years
2 and 3. Therefore, the optimal strategy is to abandon the project at the end of the irst year if the
present value of the remaining cash lows in years 2 and 3 is less than the salvage value of $650.
If the project is a success, the cash lows will be $600 in years 2 and 3, and the present value of
those cash lows at the end of year 1 at 14% is $988 (N = 2; I/Y = 14; PMT = $600; CPT PV = $988).
This is larger than the salvage value of $650, so the optimal strategy is to not abandon the project if
we determine at the end of the irst year that it is a success.
If the project is a failure, the cash lows in years 2 and 3 will only by $200. The present value drops
to $329 (N = 2; I/Y = 14; PMT = $200; CPT PV = $329), which is less than the salvage value of $650,
so if the project is a failure, the optimal strategy is to abandon the project.
If the project is a success (the probability of which is 50%), we will receive $600 at the end of each
of the three years, and the NPV is:

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 If the project is a failure (a 50% probability), we will receive $200 at the end of the irst year plus
the salvage value of $650, and the NPV is:

The project’s expected present value with the abandonment option is:
NPV = 0.5($393) + 0.5(–$254) = $69.50
The value of the option is:
value of abandonment option = $69.50 − (–$71.35) = $140.85
The abandonment option has made the project viable; we should now accept it because the NPV is
greater than 0.

LOS 19.f: Describe common capital budgeting pitfalls.

CFA® Program Curriculum, Volume 3, page 206
Common mistakes managers make when evaluating capital projects include the
following:
Failing to incorporate economic responses into the analysis. For example, if a
pro itable project is in an industry with low barriers to entry, competitors may
undertake a similar project, lowering pro itability.
Misusing standardized templates. Since managers may evaluate hundreds of projects
in a given year, they often create templates to streamline the analysis process.
However, the template may not be an exact match for the project, resulting in
estimation errors.
Pet projects of senior management. Projects that have the personal backing of
in luential members of senior management may contain overly optimistic
projections that make the project appear more pro itable than it really is. In
addition, the project may not be subjected to the same level of analysis as other
projects.
Basing investment decisions on EPS or ROE. Managers whose incentive
compensation is tied to increasing EPS or ROE may avoid positive long-term NPV
investments that have the short-run effect of reducing EPS or ROE.
Using the IRR criterion for project decisions. Using IRR may result in con licts with
the NPV approach for mutually exclusive projects. The NPV criterion is
economically sound, accurately re lects the goal of maximizing shareholder wealth,
and should drive the project accept/reject decision when IRR and NPV are in
con lict.
Poor cash low estimation. For a complex project, it is easy to double count or fail to
include certain cash lows in the analysis. For example, the effects of in lation must
be properly accounted for.
Misestimation of overhead costs. The cost of a project should include only the
incremental overhead costs related to management time and information
technology support. These costs are often dif icult to quantify, and over or
underestimation can lead to incorrect investment decisions.
Using the incorrect discount rate. The required rate of return on the project should
re lect the project’s risk. Simply using the company’s WACC as a discount rate

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without adjusting it for the risk of the project may lead to signi icant errors when
estimating the NPV of a project.
Politics involved with spending the entire capital budget. Many managers try to
spend their entire capital budget each year and ask for an increase for the following
year. In a company with a culture of maximizing shareholder value, managers will
return excess funds whenever there is a lack of positive NPV projects and make a
case for expanding the budget when there are multiple positive NPV opportunities.
Failure to generate alternative investment ideas. Generating investment ideas is the
most important step of the capital budgeting process. However, once a manager
comes up with a “good” idea, they may go with it rather than coming up with an
idea that is “better.”
Improper handling of sunk and opportunity costs. Managers should not consider
sunk costs in the evaluation of a project because they are not incremental cash
lows. Managers should always consider opportunity costs because they are
incremental. However, in reality, many managers do this incorrectly.

These accounting complications are addressed in exhaustive detail in the Study Sessions
covering Financial Statement Analysis.

1. Albert Duffy, Project Manager at Crane Plastics, is considering taking on a new capital
project. When presenting the project, Duffy shows members of Crane’s executive
management team that because the company has the ability to have employees work
overtime, the project makes sense. The project Duffy is taking on would be
described as having:
A. a fundamental option.
B. an expansion option.
C. a flexibility option.

McCool Air Conditioning Systems is considering a capital project with the following
characteristics:
The initial investment outlay is $500,000.
The project life is three years.
Annual operating cash flows have a 50% probability of being $100,000 for
three years and a 50% probability of being $280,000 for three years.
The required rate of return on the project is 10%.
There is zero salvage value at project termination.
In one year, after realizing the first cash flow, the company has the
opportunity to abandon the project and receive a cash flow of $250,000.
3. Assuming that there is no abandonment option, the project’s NPV is to:
A. –$27,498.
B. $12,545.
C. $22,622.
4. Assuming that McCool follows the optimal abandonment strategy, the NPV of the
project, inclusive of the abandonment option, is to:
A. –$12,545.
B. $7,250.
C. $12,545.
5. Steven Munn and David Hu are discussing potential capital projects for the Tryon
Corporation. Hu is concerned about making capital budgeting mistakes, and he tells

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Munn that he wants to avoid such mistakes. Munn tells Hu not to worry and makes
two statements:
: Although we use templates for streamlining the evaluation of capital
budgeting projects, the employees inputting the data in the template are highly
trained to adjust the numbers that are put into the template for the specific project,
which virtually eliminates template errors.
: All projects we consider use Tryon Corp.’s weighted average cost of
capital for the discount rate with an adjustment up or down reflecting the project’s
risk. By adjusting the discount rate for the risk of the project, we get a more accurate
representation of the project’s risk/reward tradeoff.
Should Hu say that Munn’s statements are correct or incorrect?
A. Both statements are correct.
B. Only one of the statements is correct.
C. Neither statement is correct.

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For an expansion project:
Initial outlay = FCInv + WCInv
CF = (S − C − D)(1 − T) + D = (S − C)(1 − T) + DT
TNOCF = SalT + NWCInv − T(SalT − BT)
For a replacement project, the cash lows are the same as the previous except:
Current after-tax salvage value of the old assets reduces the initial outlay.
Depreciation is the change in depreciation if the project is accepted compared to
the depreciation on the old machine.
Depreciation schedules affect capital budgeting decisions because they affect after-tax
cash lows. In general, accelerated depreciation methods lead to higher after-tax cash
lows and a higher project NPV.

In lation is a complication that must be considered as part of the capital budgeting

process:
Nominal cash lows must be discounted at the nominal interest rate, and real cash
lows must be discounted at the real interest rate.
Unexpected changes in in lation affect project pro itability.
In lation reduces the real tax savings from depreciation.
In lation decreases the value of ixed payments to bondholders.
In lation affects costs and revenues differently.

There are two methods to compare projects with unequal lives that are expected to be
repeated inde initely:
The least common multiple of lives approach extends the lives of the projects so
that the lives divide equally into the chosen time horizon. It is assumed that the
projects are repeated over the time horizon, and the NPV over this horizon is used
as the decision criterion.
The equivalent annual annuity of each project is the annuity payment each project
year that has a present value (discounted at the WACC) equal to the NPV of the
project.
Capital rationing is the allocation of a ixed amount of capital among the set of available
projects that will maximize shareholder wealth. A irm with less capital than pro itable
(positive NPV) projects should choose the combination of projects it can afford to fund
that has the greatest total NPV.

Risk analysis techniques include:

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 Sensitivity analysis involves varying an independent variable to see how much the
dependent variable changes, all other things held constant.
Scenario analysis considers the sensitivity of the dependent variable to
simultaneous changes in all of the independent variables.
Simulation analysis uses repeated random draws from the assumed probability
distributions of each input variable to generate a simulated distribution of NPV.

Real options allow managers to make future decisions that change the value of capital
budgeting decisions made today.
Timing options allow a company to delay making an investment.
Abandonment options allow management to abandon a project if the PV of the
incremental CFs from exiting a project exceeds the PV value of the incremental CFs
from continuing a project.
Expansion options allow a company to make additional investments in a project if
doing so creates value.
Flexibility options give managers choices regarding the operational aspects of a
project. The two main forms are price-setting and production lexibility options.
Fundamental options are projects that are options themselves because the payoffs
depend on the price of an underlying asset.
Approaches to evaluating a capital project using real options include: determining the
NPV of the project without the option; calculating the project NPV without the option
and adding the estimated value of the real option; using decision trees; and using option
pricing models.

Common mistakes in the capital budgeting process include:

Failing to incorporate economic responses into the analysis.
Misusing standardized project evaluation templates.
Having overly optimistic assumptions for pet projects of senior management.
Basing long-term investment decisions on short-term EPS or ROE considerations.
Using the IRR criterion for project decisions.
Poor cash low estimation.
Misestimation of overhead costs.
Using a discount rate that does not accurately re lect the project’s risk.
Politics involved with spending the entire capital budget.
Failure to generate alternative investment ideas.
Improper handling of sunk and opportunity costs.

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1. B Future expenditures should be considered. Previous expenditures associated
with, for example, advertising that has already happened are a sunk cost and should
not be included. (LOS 19.a)
2. B First-year depreciation = ($60,000)(0.2) = $12,000. Initial cash outlay = $60,000
cost − $15,000 NWC in low = $45,000 net outlay. (LOS 19.a)
3. C Year 1 operating cash low = [net income impact × (1 − t)] + (depreciation × t) =
($5,000)(0.6) + ($60,000)(0.2)(0.4) = $7,800. Terminal year cash low (excluding that
year’s operating cash low) = after-tax proceeds from sale of the new machine less
working capital return = $10,000 − [($10,000)(0.4)] − $15,000 = –$9,000. (LOS 19.a)
4. A initial net investment = –$60,000 + $15,000 = –$45,000
annual depreciation = $60,000/6 = $10,000
CF(years 1 through 6) = $5,000(1 − 0.4) + $10,000(0.4) = $7,000
TNOCF(year 6) = $10,000 − [$10,000(0.4)] − $15,000 = –$9,000
NPV = –$45,000 + $7,000 / 1.12 + $7,000 / 1.122 + $7,000 / 1.123 + $7,000 / 1.124 +
$7,000 / 1.125 + ($7,000 − $9,000) / 1.126 = –$20,780 (LOS 19.a)
5. B Initial cash outlay
= FCInv + NWCInv − Sal0 + T(Sal0 − B0)
= 10,000 + (3,000 − 1,000) − 6,000 + 0.25(6,000 − 2,000)
= 7,000
This indicates an initial cash low of –$7,000. (LOS 19.a)
6. B Statement 1 is incorrect. Depreciation reduces cash taxes paid, not interest
expense. Statement 2 is correct. Accelerated depreciation methods applied for tax
purposes result in higher tax savings and higher cash lows early in a project’s life,
which will serve to increase the project’s NPV. (LOS 19.a)
7. C Spang is incorrect with respect to both statements. All projects should not be
discounted at the real interest rate. Discount rates should be matched up with cash
lows so that real cash lows are discounted at the real interest rate and nominal
cash lows are discounted at the nominal interest rate. The second statement is
incorrect because it is rare for in lation to affect revenues and costs uniformly. The
pro its for a company will be better or worse than expected depending on how sales
outputs or cost inputs are affected by in lation. Also, contracting with customers,
suppliers, employees, and capital providers can all become more complicated as
in lation rises. (LOS 19.b)

1. B Capital budgeting analysis for expansion and replacement projects are not the
same; change in working capital can be positive or negative; and replacement
projects are mutually exclusive—B is the only correct statement. (LOS 19.c)

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2. B Using the least common multiple of lives approach:
NPV Project A = –100,000 + (75,000 / 1.10) + (75,000 − 100,000) / 1.102 + 75,000 /
1.103 + 75,000 / 1.104 = $55,095.
NPV Project B = –100,000 + 50,000 / 1.10 + 50,000 / 1.102 + 50,000 / 1.103 + 50,000
/1.104 = $58,493.
(LOS 19.c)
3. A EAAA: PV=20,000; N = 3; I/Y = 12; CPT PMT → $8,327. EAAB: PV = 25,000; N =
5; I/Y = 12; CPT PMT → $6,935. Note: take the highest EAA. (LOS 19.c)
4. A The tax shield from the loss on the sale of the old equipment is equal to the loss
times the marginal tax rate. The tax shield is treated as an initial cash in low.
Answer B describes a cash in low (a tax savings). (LOS 19.c)
5. B Statement 2 is incorrect because in the case of a replacement chain, the analyst
should use either the least common multiple of lives or equivalent annual annuity
methods to analyze mutually exclusive projects with unequal lives. Statement 1 is
correct: the “equivalent annual annuity” approach is one method of comparing
mutually exclusive projects in a replacement chain (where it is assumed that
company assets will be replaced as they wear out.) (LOS 19.c)
6. C Scenario analysis uses best and worst case scenarios to determine the most
likely outcome. The other statements are true. (LOS 19.d)
7. B Under capital rationing, the combination of projects with the highest total NPV
should be selected, subject to the constraint that the total investment required not
exceed the allocated capital budget. Capital rationing evaluation is only applied to
positive NPV projects. (LOS 19.c)
8. B Since the capital budget is only $80,000, this is an example of capital rationing
since Eldon has more pro itable projects than it has capital. The objective here is to
maximize the NPV within the budget, which means that Projects 2, 3, and 4 should
be taken for a combined NPV of $33,000. Note that even though money is left over
with this combination, it has the highest total NPV of the answer choices listed.
Choosing Projects 1, 3, and 5 uses the entire capital budget but results in a total
NPV of only $31,000. Choosing Projects 1, 3, and 4 would exceed the capital budget.
(LOS 19.c)
9. C By ignoring the initial $500,000 cash out low, she has overestimated project
NPV by $500,000. By ignoring the terminal cash in low of $500,000, she has

underestimated project NPV by

The net effect is to overestimate NPV by $500,000 − $310,000 = $190,000.
(LOS 19.c)

1. C The project described has a production- lexibility option, which includes

overtime for workers, producing a different product, or using different inputs. In
any case, the use of real options offers lexibility that can improve the NPV
estimates for individual projects. (Module 19.3, LOS 19.e)

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2. A The expected annual after-tax operating cash low is 0.50($100,000) +
0.50($280,000) = $190,000. The cash lows discounted at the 10% cost of capital for
the project give an NPV of:

(Module 19.1, LOS 19.a)

4. B The optimal abandonment strategy would be to abandon the project in one year
if the subsequent cash lows are worth less than the abandonment value. If at the
end of the irst year the low cash low occurs, McCool can abandon the project,
receive $250,000 instead of $173,554 (present value of $100,000 over the next two
years). If the high cash low occurs, the present value of the cash low for the
remaining two years is $485,950, so McCool would not want to abandon the
project.
If the high cash low occurs, the total present value of the project would be:

If the low cash low occurs, McCool would receive the irst year cash low and the
abandon value, and no further cash lows. In that case, the NPV would be:

With the abandonment option, the expected NPV is 0.50($196,319) + 0.50 (–

$181,818) = $7,250. Note that the NPV was negative without the option but positive
when the option is included in the analysis. (Module 19.3, LOS 19.e)
5. B Simply adjusting the numbers input into templates does not eliminate the
possibility that the templates themselves may be incorrectly applied. Statement 1 is
incorrect. Statement 2 is correct because a methodology is used that adjusts the
discount rate for the risk of the project and does not simply use a single discount
rate for all projects. (Module 19.3, LOS 19.f)

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