LM05 Capital Investments and Capital Allocation 2024 Level I Notes

LM05 Capital Investments and Capital Allocation

1. Introduction ...........................................................................................................................................................2
2. Capital Investments ............................................................................................................................................2
3. Capital Allocation .................................................................................................................................................4
4. Capital Allocation Principles and Pitfalls................................................................................................. 10
5. Real Options ........................................................................................................................................................ 12
Summary................................................................................................................................................................... 14

This document should be read in conjunction with the corresponding reading in the 2023 Level I CFA®
Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright
2022, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights
reserved.

Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of
the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are
trademarks owned by CFA Institute.

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LM05 Capital Investments and Capital Allocation 2024 Level I Notes

1. Introduction
Capital investments are investments with a life of one year or more. Companies make capital
investments to generate value for their shareholders.
Capital allocation is the process by which companies make capital investment decisions.
Capital allocation is important because it impacts a company’s future.
This learning module covers:
• Types of capital investments – going concern, regulatory/compliance, expansion, and
other projects
• Steps in a typical capital allocation process
• Basic investment decision criteria – NPV, IRR, and ROIC
• Principles of capital allocation and common capital allocation pitfalls
• Types of real options – timing, sizing, flexibility, and fundamental options

2. Capital Investments
Capital investments are shown on the balance sheet as long-term assets. A portion of the cost
is recorded on the income statement periodically as a non-cash depreciation or amortization
expense over the asset’s useful life. In subsequent periods, the amount on the balance sheet
is shown on a net basis, i.e., initial cost – accumulated depreciation. The net value declines to
zero or a salvage value at the end of the asset’s useful life. Exhibit 1 from the curriculum
illustrates this process.

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LM05 Capital Investments and Capital Allocation 2024 Level I Notes

Types of Capital Projects

Companies invest for two primary reasons – to maintain their existing business and to grow
it.
Projects undertaken by companies to maintain the business include:
• Going concern projects: Projects necessary to continue current operations and
maintain existing size of the business or to improve business efficiencies.
Example: machine replacement, infrastructure improvement
• Regulatory/Compliance projects: Projects typically required by a third party, such as
the government regulatory body, to meet specified safety and compliance standards.
Example: factory pollution control installation, performance bond posting to
guarantee satisfactory project completion
Projects undertaken by companies to expand the business include:
• Expansion projects: Projects that expand business size and typically involve greater
degrees of risk and uncertainty than going concern projects.
Example: new product or service development, merger, acquisition
• Other projects: Projects, which include high-risk investments and new growth
initiatives, that are outside the company’s conventional business lines.
Example: exploration investment into a new innovation, business model, or idea
Going Concern Projects
• Projects necessary to continue current operations and maintain existing size of the
business or to improve business efficiencies.
• Most common going concern projects are replacing assets that have reached the end of
their useful life, and maintaining IT hardware and software.
• Typically, these projects do not increase revenues but they could help a company save
costs.
• They are fairly easy to evaluate as compared to the other projects.
• To fund these projects, managers often try to match the financing with the life-span of
the asset. For example, issuing a 20-year bond to fund an asset with an expected life of
20-years.
o If a company finances long-term assets with short-term financing, it faces rollover risk
– the short-term financing costs could go up.
o If a company finances short-term assets with long-term financing, it faces the risk of
overpaying in financing costs.
• To estimate the amount of capital spending on going concern projects, analysts often look
at the depreciation and amortization expense reported on the income statement.

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LM05 Capital Investments and Capital Allocation 2024 Level I Notes

Regulatory Compliance Projects

• Projects typically required by a third party, such as the government regulatory body, to
meet specified safety and compliance standards.
• These projects are unlikely to increase revenue; in fact, they may increase compliance
costs. However, regulatory/compliance costs can act as barriers to entry and protect the
industry's profitability.
• While evaluating these projects, management must determine whether the business will
still be profitable after considering the additional compliance costs.
o In most cases, companies will accept these projects and pass on the additional cost to
customers.
o However, sometimes the cost may be too high and the company may decide that it is
better off ceasing operations or shutting down the part of the business that is subject
to the new regulation.
Expansion of Existing Business
• Projects that expand business size and typically involve greater degrees of risk and
uncertainty than going concern projects.
• Some industries such as pharmaceuticals and oil and gas spend heavily (over 10% of
revenues) on expansion projects.
• If internal opportunities for expansion are limited, managers may pursue acquisitions.
However, the two main risks in acquisitions are the risk of overpaying and the difficulty
in integrating the acquirer’s business operations.
New Lines of Business and Other Projects
• Projects, which include high-risk investments and new growth initiatives, that are
outside the company’s conventional business lines.
• These projects are often observed in privately held companies or public companies
under the control of a founding owner/significant shareholder.
• These projects tend to have a venture capital element to them. There will probably be
a complete loss of investment, but if successful the project could be highly profitable.

3. Capital Allocation
Capital allocation is the process used by an issuer’s management to make capital investment
decisions.
Steps in Capital Allocation Process
The steps in the capital allocation process are as follows:

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LM05 Capital Investments and Capital Allocation 2024 Level I Notes

Step 1 – Idea generation: Most important step in the process. Investment ideas can come
from anywhere within the organization, or outside (customers, vendors, etc.). What projects
can add value to the company in the long term?
Step 2 – Investment analysis: Gathering information to forecast cash flows for each project
and then computing the project’s profitability. Output of this step: A list of profitable
projects.
Step 3 – Planning and prioritization: Do the profitable projects fit in with the company’s
long-term strategy? Is the timing appropriate? Some projects may be profitable in isolation
but not so much when considered along with the other projects. Scheduling and prioritizing
of projects are important.
Step 4 - Monitoring and post-investment review: Post-investment review helps in assessing
how effective the capital budgeting process was. How do the actual revenues, expenses, and
cash flows compare against the predictions? Post-investment review is useful in three ways:
• If the predictions were optimistic or too conservative, then it becomes evident here.
• Helps improve business operations. Puts the focus on out-of-line sales and costs.
• Helps in identifying profitable areas for fresh investments in the future, or scale down
in non-profitable ones.
Two widely used analytical tools in the ‘investment analysis’ step are NPV and IRR.
Net Present Value (NPV)
Net present value is the present value of the future after tax cash flows minus the investment
outlay.
CF1 CF2 CF3
NPV = CF0 + [ 1
]+ [ 2
]+ [ ]
(1 + r) (1 + r) (1 + r)3
Decision rule:
For independent projects:
If NPV > 0, accept.
If NPV < 0, reject.
For mutually exclusive projects:
Accept the project with higher and positive NPV.
Example
Compute NPV for projects A and B given the following data:
Cost of capital = 10%
Expected Net after Tax cash flows
Year Project A (in $) Project B (in $)

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LM05 Capital Investments and Capital Allocation 2024 Level I Notes

0 -1,000 -1,000
1 500 100
2 400 300
3 300 400
4 100 600
Solution:
Project A:
500 400 300 100
NPV = -1000 + + 1.12 + 1.13 + 1.14 = 78.82
1.1

On the exam, you can save time by using the calculator to solve for NPV instead of using the
above formula. The key strokes are given below:
Key strokes Display
[CF][2 ][CLR WORK]
nd CF0 = 0
1000 [+|-] [ENTER] CF0 = -1000
[↓] 500 [ENTER] C01 = 500
[↓] F01 = 1
[↓] 400 [ENTER] C02 = 400
[↓] F02 = 1
[↓] 300 [ENTER] C03 = 300
[↓] F03 = 1
[↓] 100 [ENTER] C04 = 100
[↓] F04 = 1
[NPV] 10 [ENTER] I = 10
[↓] CPT NPV = 78.82
Project B:
100 300 400 600
NPV = -1000 + + 1.12 + 1.13 + 1.14 = 49.18
1.1

Microsoft Excel functions can also be used to solve for the NPV. The two functions available
are:
• NPV or =NPV(rate, values) and
• XNPV or =XNPV(rate, values, dates),
where “rate” is the discount rate, “values” are the cash flows, and “dates” are the dates of
each of the cash flows.
Internal Rate of Return (IRR)
IRR is the discount rate that makes the present value of future cash flows equal to the
investment outlay. We can also say that IRR is the discount rate which makes NPV equal to 0.

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LM05 Capital Investments and Capital Allocation 2024 Level I Notes

Decision rule:
For independent projects:
If IRR > required rate of return (usually firms cost of capital adjusted for projects
riskiness), accept the project.
If IRR < required rate of return, reject the project.
The required rate of return is also called ‘hurdle rate’.
For mutually exclusive projects:
Accept the project with higher IRR (as long as IRR > cost of capital).
Example
Compute IRR for projects A and B given the following data.
Cost of Capital = 10%; Expected Net After Tax Cash Flows
Year Project A (in $) Project B (in $)
0 -1,000 -1,000
1 500 100
2 400 300
3 300 400
4 100 600
Solution:
Project A:
A very tedious method is to set up the equation below and solve for r using trial and error.
500 400 300 100
1000 = 1 + r + (1 + r)2 + (1 + r)3 + (1 + r)4 r = 14.49%

A much faster method is to use the calculator:

Key strokes Display
[CF][2nd][CLR WORK] CF0 = 0
1000[+|-] [ENTER] CF0 = -1000
[↓] 500 [ENTER] C01 = 500
[↓] F01 = 1
[↓] 400 [ENTER] C02 = 400
[↓] F02 = 1
[↓] 300 [ENTER] C03 = 300
[↓] F03 = 1
[↓] 100 [ENTER] C04 = 100
[↓] F04 = 1
[IRR][CPT] 14.49
Project B:

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LM05 Capital Investments and Capital Allocation 2024 Level I Notes

100 300 400 600

1000 = 1 + r + (1 + r)2 + (1 + r)3 + (1 + r)4 r = 11.79%

Microsoft Excel functions can also be used to solve for the IRR. The two functions available
are:
• IRR or =IRR(values, guess)
• XIRR or =XIRR(values, dates, guess)
where “values” are the cash flows, “guess” is an optional user-specified guess that defaults
to 10%, and “dates” are the dates of each cash flow.
Ranking conflicts between NPV and IRR
For single and independent projects with conventional cash flows, there is no conflict
between NPV and IRR decision rules. However, for mutually exclusive projects the two
criteria may give conflicting results. The reason for conflict is due to differences in cash flow
patterns and differences in project scale.
For example, consider two projects one with an initial outlay of $1 million and another
project with an initial outlay of $1 billion. It is possible that the smaller project has a higher
IRR, but the increase in firm value (NPV) is small as compared to the increase in firm value
(NPV) of the larger project.
In case of a conflict, we should always go with the NPV criterion because:
•The NPV is a direct measure of expected increase in value of the firm.
•The NPV assumes reinvestment of cash flows at the required rate of return (more
realistic), whereas the IRR assumes reinvestment of cash flows at the IRR rate (less
realistic).
• IRR is not useful for projects with non-conventional cash flows as such projects can
have multiple IRRs , i.e., there are more than one discount rates that will produce an
NPV equal to zero.
Comparison between NPV and IRR
NPV IRR
Advantages Advantages
Direct measure of expected Shows the return on each dollar invested.
increase in value of the firm.
Theoretically the best method. Allows us to compare return with the required rate.
Disadvantages Disadvantages
Does not consider project size. Incorrectly assumes that cash flows are reinvested
at IRR rate. The correct assumption is that
intermediate cash flows are reinvested at the
required rate.
Might conflict with NPV analysis.

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LM05 Capital Investments and Capital Allocation 2024 Level I Notes

Possibility of multiple IRRs.

Return on Invested Capital
Outside investors and analysts often do not have the information necessary to calculate a
project’s NPV and IRR. They get consolidated financial statements which includes the cash
flows associated with many projects. Therefore, they use a profitability measure - return on
invested capital to evaluate the capital allocation decisions of a company.
After tax operating profit
ROIC =
Average invested capital
Invested capital includes long-term liabilities and equity, short-term liabilities are excluded.

ROIC reflects how effectively a company’s management is able to convert capital into after-
tax operating profits. Note that the numerator excludes interest expense because it
represents a source of return to providers of debt capital, and the denominator includes
sources of capital from all providers.
If the ROIC measure is higher than the cost of capital (COC), the company is generating a
higher return for investors compared with the required return, thereby increasing the firm’s
value. We can also say that projects with positive NPV will have a ROIC that is greater than
the COC.
Example: Return on Invested Capital
(This is based on Example 8 from the curriculum.)
Assume that a company reported 24,395 in Year 2 after-tax operating profits and the
following balance sheet information.
Assets End of Year 1 End of Year 2
Cash 4,364 6,802
Short term assets 40,529 52,352
Long term assets 287,857 279,769

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LM05 Capital Investments and Capital Allocation 2024 Level I Notes

Total assets 332,750 338,923

Liabilities and Equity: End of Year 1 End of Year 2

Accounts payable 35,221 50,766
Short-term debt 21,142 5,877
Long-term debt 112,257 106,597

Share capital 15,688 15,688

Retained earning 148,442 159,995
Total liabilities and equity 332,750 338,923
Calculate the ROIC for Year 2.
Solution:
After tax operating profit After tax operating profit
ROIC = =
Average invested capital Average LT liabilities and equity
(112,257 + 15,688 + 148,442) + (106,597 + 15,688 + 159,995)
ROIC = (24,395)/ = 8.73%
2
4. Capital Allocation Principles and Pitfalls
Capital Allocation Principles
The key principles of capital allocation are:
• Decisions are based on after-tax cash flows: Decisions are not based on an
accounting/accrual basis (net income or operating income) which subtract non-cash
charges such as depreciation. Shareholder value increases only on the cash that they
have earned. Hence, any tax expenses must be deducted from the cash flows.
• Measure incremental cash flows: What incremental cash flows occur with the
investment as compared to without it? Also sunk costs are excluded, while
externalities are included.
o Exclude sunk costs: A sunk cost is one that has already been incurred and cannot be
changed. For example, already incurred costs like preliminary consulting fees
should not be included in the analysis
o Include externalities: Both positive/negative externalities should be considered in
the analysis. Cannibalization is an example of a negative externality. For example,
negative impact of a new diet soda product launch on the sales of existing soda
products.
• Timing of cash flows is crucial: Due to the time value of money, cash flows received
earlier are more valuable than cash flows received later.

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LM05 Capital Investments and Capital Allocation 2024 Level I Notes

Capital Allocation Pitfalls

Common capital allocation pitfalls can be divided into cognitive errors and behavioral biases.
Cognitive errors include calculation and other mistakes, while behavioral biases include
errors in judgment and blind spots.
Cognitive Errors in Capital Allocation
• Internal forecasting errors: Companies may make errors in their internal forecasts. The
errors could be related to incorrect costs or discount rate inputs. For example, overhead
costs such as management time, IT support, and financial systems can be difficult to
estimate. Also, companies may incorrectly treat sunk costs and missed opportunity costs;
and incorrectly use the company’s overall cost of capital, cost of debt, or cost of equity
rather than the investment’s required rate of return in their analysis.
• Ignoring costs of internal financing: Many managers consider internally generated capital
to be "free" and allocate it according to a budget that is heavily correlated with prior
period amounts. Externally raised capital, on the other hand, is regarded as "expensive"
and is used sparingly, typically only for large investments. Ideally, managers should view
all capital as having an opportunity cost, regardless of source.
• Inconsistent treatment of, or ignoring inflation: Capital allocation analysis can be done
either in ‘nominal’ terms or ‘real’ terms. Nominal cash flows include the effects of
inflation. Whereas, real cash flows are adjusted downward to remove the effect of
inflation. Nominal cash flows should be discounted at a nominal discount rate, and real
cash flows should be discounted at a real rate.
Behavioral Biases in Capital Allocation
• Inertia: The amount of capital investment in a business segment/unit for a year is highly
correlated to the amount spent in the previous year. Ideally, the amount should vary
based on the number and scale of opportunities available each year.
• Basing investment decisions on EPS, net income, or return on equity: The compensation of
managers is sometimes tied to EPS, net income, or ROE. They may therefore reject even
strong positive NPV projects that reduce these accounting numbers in the short run.
• Pushing “pet” projects: Pet projects are projects backed by senior management. They may
contain overly optimistic projections that overstate the project’s profitability.
• Failing to consider investment alternatives or alternative scenarios: During the ‘idea
generation’ step, many good alternatives are never even considered at some companies.
Many companies also fail to consider differing states of the world, which should ideally
be incorporated through breakeven, scenario, and simulation analyses.

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LM05 Capital Investments and Capital Allocation 2024 Level I Notes

5. Real Options
Real options are options that allow managers to make decisions in the future that change the
value of capital investment decisions made today. As with financial options, real options are
contingent on future events. The difference is that real options deal with real assets.
Types of real options include:
• Timing options: A company can delay investing until it has better information.
• Sizing options: If a company can invest in a project and then abandon it if its financial
results are weak, it has an abandonment option. Conversely, if the company can make
additional investments when financial results are strong, it has a growth option.
• Flexibility options: Once an investment is made, operational flexibilities such as
changing the price (price setting option), or increasing production (production
flexibility option) may be available.
• Fundamental options: In this case, the whole investment is an option. For example, the
value of an oil well or refinery depends on the price of oil. If oil prices are low, a
company may not drill a well. If oil prices are high, the company may pursue drilling.
There are several approaches to evaluating capital allocation projects with real options.
1. Use DCF analysis without considering options. If the NPV of the project without
considering options is positive, then we can go ahead and make the investment. The
presence of real options will simply add even more value. Therefore, it is not
necessary to determine the value of the options separately.
2. If NPV is negative without considering options, then calculate project NPV as: Project
NPV = NPV (based on DCF alone) – Cost of options + Value of options. Check if the
project NPV turns positive after the options are considered.
3. Use decision trees and option pricing models. They can help in many sequential
decision-making problems.
Example: Capital Allocation Using a Decision Tree
(This is Example 9 from the curriculum.)
Assume that Gerhardt Corporation is considering a €500 million outlay for a capital
investment in a facility to produce a new product. Gerhardt assigns a 60% probability to a
successful product launch, which is expected to return €750 million in one year’s time.
Gerhardt’s finance team has also conducted an analysis of alternative facility uses,
summarizing the timing and probability of cash flows associated with each real option in the
following decision tree.

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LM05 Capital Investments and Capital Allocation 2024 Level I Notes

1. Calculate the NPV of Gerhardt’s project without real options using a 10% required rate of
return (r).
2. Calculate the NPV of Gerhardt’s project with real options using a 10% required rate of
return (r).
Solution to 1:
The NPV without real options is a probability-weighted cash flow if the product is
successfully launched (60%) and a 40% probability that future cash inflows are zero.
CF1 (0.6 × 750)
NPV = CF0 + = −500 + = −90.91
(1 + r)1 1.10
Because NPV = –€90.91, Gerhardt should not pursue the project, based on the NPV decision
rule.
Solution to 2:
CF1 CF2
NPV = CF0 + +
(1 + r)1 (1 + r)2
(0.6 × 750) [(0.4 × 0.3) × 600] + [(0.4 × 0.3) × 400]
NPV = −500 + + = 8.26
1.10 (1.10)2
The NPV with real options equals €8.26, which implies based on the NPV decision rule that
Gerhardt should invest in the new production facility if alternative uses in the future are
considered.

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LM05 Capital Investments and Capital Allocation 2024 Level I Notes

Summary
LO: Describe types of capital investments.
Companies invest for two primary reasons – to maintain their existing business and to grow
it.
Projects undertaken by companies to maintain the business include:
• going concern projects
• regulatory/compliance projects
Projects undertaken by companies to expand the business include:
• expansion projects
• other projects
LO: Describe the capital allocation process, calculate net present value (NPV), internal
rate of return (IRR), and return on invested capital (ROIC), and contrast their use in
capital allocation.
Capital allocation is the process used by an issuer’s management to make capital investment
decisions.
The typical steps companies take in the capital allocation process are:
1. idea generation
2. investment analysis,
3. capital allocation planning
4. post-audit/monitoring
Net present value (NPV) is the present value of the future after-tax cash flows, minus the
investment outlay (cost of the project). For independent projects, accept all projects with
positive NPV. For mutually exclusive projects, accept the project with the higher NPV.
Internal rate of return (IRR) is the discount rate which makes NPV equal to 0. For
independent projects, if IRR is greater than opportunity cost (required rate of return), accept
the project, otherwise reject the project. For mutually exclusive projects, accept the project
with the higher IRR as long as the IRR is greater than the opportunity cost.
ROIC reflects how effectively a company’s management is able to convert capital into after-
tax operating profits.
After tax operating profit
ROIC =
Average invested capital
LO: Describe principles of capital allocation and common capital allocation pitfalls.
The key principles of capital allocation are:
• Decisions are based on after-tax cash flows.

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LM05 Capital Investments and Capital Allocation 2024 Level I Notes

• Measure incremental cash flows. Exclude sunk costs and include externalities.
• Timing of cash flows is crucial.
Common capital allocation pitfalls can be divided into cognitive errors and behavioral biases.
Cognitive errors
• Internal forecasting errors
• Ignoring cost of internal financing
• Inconsistent treatment of, or ignoring inflation
Behavioral biases
• Inertia
• Basing investment decisions on EPS, net income, or return on equity
• Pushing pet projects
• Failing to consider investment alternatives or alternative scenarios
LO: Describe types of real options relevant to capital investments.
The types of real options include:
1. Timing options
2. Sizing options - abandonment options or growth options
3. Flexibility options - price-setting options or production-flexibility options
4. Fundamental options
If NPV is positive without considering options, go ahead and make the investment.
If NPV is negative without considering options, calculate NPV (based on DCF alone) – Cost of
options + Value of options.

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