8/7/2017 December 2017 CFA Level 1: CFA Exam Preparation (study notes, practice questions and mock exams)

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CFA Exam: Dec. 2017 Level I (http://analystnotes.com/cfa-exam-dec.html)

/ Study Session 10. Corporate Finance: Corporate Governance, Capital Budgeting, and Cost of Capital (http://analystnotes.com/cfa-study-session-corporate-nance-corporate-
governance-capital-budgeting-and-cost-of-capital.html)
/ Reading 35. Capital Budgeting (http://analystnotes.com/cfa-reading-capital-budgeting.html) / LOS 35.a.

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Subject 1. Capital Budgeting: Introduction

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Capital budgeting is the process of planning expenditures on assets (xed assets) whose cash ows are expected to extend beyond one year.
Managers analyze projects and decide which ones to include in the capital budget.

"Capital" refers to long-term assets.

The "budget" is a plan which details projected cash inows and outows during a future period.

The typical steps in the capital budgeting process:

Generating good investment ideas to consider.

Analyzing individual proposals (forecasting cash ows, evaluating protability, etc.).
Planning the capital budget. How does the project t within the company's overall strategies? What's the timeline and priority?
Monitoring and post-auditing. The post-audit is a follow-up of capital budgeting decisions. It is a key element of capital budgeting. By comparing
actual results with predicted results and then determining why dierences occurred, decision-makers can:

Improve forecasts (based on which good capital budgeting decisions can be made). Otherwise, you will have the GIGO (garbage in,
garbage out) problem.
Improve operations, thus making capital decisions well-implemented.

Project classications:

Replacement projects. There are two types of replacement decisions:

Replacement decisions to maintain a business. The issue is twofold: should the existing operations be continued? If yes, should the same
processes continue to be used? Maintenance decisions are usually made without detailed analysis.
Replacement decisions to reduce costs. Cost reduction projects determine whether to replace serviceable but obsolete equipment. These
decisions are discretionary and a detailed analysis is usually required.

The cash ows from the old asset must be considered in replacement decisions. Specically, in a replacement project, the cash ows from
selling old assets should be used to oset the initial investment outlay. Analysts also need to compare revenue/cost/depreciation before and
after the replacement to identify changes in these elements.

Expansion projects. Projects concerning expansion into new products, services, or markets involve strategic decisions and explicit forecasts of
future demand, and thus require detailed analysis. These projects are more complex than replacement projects.

Regulatory, safety and environmental projects. These projects are mandatory investments, and are often non-revenue-producing.
with anything?

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8/7/2017 December 2017 CFA Level 1: CFA Exam Preparation (study notes, practice questions and mock exams)
Others. Some projects need special considerations beyond traditional capital budgeting analysis (for example, a very risky research project in
which cash ows cannot be reliably forecast).

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