8/25/22, 4:39 PM CMA Exam Review - Part 2 - Section E: Investment Decisions

Study Guide
Section E: Investment Decisions

Capital can refer to assets and/or the financing used to acquire assets—debt and/ or equity, in particular. Even the most stable of firms can only borrow up to a
certain level or issue a limited amount of shares of common stock to raise capital.
Organizations have limited capital resources and every firm must evaluate investment projects carefully. Management accountants often have a key role in deciding
whether an investment is worth undertaking. Content in this section begins with an overview of the capital budgeting process and then reviews the fundamental
principles that can facilitate intelligent choices between two or more investment alternatives.

LOS
Learning Outcome Statements Overview: Investment Decisions

1.  Section E.1. Capital Budgeting Process

The candidate should be able to:

a. Define capital budgeting, and identify the steps or stages undertaken in developing and implementing a capital budget for a project.
A. Capital budgeting—The process of making long-term investment decisions. It is a decision-making process that enables a firm to evaluate the viability of
a long-term project and whether it is worth undertaking.
B. The steps in the capital budgeting process are:
i. Identify and define projects.
ii. Evaluate and select the project.
iii. Monitor and review the project.
b. Identify and calculate the relevant cash flows of a capital investment project on both a pretax and an after-tax basis.
A. Key points in evaluating capital investment cash flows are:
Income statement items that do not affect cash, such as depreciation expense, amortization expense, gains, and losses, are ignored in cash flow
analysis problems, except for any effects they may have on taxes. Additionally, expenses and revenues are adjusted to remove deferrals and
accruals, such as unearned revenues, prepaid expenses, accrued revenues, and accrued expenses.
All items affecting cash flows must be examined regardless of whether they are revenues or expenses for the accounting period.
Sunk costs (unrecoverable past outlays) are ignored because they are historical costs that are not relevant to the investment decision.
Opportunity costs (what is lost by not taking the next-best alternative) must be included and typically are treated as a cash outlay at the onset of
the project.
Investments in net working capital are treated as cash outflows at the time they occur and as cash inflows (in full) when they are released.
The anticipated effects of inflation must be taken into account.
Depreciation expenses are relevant in capital budgeting only to the extent that they affect the firm's tax obligation. Depreciation provides the firm
with non-cash expenses that are tax deductible.
c. Demonstrate an understanding of how income taxes affect cash flows.
A. In order to accurately project the profitability of a project, a company must identify all the related revenues and expenses, including the income tax effect
of those cash flows. Taxes can have a large impact on overall profitability. Capital investments typically are depreciated on an accelerated basis, which
provides greater tax deductions early on in the project timeline.
d. Distinguish between cash flows and accounting profits, and discuss the relevance to capital budgeting of incremental cash flow, sunk cost, and opportunity
cost.
A. Accounting profits typically differ from the cash flows of a company because of the accrual basis of accounting, treatment of capital expenditures, and
other non-cash operating revenues and expenses. For example, the purchase of a piece of equipment would be an immediate cash outflow but would
show up in the accounting profit only through the process of depreciation over the estimated useful life of the asset.
B. Incremental cash flow—The additional operating cash flow received or expended from taking on a new project.
C. Sunk costs—Ignored in capital budgeting because they are historical (unrecoverable) costs that are not relevant to the investment decision.
D. Opportunity costs—Included in capital budgeting as a cash outlay at the start of the project since they provide comparisons against the next best
alternative.
e. Explain the importance of changes in net working capital in capital budgeting.
A. Changes in net working capital (i.e., current assets less current liabilities) must be considered in the initial cash flow of the project as funds are often
needed to initiate the project. Those cash outflows are not included in determining accounting profits but are a resource that needs to be funded. If
changes in net working capital were ignored, the investment return would be incorrect. Typically, net working capital funds are assumed to be returned
to the company in full at the end of the project's life.
f. Discuss how the effects of inflation are reflected in capital budgeting analysis.
A. Inflation can have a large impact on the real rate of return on a project. Since the hurdle rate (or required rate of return for a project) embodies a
premium for inflation, the estimated cash flows must also reflect inflation.
g. Define hurdle rate.
A. Hurdle rate (also called the minimum required rate of return)—Determines how rapidly the value of the dollar decreases over time. Management
determines the rate for evaluating capital budgeting projects, and it should include the effects of expected inflation and risk.
h. Identify alternative approaches to dealing with risk in capital budgeting.
A. Sensitivity analysis-A what-if technique evaluating how net present value (NPV), internal rate of return (IRR), and other indicators of the profitability of a
project change if the discount rate, operating costs, sales, or other factors vary from one case to another.
B. Simulations-Allow testing of a capital investment project before it is accepted. Because the actual future values for cash flows and discount rates for
investment projects are not known with certainty, hypothetical cash flows and discount rates are assumed and can be studied using a simulation model.
C. Scenario analysis-Approach to evaluating risk that uses single-point estimates where each possibility is assigned a best-guess estimate. Scenarios (such
as best, worst, or most likely case) for each input variable are chosen, and the results are reported.

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8/25/22, 4:39 PM CMA Exam Review - Part 2 - Section E: Investment Decisions
D. Monte Carlo simulation-Based on the use of computational algorithms that rely on random sampling in order to compute results. The Monte Carlo
method uses computerized simulations, which are a class of computational algorithms that rely on repeated random sampling (typically over a thousand
or more iterations) to compute their results.
i. Distinguish among sensitivity analysis, scenario analysis, and Monte Carlo simulation as risk analysis techniques.
A. See item A above for descriptions of sensitivity analysis, scenario analysis, and Monte Carlo simulations.
j. Explain why a rate specifically adjusted for risk should be used when project cash flows are more or less risky than is normal for a firm.
A. A firm needs to use a risk-adjusted rate when evaluating projects that are outside of the norm for the firm. For example, a company with a required rate of
return of 12% should not use only that rate in its computations because projects need to be evaluated on the basis of risk as well. A more risky project
might require a 14% hurdle rate in order to compensate the company for the extra risk and uncertainty it is taking on.
k. Explain how the value of a capital investment is increased if consideration is given to the possibility of adding on, speeding up, slowing up, or discontinuing
early.
A. Companies can use another analysis tool called real options valuation (ROV) to value a project. ROV assumes that management can actively modify the
project throughout its life by responding to each outcome (in other words, options are exercised) and the possibility of a large negative outcome is
reduced or eliminated. The ROV value of a project typically is higher than its net present value. The more real options that are available, the less risk
involved and the higher the value of the project.
l. Demonstrate an understanding of real options, including the options to abandon, delay, expand, and scale back (calculations not required).
A. As discussed above, real options reduce the uncertainty, and therefore the risk, of a project. They add more flexibility to mitigate risks throughout the life
of a project. Some real options include:
Abandon-Cease the project by getting rid of assets or diverting the assets to other uses.
Expand-Start a project out small and increase the investment as the project develops.
Postpone-Delay the project until more information is collected and analyzed.
Adapt-Adjust output or production methods in response to demand or other changes in circumstances.
m. Identify and discuss qualitative considerations involved in the capital budgeting decision.
A. Whatever classification scheme a company uses, organizational strategies and objectives will influence the evaluation criteria and decision procedures in
making a capital investment. It is important to consider qualitative factors in evaluating capital budgeting projects, such as the impact on employee
morale, the support of the company's mission statement, and the company's reputation.
n. Describe the role of the post-audit in the capital budgeting process.
A. Just as any budgeting process, an audit should be conducted after the capital investment project to compare actual results versus expected results. This
data can be used for future decisions and for evaluation purposes.

2.  Section E.2. Capital Investment Analysis Methods

The candidate should be able to:

a. Demonstrate an understanding of the two main discounted cash flow (DCF) methods, net present value (NPV) and internal rate of return (IRR).
A. Net present value (NPV)—Uses a specified discount rate to determine the present value of a project's future cash flows less the initial investment in the
project.
B. Internal rate of return (IRR)—Estimates the discount rate at which the present value of all the subsequent net cash inflows after the initial investment
equals the initial cash outlay(s) of the investment.
b. Calculate NPV and IRR.
A. There are six steps in determining the NPV for a capital project:
1. Determine the after-tax net cash flows for each year.
2. Identify the required rate of return (RRR).
3. Determine the discount factor each year (using the appropriate present value [PV] table, or a calculator or spreadsheet program) for the RRR in
Step 2.
4. Determine the PV for the net cash flows; multiply the amount for Step 1 by the amount of Step 3.
5. Total the amounts in Step 4 for all years of the investment.
6. Subtract the initial investment amount (year 0 cash flow).

B. There are six steps in determining IRR for a capital project with uniform net cash flows:
1. Determine the total initial investment for the project (total cash outflows and commitments).
2. Identify the predetermined criterion cutoff rate of return (the required rate).
3. Determine net cash inflows for each year.
4. Divide the initial investment (Step 1) by the annual cash flow (Step 3) to obtain the IRR factor, which is basically the present value interest factor for
an annuity (PVIFA).
5. Refer to the PV of an annuity table to locate a discount rate at the specified number of years that matches the IRR factor (or the one closest to it).
6. Compare the IRR rate (Step 5) to the chosen criterion cutoff rate (Step 2). In the NPV example above, the NPV was positive, meaning the rate of
return was greater than the hurdle rate, or RRR. In order to determine the IRR on the project in that example, you can increase the discount rate
(10%) until the NPV gets near zero.
c. Demonstrate an understanding of the decision criteria used in NPV and IRR analyses to determine acceptable projects.

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8/25/22, 4:39 PM CMA Exam Review - Part 2 - Section E: Investment Decisions
A. An NPV of zero means the investment earns the same rate of return as the RRR. A positive NPV indicates it earns a higher rate than the required rate and
should be accepted. A negative NPV indicates it earns a lower rate than the required rate and should be rejected.
B. IRR is compared to the RRR. If the IRR is higher than the RRR, it is an acceptable project as it would result in a positive NPV.
d. Compare NPV and IRR focusing on the relative advantages and disadvantages of each method, particularly with respect to independent vs. mutually exclusive
projects and the “multiple IRR problem.”
A. Both NPV and IRR methods depend heavily on an accurate hurdle rate. If the hurdle rate is inaccurate, then the decision may not be accurate.
B. The advantages of both methods are that they each consider the time value of money, the initial cash investment, and all cash flows after the initial
investment.
C. A major difference is that the end result of NPV is a dollar figure whereas the final computation for IRR is a percentage. Thus, NPV has an advantage,
because NPV values of individual projects can be added together to estimate the effect of accepting some possible combination of projects. However, IRR
has an advantage in that it allows for comparability across different divisions with different initial investment amounts, while NPV does not.
D. Another major advantage of NPV over IRR is that NPV can be determined easily using different desired rates of return for different periods.
E. If projects are mutually exclusive, the NPV and IRR methods might produce conflicting rankings. NPVs can be added together to produce an overall NPV,
but IRR rates cannot be added together. In addition, these facts need to be considered when the costs of the projects, the timing and amount of cash
flows, and the timelines (i.e., project lives) are different.
e. Explain why NPV and IRR methods can produce conflicting rankings for capital projects if not applied properly.
A. In comparing two projects with different initial cash outflows, one may produce a high IRR and a low NPV. The other project may produce a lower IRR but
a higher NPV. Depending on the method, each project would be selected differently.
f. Identify assumptions of NPV and IRR.
A. NPV assumes that cash flows are reinvested at the desired rate of return (cost of capital).
B. IRR assumes that cash flows are reinvested at the internal rate of return instead of the required rate. This is often a less realistic assumption, and is seen
by many as a limitation of the IRR method.
g. Evaluate and recommend project investments on the basis of DCF analysis.
A. The information outlined above provides general guidelines and analysis of whether to accept or reject a project.
h. Demonstrate an understanding of the payback and discounted payback methods.
A. Similar to the net present value (NPV) and internal rate of return (IRR) techniques, the payback period (PP) does not distinguish between types of cash
inflows. As a simple measure of cash inflows, the PP also can be used to evaluate capital investments having uniform net cash flows or uneven cash
flows. The payback period of a capital investment, assuming uniform cash flows (i.e., an annuity), is:

Total Initial Investment

Payback Period =
Expected Annual Net Cash Flow

B. The payback period of a capital investment, assuming uneven cash flows, is:

Unrecovered Cost at the Beginning of the Last Year

Payback Period = Years Until Full Recovery +
Cash Flow During the Last Year

C. The discounted payback is similar to the payback method except that it uses present value, or discounted value, of net cash flows. The formulas above
can be applied the same with the exception that the annual cash flows must be discounted back to present value before using them in the formula.
i. Identify the advantages and disadvantages of the payback and discounted payback methods.
A. Advantages of the payback method:
Uses a simple calculation
Produces results that are easy to understand
Provides a rough measure of liquidity and risk
B. Disadvantages of the payback method:
Ignores the time value of money
Ignores cash flows after the payback period (e.g., what if they are negative?)
Provides no measure of profitability
Promotes the acceptance of short-term projects if the target payback period is too short
C. The advantage of the discounted payback method is that it addresses the major disadvantage of the payback method by not ignoring the time value of
money.
j. Calculate payback periods and discounted payback periods.
A. Using the formulas above, you can calculate the payback periods of any project.

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