CMA Part 2 Textbook Section E

2022 Edition
CMA
Preparatory Program
Part 2
Section E
Strategic Financial Management
Brian Hock, CMA, CIA

and
Lynn Roden, CMA
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Acknowledgements
Acknowledgement is due to the Institute of Certified Management Accountants for

permission to use questions and problems from past CMA Exams. The questions and
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Florida 32701 USA. Reprinted with permission.
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CMA Part 2 Table of Contents
Table of Contents
Section E – Investment Decisions ................................................................................ 116

Study Unit 1: E.1. Capital Budgeting Process and Relevant Cash Flows ................. 117
Capital Budgeting Process Overview 117
The Stages in Capital Budgeting 118
Terms Used in Capital Budgeting 119
The Difference Between Cash Flows and Accounting Profits 120
Identifying and Calculating the Relevant Cash Flows 120
Depreciation for Income Tax Purposes 126
Other Tax Considerations 128
Irrelevant Cash Flows 128
Example of Calculation of After-Tax Relevant Cash Flows 129
Study Unit 2: E.2. Payback and Discounted Payback Methods ................................. 131
E.2. Capital Investment Analysis Methods 131
Payback Period or Payback Method 131
Discounted Cash Flow Methods of Capital Budgeting 133
Discounted Payback Period or Method (Breakeven Time) 134
Study Unit 3: E.2. Net Present Value Method ............................................................... 135
Net Present Value (NPV) Method 135
The Importance of the Discount Rate Choice 143
Study Unit 4: E.2. Internal Rate of Return .................................................................... 147
Internal Rate of Return (IRR) 147
Study Unit 5: E.2. Capital Budgeting Methods – Other Topics .................................. 152
Incremental Analysis: A New Asset Replacing an Old Asset 152
Summary and Review of Relevant Cash Flows 161
Study Unit 6: E.2. Risk in Capital Budgeting ............................................................... 163
Risk in Capital Budgeting 163
Capital Rationing in Capital Budgeting 169
Study Unit 7: E.2. Real Options in Capital Budgeting ................................................. 171
Real Options in Capital Budgeting 171
The Qualitative Factor in Capital Budgeting Decisions 174
Appendix A – Present Value Factors ............................................................................ 175

Appendix B – Example of IRR ....................................................................................... 177
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Study Unit 1: E.1. Capital Budgeting Process and Relevant Cash Flows CMA Part 2
Section E – Investment Decisions

Introduction to Investment Decisions
The Investment Decisions section accounts for 10% of the CMA Part 2 exam. The whole exam will contain
100 multiple-choice questions and 2 essay questions. Topics within an examination part and the subject
areas within topics may be combined in individual questions. Therefore, it is difficult to predict how many
multiple-choice questions will come from this section or if there will be any essay questions from this section
on any given exam. The best approach to preparing for this exam is to know and understand the concepts
well and be ready for anything.
Investment Decisions focuses on capital budgeting, which refers to a group of methods to evaluate possible
capital projects in which to invest. Capital budgeting is used to make long-term planning decisions, which
usually involve large sums of money and extended time commitments. Therefore, it is critical to the com-
pany’s success that its management makes correct decisions in these matters.
Note: The process of financing capital investments is covered in Raising Capital (Section B in Volume 1
of this book) and is not discussed in this section.
To succeed in this section of the exam, it is important to be competent in the following areas:
• Calculating the cash flows for all of the years of a project, including the cash flows resulting from
disposal of the assets at the end of the project.
• Calculating the Depreciation Tax Shield.
• Calculating the Net Present Value.
• Calculating the Internal Rate of Return.
• Determining which project or projects to invest in.
• Calculating and using other covered methods, such as the Payback Method.
116 © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited.
Section E Study Unit 1: E.1. Capital Budgeting Process and Relevant Cash Flows
Study Unit 1: E.1. Capital Budgeting Process and Relevant Cash Flows
Capital Budgeting Process Overview
Capital—whether debt, equity, or retained earnings—is a limited resource, and a company must carefully
manage its capital, protect it, and make it grow through identifying and taking advantage of investment
opportunities as they arise. However, a company’s management needs a method to decide whether or not
a particular project under consideration will contribute to profits and thus to the value of the firm’s equity
and the wealth of its shareholders. Furthermore, if several projects are under consideration, management
needs to be able to identify which ones are the most profitable.
Capital budgeting is the process used to evaluate potential major projects or investments. A new plant,
a new product line, a new business under consideration, or other similar long-term investments are projects
that might be evaluated and either approved or rejected using capital budgeting techniques.
Through capital budgeting, management can evaluate different investment opportunities and identify those
that will contribute the most to profits and thus to the value or wealth of the firm and its owners, the
shareholders. Capital budgeting methods focus on the expected value of net cash flow (as opposed to net
income) throughout the entire life of the project, including all expected cash inflows, expected cash
outflows, and expected cash savings (such as tax savings resulting from the depreciation of the purchased
assets). Thus, capital budgeting is a “life-cycle” or “cradle-to-grave” approach to selecting, implementing,
and monitoring the results of long-term investments.
Capital budgeting uses the incremental approach to determine the expected cash inflows, outflows, and
cost savings of a potential investment. With the incremental approach, the only cash flows relevant to the
analysis are those that would be additional as a result of the activity. On the other hand, if the decision
calls for a choice between two or more alternatives, the differential approach is used, in which the only
cash flows relevant to the analysis are those that would differ between or among the alternatives.
Note: The terms “incremental” and “differential” are sometimes used interchangeably; however, they
are not the same.
• Incremental cash flows are cash flows that would be additional as the result of a potential activity.
• Differential cash flows are cash flows that differ between or among two or more potential alterna-
tives.
Four capital budgeting techniques, offering different ways to analyze a project, are tested on the CMA exam.
• The Net Present Value Method and the Internal Rate of Return Method use the time value
of money.1 The time value of money recognizes the fact that a $1,000,000 net cash inflow received
next year is worth more than a $1,000,000 net cash inflow received five years from now. Therefore,
to make the analysis meaningful, the expected net cash flows for each of the years over the entire
life of the project are discounted to their present values at the beginning of the project’s life using
the firm’s required rate of return.
• In a third method, the Payback Method, the future net expected cash inflows are compared with
the net initial investment (cash outflow) to determine the time required to recoup the net initial
investment, without considering the time value of money.
• A variation of the Payback Method, the Discounted Payback Method, also uses the time value
of money. It uses the present value of the expected cash flows to calculate the payback period
instead of the undiscounted expected cash flows.
1
An explanation of Time Value of Money concepts is available to download from My Studies alongside the download for
this textbook. The time value of money is a very important concept in capital budgeting.
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The Stages in Capital Budgeting

The process of making capital investment decisions includes six stages:
1) Identification Stage: In this initial phase, management identifies which capital expenditure pro-
jects are necessary to accomplish its objectives such as expanding into a new market or reducing
expenses.
2) Search Stage: The company explores a variety of capital investments that will achieve the organ-
izational objectives.
3) Information-Acquisition Stage: The company determines the expected costs and benefits, both
quantitative and qualitative, of the different capital investments.
There are four main steps for determining net cash flows for each potential project:
a. Determine the net investment and initial-cost cash outflow, which are the net cash outflows
associated with the increase in long-term assets needed for the project or projects under con-
sideration, as well as the initial cash outflows for activities such as advertising, employee
training, and research and development.
b. Determine the additional net working capital requirement, which is the increase in net current
assets (that is, current assets minus current liabilities) that will result from the investment
decision. The additional net working capital that is required must be treated as an investment
because it represents short-term assets unavailable for other purposes.
c. Determine the estimated subsequent net operating cash flows for each future period in which
the acquired assets will be used. Reliable estimates of revenues, expenses, and also tax sav-
ings due to tax-deductible depreciation expense on the assets are essential for this process.
d. Determine all the net cash flows at the project’s conclusion related to the disposal of the long-
term assets and release of the working capital.
Note: All amounts used in the Information-Acquisition Stage are net amounts, that is, cash
inflows minus cash outflows.
4) Selection Stage: On the basis of financial analysis and nonfinancial considerations, the company
chooses the project or projects to implement.
5) Financing Stage: The company obtains the necessary project funding.
6) Implementation and Control Stage: The project is implemented and monitored over time.
Although each of the six stages is important, the following discussion will focus on the Information-Acqui-
sition Stage and the Selection Stage, examining potential investments from a purely financial viewpoint.
However, in real-world analysis of potential projects, it is important to realize that there may be non-
financial considerations that may prompt a company to select an investment that may not be the most
financially rewarding. For example, the company might invest in a project that has low or negative net cash
flows but which would benefit the local community and raise the company’s philanthropic profile.
Terms Used in Capital Budgeting

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

Accounting profit is the profit (or loss) determined on the income statement using generally accepted
accounting principles. Cash flow is cash receipts less cash disbursements.
The difference between the two arises because of items reported on the income statement that do not
represent cash received or disbursed during the reporting period, or items that represent cash received or
disbursed during the reporting period that are not reported on the income statement. For example:
• When an investment is made in a project, cash is disbursed but the cost is reported on the income
statement as depreciation expense and allocated over all the periods during which the asset will
provide benefit to the company. The cash disbursement at the beginning of the project is a cash
outflow at that time, but is not expensed at that time. On the other hand, the depreciation expense
recorded during the subsequent periods as the asset is used reduces accounting profit during those
periods, but does not represent a cash outflow during those periods.
• Revenues are recognized on the income statement in the accounting period in which a performance
obligation is satisfied, but cash may not be received from the customer until a later period or may
even be received before the performance obligation is satisfied and the revenue is recognized.
• Expenses are recognized on the income statement in the period in which the revenues they relate
to are recognized on the income statement, but the cash may be paid out either before or after
the expense is recognized.
Note: Estimated cash flows are used to evaluate prospective capital budgeting projects. Cash flows
are a better measure of the net economic benefits and costs associated with a prospective project than
profits.
Identifying and Calculating the Relevant Cash Flows

To correctly perform the different capital budgeting methods, it is important to be able to recognize the
relevant cash flows in each of the years of a given project because almost all capital budgeting analyses
will be based upon individual cash flow analyses. All four capital budgeting methods tested on the CMA
exam rely on the relevant expected cash inflows and outflows.
Note: Each individual cash flow is discussed first without reference to the tax effect of the cash flow.
After the cash flow is discussed, the tax implications, if there are any, are then covered. It is important
to know which cash flows have an associated tax implication and which do not.
“Relevant Cash Flows” Defined

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

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

• The initial cash outflows that represent the investment in the capital project take place at the very
beginning of the first year of the project. The beginning of the first year of the project is identified
in the capital budgeting analysis as “Year 0” or “Time 0.”
• In any capital budgeting analysis that uses time value of money concepts,2 all expected cash flows
are treated as though they will take place at the end of the year in which they are expected to
occur, even though they will probably take place throughout the year. The year-end assumption
makes the use of present value concepts possible, and any error introduced by that assumption is
not material enough to change the decision.
Therefore, if an exam question says that a particular cash flow is received at the beginning of a
year, for capital budgeting purposes it must be treated as if it were received at the end of the
previous year.
• However, expected cash flows used in the Payback Method (not a method that uses time value
of money concepts) are treated as though they will take place evenly throughout each year fol-
lowing the initial cash outflow at the beginning of the project.
Expected Cash Flows at the Beginning of the Project (Year 0)

All expected cash flows at the beginning of a project relate to the net initial investment. In capital budgeting
analysis, the date of the initial investment may be referred to as either “Year 0” or “Time 0.” Cash flows,
both inflows and outflows, that occur at the beginning of a project take place one year before the end of
Year 1.
Year 0 cash flows consist of three components:
1) Initial investment. The initial investment is the cash outflow necessary to get the project op-
erating, such as purchase or construction of assets, transportation costs to have the assets shipped
to the location where they will be used, installation and setup, testing, and other related costs.
Tax Effect: There is no immediate tax effect with respect to the initial investment. However,
beginning with the first full year of operation, tax benefits will arise over the life of the project
as the capital assets are depreciated. The tax benefit received from the depreciation, called the
depreciation tax shield, is covered later as an annual cash flow over the life of the project.
2
Present Value, Internal Rate of Return, and the Discounted Payback Method use time value of money concepts. An
explanation of Time Value of Money concepts is available to download from My Studies alongside the download for the
textbook.
2) Initial working capital investment. Working capital, also known as net working capital, is
total current assets minus total current liabilities. An expected increase in working capital means
that accounts receivable and inventory are expected to increase due to the project under consid-
eration. Cash will be required to purchase the inventory and to support the increase in receivables.
The increase in accounts receivable represents goods supplied or services rendered for which the
company has incurred costs but for which it has not yet received payment.
On the liability side of the balance sheet, accounts payable related to the purchased inventory will
also increase. However, the increase in accounts payable will not be as great as the increase in
accounts receivable and inventory.
Thus, net working capital will increase by the amount of the increase in current assets minus the
amount of the increase in current liabilities related to the project. This increase in working capital
is a cash outflow at the beginning of the project.
For example, if a new, higher-capacity machine replaces an older one resulting in higher production
and higher sales, the initial working capital investment will be the difference between the working
capital investment required for the new machine and the working capital investment required for
the old machine. In this case, the initial working capital investment is an incremental amount.
Tax Effect: There is no tax effect related to working capital. Therefore, the amount that needs
to be included in the capital budgeting analysis is the actual amount of the increase in working
capital that the company expects to occur.
3) Cash received from the disposal of old or outdated assets. In the process of beginning a
project, assets might need to be liquidated. For example, a new project might require the company
to purchase a new machine to replace an older machine. Since the older machine is now obsolete,
the company might wish to maximize a cash return for the older machine (perhaps through a
heavily discounted resale or a tax-deductible, charitable contribution) rather than throw it away.
Cash received from the disposal of old or outdated assets is a cash inflow and therefore reduces
the initial investment for the newer assets.
Tax Effect: When an old asset is sold, there is an income tax effect related to the gain or loss
on the sale. The amount of the gain or loss is the difference between the cash received from
the sale and the tax basis of the asset (that is, its book value for tax purposes). The tax basis
is the asset’s book value for tax reporting purposes, which may be different from the asset’s
book value for financial reporting purposes. In some questions on the exam, both the book
value and the tax basis will be given. However, on other questions, only the book value of the
asset may be given. If only the book value is given, then use the book value to calculate the
gain or loss. But if both the book value and the tax basis are given, use the tax basis.
Any gain on the sale is taxed, and the amount of the income tax constitutes a reduction in the
net cash inflow from the sale.
Any loss on the sale constitutes a reduction of net taxable income, which lowers the company’s
total income tax burden. The amount of the tax savings that results increases the net cash
inflow received from the sale of the asset for the purposes of the capital budgeting analysis.
Therefore, a loss on the disposal of the old assets creates an increase to net cash flow in the
form of lower income taxes. If an old asset is donated to a qualified charitable organization, the
tax savings received as a result of the tax deduction for the donation is a cash inflow from the
disposal.
Annual Net Cash Flows

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

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

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

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

The termination of a project creates a number of potential cash flows:
1) Cash received from the disposal of equipment. Cash received from the sale of related assets
(equipment, machines, or the investment project itself) is a cash inflow in the project’s final year.
Tax Effect: If the sale of the assets results in either a gain or a loss, there will be a tax effect.
The gain or loss is calculated by subtracting the tax basis (or book value, if the tax basis is not
given) from the cash received and multiplying the result by the tax rate. Remember that the
tax basis is the full cost of the asset minus accumulated tax depreciation on the sale date.
If there is a gain, reduce the cash inflow by the taxes paid on the gain. If there is a loss, it will
be tax deductible and will result in tax savings. Add the tax savings to the cash received from
the sale to calculate the cash inflow. This tax treatment is calculated in the same way as the
calculation of the gain or loss on the sale of old assets at the beginning of the project.
As with the sale of old assets, in the event of a loss it must be assumed that the company has
other capital gains from which it can deduct the loss and thus is able to use the loss to lower its
tax bill.
A problem may indicate that the company’s tax rate for capital gains is different from its tax
rate for cash flows from operations. If this occurs, use the tax rate for capital gains to calculate
the tax due on the gain.
2) Recovery of working capital. The initial incremental investment in working capital and any sub-
sequent investments in working capital are usually fully recouped at the end of the project. The
final accounts receivable will be collected and not replaced with other accounts receivable for this
project. The inventory associated with the project will have been used in production and the fin-
ished goods will have been sold. All the related accounts payable will have been paid. It is also
possible for an investment in working capital to be recovered before the end of the project. When-
ever working capital is recovered, it is a cash inflow in the year of recovery.
Tax Effect: There is no tax effect related to working capital because working capital is neither
an income nor an expense. Therefore, the amount that needs to be included in the capital
budgeting analysis is the actual amount of the working capital that is recovered at the end of
the project.
Note: It is very common on the exam for a question to ask only for the cash flows in the final year of
the project. Remember that there are usually two events in this type of question: 1) the sale of the
assets themselves and 2) the release of working capital. Of these, only the gain or loss on the sale
of the asset generates a tax effect. The release of working capital is not a taxable event.
In addition, there may be after-tax operating cash flows and/or a depreciation tax shield for the final
year of operations. Whether to use these or not in the answer depends on what the question asks for
and what information is given. For example, if the equipment will be fully depreciated before the final
year, there will be no depreciation tax shield in the final year. And even though there may be cash flow
from operations and depreciation in the final year, the question may ask only for the cash flows related
to the disposition of the equipment.
Depreciation for Income Tax Purposes

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

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

20X2 1 year’s depreciation
20X3 1 year’s depreciation
20X4 ½ of one year’s depreciation
Note that the preceding depreciation schedule works out to three full years of depreciation, but the depre-
ciation is taken over a period of four tax years.
The U.S. Internal Revenue Service (IRS) provides MACRS tables that give the percentage of the original
cost to be depreciated each year. There are several tables, each incorporating a given convention, and the
half-year convention is the most commonly used. The percentages for the first and last year in the half-
year convention table have already been adjusted to reflect one-half year’s depreciation in those years.
Therefore, when calculating annual depreciation amounts using the MACRS tables, the percentages should
be used as given.
For example, for an asset that is being depreciated over three years using MACRS and the half-year con-
vention, here are the percentages given in the tables:
Year 1 33.33%
Year 2 44.45%
Year 3 14.81%
Year 4 7.41%
Total 100.0%
The first year’s depreciation in the schedule above is 33.33% of the asset’s total cost. If one full year’s
depreciation were recorded in the first year, the full year amount would be 66.67% of the asset’s total cost.
One-half of that is 33.33%. The final year’s depreciation is adjusted similarly.
Exam Tip: Knowledge of these percentages is not necessary for the exam. If MACRS is to be
used on the exam, the percentages will be given in the question.
Example: The amount of depreciation to be taken for each year for an asset with an original cost of
$90,000 that is being depreciated as three-year property using MACRS and the half-year convention will
be as follows:
Year 1 33.33% $29,997
Year 2 44.45% 40,005
Year 3 14.81% 13,329
Year 4 7.41% 6,669
Totals 100.00% $90,000
Straight-Line Depreciation When Used for Tax Purposes

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

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

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

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

Financing cash flows associated with the project—principal and interest payments on new debt or dividends
on new stock issued—are irrelevant and are not a part of any capital budgeting analysis. The cost of
the financing is captured in the discount rate, or hurdle rate, 3 used to discount the future cash flows for
discounted cash flow methods (which will be explained later). To include the cash flows for financing in the
analysis would be to double count them. If financing can be obtained on a more favorable basis than antic-
ipated, it could add value to the project; however, the financing cash flows are never included in the capital
budgeting analysis that is used to decide whether or not to accept a proposed capital budgeting project.
Example of Calculation of After-Tax Relevant Cash Flows

CMA Products, Inc. is considering the purchase of a new piece of equipment to introduce a new product
line. The equipment will cost $125,000 including setup costs, installation, and testing. The estimated before-
tax annual cash flow from operations is $50,000, and the investment will require an initial investment in
working capital of $25,000. The estimated salvage value at the end of Year 9 is $10,000. CMA has an
effective income tax rate of 30%.
The equipment will have an economic life of nine years but will be depreciated for tax purposes over seven
years using MACRS. The MACRS depreciation rates for each of the eight years (using the half-year conven-
tion) are:
Year 1 14.29%
Year 2 24.49%
Year 3 17.49%
Year 4 12.49%
Year 5 8.93%
Year 6 8.92%
Year 7 8.93%
Year 8 4.46%
The relevant after-tax cash flows are:
1) Net Initial Investment:

Initial investment in equipment $(125,000) cash outflow
Initial investment in working capital (25,000) cash outflow
Disposal of old equipment 0.00
Net Initial Investment $(150,000)
2) After-Tax Cash Flow from Operations (excluding depreciation effect):
$50,000 before-tax CF × (1 − 0.30) = $35,000 net cash inflow per year
3
The hurdle rate is the minimum rate of return on a project or investment required by company management or an
investor. The company’s cost of capital is usually the hurdle rate for a capital budgeting project. However, if management
perceives unusual risk in an investment, it should set the hurdle rate higher than the cost of capital to compensate for
the additional risk it is taking.
3) Depreciation Tax Shield (30% of depreciation; varies due to varying MACRS depreciation
rates):
Year 1 $125,000 × 0.1429 × 0.30 = $5,359

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

Cash received from disposal $10,000
Gain on disposal: $10,000 − $0 tax basis = $10,000
Income tax is 30% on the gain: $10,000 × 0.30 (3,000)
After-tax cash flow from disposal, Year 9 $ 7,000
Therefore, the relevant, after-tax cash flows per year are:
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9
Initial (125,000)
Investment in
Equipment
Working ( 25,000) 25,000*

Capital
Increase
After-Tax Cash 35,000 35,000 35,000 35,000 35,000 35,000 35,000 35,000 35,000
Flows from
Operations
Depreciation 5,359 9,184 6,559 4,684 3,349 3,345 3,349 1,671 -0-
Tax Shield
After-Tax CF 7,000
from Disposal
Total After Tax (150,000) 40,359 44,184 41,559 39,684 38,349 38,345 38,349 36,671 67,000
Cash Flows
* Recovery of released working capital.
Note: Any increase in working capital that occurs during any year subsequent to Year 0 is a reduc-
tion of the cash inflows for that period. In the preceding example, the increase in working capital came
in Year 0. However, increases in working capital could occur in other years, as well.
The working capital is released in the final year of the project and becomes a cash inflow at that time.
Section E Study Unit 2: E.2. Payback and Discounted Payback Methods
Study Unit 2: E.2. Payback and Discounted Payback Methods

E.2. Capital Investment Analysis Methods
To answer capital budgeting questions, candidates must be able to make calculations related to different
investment analysis methods and also make decisions about which investment or investments a company
should pursue given a set of circumstances.
The capital budgeting methods that are covered on the CMA exam are:
1) Payback Period or Payback Method
2) Discounted Payback Period or Discounted Payback Method (Breakeven Time)
3) Net Present Value
4) Internal Rate of Return
All of the four methods are based on the relevant after-tax cash flows as demonstrated previously and also
use time value of money concepts. An explanation of Time Value of Money concepts is available to download
from My Studies alongside the download for this textbook.
Payback Period or Payback Method

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

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

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

(150,000) 40,359 44,184 41,559 39,684 … 67,000
Cash Flows
Cumulative
(150,000) (109,641) (65,457) (23,898) 15,786
Cash flows
* Recovery of released working capital.
Section E Study Unit 2: E.2. Payback and Discounted Payback Methods
The cumulative cash flow from the project becomes positive sometime during Year 4. Assuming that the
cash flows occur evenly throughout the year, the exact payback period is 3.6 years, calculated as follows:
Number of the project year in the final year when cash flow is negative: 3
Plus: a fraction consisting of:

Numerator = The positive value of the negative cumulative cash inflow
amount from the final negative year 23,898
Denominator = Cash inflow for the following year 39,684
23,898
Payback Period = 3 + = 3.6 years
39,684
Benefits of the Payback Method of Capital Budgeting
• It is simple and easy to understand.
• When a company has several proposals to consider, the payback method can be useful for prelimi-
nary screening by showing which ones will recoup the company’s investment quickly.
• It can be useful when expected cash flows in later years of the project are uncertain. Cash flow
predictions for periods far in the future are less certain than predictions for three to five years ahead.
• It is helpful for evaluating an investment when the company desires to recoup its initial investment
quickly.
• Since the Payback Method favors projects with short time horizons, it can be used to concentrate
on more liquid projects and thus avoid tying up capital for long periods of time.
• The Payback Method can help a company manage risk when evaluating the feasibility of a project
in an unstable environment, where quick profit-making is preferable.
Limitations of the Payback Method of Capital Budgeting
• It ignores all cash flows beyond the payback period and does not consider total project profitability.
Therefore, a project that has large expected cash flows in the latter years of its life could be rejected
in favor of a less profitable project that has a larger portion of its cash flows in its early years.
• The Payback Method does not incorporate the time value of money. Therefore, interest lost while
the company waits to receive money from the project is not considered.
• It does not consider a project’s return on investment.
• It does not consider a project’s profitability or the amount of risk.
• It ignores the cost of capital, so the company could accept a project for which it will pay more for
its capital than the project can return.
Discounted Cash Flow Methods of Capital Budgeting
Introduction to Discounted Cash Flow Methods

Discounted cash flow (DCF) methods measure all of the expected cash inflows and outflows of a project
using time value of money concepts. The premise of time value of money concepts is that money received
today is worth more than money received in any future period. In a discounted cash flow analysis, the
earlier that a project is able to generate cash inflows the better, because cash flows received earlier in a
project’s life are worth more than cash flows received later.
Study Unit 2: E.2. Payback and Discounted Payback Methods CMA Part 2
Note: An explanation of Time Value of Money is available in My Studies alongside the download for this
textbook. Candidates who are not familiar with time value of money concepts should read that infor-
mation before proceeding. Present value tables are available in that document and also in Appendix A.
Discounted cash flow methods focus on the expected cash inflows and outflows from the project rather than
using income as the measurement basis, as in accrual accounting. The focus of discounted cash flow meth-
ods is on the cash return that can be obtained in the future for a cash outlay now.
In discounted cash flow analysis, unless otherwise directed, always assume that all expected cash flows
occur at the end of the year. In some instances, a problem may say that a particular cash flow occurs at
the beginning of the year. If that happens, treat the cash flow occurring at the beginning of the year as
though it occurs at the end of the previous year.
Though this assumption about cash flows occurring only at the end of a year is not in line with reality, it is
a necessary assumption in order to be able to use discounted cash flow techniques to determine the present
value of the expected cash flows. The inaccuracy introduced by this assumption is not material to the
analysis and would not cause a change in the decision.
The Discounted Payback Method, the Net Present Value Method, and the Internal Rate of Return Method
use discounted cash flows.
Discounted Payback Period or Method (Breakeven Time)

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

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

(150,000) 40,359 44,184 41,559 39,684 38,349 … 67,000
Cash Flows
PV of $1 Factor
1.000 0.909 0.826 0.751 0.683 0.621
for 10%
Discounted
(150,000) 36,686 36,496 31,211 27,104 23,815
Cash Flow
Cumulative Dis-
counted Cash (150,000) (113,314) (76,818) (45,607) (18,503) 5,312
Flows
*Recovery of released working capital
Section E Study Unit 3: E.2. Net Present Value Method
Note that each annual cash flow amount is discounted individually using the present value of $1 factor for
10% for the appropriate term. Discounting each annual cash flow individually is necessary because the cash
flows vary each year, and the present value of an annuity factor cannot be used when cash flows vary. Yet
even if the cash flows did not vary during the period of the project, each year’s cash flow would still need
to be discounted individually when the Discounted Payback Method is being used. Annual discounted cash
flow information is needed to determine the number of years until the initial investment is paid back in
discounted cash inflows. Discounting a series of cash flows as an annuity results in only one amount: the
present value of all the future expected cash flows, and that is not useful for calculating the Discounted
Payback Period.
Because the Discounted Payback Method uses cumulative discounted expected cash flows instead of cu-
mulative undiscounted expected cash flows, the payback period is longer under the Discounted Payback
Method than it is under the Payback Method.
Calculation of the Discounted Payback Period:
Number of the project year in the final year when cash flow is negative: 4
Plus: a fraction consisting of:

Numerator = The positive value of the negative cumulative discounted
cash inflow amount from the final negative year 18,503
Denominator = Discounted cash inflow for the following year 23,815
18,503
Discounted Payback Period = 4 + = 4.8 years
23,815
The Discounted Payback Period is 4.8 years, compared with 3.6 years under the Payback Method using
undiscounted cash flows.
The benefits and limitations of the Discounted Payback Method are similar to those of the Payback Method
with one difference: because it uses discounted cash flows, the Discounted Payback Method does incorpo-
rate the time value of money. However, it still fails to account for expected cash flows after the payback
period.
Exam Tip: If a question asks for the breakeven time, it is asking for the Discounted Payback Period.
Study Unit 3: E.2. Net Present Value Method

Net Present Value (NPV) Method
The Net Present Value (NPV) method is based on the present value of the expected monetary gain or loss
from a project. All expected cash inflows and outflows are discounted to the beginning of the project, using
the required rate of return. The NPV of an investment or project is the difference between the present
value of all future expected cash inflows and the present value of all (initial and future) expected
cash outflows, using the required rate of return.4
Thus, a project’s NPV is the present value of its future expected cash inflows minus the present value of its
future expected cash outflows. The initial cash outflow occurs at the very beginning of the project, so that
amount is not discounted (or if it is, it is “discounted” by multiplying it by 1.0). Some projects may have
other net cash outflows (negative cash flows) in subsequent years of the project. If so, those future negative
4
“Hurdle” rate, “discount rate,” “cutoff rate,” and “cost of capital” may all be used in the exam to refer to the required
rate of return.
Study Unit 3: E.2. Net Present Value Method CMA Part 2
cash flows are also discounted and the discounted cash outflow amounts are also deducted from the present
value of the project’s future expected cash inflows.
The present value of the expected cash flows is calculated using a discount rate that is the company’s
required rate of return (RRR), which is one of two options:
1) The return the company can expect to receive in the market for an investment of comparable
risk
2) The minimum rate of return that the project must earn to justify investment of the resources
This required rate of return is also called the discount rate, hurdle rate, or opportunity cost of capital.
Generally, the company’s cost of capital is used as the discount rate.5 However, the required rate of return
used to discount the future expected cash flows and compute the NPV must be appropriate to the pro-
ject’s risk. Adjustment of the required rate of return to reflect risk is covered in more detail later.
Relevant expected cash flows used in the Net Present Value capital budgeting analysis include:
• Initial net cash outflows, including the cost of the asset or assets and increased working capital
requirements
• Initial cash inflow from the sale of existing assets if new assets are replacing existing assets,
net of the tax effect of any gain or loss
• Net cash outflows that may be expected to occur subsequent to the beginning of the
project, such as additional investments required during the project
• Operating cash inflows (increased revenues and reduced expenses) net of related income taxes
• Operating cash outflows (expected operating losses or increased expenses) net of the related
reduction in income taxes
• Tax savings from the depreciation tax shield
• Cash proceeds from the sale of the asset at the end of the project, net of the tax effect of any
gain or loss on the sale
• Working capital released at the end of the project
Note: Recall that in discounted cash flow analysis, unless otherwise directed, always assume that all
expected cash flows occur at the end of the year. The net present value that results will be slightly
understated because cash flows actually occur uniformly throughout each year. However, the net present
value will be usable because any inaccuracy introduced by that assumption will not be material to the
analysis and would not cause a change in the decision.
5
Cost of capital is covered in Section B, Corporate Finance, in Volume I of this textbook.
Interpretation of an NPV Analysis

An NPV analysis is interpreted as follows:
• When a project has a positive NPV, it will be profitable because it will earn more than it will cost
the company. Shareholder wealth will increase. The project is acceptable.
• When a project has a zero NPV, the present value of its expected future cash inflows is exactly
equal to the present value of the expected cash outflows. Shareholder wealth would neither in-
crease nor decrease. A project with a zero NPV is questionable at best. Technically, the company
would not lose money on it, but a zero NPV does not provide any motivation to embark upon the
project. Furthermore, the project would have no margin of safety. If the expected cash inflows
were not achieved, the project could quickly become unprofitable.
• When a project has a negative NPV, the project would be unprofitable because it would cost the
company more than it could earn. Shareholder wealth would decrease. The project is not accepta-
ble.
Calculation of Net Present Value

Note: Net Present Value can be calculated with a financial calculator or calculated manually using factor
tables. Five models of financial calculators are permitted in the CMA exams, according to the ICMA’s CMA
Candidate Handbook, but they are optional and are not required. If present value is called for in an exam
question, the factor tables will be provided. The five models of financial calculators permitted are:
 Texas Instruments BA II Plus (not the BA II Plus Professional),
 HP 10bII+,
 HP 12c, or
 HP 12c Platinum.
 The HP 10BII is also valid for use on the exam but is no longer available for purchase.
The following discussion explains calculation of NPV using factor tables.
Example 1: A Series of Unequal Cash Flows

Returning to the example of CMA Products: CMA Products, Inc. is considering the purchase of a new piece
of equipment to introduce a new product line. The equipment will cost $125,000 including setup costs,
installation, and testing. The estimated before-tax annual cash flow from operations is $50,000, and the
investment will require an initial investment in working capital of $25,000. The estimated salvage value at
the end of Year 9 is $10,000. CMA has an effective income tax rate of 30%. The required rate of return for
CMA Products is 10%.
tion) are:
Year 1 14.29%
Year 2 24.49%
Year 3 17.49%
Year 4 12.49%
Year 5 8.93%
Year 6 8.92%
Year 7 8.93%
Year 8 4.46%
The calculation of the project’s NPV follows.
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9
Net Initial
(125,000)
Investment
Working Capi-
(25,000) 25,000*
tal Increase
After-Tax Cash
Flows from Op- 35,000 35,000 35,000 35,000 35,000 35,000 35,000 35,000 35,000
erations
Depreciation
5,359 9,184 6,559 4,684 3,349 3,345 3,349 1,671 -0-
Tax Shield
After-Tax Cash
Flows from 7,000
Disposal
Total After Tax

(150,000) 40,359 44,184 41,559 39,684 38,349 38,345 38,349 36,671 67,000
Cash Flows
PV of $1 Factor
1.000 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424
for 10%
Discounted
(150,000) 36,686 36,496 31,211 27,104 23,815 21,627 19,673 17,125 28,408
Cash Flow
Cumulative
Discounted (150,000) (113,314) (76,818) (45,607) (18,503) 5,312 26,939 46,612 63,737 92,145
Cash Flows
*Recovery of released working capital.
The cumulative discounted expected cash flow at the end of the project, which is its NPV, is $92,145.6
The NPV of a project is also the sum of all the discounted cash inflows and outflows from the project over
its life minus the initial investment. In this case, the sum of all the discounted cash inflows from the project
over its life is $242,145, while the net investment is $150,000. Thus, the NPV is $242,145 − $150,000 =
$92,145.
Since the NPV is positive, this project is acceptable.
If all the future expected net cash flows are positive, the Net Present Value can be calculated as:
NPV = PV of future expected net cash inflows – initial investment
If some future expected net cash flows are negative, the Net Present Value is calculated the same
way as it was in the above example, except that the negative discounted cash flows reduce the cumulative
discounted cash flows.
6
The number of decimal places in the factors used to calculate the present values of the cash flows will affect the
project’s net present value. The greater the number of decimals used in the factors, the more accurate will be the
calculation of the NPV. Factors used in examples in this book are from the factor tables provided in Appendix A in this
volume. The use of rounded factors does not impact the decision that would result from use of the resulting NPV.
Note: The cash outflows in Year 0 are multiplied by 1.000 on the “PV of $1 Factor” line in the cash flow
analysis because they are, in a sense, already discounted. They occur at the point to which all the future
cash flows are being discounted.
If additional cash outflows are planned for future periods, those additional cash outflows will need to be
included as a reduction in the future net cash flows and discounted along with them.
Example 2: A Series of Equal Cash Flows

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

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

Cash flows that go on and on without end are called a “stream of perpetual cash flows.” If the annual
amounts are all the same, the cash flow is called a “perpetual annuity.”
The present value of a stream of perpetual, equal, cash flows is called the Zero Growth Dividend Model,
which is also used for valuing preferred stock.7 Calculation of the net present value of a perpetual annuity
is a two-step process:
1) The present value of the annual cash inflows is:
Annual cash flow

PV =
Required rate of return
2) The net present value of the project is the present value calculated in Step 1 minus the initial
investment:
NPV = PV – Initial investment
7
See Vol. 1 of this textbook, Section B, Long-Term Financial Management, for information on valuing preferred stock.
Example: Perpetua Enterprises plans to invest $40,000 in a project expected to generate after-tax cash
flow of $5,000 each year, beginning with Year 1 and continuing indefinitely. Perpetua’s required rate of
return is 10%. What is the NPV of the project?
1) The present value of a perpetual stream of $5,000 after-tax cash flows, discounted at 10%, is:
Annual cash flow

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

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

PV =
Required rate of return − Growth rate
2) The net present value of the project is the present value minus the initial investment:
The formula for the present value of a growing annuity is the same as the formula for the Constant Growth
Dividend Model, which is used for valuing common stock when the dividends are growing.8 The Constant
Growth Dividend Model is:
Next annual dividend (expected next period)

P0 =
Investors’ required rate of return – the annual future growth rate of the dividend
The dividend used in the Constant Growth Dividend model needs to be the next annual dividend. So, when
using this model to calculate the present value of a growing stream of perpetual cash flows, make sure to
use the cash flow amount expected at the end of the first year.
8
For information on valuing common stock, see Vol. 1 of this textbook, Section B, Long-Term Financial Management.
Example: Perpetua Enterprises plans to invest $40,000 in a project. Perpetua Enterprises expects the
net after-tax cash flow at the end of the first year to be $5,000, but it expects the cash flow to grow
by 5% each subsequent year in perpetuity. Perpetua’s required rate of return is 10%. What is the
NPV?
1) The present value of this growing, perpetual stream of after-tax cash flows is
$5,000
PV = = $100,000
0.10 – 0.05
2) The net present value (NPV) of the project is the $100,000 present value of the cash inflows minus
the initial investment of $40,000:
NPV = $100,000 − $40,000
NPV = $60,000
The Importance of the Discount Rate Choice

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

To determine the appropriate discount rate to use, start with the optimal capital structure. “Capital
structure” refers to the funding structure or the composition of a company’s long-term debt, common eq-
uity, and preferred stock. The optimal capital structure is the unique capital structure that minimizes the
company’s composite cost of long-term capital and therefore maximizes its value. The proportion of each
capital component in the optimal capital structure is multiplied by its cost to the company and the result is
its Weighted Average Cost of Capital (WACC).9
The WACC is the opportunity cost of capital for the company’s existing assets. The weighted average
cost of capital is the appropriate discount rate for capital budgeting decisions and NPV calculations as long
as the riskiness of the project is the same as the riskiness of existing projects.
9
The weighted average cost of capital is covered in Volume 1 of this textbook, Section B, Corporate Finance, Long-Term
Financial Management, Cost of Capital.
For the risk premium to remain unchanged as a result of the capital expansion project, the following con-
ditions must be met:
• New assets financed by the new capital must not substantially change the operating environment.
• The new capital must be raised in the same proportions as the existing capital, so that the firm’s
capital structure and financial risk remain the same.
The optimal mix of the various sources of capital (such as debt, preferred stock, and common stock) is a
controversial issue in finance. Even so, by raising new capital in the same proportions as existing capital,
the firm should leave its financial risk unchanged. Assuming the above conditions are met, a company’s
current weighted average cost of capital can be used as the required rate of return.
Using NPV
In general, any project with a positive NPV should be accepted because these projects will increase share-
holder wealth. Conversely, any project with a negative NPV should be rejected. However, perhaps due to
limited funds or certain nonfinancial factors, not all projects with positive NPVs will be chosen. Therefore, a
more accurate statement is that any project with a positive NPV is a candidate for further consideration.
When a firm has limited funds to invest, NPV enables management to rank the various projects according
to the amount that each one is expected to return.
Exam questions about NPV can become fairly detailed and include a lot of information. It is best to focus
on the present value of the cash flows, both cash in and cash out, associated with the project.
In working with the cash flows, remember that even though depreciation is a non-cash expense, it
does have a cash flow impact through reduction of the income taxes paid.
Problems With NPV

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

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

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

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

A project may provide cash flows beyond its initial expected lifetime, which can provide additional share-
holder value; but those additional cash flows are not recognized in the NPV analysis.
The Effect of the Discount Rate on NPV and the NPV Profile
The discount rate used has an important effect on the final NPV. The higher the discount rate, the lower
the NPV; and the lower the discount rate, the higher the NPV.
Below is an example of a project and the NPVs that result from various hurdle rates used to discount its
cash flows:10
Project Y
Hurdle Rate Project NPV
25% $(50,368)
20% 2,500
15% 54,200
10% 116,800
5% 193,200
0% 287,000
A graph that shows the relationship between a project’s net present values at various discount rates is
called the project’s NPV Profile. Following is the NPV Profile of the project above:
$350,000
NPV Profile
$300,000 Project Y
$250,000
$200,000
NPV
$150,000
$100,000
$50,000
$0
0% 5% 10% 15% 20% 25%
-$50,000
-$100,000 Discount Rate
10
The NPVs in this chart cannot be recalculated because the backup information for them is not provided.
The NPV profile line crosses the x-axis at a discount rate of a little more than 20%. The table showing
Project Y’s various possible hurdle rates and the resulting NPVs at each rate shows that at a discount rate
of 20%, the NPV is closest to zero, and at a discount rate of 25%, the NPV profile line is in negative territory,
or $(50,368) on the graph above.
The NPV Profile graph will be used in the next topic, Internal Rate of Return.
Benefits of the Net Present Value Method of Capital Budgeting
• It provides an estimate of the profitability of a project and the amount of change in shareholder
wealth that should take place if the project is undertaken.
• It takes into consideration the time value of money.
• Net present value incorporates the impact of all the cash flows associated with the project.
• It can be used to manage risk in a project by adjusting the required rate of return used as the
discount rate to compensate for projects with higher or lower risk than the company’s current pro-
jects.
• NPV enables ranking of potential projects according to their expected returns, which is useful when
a firm has limited funds for capital projects.
Limitations of the Net Present Value Method of Capital Budgeting
• NPV incorporates an assumption that all cash inflows from the project will be reinvested at the
required rate of return, which may not be the case and which may lead to an incorrect evaluation of
the project’s true worth.
• Since the NPV is expressed as a monetary amount, it does not provide an expected rate of return
on the investment.
• There is the risk of incorrect assumptions, which can affect the validity of the results.
• The net present value is very sensitive to the discount rate used, and that rate is subject to estima-
tion.
• The firm’s actual cost of capital may vary significantly from the discount rate used in the NPV analysis
due to market fluctuations, which can cause the actual change in shareholders’ value to be different
from the initial estimates.
• NPV is not useful for comparing projects of different sizes.
• Cash flows beyond the initial expected lifetime of the project are not recognized in an NPV analysis
but can provide additional shareholder value.
Section E Study Unit 4: E.2. Internal Rate of Return
Study Unit 4: E.2. Internal Rate of Return

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

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

Below are the various hurdle rates and the NPVs of each for Project Y again:
Project Y
Hurdle Rate Project NPV
25% $(50,368)
20% 2,500
15% 54,200
10% 116,800
5% 193,200
0% 287,000
On the following graph of Project Y’s NPV Profile (the graph of the above chart), the NPV profile line crosses
the horizontal axis where the NPV is zero, at approximately 20%.
Study Unit 4: E.2. Internal Rate of Return CMA Part 2
The point where the NPV profile line crosses the horizontal axis—where the NPV is zero—is the project’s
IRR. This project’s IRR is approximately 20%, because that is the discount rate at which the project’s NPV
becomes zero.
$350,000
NPV Profile
$300,000 Project Y
$250,000
$200,000
NPV
$150,000
$100,000
$50,000
$0
0% 5% 10% 15% 20% 25%
-$50,000
-$100,000 Discount Rate
Evaluating IRR
If the IRR is higher than the required rate of return management has established for the project (or the
hurdle rate), the project is acceptable. If the IRR is lower than the required rate of return, the project is
not acceptable and should not be considered further.
Remember that the IRR is a rate, in contrast to NPV, which is a monetary amount.
Note: The IRR calculation incorporates an assumption that the cash inflows from the project can be
reinvested at the project’s Internal Rate of Return; however, the cash inflows from the project may
not be able to be reinvested at the assumed rate. If the cash inflows cannot be reinvested at the Internal
Rate of Return, then the IRR will not represent a project’s true rate of return.
The modified IRR attempts to deal with this problem. The modified IRR incorporates an assumption
that the cash flows received from the project are reinvested at the company’s cost of capital rate,
rather than the IRR rate.
Example: The following facts relate to a proposed capital budgeting project.
• The initial investment is $150,000.

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

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

A conventional project begins with a cash outflow followed by several cash inflows. In other words, the
direction of the cash flow changes just once, from negative in Year 0 to positive in Year 1, and remains
positive throughout the remainder of the project’s life. However, not all projects follow this conventional
pattern. Cash flows might change in different directions over the course of many years, alternating between
positive and negative.
If a project has a negative expected cash flow or flows after Year 0, for instance if an additional investment
is required during a subsequent year, the project is called a nonconventional project. A nonconventional
project may have more than one IRR because more than one discount rate will cause the project’s NPV to
be zero. The number of IRRs will be equal to the number of sign changes in the cash flows, including the
sign change following the initial investment in Year 0. In other words, a conventional project will have only
one IRR because it has only one sign change: the change from a negative cash flow in Year 0 to a positive
cash flow in Year 1. But a nonconventional project that has a sign change after the initial investment
because of a negative cash flow in a subsequent year will actually have three sign changes and three IRRs:
the first sign change when the negative cash flow in Year 0 becomes a positive cash flow in Year 1, and
then two more sign changes. One of the additional sign changes takes place when the cash flow becomes
negative in the subsequent year and the other additional sign change takes place when the cash flow again
becomes positive during a later year.
Multiple IRRs are usually not a problem, since generally only one of the IRRs will fall within reasonable
parameters, while the other IRRs can vary widely, such as 500% or −50%, or even as high as 10,000%.
However, if the multiple solutions cause a financial calculator to return an error message, then the IRR
cannot be calculated on the financial calculator.
Thus, if a project has more than one change in annual cash flow direction, it is better to evaluate it on the
basis of its NPV rather than on its IRR.
Study Unit 4: E.2. Internal Rate of Return CMA Part 2
Mutually Exclusive Projects

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

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

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

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

Year 1 800,000 70,000
Year 2 475,000 150,000
Year 3 7,000 525,000
Year 4 5,000 800,000
Net Discounted Cash Flow 287,000 545,000
IRR 20.3% 14.2%
Below is a table showing the two projects’ NPVs at various required rates of return (or hurdle rates):
Project J Project K
Hurdle Rate NPV NPV
25% ( 50,368) (251,520)
20% 2,500 (123,200)
15% 54,200 ( 20,100)
10% 116,800 116,800
5% 193,200 299,400
0% 287,000 545,000
The table shows a number of significant facts:
1) At the hurdle rate of 10%, the NPVs of the two projects are identical: $116,800. Therefore, for
these two projects, 10% is the crossover rate.
2) The hurdle rate used determines which of the two projects has a higher NPV, and the dividing point
is the crossover rate.
• When discounted at hurdle rates higher than the crossover rate, the NPVs and the IRRs give
the same result: Project J is the better project.
• When discounted at hurdle rates lower than the crossover rate, NPV and IRR give different
results. Project K is the more attractive project according to the NPVs, though Project J has
the higher IRR.
When the timing of cash flows for mutually exclusive projects is different, the IRR can give varying results
depending on the hurdle rate used. NPV is more reliable because its results show amounts of profit instead
of rates of return for the two projects.
Study Unit 5: E.2. Capital Budgeting Methods – Other Topics CMA Part 2
Benefits of the Internal Rate of Return Method of Capital Budgeting
• As a discounted cash flow method, the IRR accounts for the time value of money.
• The IRR can be compared with a required rate of return that is based on market return rates for
similar investments or another hurdle rate chosen by management.
• It is easier for managers to understand and interpret than net present value.
Limitations of the Internal Rate of Return Method of Capital Budgeting
• The IRR incorporates an assumption that the cash inflows from the project will be reinvested at the
Internal Rate of Return. If that is not a valid assumption, the calculated IRR will not represent the
project’s true rate of return.
• If a project is nonconventional (has a negative cash flow or flows after Year 0), it will have more
than one IRR, or the IRR may not be able to be calculated.
• When investments are mutually exclusive and are of different sizes or have different cash flow
patterns, the information provided by the IRR may not be useful for decision making.
Study Unit 5: E.2. Capital Budgeting Methods – Other Topics

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

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

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

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

To summarize the NPV versus the IRR capital budgeting methods in the event of a conflict:
1) In most instances when there is a conflict between NPV and IRR, rely on the NPV.
2) When there is a scale difference because the investments are of different amounts, IRR and NPV
can return different results. The correct choice depends on whether the firm’s goal is to maximize
shareholder wealth (use NPV) or to maximize the rate of return on investments (use IRR). Short-
lived projects with smaller up-front investments may have very high IRRs but may not add much
value either to the firm or to shareholder wealth.
3) Rely on IRR instead of NPV in the case of a scale difference only if the firm’s goal is to maximize
return on investment instead of maximizing shareholder wealth.
Capital Budgeting and Inflation

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

Real Expected Cash Flow =
(1 + Inflation Rate)n
Example: An $11,000 nominal expected cash flow to be received in one year when inflation is expected
to be 2% annually is equivalent to real cash flow received in one year of:
$11,000
Real Expected Cash Flow = = $10,784
(1.02)1
If that same $11,000 nominal expected cash flow were to be received in two years instead of one, with
an expected inflation rate of 2% annually over the two-year period, the real expected cash flow to be
received in two years is:
$11,000
Real Expected Cash Flow = = $10,573
(1.02)2
A nominal rate of return can be converted to a real rate of return as follows:
1 + Nominal Rate
Real Rate of Return = − 1
1 + Inflation Rate
Example: With a nominal rate of return of 6% and an inflation rate of 2%, convert the nominal rate
of return to a real rate of return as follows:
1 + 0.06
Real Rate of Return = − 1 = 3.92%
1 + 0.02
Converting Real Cash Flows and Rate of Return to Nominal Cash Flows and Rate of Return
Sometimes, the real expected cash flows and rate of return need to be converted to nominal expected
cash flows and rate of return for capital budgeting purposes.
For example, a company is considering investing in a product and expects to sell 1,000 units each year for
four years. Furthermore, it expects a net cash inflow of $10 per unit if there were no inflation during the
life of the project. Therefore, with no inflation, the company can expect a net cash inflow of $10,000 per
year for the life of the project ($10 per unit multiplied by 1,000 units sold each year).
However, if inflation is factored in during the sales period, the company should expect progressively higher
cash inflows in each subsequent year, even though no increase in sales volume takes place. These increased
figures are nominal expected cash flows, and they represent the transactions that will be recorded in the
accounting system. The net expected cash inflows of $10,000 assuming no inflation are the real expected
cash inflows, which are not recorded in the accounting system.
Real expected cash flows and rates of return can also be converted to nominal cash flows and rates of
return.
To convert a real expected cash flow to a nominal expected cash flow, multiply the real cash flow by the
inflation factor, which is (1 + Inflation Rate)n, where n is the number of years from Year 0:
Nominal Expected Real Expected Cash Flow ×

=
Cash Flow (1 + Inflation Rate)n
Example: The following illustrates real expected cash flows converted to nominal expected cash flows
for capital budgeting.
Assume that real expected cash inflows are $10,000 per year for four years, and expected annual infla-
tion is 3%:
Before-Tax Before-Tax
Expected Expected
Real Cash Cumulative Nominal Cash
Year Flows Inflation Factor Inflows
1 $10,000 × 1.031 or 1.0300 = $10,300
2 10,000 × 1.032 or 1.0609 = 10,609
3 10,000 × 1.033 or 1.0927 = 10,927
4 10,000 × 1.034 or 1.1255 = 11,255
This capital budgeting analysis can now use the nominal expected cash flows calculated for Years 1
through 4. The amount of the initial investment is not adjusted, because it is assumed to take place
before the impact of the future inflation.
Future expected cash flows and the required rate of return both need to be adjusted for inflation. In other
words, if one is adjusted, the other must also be adjusted.
The real required rate of return is the rate of return required to cover the risk inherent in an investment.
Like real cash flow, it assumes no inflation. The real rate of return includes two components:
1) The risk-free rate of return, assuming no expected inflation, which is approximated by the rate for
long-term government bonds.
2) A risk premium, which is required to compensate for the business risk foreseen.
The nominal required rate of return consists of three elements because it includes a component for
inflation:
1) The risk-free rate of return, assuming no expected inflation, which is approximated by the rate for
long-term government bonds.
2) A risk premium, which is required to compensate for the business risk foreseen.
3) An inflation element, which is a premium above the real rate that is required to offset the expected
decline in purchasing power due to inflation.
Rates of return quoted on financial markets are nominal rates because investors demand compensation
for both the investment risk they assume and for the expected decline in their purchasing power due to
inflation.
The nominal rate of return will be slightly higher than the real rate plus the inflation component because
inflation decreases the purchasing power of both the principal and the real rate of return earned each year.
The nominal rate of return is calculated as follows:
Nominal Rate of Return = (1 + Real Rate of Return) × (1 + Inflation Rate) – 1
Example: If inflation is expected to be 3% per year, to convert a real rate of return of 5% to a nominal
rate of return, the calculation is:
Nominal Rate = (1 + 0.05) × (1 + 0.03) − 1
= (1.05 × 1.03) − 1
= 1.0815 − 1
= 0.0815 or 8.15%
When incorporating inflation into a capital budgeting analysis, adjust both the expected real cash flow and
the real required rate of return to nominal values. The nominal required rate of return, as shown above, is
used to determine the present value of each of the annual nominal expected cash flows.
The same nominal rate of return is used to discount the expected cash flow for every year of the project;
it is not adjusted upward annually.
Note: If the required rate of return used to discount the cash flows of a project includes a premium for
inflation, then expected cash flows used in the analysis must also include a premium for infla-
tion.
Example: The following illustrates the calculation of net present value using adjustments for inflation.
• The inflation rate is 3%.

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

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

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

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

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

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

∓ Net (increase) decrease in operating expenses, excluding depreciation
= Net incremental operating cash flow before taxes
∓ Net (increase) decrease in income taxes on operating cash flow
= Net incremental operating cash flow after taxes
± Depreciation tax shield: net increase (decrease) in depreciation expense for
tax purposes × tax rate
= Incremental net cash flow for the period
Determining Incremental Net Cash Flow in Final Year of the Project
Incremental net cash flow for the period (as above), not including project
termination considerations
± Proceeds from sale or (costs of disposal) of asset(s)
∓ (Taxes on gain) or tax savings on loss from disposal of asset(s)
± Recovered net working capital or (increased net working capital)
= Final year’s incremental net cash flow
Section E Study Unit 6: E.2. Risk in Capital Budgeting
Study Unit 6: E.2. Risk in Capital Budgeting

Risk in Capital Budgeting
Capital budgeting always entails risk, and risk must be factored into the capital budgeting process.
The expected value of future cash flows used for each year in a capital budgeting analysis is an average
of all the possible cash flows for that year as determined by management. The expected cash flows used
are weighted averages of all of the possible cash flows, with the probabilities of each cash flow occurring
serving as the weights. Thus, several possible cash flows will be projected for each year of a project’s life
and probabilities will be determined for each possible cash flow for each year so that the expected value of
the cash flows for each year can be calculated.
An expected value is a “long-run” average value. The expected value is used to express the most likely
result of a decision in situations involving risk and uncertainty. However, an expected value is more reliable
as a long-run average forecast and less reliable as a forecast for the net cash flow for an individual project
for a given year. Despite not being reliable as a short-term forecast, expected value is often used to project
future cash flows from individual projects because it is the best method available for obtaining a forecast.
Due to its long-run nature, though, achievement of the expected cash flows used in a capital budgeting
analysis is not a certainty. The problem with using expected value as a forecast for a specific project is that
any given project has only one opportunity to achieve its cash flow for each of the years of its duration and
then the project is complete. The cash flow actually achieved for any project could be anywhere from its
lowest possible cash flow to its highest possible cash flow or even outside that range. Numerous factors can
affect a project’s net cash flows.
Risk for an investment can be measured by the variability, or dispersion, of its potential returns around
their average, or mean, return. (The mean is the weighted average, or the expected value.) The dispersion
of a set of potential returns about their mean is measured by the variance and the standard deviation of
the potential returns. The amount of dispersion is important because it is a measurement of risk. If the
values are highly dispersed about their mean, then they vary widely from their expected value.
Note: Variation in potential results causes risk, because the more variation there is in the potential cash
flows, the greater the risk will be that the actual value will not fall within the anticipated interval.
The more widely that the potential investment returns are dispersed, the greater will be the potential for
loss or gain and thus the riskiness of the investment increases. In determining the various possible cash
flows for use in calculating each year’s expected cash flow, management must:
1) Determine which influences (for example economic events, labor conditions, or international con-
ditions) have affected the net cash flows of similar projects in the past
2) Determine probabilities of each influence or event occurring
3) Make assumptions about the effect or effects of each influence on the project.
After following these steps, the financial manager can estimate the impact that each assumption might
have on the various possible net cash flows in each year of the project’s life and, using the probabilities,
calculate the expected cash flows for each year of the project’s life. A project judged to be riskier may be
evaluated using a higher required rate of return in order to compensate for the increased risk.
Risk analysis can be focused narrowly on each investment opportunity or on the entire investment portfolio.
In theory, a diversified portfolio can lower the overall risk of investments because different risks may affect
different assets. Cash flows and rates of return that are higher than expected on some projects can offset
cash flows and rates of return that are lower than expected on other projects.
Study Unit 6: E.2. Risk in Capital Budgeting CMA Part 2
Example: XYZCo is comparing two capital budgeting proposals, both for one-year projects and both
requiring the same investment. Management has made several forecasts for the cash flows, as follows:
Project A Project B
Economy in a deep recession $200,000 $100,000
Economy in a mild recession 250,000 200,000
Economy stable 300,000 300,000
Economy in a minor expansion 350,000 400,000
Economy in a major expansion 400,000 500,000
The company’s economists forecast that the probability of a deep recession occurring next year is 5%,
a mild recession 10%, a stable economy 50%, a minor expansion 25%, and a major expansion 10%.
Using these probabilities, the expected values of the cash flows for both projects are as follows:
Probability Project A Project B

(P) Cash Flow CF×P Cash Flow CF×P
Economy in a deep recession 5% $200,000 $ 10,000 $100,000 $ 5,000
Economy in a mild recession 10% 250,000 25,000 200,000 20,000
Economy stable 50% 300,000 150,000 300,000 150,000
Economy in a minor recession 25% 350,000 87,500 400,000 100,000
Economy in a major expansion 10% 400,000 40,000 500,000 50,000
Expected Value $312,500 $325,000
The expected value of Project B’s cash flow is higher than the expected value of Project A’s cash flow.
However, a review of the ranges of the potential cash flows for both projects reveals that Project B’s
cash flow is riskier because the range of possible cash flows is greater. Project B’s lowest possible cash
flow is $100,000 and its highest possible cash flow is $500,000, whereas Project A’s lowest possible cash
flow is $200,000 and its highest possible cash flow is $400,000. The range of Project B’s potential cash
flows is $400,000, whereas the range of Project A’s potential cash flows is only $200,000.
This range of potential cash flows is called the dispersion of the possible cash flows about their means,
or their expected values. “Dispersion” describes how much the individual data points are scattered or
spread out around their expected value. The narrower the distribution of the data, the lower the project’s
risk will be. The wider the distribution of data, the higher the project’s risk will be. Therefore, Project B
is riskier than Project A.
The risk of each project can be inferred from the dispersion of its possible cash flows, but the risk can
be quantified by calculating the variance and standard deviation of each set of cash flows. Calculation of
the variance and standard deviation of a set of data is outside the scope of the CMA Part 2 exam and
thus is not discussed here. Variance and standard deviation are tested on the CMA Part 1 exam and are
covered in study materials for that exam.
Analysis of Risk
Risk is a constant concern for decision-makers, and therefore it is essential to have the proper skills to
analyze and calculate risk. Unfortunately, risk is volatile and unpredictable by its nature, and so risk iden-
tification and mitigation is difficult to execute effectively. Furthermore, risk events often arise from a diverse
range of events that only converge in the future, and it can be a particular challenge to keep track of all
possible factors that might lead to a specific event. In many instances, risk analysis depends on a degree
of business intuition and creative guesswork. Even so, managers can use a number of techniques to help
them get a grasp on the scope of the risks they face and, in many instances, provide meaningful approaches
to mitigating and reducing the likelihood and effect of risk.
Sensitivity Analysis
Sensitivity analysis can be used to determine how cash flows are expected to vary with changes in under-
lying assumptions. Using expected cash flows, the NPV and IRR of the project are determined. Next, the
key assumptions used in making the original expected cash flow projections are identified. One assumption
at a time is then changed, leaving the other assumptions unchanged; the NPV and IRR are recalculated to
determine what effect changing one assumption would have on those measures. This process may show
some area of risk that the company had not been aware of previously and thus indicate that the investment
is riskier than originally thought.
Scenario Analysis
In scenario analysis, the NPV or IRR of a project is analyzed under a series of specific scenarios, which are
based on macroeconomics, factors specific to the industry the firm operates in, and factors specific to the
company itself. Revenues, expenses, and ratios under each of the scenarios are estimated, and the NPV
and IRR of the project under each scenario are estimated. The decision to accept or reject the project is
based on the NPVs and IRRs under all the scenarios, not just one.
Simulation Analysis
Simulation analysis allows for more than one uncertain element in the analysis. Therefore, simulation anal-
ysis is more comprehensive than sensitivity analysis. Simulations can be used to develop possible outcomes,
using statistical methods and computing the NPV and IRR for each set of outcomes. All of the results from
the simulations are then summarized into average, variance, coefficient of variation, and so forth, for all
the statistics across all the simulation runs. The final decision is based on the summary statistics. Simulation
analysis is, however, an expensive method and will generally be used only for larger projects.
Monte Carlo Simulation and “What-If” Risk Analysis

“What-if” analysis is a type of risk analysis that uses randomly generated values for probabilistic inputs.
The goal of risk analysis is to determine the probability of a negative event (such as a loss) and the mag-
nitude of potential damages if it occurs. The analyst estimates the ranges for the probabilistic inputs, such
as labor costs or materials costs, and then “what-if” analysis is used to determine a worst-case scenario
(that is, what would happen in the worst of circumstances) and a best-case scenario (that is, what would
happen in the best of circumstances). In addition, the base-case scenario represents the most likely cir-
cumstances based on the analyst’s estimates of the most likely probabilistic inputs. What-if analysis like
this does not utilize simulation. It can provide a variety of scenarios, but it reveals little about their prob-
abilities.
Monte Carlo simulation can be used to develop an expected value when the situation is complex and the
values cannot be expected to behave predictably. Monte Carlo simulation uses repeated random sampling
and can develop probabilities of various scenarios coming to pass that can be used to compute a result that
approximates an expected value.
Adding a Monte Carlo simulation to the model allows analysts to assess various scenario probabilities be-
cause they can generate random values for the probabilistic inputs based on their probability distributions.
The analyst can determine ranges for the probabilistic inputs (such as labor costs or materials costs) and
also their probability distributions, means, and standard deviations. The computer-simulation application
then generates the random values for the probabilistic inputs based on their ranges, probability distribu-
tions, means, and standard deviations as determined by the analyst.
The values for the probabilistic inputs are used to generate multiple possible scenarios, similar to performing
statistical sampling experiments, except that it is done on a computer and over a much shorter time span
than actual statistical sampling experiments. Enough trials are conducted (indeed, hundreds or thousands)
with different values for the probabilistic inputs in order to determine a probability distribution for the
resulting scenario, which is the output. The repetition is an essential part of the simulation.
For example, if the simulation is run to evaluate the probability that a new product will be profitable, the
output may include an average profit and the probability of a loss. Furthermore, the average profit that
results should be a reasonable approximation of expected profit.
Benefits of Simulation
• Simulation is flexible and can be used for a wide variety of problems.

• It can be used for “what-if” situations, because it enables the study of the interactive effect of
variables.
• Simulation is easily understood.
• Many simulation models can be implemented without special software packages, because most
spreadsheet packages provide useable add-ins. For more complex problems, simulation applications
are available.
Limitations of Simulation
• Simulation is not an optimization technique. It is a method that can predict how a system will
operate when certain decisions are made for controllable inputs and when randomly generated val-
ues are used for the probabilistic inputs.
• Although simulation can be effective for designing a system that will provide good performance,
there is no guarantee it will be the best performance.
• The results will be only as accurate as the model that is used. A poorly developed model or a model
that does not reflect reality will provide poor results and may even be misleading.
• There is no way to test the accuracy of assumptions and relationships until a certain amount of time
has passed.
Note: A post-completion audit (or post-audit) of a capital budgeting project compares the actual
benefits and costs of the project with the original estimates. Post-completion audits should be done for
all large projects and for all strategically important projects, regardless of size. They should also be done
for a sample of smaller projects.
A post-audit lets management know how closely the actual results of the project matched the original
estimates. The feedback from a post-audit helps management learn where its forecasts may have been
inaccurate and to understand which important factors may have been omitted from its capital budgeting
analysis. The information gained from a post-audit can help to improve future capital budgeting analyses.
A post-completion audit also interjects discipline and control into the capital budgeting process. When
managers know that a post-completion audit will be done, they should be more careful in developing
their initial assumptions and estimates before making an investment decision. They may also be more
attentive to the management of the investment project once undertaken, in order to keep it “on track.”
Adjustments to the Discount Rate for Risk

The company’s weighted average cost of capital (WACC) is the appropriate hurdle rate in capital budgeting
decisions and NPV calculations as long as the project’s riskiness is the same as the riskiness of the
company’s existing business. If a project has risk characteristics that differ from the risk of the com-
pany’s existing business, the company’s WACC can be adjusted and a risk-adjusted discount rate used
in the capital budgeting analysis to reflect the amount of risk in the project.
Risk-Adjusted Discount Rate = Weighted Average Cost of Capital +/− Risk Adjustment
1) A company should increase the discount rate used in capital budgeting for investments that are
riskier or more uncertain than the company’s present portfolio of investments. A higher discount
rate requires higher expected future cash flows for the investment to be acceptable, which makes
fewer investments acceptable.
2) A company should lower the discount rate used for investments it judges to be less risky than
the company’s present portfolio of investments, which increases the probability that a given in-
vestment will be acceptable.
When the risk adjustment is an increase to the firm’s WACC, the risk adjustment is called a risk premium.
For the WACC to be used as a hurdle rate without any risk adjustment, the following two conditions must
be met:
1) The new project must not substantially change the firm’s operating environment. If a new project
introduces significant change, risks (as discussed above) will enter into the equation and must be
accounted for.
2) The new capital must be raised in the same proportions as the existing capital, so that the com-
pany’s financial risk remains the same.
If either of these two assumptions does not hold true, the discount rate used as the required rate of return
must be adjusted to reflect the change in the firm’s risk profile that will result from the project.
Thus, a higher risk-adjusted discount rate reflects higher risk, since with a higher discount rate, the
expected cash flows from the investment will need to be higher to create a positive NPV. If the expected
cash flows are not higher, increasing the discount rate could change a positive NPV to a negative NPV, and
the project would be more likely to be rejected. Conversely, if the project is safer than the existing business
of the firm, a discount rate that is lower than the present Weighted Average Cost of Capital should be used
as the required rate of return, increasing the chances of the project’s being accepted.
However, discount rates should not be adjusted for nonmarket risks that are unique or diversifiable, such
as the possibility that a new drug may not be approved or that a drilling project will be unsuccessful.
Instead, the expected cash flows should be adjusted to reflect those risks. If expected project cash
flows give weight to all possible outcomes, both favorable and unfavorable, they will be correct on average.
In other words, the expected cash flows for some projects will be too high and for other projects they will
be too low, but over a long period of time and several projects, the total actual cash flows should be close
to the total expected cash flows.
After adjusting cash flow forecasts for the nonmarket, or diversifiable, risks, management should then
consider whether or not systematic, or market, risks require adjustment of the discount rate.
Example 1: A company is considering a new project that involves entering a new market where com-
petition is stiff and the risk of failure is high. Because of these factors, the project will add significant
business risk to the company’s operating environment, and, as a result, investors will require a higher
rate of return to compensate. The firm’s weighted average cost of capital will increase, so management
should evaluate the project using a higher required rate of return.
Example 2: A company decides to use more debt to finance a new project than it has in its current
capital structure, thus raising the amount of debt in its capital structure. Up to a certain point, additional
debt is not a problem for the company or its investors. However, if the proportion of debt in the com-
pany’s capital structure becomes too high, investors will become more nervous because of the increased
possibility that the company might not be able to service its debt and could go into default. Under such
conditions, potential investors in the new debt to be issued will require a risk premium to invest in the
bond. The rate of return the company will have to pay on its debt will increase. The cost of the firm’s
equity will increase as well because equity investors will require a higher expected rate of return to buy
or hold the company’s common stock. As a result, the company’s overall weighted average cost of capital
will increase, so a higher discount rate should be used in the capital budgeting analysis.
(Continued)
Example 3: A company decides to replace an old machine with a newer model. This change will probably
not alter the company’s operating environment and therefore carries little risk. Management would prob-
ably use its weighted average cost of capital as the required rate of return for discounting the cash flows
from the new machine that is simply replacing an old machine.
However, if the company is considering a new machine to enter a new line of business, the project will
most certainly introduce uncertainty and risk. Because of the increased risk in entering a new line of
business, the company’s required rate of return would be higher for the new machine purchased for that
purpose. Management would therefore use a risk-adjusted discount rate to analyze the purchase of the
second machine.
Note: The preceding guidelines for risk-adjusting the discount rate apply only to projects with positive
net cash flows, in other words projects with cash inflows that exceed their cash outflows. If all of the
cash flows for a project are negative, for example because the project has only costs and no related
revenues or has revenues that are lower than its costs, the guidelines for risk-adjusting the discount
rate are reversed. The discount rate for a project with greater risk should be decreased, whereas the
discount rate for a project with lesser risk should be increased.
The Capital Asset Pricing Model and the Required Rate of Return for a Project
Risk analyses can be used to assign a beta to a project. Then, using the Capital Asset Pricing Model (CAPM)
with the project’s assigned beta,11 the risk-free rate of return and the expected return on the market,
management can determine the amount of the risk premium needed and the required rate of return (that
is, the risk-adjusted discount rate to be used as a discount rate).
The formula for the Capital Asset Pricing Model (CAPM) is
R = RF + β(RM − RF)
Where: R = Investors’ required rate of return

RF = Risk-free rate of return
β = Beta coefficient
RM = Market’s required rate of return
Using the CAPM, the project’s assigned beta, the risk-free rate of return, and the expected return on the
market, the required rate of return for the project can be calculated.
Example: Prospect Industries uses the Capital Asset Pricing Model to determine the required rate of
return on investment projects. The beta value it has assigned to Project Y is 1.2, the risk-free rate is
3%, and the expected return on the market is 10.5%. The required return (R) for Project Y is
R = RF + β(RM − RF)
R = 0.03 + 1.2(0.105 – 0.03)
R= 0.12 or 12%.
Prospect Industries will use a hurdle rate of 12% to evaluate Project Y.
 If the NPV of the project is positive when using 12% as the discount rate, the project will be acceptable.
 If the calculated IRR of the project is greater than 12%, the project will be acceptable.
11
The Capital Asset Pricing Model is covered in this textbook in Section B, Volume 1, Corporate Finance. As explained
there, beta is a measurement of an investment’s systematic, or undiversifiable, risk.
Net Present Value and Risk-Adjusted Discount Rates

Net Present Value as a capital budgeting method has a unique advantage over other capital budgeting
methods because cash flows used in an NPV analysis can be discounted individually by component.
Different discount rates can be used to calculate the present values of different annual cash flows through-
out a single project analysis. For example, if the cash flow from the depreciation tax shield is relatively
certain but the operating cash flows are less certain, the net after-tax operating cash flows can be dis-
counted at a higher rate than the rate used to discount the depreciation tax shield cash flows to reflect the
greater risk in the operating cash flows.
The ability to assign different hurdle rates for different components of a project provides a flexibility when
the Net Present Value method is used that is not available with other capital budgeting methods.
Capital Rationing in Capital Budgeting

If a company has an unlimited amount of capital available, then deciding which project or projects to invest
in is a simple decision—the company should invest in all of the projects that have positive NPVs or IRRs
higher than required, or whatever criteria have been set by the company. However, in a situation where
there is a limited amount of money for investment, it becomes much more critical to determine which
individual project or projects will provide the highest total return on investments for the company.
The process of determining the group of projects that fulfills both requirements is to first screen and rank
the projects by calculating each project’s profitability index and giving priority to those with the highest
profitability indices, then confirming by totaling the NPVs and the initial investments. The profitability index
is a benefit/cost ratio that represents the ratio of the benefits (present value of the net cash inflows) to the
costs (present value of the net cash outflows) of a project.
PV of Future Net Positive Cash Inflows

Profitability Index = Net Initial Investment + PV of Future Net
Negative Cash Flows (if any)
However, the profitability index is best used as a first step only, because use of the profitability index alone
to select projects can result in a less than optimal total net present value. If management simply selects
the projects in order of each one’s profitability index, some of the capital budget may be unused. When the
company gets close to its maximum amount of capital funding available, the next best project may be too
large and would put the company over the limit, so no further capital projects can be selected. Thus, it is
better to search for the combination of projects that will use more of the capital budget, while at the same
time optimizing the net present value of all the projects selected.
NPV is the best way to select the group of projects that will maximize shareholder wealth because NPV
results in an absolute amount of increased discounted cash flow. When more than one project can be
selected but not all of them can be selected, the group of projects that comes closest to using all of the
funds available and does so with the highest total NPV will maximize shareholder wealth.
Example: Chips, Inc. has the following investment opportunities. Required investment outlays and the
present values of the future estimated net cash inflows for each of the investments are as follows:
PV of PV of Future Estimated
Project Investment Cost Net Cash Inflows
I $300,000 $ 350,000
II 450,000 630,000
III 650,000 1,170,000
IV 750,000 1,200,000
Chips, Inc.’s budget ceiling for initial outlays during the present period is $1,500,000. The proposed
projects are independent of each other. Which project or projects should Chips accept?
Solution: The goal is to find the combination of projects having the highest total NPV that avoids ex-
ceeding the amount of capital available, which is $1,500,000. All four projects would require $2,150,000
in total outlay, so not all of the projects can be accepted.
The first step is to calculate the profitability index and the NPV of each project.
• The profitability index is the present value of the future estimated net cash inflows divided by the
present value of the future net negative cash flows (the initial investment cost).
• The NPV for each project is the present value of the future estimated net cash inflows minus the
present value of the future net negative cash flows (the initial investment cost).
PV of Future Estimated PV of Profitability
Project Net Cash Inflows Investment Cost NPV Index
I $ 350,000 $300,000 $ 50,000 1.2
II 630,000 450,000 180,000 1.4
III 1,170,000 650,000 520,000 1.8
IV 1,200,000 750,000 450,000 1.6
The highest profitability indices are those of Projects III and IV. Projects III and IV also have the highest
NPVs. The total of their NPVs is $970,000, and that is higher than any other possible combination of
projects. The total investment for those two projects is $1,400,000, which is within the budget limit.
Therefore, Projects III and IV should be accepted.
Section E Study Unit 7: E.2. Real Options in Capital Budgeting
Study Unit 7: E.2. Real Options in Capital Budgeting

Real Options in Capital Budgeting
To analyze a proposed capital budgeting project using NPV, it is necessary to make estimates of expected
future cash flows and an appropriate discount rate. At the most basic level, management can calculate a
single NPV, decide to embark upon a project, and then wait until the project’s term runs its course—a
decidedly passive approach. However, a project’s NPV can be calculated only with information known at the
time the estimates are made, and the choice is between accepting or rejecting the project. Thus, the NPV
approach ignores the fact that other choices may be made and that the option to make those other choices
can have value.
The real options approach addresses the problem of optimizing a real asset (such as a piece of equipment,
a building, land, a project, and so forth) under conditions of uncertainty, given the available options.12 Real
options goes beyond the basic passive approach to NPV and project management. Instead, real options
provide a framework for strategic decision-making as the project goes along. In essence, real options begin
with an initial choice that is then followed by additional choices that factor in as more information becomes
available.
Wayne S. Upton, Jr. provides a comprehensive discussion of real options:
A real option is easier to describe than to define. A financial option is a contract that grants
to the holder the right but not the obligation to buy or sell an asset at a fixed price within
a fixed period (or on a fixed date). The word option in this context is consistent with its
ordinary definition as “the power, right or liberty of choosing.” Real option approaches at-
tempt to extend the intellectual rigor of option-pricing models to valuation of nonfinancial
assets and liabilities. Instead of viewing an asset or project as a single set of expected cash
flows, the asset is viewed as a series of compound options that, if exercised, generate
another option and a cash flow. . . .
Proponents argue that the application of option pricing to nonfinancial assets overcomes
the shortfalls of traditional present value analysis, especially the subjectivity in developing
risk-adjusted discount rates. They contend that a focus on the value of flexibility provides
a better measure of projects in process that would otherwise appear uneconomical. 13
Those who employ the real options approach consider capital budgeting investment opportunities as if they
were American call options, with the exercise price as the investment amount and the underlying asset as
the project. The act of investing may create new options, such as the option to abandon a project or the
option to expand it. Having an option to abandon a capital project is similar to owning a put option, which
is the right but not the obligation to sell the project at a set price before a certain expiration date. Real
options have value, in the same way that put and call options have value.
For example, a company might consider a project that, while attractive, has a negative NPV. Under most
conditions, the company should avoid the project. However, it is possible that, based on real options anal-
ysis, a company might be more willing to undertake such a project because it could offer expansion
opportunities or because it could be abandoned if conditions turned unfavorable. Moreover, the company
could even restart the project later if conditions turned favorable. These types of options—the flexibility to
stop, restart, or reconsider—can have specific values assigned to them. It is possible that a negative NPV
project would be undertaken because of the value of its options.
12
The idea of “real options” was developed in 1977 by MIT professor Stewart C. Myers. Myers took the concept of
financial options—American call options in particular—and applied the concept to capital budgeting under conditions of
uncertainty.
13
Wayne S. Upton, Jr., Business and Financial Reporting, Challenges from the New Economy (Norwalk, Connecticut:
Financial Accounting Standards Board, 2001), 92-93.
Study Unit 7: E.2. Real Options in Capital Budgeting CMA Part 2
The following is a list of a few common real options:
1) The option to make follow-on investments if the immediate investment project succeeds.
For example, a company is evaluating an investment in a new $100 million plant to manufacture
a newly-developed product, but the project would require very high sales volume to result in a
positive NPV. A real option could be to build a smaller plant instead for only $10 million, then wait
to see if the new product is successful. If the product does sell well, then the $100 million plant
could be built. In this example, the cost of the option is $10 million. The company is acquiring a
real option to expand while obtaining strategic “first-mover” (that is, first into a market) advantage.
2) The option to abandon a project. If actual cash flows turn out to be much lower than forecasted,
it is helpful to have the option to cancel a project and recover the investment by selling it. If the
abandonment value of the assets is greater than the present value of the future expected cash
flows from continuing the project, the project can and ought to be abandoned. Thus, the option to
abandon a project is comparable to a put option on a financial asset.
A project might be temporarily abandoned if actual cash flow is below forecasted cash flow and
then revived when market conditions improve and prices rebound. The project’s value may be
greater with an abandonment option than without one.
3) The option to wait and learn more before investing. A real options approach can be taken to
find the optimal timing of an investment. For example, if a project’s expected net cash flows are
high, the company may want to invest without delay in order to capture those cash flows. However,
if the forecasted cash flows are lower, managers may be more inclined to wait to invest, even if
the NPV of the project is positive. The company could wait another year to learn more about the
market for the proposed project. Therefore, if an outcome’s potential is highly variable, it may be
more valuable to take the wait and learn option.
For example, a company owns a tract of land that it wishes to develop into a revenue-generating
enterprise. However, once the land has been converted to a particular use, its flexibility becomes
limited and its function can be changed only after great expense. By waiting, the company can
observe changes in values of developed properties in the same neighborhood to make better esti-
mates of expected cash flows from alternative investments. As time passes, expected cash flows
from one of the investment alternatives may emerge as being significantly higher than the others.
The greater the variability in possible outcomes is, the greater is the value of the option to wait
and learn.
4) The option to vary the inputs to the production process, the production methods, or the
firm’s output or product mix. Equipment can be designed to operate in different ways or with
different raw materials, depending upon specific conditions. Production can be shifted from one
product to another to adapt to changing market demands. Even if this shift increases production
cost, it can result in additional cash flow if the alternative would be production of a product that is
not marketable due to insufficient demand.
Upton adds the following examples:
1) Growth options. An example of a growth option is the decision to invest in entry into a new
market.
2) Flexibility options. An example of a flexibility option is the choice between building a single,
centrally located facility or two facilities in different locations.14
14
Upton, Business and Financial Reporting, Challenges from the New Economy, 92, citing Martha Amram and Nalin
Kulitilaka, Real Options: Managing Strategic Investment in an Uncertain World (Boston: Harvard Business School Press,
1999), 10.
Section E Study Unit 7: E.2. Real Options in Capital Budgeting
Bailout Payback and Real Options

The Bailout Payback is a variation on the Payback Period method of capital budgeting, and it is one method
of quantifying a real option. The Bailout Payback Period is calculated in the same way as the Payback Period,
but it recognizes that the project may end prematurely and the assets may be sold. The after-tax salvage
value of the project assets at various dates is added to the project’s cash inflows through the same dates.
This process essentially includes in the payback period a calculation of the cash flows that would result upon
termination of the project at various dates. The Bailout Payback method of analyzing a capital budgeting
project is one method of quantifying the abandonment option and offers a form of protection if things could
go wrong.
Although calculating the Bailout Payback Period is not required for the exam, exam takers may need to be
aware of it and its uses.
Valuing Real Options
Valuing the Real Option

Because options limit the downside potential of a project, the value of a real option is increased when the
uncertainty relating to its underlying asset is greater. Thus, the greater the number of options and the
greater the uncertainty surrounding their use, the greater the worth of a project with real options.
To value a real option, the first step is to value the project as if it had no options attached. Next, the various
options and possible results are set up using the various possible outcomes. The expected value of the
project with the option or options is determined. Possible events may include permanent abandonment,
temporary abandonment, varying inputs or outputs, varying the production mix, and so forth.
The project’s NPV with the real option is its value without the real option plus the value of the real option:
Project Worth = NPV Without the Real Option + Real Option Value
Thus, the value of a real option can be determined by calculating the net present value of the project
without the real option, then calculating its net present value with the real option, and then finding the
difference.
Real Option Value = Project Worth (NPV of project with the real option)
– NPV of Project Without the Real Option
Monte Carlo Simulation

Monte Carlo analysis may be used to determine a project’s NPV with the real options by building all of the
possible payoffs under the real options into the Monte Carlo analysis model. The result is an averaged
approximate NPV with the real options.
A Monte Carlo simulation employs computer simulation to help decision-makers consider all possible com-
binations of project outcomes. When used in capital budgeting, this simulation utilizes a model where all
the variables are defined: market size, product price, market share, unit variable cost, and fixed cost. The
probabilities of each possible outcome for each variable are specified and the effect of all the possible events
on subsequent years’ results is determined. After all relevant information is built into the model, the com-
puter creates random scenarios and calculates the resulting cash flows for each period. After multiple
iterations, an estimate of the probability distributions of the project’s cash flows emerges. The accuracy of
the estimate will depend upon the accuracy of the model and the interrelationships among the variables.
Study Unit 7: E.2. Real Options in Capital Budgeting CMA Part 2
The probability distributions of the cash flows help an analyst calculate expected cash flows, which can then
be discounted to find their present values. Several NPVs are calculated based on the random choices of
variables, and the NPVs are averaged to get an approximate NPV for the project.
However, because a Monte Carlo simulation emphasizes expected value, its results can be less than realistic
if variables such as market growth, market share, costs, and so forth diverge from expected levels.
The Qualitative Factor in Capital Budgeting Decisions

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

Present Value of $1 Table
Interest Rate
1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 12% 14% 16% 18% 20%
1 .990 .980 .971 .962 .952 .943 .935 .926 .917 .909 .893 .877 .862 .847 .833 1
2 .980 .961 .943 .925 .907 .890 .873 .857 .842 .826 .797 .769 .743 .718 .694 2
3 .971 .942 .915 .889 .864 .840 .816 .794 .772 .751 .712 .675 .641 .609 .579 3
4 .961 .924 .888 .855 .823 .792 .763 .735 .708 .683 .636 .592 .552 .516 .482 4
5 .951 .906 .863 .822 .784 .747 .713 .681 .650 .621 .567 .519 .476 .437 .402 5
6 .942 .888 .837 .790 .746 .705 .666 .630 .596 .564 .507 .456 .410 .370 .335 6
7 .933 .871 .813 .760 .711 .665 .623 .583 .547 .513 .452 .400 .354 .314 .279 7
Number of Periods
8 .923 .853 .789 .731 .677 .627 .582 .540 .502 .467 .404 .351 .305 .266 .233 8
9 .914 .837 .766 .703 .645 .592 .544 .500 .460 .424 .361 .308 .263 .225 .194 9
10 .905 .820 .744 .676 .614 .558 .508 .463 .422 .386 .322 .270 .227 .191 .162 10
11 .896 .804 .722 .650 .585 .527 .475 .429 .388 .350 .287 .237 .195 .162 .135 11
12 .887 .788 .701 .625 .557 .497 .444 .397 .356 .319 .257 .208 .168 .137 .112 12
13 .879 .773 .681 .601 .530 .469 .415 .368 .326 .290 .229 .182 .145 .116 .093 13
14 .870 .758 .661 .577 .505 .442 .388 .340 .299 .263 .205 .160 .125 .099 .078 14
15 .861 .743 .642 .555 .481 .417 .362 .315 .275 .239 .183 .140 .108 .084 .065 15
16 .853 .728 .623 .534 .458 .394 .339 .292 .252 .218 .163 .123 .093 .071 .054 16
18 .836 .700 .587 .494 .416 .350 .296 .250 .212 .180 .130 .095 .069 .051 .038 18
20 .820 .673 .554 .456 .377 .312 .258 .215 .178 .149 .104 .073 .051 .037 .026 20
30 .742 .552 .412 .308 .231 .174 .131 .099 .075 .057 .033 .020 .012 .007 .004 30
40 .672 .453 .307 .208 .142 .097 .067 .046 .032 .022 .011 .005 .003 .001 .001 40
175
Present Value Factors CMA Part 2
Present Value of a $1 Annuity Table (Ordinary Annuity)
Interest Rate
1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 12% 14% 16% 18% 20%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.893 0.877 0.862 0.847 0.833 1
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 1.690 1.647 1.605 1.566 1.528 2
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 2.402 2.322 2.246 2.174 2.106 3
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 3.037 2.914 2.798 2.690 2.589 4
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 3.605 3.433 3.274 3.127 2.991 5
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 4.111 3.889 3.685 3.498 3.326 6
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 4.564 4.288 4.039 3.812 3.605 7
Number of Periods
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 4.968 4.639 4.344 4.078 3.837 8
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 5.328 4.946 4.607 4.303 4.031 9
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 5.650 5.216 4.833 4.494 4.192 10
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 5.938 5.453 5.029 4.656 4.327 11
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 6.194 5.660 5.197 4.793 4.439 12
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 6.424 5.842 5.342 4.910 4.533 13
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 6.628 6.002 5.468 5.008 4.611 14
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606 6.811 6.142 5.575 5.092 4.675 15
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824 6.974 6.265 5.668 5.162 4.730 16
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201 7.250 6.467 5.818 5.273 4.812 18
20 18.046 16.351 14.877 13.590 12.462 11.470 10.594 9.818 9.129 8.514 7.469 6.623 5.929 5.353 4.870 20
30 25.808 22.396 19.600 17.292 15.372 13.765 12.409 11.258 10.274 9.427 8.055 7.003 6.177 5.517 4.979 30
40 32.835 27.355 23.115 19.793 17.159 15.046 13.332 11.925 10.757 9.779 8.244 7.105 6.233 5.548 4.997 40
176
Appendix B Example of IRR
Appendix B – Example of IRR

When the annual expected cash flows for a capital budgeting analysis vary, the calculation of the IRR can
be complicated. The steps that are required are set out below, followed by a numerical example in which
all of the calculations are shown. In all likelihood, this type of problem will not appear on the exam; however,
it is presented here in order to provide a more complete understanding of IRR.
The steps to calculate the IRR of an investment project when the cash flows vary from year to year are:
1) Calculate a preliminary NPV of the project using any rate as a preliminary discount rate. Once the
preliminary NPV of the project is known, use the preliminary discount rate and the preliminary NPV
calculated at that rate to make an initial estimate of which discount rate might cause the NPV to
become zero.
• If the preliminary NPV of the project is negative, the preliminary discount rate used in calcu-
lating the NPV was too high. The IRR will be lower than that discount rate.
• If the preliminary NPV of the project is positive, the preliminary discount rate was too low.
The IRR will be higher than that discount rate.
2) Make an initial estimate of the discount rate that would bring the NPV to zero and calculate the
NPV of the project using that initial estimated discount rate.
3) If the initial estimated discount rate results in an NPV that is on the opposite side of zero from
the preliminary NPV, the IRR will be somewhere in between the two discount rates used in calcu-
lating the two NPVs. If the NPV at that discount rate is not on the other side of zero from the
original NPV, try another discount rate until a rate is found that does result in an NPV that is on
the opposite side of zero from the preliminary NPV. The IRR will be somewhere in between the
discount rate used that resulted in a positive NPV and the discount rate used that resulted in a
negative NPV. For a multiple-choice question, look at the answer choices to see if one of them falls
between the two rates. If so, that is the answer.
4) If two or more answer choices are between the two discount rates, look further. First, try straight-
line interpolation to find the discount rate in between the two rates that results in an NPV of zero:
Step 1: Calculate the difference between the two NPVs on either side of zero. Since one is negative
and one is positive, the difference between the two NPVs is the sum of their absolute values.
Step 2: Calculate the difference between the two discount rates that resulted in NPVs on either
side of zero by subtracting the smaller rate from the larger rate.
Step 3: The rate at which the NPV will be zero will be in between the two rates, a pro rata distance
from the lower rate that is equivalent to the NPV at the lower rate divided by the difference between
the two NPVs, and that quantity multiplied by the difference between the two rates (as a
decimal).
Step 4: Add the result of Step 3 to the lower of the two discount rates (as a decimal) to find the
estimated IRR. The interpolation formula to estimate the IRR is:
Discount rate NPV @ lower rate Difference be-

Estimated
where NPV is + × tween the two =
Difference between the rates IRR
positive
two NPVs
If the estimation made using the preceding formula results in a rate that is close to one of the
answer choices, stop here. If this estimation still does not provide a usable answer, it may be
because the two rates are too far apart and the interpolation is not accurate enough. Go to the
next step.
177
Example of IRR CMA Part 2
5) Find two discount rates that are only 1% apart that will result in NPVs that are on either side of
zero. Do this by calculating the NPV using additional rates to narrow the spread down to the point
where, for example, the IRR must be between 13% and 14%. Having only a 1% spread makes the
interpolation more accurate. Check the answer choices again to see if one can be chosen now. If
not, go to the next step.
6) Use straight-line interpolation as described in Step 4 to calculate what discount rate in between
the two rates that are 1% apart will cause the NPV to be zero.
Example: ACM Petroleum, Inc., an oil wholesaler, is planning to purchase an additional truck to transport
its oil because of recent sales growth. The truck will cost $100,000. ACM estimates the after-tax cash
flow from the new truck will be $20,000 per year (starting 1 year after the purchase), and the truck will
last for seven years. ACM’s required rate of return is 10% and projects that at the end of seven years it
will be able to sell the truck for a net amount of $30,000 after deduction of income tax due on the gain.
The discounted cash flows are calculated as follows, first using a preliminary discount rate of 10%:
PV of ordinary annuity i=10%, n=6 × $20,000 = 4.355 × $20,000 = $ 87,100
Plus: PV of cash inflow, Year 7:
PV of $1 i=10%, n=7 × ($20,000 + $30,000) = 0.513 × $50,000 = 25,650
Equals: Discounted cash inflows of the project $112,750
NPV = $112,750 − $100,000 = $12,750
With a preliminary discount rate of 10%, the NPV is $12,750. Therefore, because the NPV needs to come
down, the initial estimate of the discount rate that would cause NPV to be zero will be higher than 10%.
Calculate the NPV using an initial estimated rate of 14%:

PV of ordinary annuity i=14%, n=6 × $20,000 = 3.889 × $20,000 = $ 77,780
Plus: PV of cash inflow, Year 7:
PV of $1 i=14%, n=7 × ($20,000 + $30,000) = 0.400 × $50,000 = 20,000
Equals: Discounted cash inflows of the project $ 97,780
NPV = $97,780 − $100,000 = $(2,220)
Since the NPV has gone from positive at 10% to negative at 14%, the discount rate that will result in an
NPV of zero will be somewhere in between 10% and 14%. The two rates can be used to interpolate.
NPV at 10% = $12,750

Less: NPV at 14% = ( 2,220)
Difference $14,970
The difference between 10% and 14% is 4% or 0.04.
Therefore, the discount rate that will cause the NPV to be zero will be 10% plus a fraction of another
4%.
That fraction is 12,750 (the amount by which the NPV is greater than zero when a discount rate of 10%
is used) divided by 14,970 (the difference between the NPV at 10% and the NPV at 14%), multiplied by
the difference between 10% and 14%, which is 4% or 0.04.
IRR = 0.10 + [ (12,750 ÷ 14,970) × 0.04 ] = 0.1341, or 13.4%
If this procedure produces an answer that is accurate enough, the process ends here. If that answer is
not accurate enough, narrow the range of rates so there is no more than 1% between the two rates that
are on opposite sides of zero NPV. Use trial and error, calculating the NPV using different discount rates
until it is narrowed down to two rates that are only 1% apart.
178

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CMA Part 2 Textbook Section E

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2022 Edition

Strategic Financial Management

Brian Hock, CMA, CIA

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(866) 807-HOCK or (866) 807-4625

Published October 2021

Acknowledgement is due to the Institute of Certified Management Accountants for

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Throughout these materials, we have chosen particular language, spellings, structures

This material is designed exclusively to assist people in their exam preparation. No

Section E – Investment Decisions ................................................................................ 116

Appendix A – Present Value Factors ............................................................................ 175

Section E – Investment Decisions

• Calculating the Depreciation Tax Shield.

• Calculating the Net Present Value.

• Calculating the Internal Rate of Return.

• Determining which project or projects to invest in.

The Stages in Capital Budgeting

5) Financing Stage: The company obtains the necessary project funding.

Terms Used in Capital Budgeting

The Difference Between Cash Flows and Accounting Profits

Identifying and Calculating the Relevant Cash Flows

“Relevant Cash Flows” Defined

“Expected Cash Flow” Defined

When Do Cash Flows Take Place?

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

Year 0 cash flows consist of three components:

Annual Net Cash Flows

Operating Cash Flows

Cash Outflows for Follow-Up Investments

Depreciation Tax Shield – A Cash Inflow

Cash Flows at the Disposal or Completion of the Project

Depreciation for Income Tax Purposes

MACRS Depreciation for Tax Purposes

20X1 ½ of one year’s depreciation

Straight-Line Depreciation When Used for Tax Purposes

Other Tax Considerations

Irrelevant Cash Flows

Sunk Costs and Allocated Common Costs

Financing Cash Flows

Example of Calculation of After-Tax Relevant Cash Flows

The relevant after-tax cash flows are:

1) Net Initial Investment:

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

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

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

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

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

Working ( 25,000) 25,000*

* Recovery of released working capital.

Study Unit 2: E.2. Payback and Discounted Payback Methods

1) Payback Period or Payback Method

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

3) Net Present Value

4) Internal Rate of Return

Payback Period or Payback Method

Initial net investment

Example of the Payback Method with Unequal Annual Cash Flows

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

Total After Tax

* Recovery of released working capital.

Plus: a fraction consisting of:

Denominator = Cash inflow for the following year 39,684

Benefits of the Payback Method of Capital Budgeting