Breaking down capital budgeting for the CFA L1 Exam

This post has everything you need to know to ace the capital budget questions most likely to be asked on the CFA Level 1 exam.

We do that by outlining all of the key considerations for capital budgeting problems. We'll break down the different types of projects a firm engages in, the idea of independent vs. mutually exclusive projects, and the other basic qualititative guidelines which are suited for a multiple choice question. From there we also talk about project decision rules and the key factors to consider when solving for/comparing Net Present Value (NPV) and IRR (the internal rate of return).

Types of capital budgeting projects

Not all projects are created equal. Some investments a firm just has to make--replacing worn out equipment for example. Others are more strategic--should we invest in a new factory in front of projected growth or should we launch a completely new business line. The curriculum buckets capital projects into 5 buckets: 

  • Replacement projects – Projects to maintain the business are usually made without detailed analysis. Cost reduction/enhancement replacement projects do require detailed analysis
  • Expansion projects – Projects to increase the size of the business are complex and require detailed projections of future demand
  • New Product / Markets – Lots of uncertainty, detailed analysis
  • Mandatory Projects – Often mandated by governments/insurance, these may not be revenue generating
  • Other – Pet projects or moonshots

Steps in the Capital Budgeting Process

This is pretty minor, but here's the outline of how a firm actually goes about deciding how they will allocate money:

  1. Generate the project ideas – These can be top-down or bottoms-up within the organization
  2. Analyze the different project proposals – Forecast each project’s CF and evaluate profitability
  3. Create the firm-wide capital budget – Prioritize profitable projects based on timing of cash flows, company budget, and overall strategy
  4. Monitor decisions and conduct a post-decision audit – Look at forecasts vs. reality and gauge reasons for any difference

Independent vs. Exclusive Projects

Independent projects have CFs that are unrelated to one another.

Mutually exclusive projects are in direct competition with one another (Note that project sequencing occurs when investing in a project today creates futures opportunities to invest in additional opportunities)

The distinction between the type of project will most likely come up in a problem asking you to choose which mutually exclusive project to pursue based on different NPV or IRRs (see below). 

Unlimited Funds vs. Capital Rationing

The concept here is vey simple. With unlimited funds a firm can undertake all positive NPV projects whereas if t faces any capital constraints a firm has to prioritize its different projects in order to maximize total NPV. This could be tested with a question asking you to pick the best combination of projects to pursue.

Capital Budget Project Decision Rules

Once you can point out (on a CFA Level 1 multiple choice question) the type of project, then its time to start thinking about how a firm decides if a project would be a net-positive to the them. We do this using decision rules. 

When faced with this situation we rank a project according to Net Present Value (NPV) or the Internal Rate of Return (IRR).

We undertake a project if its NPV > 0 or its IRR > the given hurdle rate. 

(Note that if IRR = the interest rate then the NPV is equal to zero)

The theory here is that any project with a positive NPV would be net accretive and thus increase the share price. Conversely any project where NPV < 0 leads to a loss in share price. You should have this rule memorized as you are guaranteed a L1 question on whether to embark on a certain capital expenditure.

Comparing NPV and IRR for Mutually Exclusive Projects

For a single project, NPV and IRR will result in the same decision. Any project with a positive NPV will have an IRR > required rate of return and vice versa.

However when facing mutually exclusive projects or projects with non-conventional cash flow patterns NPV and IRR can give conflicting answers.

This is a result of both the different initial costs and the timing of cash flows. Note: You should know that the sooner cash flows occur the higher an IRR will be, even if the ultimate NPV is lower.

The prioritizatino rule when IRR and NPV give different answers is simple: always choose the project with the highest NPV value.

Pros/Cons and Key Assumptions of NPV and IRR

Advantages to using NPV

On the plus side Net Present Value directly measures the increase in value of the firm as a result of a certain project. Its final calculation also assumes that any cash flows from the project are reinvested at the opportunity cost of capital (where n = the time of the project). There are three drawbacks of NPV however:

Drawbacks to using NPV

  • Based on external market-determined discount rate (r)
  • Assumes r stable over time
  • Doesn’t consider total NPV against the overall size of project (i.e. deploying a $1 million to generate $10k sucks)

Advantages to IRR

The interal rate of return considers both TVM and all cash flows. It is also a less subjective measure than NPV. This is because its calculation dooes not depend on an external rate of return. IRR is also easy to understand and widely accepted.

Disadvantages to IRR - The one key drawback to IRR is that it assumes all cash flows are reinvested at the IRR. 

Final Principles for solving capital budgeting problems

We've covered a lot of ground in this post. But before we let you go keep in mind when solving for NPV or IRR and applying the above concepts that your decisions for the L1 exam should ALWAYS:

  • Be made based on incremental cash flows not accounting income.
  • Use after-tax cash flows based on opportunity costs
  • Ignore sunk costs, i.e. think on the margin
  • Externalities including cannibalization are important (cannibalization is when a new project takes revenue away from an existing product)
  • The timing of cash flows is critical (NPV calculation considers TVM)
  • The discount rate in the calculation takes into consideration the firm’s cost of capital

Bonus Section: Payback Period

Also included in the Corporate Finance study session and within the Capital Budgeting reading, is a brief mention that not all firms use NPV or IRR to make capita allocation decisions (even though NPV is preferred).

While most U.S. firms and many firms run by people with M.B.As (yes, the CFA Institute literally uses the words, "people with MBAs) use NPV, there are a lot of firms, particularly in Europe that use something called payback period. 

The payback period is the number of years it takes to recover the initial cost of an investment. The shorter the payback period the better. 

That's because the payback period suffers from a couple of major drawbacks.

First, the measure does not take into account cash flows beyond the payback period. By ignoring any other future cash flows the payback period inherently In fails to take into account the terminal value of the project. So it doesn't end up actually measuring profitability.

Second, the payback period doesn’t discount the cash flows that are even considered in the first place, thus ignoring TVM altogether.

We can tweak the payback period to address the TVM question by using a discounted payback period instead. The discounted payback period uses PV of a project’s estimated CFs to recover its initial investment. It is always > than the PB. Does discount CFs but doesn’t consider them past the payback period.