Library/CFA (Chartered Financial Analyst)/CFA Program Curriculum 2026 — Corporate Issuers (Level I, Volume 3)/Learning Module 5 Capital Investments and Capital Allocation

Learning Module 5 Capital Investments and Capital Allocation

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Overview, Project Types and Capital Allocation Process5 min

This chapter defines capital investments (projects with lives >1 year) and groups them: going concern (maintenance/replacement), regulatory/compliance (mandatory), expansion of existing business (increase scale or scope), and new lines/other (high risk, outside core). Capital projects are capitalized and depreciated; cash flows—not accounting profits—should drive decisions. The capital allocation process comprises idea generation, investment analysis (forecasting after-tax incremental cash flows, timing, and volatility), planning/prioritization (select projects that maximally enhance shareholder value subject to constraints), and monitoring/post-investment review. Two primary project evaluation tools are NPV and IRR. NPV equals the present value of after-tax incremental cash inflows less initial and subsequent outflows, discounted at the project required rate of return; invest if NPV >= 0. IRR is the discount rate that makes NPV = 0 and is useful to compare to a hurdle rate, but assumes interim cash flows are reinvested at IRR and can produce multiple solutions for nonconventional cash flows; use NPV when cash-sign changes occur. Spreadsheet functions include NPV and IRR for evenly spaced end-of-period flows and XNPV/XIRR for dated or irregular flows. ROIC is a firm-level, accounting-based measure: after-tax operating profit divided by average invested capital (equity plus long-term liabilities); it helps assess whether a firm creates value versus investors' required return; ROIC decomposes into operating profit margin times capital (asset) turnover, so firms raise ROIC via margin or turnover improvements.

Key Points

Capital projects: going concern, regulatory/compliance, expansion, new lines/other
Capitalized costs are depreciated; cash flows drive investment decisions
Capital allocation steps: idea generation, investment analysis, planning/prioritization, monitoring
NPV is primary decision criterion: accept if NPV >= 0
IRR has reinvestment assumptions and multiple-IRR limitations; use NPV if cash signs change
ROIC is a firm-level measure comparing after-tax operating profit to invested capital

Modeling Principles, NPV/IRR Calculation, and ROIC6 min

When modeling projects, use after-tax incremental cash flows only, exclude sunk costs, account for tax depreciation effects, avoid double counting, and include cannibalization or synergies with other firm operations. Timing, duration, and volatility of cash flows matter; moving cash flows between periods changes NPV and IRR. Example calculations: NPV = sum of CFt/(1+r)^t; use XNPV for irregular dates. IRR solves sum CFt/(1+IRR)^t = 0 and can be found via spreadsheet IRR/XIRR; IRR assumes reinvestment at IRR. ROIC = (1 − tax rate)*operating profit / average long-term liabilities and equity (average invested capital), and can be decomposed into after-tax operating margin times capital turnover. Analysts should compare ROIC to a blended required return for debt and equity to judge firm-level value creation. Limitations: ROIC is accounting-based (not purely cash), backward-looking, and sensitive to measurement choices in the denominator. For mutually exclusive projects choose the higher NPV even if IRR differs.

Key Points

Include only incremental after-tax cash flows; exclude sunk costs
Use XNPV/XIRR for irregular or dated cash flows
IRR assumes reinvestment at IRR; multiple IRRs possible with sign changes
ROIC is calculated using operating profit after tax over average invested capital
Choose higher NPV for mutually exclusive projects

Pitfalls, Behavioral Biases, and Real Options6 min

Common pitfalls: forecasting errors, ignoring the opportunity cost of internal funds (internal cash has equity opportunity cost), inconsistent inflation treatment (use nominal cash flows with nominal discount rate or real with real), inertia (capital budgets tied to prior years), over-reliance on accounting metrics (EPS), pet projects and failure to consider alternatives or scenarios. Real options grant the firm rights (not obligations) to alter project timing, size, or operations in the future: timing options (defer), sizing/abandonment options (shut down or expand), flexibility options (pricing, operating modes), and fundamental options dependent on external variables (commodity prices or regulation). Valuation approaches: (1) if NPV positive without options, options add value; (2) NPV with options = NPV without options − option cost + option value; (3) decision trees and option pricing models when prerequisites exist. Management should monitor projects and incorporate option values when material. Good governance, post-investment review, and alignment of incentives (avoid EPS-only pay) reduce misallocation risks.

Key Points

Forecast errors, ignoring internal financing cost, and inflation mismatches are common modeling mistakes
Behavioral biases include inertia, EPS-driven decisions, and pet projects
Real options (timing, sizing/abandonment, flexibility, fundamental) add value by providing managerial flexibility
Valuation methods include adjusting NPV with option value and decision trees
Monitoring and governance help detect biases and validate assumptions

Questions

Question 1

Which of the following best describes a going-concern capital project?

Learning Module 5 Capital Investments and Capital Allocation

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