This lesson extends the capital budgeting analysis by examining the estimation of project cash flows, the incorporation of risk into investment decisions, and the practical constraints of capital rationing. It covers techniques such as sensitivity analysis, scenario analysis, and the use of real options, as detailed in the CFA Corporate Finance study session .

 

  • Cash Flow Estimation: Accurate cash flow estimation is critical for effective capital budgeting. The CFA study session covers “Cash Flow Projections” with detailed sections on “Straight-Line and Accelerated Depreciation Methods,” “Cash Flows for a Replacement Project,” “Spreadsheet Modeling,” and “Effects of Inflation on Capital Budgeting Analysis” . The Pearson Corporate Finance textbook includes a chapter on “Project appraisal applications” covering “Incremental cash-flow analysis” and “Replacement decisions” .

  • Stand-Alone Risk Analysis: The CFA study session covers “Risk Analysis of Capital Investments—Stand-Alone Methods” and “Risk Analysis of Capital Investments—Market Risk Methods” . Key techniques include:

    • Sensitivity Analysis: Examines the effects of changing each key variable individually on the project’s NPV.

    • Scenario Analysis: Evaluates multiple possible outcomes (e.g., optimistic, pessimistic, and most likely scenarios).

    • Monte Carlo Simulation: Uses probability distributions to model the risk of a project.

  • Mutually Exclusive Projects with Unequal Lives: When comparing projects with different economic lives, special techniques are needed. The CFA study session covers “Mutually Exclusive Projects with Unequal Lives” . The Pearson Corporate Finance textbook includes an appendix on “The problem of unequal lives” .

  • Capital Rationing: Capital rationing occurs when a firm has more acceptable investment opportunities than it has funds to finance them. The CFA study session covers “Capital Rationing” . The Pearson Corporate Finance textbook includes a section on “Investment evaluation and capital rationing” . In such situations, the profitability index (PI) is often used to rank projects.

  • Real Options: Real options analysis captures the value of strategic flexibility in investment decisions. The CFA study session covers “Real Options” . The Pearson Corporate Finance textbook covers “Capital investment options” .

 

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