Capital budgeting and cost of capital - Project evaluation a...

Learning Outcomes

This article explains how to evaluate and compare capital investment projects using core CFA Level 1 tools and concepts. It focuses on identifying and forecasting relevant, incremental after-tax cash flows, distinguishing them from sunk costs and non-incremental overheads, and incorporating opportunity costs into project appraisal. The article shows how net present value (NPV) and internal rate of return (IRR) are calculated, interpreted, and used in decision-making, including the correct ranking of mutually exclusive projects. It also explains when simple return metrics such as return on invested capital (ROIC) are useful, and why NPV should remain the primary value-based criterion. Particular attention is given to the role of the weighted-average cost of capital (WACC) as the appropriate discount rate, how it reflects project and firm risk, and how misestimating WACC can distort investment decisions. Finally, the article highlights common analytical pitfalls tested in the exam and reinforces how disciplined capital budgeting supports shareholder value creation.

CFA Level 1 Syllabus

For the CFA Level 1 exam, you are expected to understand and apply the fundamentals of capital budgeting and cost of capital, with a focus on the following syllabus points:

• Identifying types of capital investment projects and categorizing their purposes.
• Calculating and interpreting the net present value (NPV) and internal rate of return (IRR) for individual projects.
• Comparing the use of NPV, IRR, and other return metrics (like ROIC) in making project decisions.
• Understanding the role and calculation of the weighted-average cost of capital (WACC) as a discount rate for project decisions.
• Distinguishing between relevant, incremental project cash flows and sunk or non-incremental costs.
• Recognizing pitfalls in project evaluation, such as incorrect discount rates, inconsistent inflation treatment, and ignoring opportunity costs.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the principal difference between NPV and IRR as measures for project assessment?
2. Which types of cash flows should be included when evaluating a potential capital investment?
3. Why is the WACC typically used as a project discount rate, and what are the consequences of using an unadjusted WACC for high-risk projects?
4. What is the incremental effect on firm value of a positive-NPV project?

Introduction

Capital budgeting assesses a company’s long-term investments, such as machinery, new production facilities, IT systems, or acquisitions, aimed at value creation. Sound project evaluation requires correctly identifying relevant cash flows, applying suitable return measures, and using an appropriate discount rate that reflects the risk borne by capital providers.

Key Term: capital budgeting
The process of analyzing and selecting long-term investments that add value to the firm.

Key Term: cost of capital
The required rate of return demanded by investors to compensate for the risk of their capital provided to the company.

TYPES OF CAPITAL INVESTMENTS

Companies undertake several categories of capital investments:

• Going concern/maintenance projects: Replace worn or obsolete assets to sustain current operations.
• Regulatory/compliance projects: Required by law or regulation, often with no direct revenue benefit.
• Expansion projects: Increase capacity or extend business scope (often riskier, with higher uncertainty).
• Other discretionary projects: New lines of business, strategic acquisitions, or technological innovation.

Each investment should be evaluated on its expected cash flows and strategic relevance. Regulatory projects may be essential even with negative NPV, whereas discretionary investments should increase shareholder wealth.

FUNDAMENTALS OF CAPITAL ALLOCATION

The capital allocation process involves:

1. Generating ideas for potential investments.
2. Forecasting project cash flows: Only after-tax, incremental cash flows matter.
3. Assessing project viability using decision rules, primarily NPV and IRR.
4. Prioritizing among investment opportunities, taking constraints into account.
5. Monitoring project performance and revising the analysis if significant changes occur.

Principles for Project-related Cash Flows

• Include only future, incremental after-tax cash flows directly attributable to the project.
• Ignore sunk costs and allocated overheads that would not change regardless of project acceptance.
• Include opportunity costs where existing assets or resources are redeployed due to the new project.

Key Term: incremental cash flow
The net after-tax cash inflow or outflow expected due to accepting a project, relative to not undertaking it.

Key Term: sunk cost
A past expenditure that cannot be recovered and is irrelevant for project analysis.

MEASURES FOR PROJECT APPRAISAL

Net Present Value (NPV)

NPV equals the present value of forecasted project cash inflows minus the initial investment and any future outflows, discounted at the WACC. A positive NPV means the project should be accepted; it will increase shareholder value.

Key Term: net present value (NPV)
The sum of all discounted after-tax cash flows for a project, using the cost of capital as the discount rate.

Internal Rate of Return (IRR)

IRR is the discount rate that sets NPV to zero. IRR greater than the required rate of return means the project is acceptable, but NPV remains the preferred criteria, especially when ranking mutually exclusive projects.

Return on Invested Capital (ROIC)

ROIC evaluates the firm’s aggregate profitability over time, dividing after-tax operating profit by average total invested capital (long-term equity plus long-term debt).

Key Term: weighted-average cost of capital (WACC)
The blended required return of all capital providers (debt and equity), weighted by their market value proportions and adjusted for tax deductibility of interest.

Worked Example 1.1

Question: A firm is considering a EUR30m investment expected to generate EUR9m of annual after-tax cash flows for 5 years. The WACC is 8%. What is the project’s NPV?

Answer:
NPV = –30 + 9/(1.08) + 9/(1.08)^2 + 9/(1.08)^3 + 9/(1.08)^4 + 9/(1.08)^5 = –30 + 9 × 3.993 = –30 + 35.94 = EUR5.94m.
The project should be accepted; it increases firm value by EUR5.94m.

Worked Example 1.2

Question: A company’s WACC is 10%. Two mutually exclusive projects have the following characteristics. Project X: IRR = 13%, NPV = USD2m. Project Y: IRR = 16%, NPV = USD1.2m. Which project should the company undertake?

Answer:
The company should accept Project X, because its higher NPV adds more to shareholder wealth, despite Y’s higher IRR.

Exam Warning

Using IRR as the sole decision rule can give incorrect rankings when projects have non-conventional cash flows or mutually exclusive alternatives. Always prefer NPV when choosing among competing projects.

COST OF CAPITAL AND DISCOUNT RATES

The appropriate discount rate for project cash flows is usually the WACC, reflecting the risk of the project if it matches the company’s average risk profile. For higher risk projects (compared to the company average), a higher discount rate should be used; for low-risk projects, a lower rate may be suitable.

Worked Example 1.3

Question: A firm’s capital consists of 40% debt (post-tax cost 4%) and 60% equity (cost 9%). What is the WACC?

Answer:
WACC = 0.4 × 4% + 0.6 × 9% = 1.6% + 5.4% = 7.0%.
This is the rate used to discount project cash flows.

COMMON PITFALLS IN PROJECT APPRAISAL

• Mixing nominal and real cash flows and discount rates.
• Failing to account for incremental cash flows.
• Ignoring opportunity costs or double counting cash flows.
• Using incorrect WACC when project risk differs from company average.
• Overly optimistic cash flow forecasts or underestimating required investment.
• Allocating capital based on accounting measures (e.g., EPS) rather than value creation.
• Ignoring effects of project timing or flexibility (real options).
• Including sunk costs or irrelevant overhead allocation.

Revision Tip

Always check cash flows are after-tax, incremental, and exclude sunk costs or non-cash charges unrelated to capital expenditure.

Summary

Sound capital budgeting ensures companies only invest in projects that increase firm value. NPV and IRR are the most important decision rules—NPV is preferred when projects conflict. Project cash flows must be incremental, after-tax, and discounted at an appropriate rate—WACC is normally suitable for projects with average risk. Avoid common analytical errors and always prioritize value creation for shareholders.

Key Point Checklist

This article has covered the following key knowledge points:

• Distinguish between types of capital investment projects and their appraisal.
• Identify relevant incremental cash flows for project evaluation.
• Calculate and interpret NPV, IRR, and ROIC.
• Apply the WACC as the project discount rate.
• Prefer NPV over IRR for mutually exclusive projects or when ranking alternatives.
• Avoid including sunk costs or irrelevant overheads in project appraisals.
• Recognize the importance of project risk in selecting an appropriate discount rate.

Key Terms and Concepts

• capital budgeting
• cost of capital
• incremental cash flow
• sunk cost
• net present value (NPV)
• weighted-average cost of capital (WACC)