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CFA Level I · CFA Level I Exam

Capital Investments and Capital Allocation for CFA Level I

Capital investments and capital allocation cover how a firm decides which long-term projects to fund. You estimate incremental after-tax cash flows, discount them at the project's cost of capital, and accept projects with positive NPV or IRR above the required return. Then you handle rankings, rationing, real options and risk.

What this chapter covers

This chapter sits in Corporate Finance. It shows how a company turns a list of possible projects into a funded plan. You learn the capital budgeting process, how to build incremental cash flows, and the decision rules: NPV, IRR, payback, discounted payback, ROI and the profitability index.

The second half deals with harder judgement. What happens when NPV and IRR disagree? What is a real option worth? How should a firm choose when funds are limited? How do you test a project for risk with sensitivity, scenario and simulation analysis? The chapter ends with common pitfalls and how investment decisions can affect firm value and stock price.

The chapter links to many other areas. Time value of money and discounting come from Quantitative Methods. Cost of capital is needed for the discount rate. Cash flow estimation uses ideas from Financial Statement Analysis, such as depreciation and taxes. Valuation effects connect to Equities, because the market prices a firm on expected returns from its investments.

Corporate Finance carries a modest weight in the 2027 curriculum (6-9%), so each chapter has to be learned efficiently. This chapter is compact, mostly rule-based and numerical, which makes it a good source of reliable marks. Questions are standalone three-option items, so you can often eliminate two options by checking the sign of NPV, the direction of a ranking conflict, or whether a cash flow should be included at all. With no penalty for wrong answers, solid concepts here let you answer quickly and save time for harder topics.

Capital Investments and Capital Allocation: topics in the order to study them

  1. 1Capital Budgeting Process and Project CategoriesStart with the vocabulary: the steps of the process and types of projects such as replacement, expansion and mandatory ones.
  2. 2Cash Flow Estimation for Capital ProjectsEvery decision rule uses cash flows, so you must know how to build incremental after-tax flows first.
  3. 3NPV and IRR Investment Decision RulesThese are the core rules, and later topics are mostly about their limits.
  4. 4Payback, Discounted Payback, ROI and Profitability IndexThese secondary measures are easier once NPV is clear, and you can compare their strengths and flaws.
  5. 5Conflicts Between NPV and IRR RankingsThis needs both rules in hand and explains why NPV is preferred for mutually exclusive projects.
  6. 6Real Options in Capital BudgetingReal options extend plain NPV by adding the value of flexibility.
  7. 7Capital Rationing and Project Risk AnalysisRationing and risk tools build on ranking rules and the NPV framework.
  8. 8Common Capital Budgeting Pitfalls and Valuation EffectsFinish with errors and firm-level effects, which tie the whole chapter together.

How to prepare Capital Investments and Capital Allocation

Aim to understand the logic first, then practise the calculations until they are quick on your calculator.

  1. Read the process and project categories once, and write a one-line definition for each category.
  2. Practise building cash flows in a fixed layout: initial outlay, operating cash flows after tax, and terminal flows. Include working capital and the tax effect of depreciation and salvage.
  3. Learn the NPV and IRR rules, then solve each type with the cash flow keys on your TI BA II Plus (CF, NPV, IRR) or HP 12C (CFj, Nj, NPV, IRR).
  4. Make a comparison table in your notes for payback, discounted payback, ROI and profitability index: formula, advantage and weakness.
  5. Work through NPV versus IRR conflicts using one example with different project scale and one with different cash flow timing. Note why the ranking differs.
  6. Practise short conceptual items on real options, rationing and risk analysis. Say aloud why two options are wrong before choosing the answer.
  7. In the last week, redo missed questions and time yourself at about 90 seconds each.

Common mistakes in Capital Investments and Capital Allocation

  • Including sunk costs or interest payments in project cash flows

    Fix: Ask whether the cash flow changes because of the decision. If not, exclude it. Treat financing effects through the discount rate.

  • Forgetting the tax effects and working capital in cash flow estimation

    Fix: Use a checklist: after-tax operating flows, depreciation tax shield, working capital investment and recovery, and after-tax salvage.

  • Choosing the project with the higher IRR when NPV disagrees

    Fix: For mutually exclusive projects, NPV measures the increase in value in currency terms. Choose the higher NPV.

  • Treating payback as a full measure of value

    Fix: Remember that payback ignores time value and later cash flows. Use it only as a liquidity-style indicator.

  • Misreading calculator cash flow entries

    Fix: Clear the registers first, enter the outlay as negative, include zero flows, and sanity-check the result with the sign of NPV.

  • Ignoring the value of flexibility in a project

    Fix: When a question mentions the option to delay, expand, abandon or switch, remember that the real option adds value to the standalone NPV.

Last-day revision: Capital Investments and Capital Allocation

  • Use incremental, after-tax cash flows only; ignore sunk costs and include opportunity costs and externalities.
  • Financing costs are not in project cash flows; they are captured in the discount rate.
  • NPV = Σ CFt ÷ (1 + r)^t, with CF0 as the initial outlay. Accept if NPV > 0.
  • Accept on IRR when IRR is greater than the required rate of return.
  • For mutually exclusive projects with conflicting ranks, choose the higher NPV.
  • Conflicts arise from differences in project size or in the timing of cash flows.
  • Payback ignores time value and cash flows after the payback period; discounted payback fixes the first but not the second.
  • Profitability index = PV of future cash flows ÷ initial investment; accept if PI > 1.
  • Changes in net working capital are cash flows, usually recovered at the project's end.
  • Real options include timing, sizing, flexibility and fundamental options; they add value to base NPV.
  • Under capital rationing, pick the combination of projects with the highest total NPV within the budget.
  • Sensitivity changes one input, scenario analysis changes several together, and simulation uses probability distributions.

Capital Investments and Capital Allocation practice questions

Capital Investments and Capital Allocation in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Capital Investments and Capital Allocation: frequently asked questions

What is the most important topic in capital investments and capital allocation?

NPV and IRR decision rules are the core. Most other topics, such as ranking conflicts and rationing, depend on understanding them. Master these first.

Do I need a financial calculator for this chapter?

Yes. The TI BA II Plus and HP 12C are the approved calculators, and both have cash flow functions for NPV and IRR. Practise entering uneven cash flows until it is automatic.

Why is NPV preferred over IRR?

NPV measures the change in value in currency terms and assumes reinvestment at the discount rate. IRR can mislead when projects differ in scale or cash flow timing. For mutually exclusive projects, NPV gives the better decision.

How does this chapter connect to the rest of Corporate Finance?

It uses the cost of capital as the discount rate and links to capital structure through financing. It also connects to valuation, because investment decisions drive firm value.