CFA Level I Exam · Capital Investments and Capital Allocation

Common Capital Budgeting Pitfalls and Valuation Effects

Updated 7 October 2026 · Fact-checked

Capital budgeting pitfalls are analyst errors that distort project NPV, such as ignoring opportunity costs, mishandling sunk costs, or using the wrong discount rate. A positive NPV project raises company value by its NPV. The stock price rises by NPV ÷ shares outstanding only for the unanticipated NPV, and with no new financing effects.

Understand Common Capital Budgeting Pitfalls and Valuation Effects

Capital budgeting is only as good as the cash flows and discount rate you feed in. Most exam questions in this area test whether you can spot a bad input, not whether you can run the NPV arithmetic.

The common pitfalls are: overestimating cash flows because of behavioral bias such as overconfidence or the desire to win approval; ignoring the cost of capital or using one rate for projects with different risk; including sunk costs; excluding opportunity costs and externalities; double counting by also deducting financing costs in cash flows already discounted at the cost of capital; failing to consider real options; and ignoring inflation consistency (nominal flows need a nominal rate, real flows a real rate). Other errors include basing decisions on accounting income rather than cash flow, and ignoring taxes or working capital.

Accounting income is revenue minus expenses under accounting rules. It uses historical cost depreciation and deducts interest expense but not a charge for equity capital. Economic income is the cash flow generated by an asset plus the change in its market value over the period. Equivalently, it is cash flow minus economic depreciation, where economic depreciation is the beginning market value minus the ending market value (a rise in value is negative depreciation). Economic income is what matters for valuation. Accounting income can differ from it because book depreciation is not the real decline in value.

Related ideas are economic profit (also called residual income): net operating profit after tax minus the dollar cost of capital, NOPAT − (WACC × capital). When the capital charge is based on beginning-of-period capital, and the initial investment is treated as part of that capital base, the project NPV equals the present value of its future economic profits. The initial outlay is captured in the capital base rather than as a separate term. Market value added is the market value of the firm minus its invested capital. It equals the present value of all the firm's future economic profits, so it is the sum of the NPVs of all its projects, existing and expected.

The claims valuation approach splits the firm's cash flows between its claimants, debt holders and equity holders. Value of the firm equals value of debt plus value of equity. It is useful because it shows who gains from a project. A positive NPV project adds to equity value, and if it is financed so that debt is fairly priced, the whole NPV goes to shareholders. Whether the market price moves depends on expectations: the stock price changes only to the extent the project's NPV is better than what the market had already assumed. A project the market already expected has no new price effect. If the project's cash flows are uncertain, the price reacts to the change in the market's expected NPV, not to the original estimate. Also, managers who accept projects by IRR or accounting EPS may reject value-adding projects that reduce near-term earnings.

Key formulas to remember

Economic income: Economic income = Cash flow + (Ending market value − Beginning market value) = Cash flow − Economic depreciation; Cash flow plus the change in market value; the change is the negative of economic depreciation.
Economic depreciation: Economic depreciation = Beginning market value − Ending market value; Can be negative if market value rises.
Economic profit (residual income): EP = NOPAT − (WACC × Capital) = EBIT(1 − t) − WACC × Capital; Positive EP means the project earns more than its capital cost. Capital is measured at the beginning of the period.
NPV and economic profit: NPV = Σ EP_t ÷ (1 + WACC)^t, for t = 1 to N; Holds when the capital charge uses beginning-of-period capital and the initial investment is part of the capital base, so the outlay is not a separate term.
Market value added: MVA = Market value of firm − Capital invested = PV of all future economic profits; Shows value created over the capital provided; it equals the sum of the NPVs of the firm's projects.
Claims valuation: Firm value = Value of debt + Value of equity; Project value is split among claimants.
Stock price effect: Change in price per share ≈ Unanticipated NPV ÷ Shares outstanding; Applies when the project was not already anticipated by the market and there are no new financing effects.

How to solve Common Capital Budgeting Pitfalls and Valuation Effects questions

Use this method for any question on pitfalls, income measures or valuation effects.

1Identify what is asked: a pitfall, an income measure, a claims split, or a price effect.
2For pitfall questions, test each option against the rules: is the item incremental, after-tax, and a future cash flow? Sunk costs and financing costs inside cash flows are errors; opportunity costs and externalities belong in.
3Check consistency: nominal flows with nominal rate, real with real, and the discount rate matching project risk.
4For income questions, compute cash flow plus change in market value for economic income, and compare with accounting figures.
5For economic profit, compute NOPAT minus WACC times beginning capital, then discount if NPV is requested.
6For price effects, compute NPV, divide by shares outstanding, and check whether the project was already expected by the market.
7Eliminate the two wrong options and choose the one consistent with value maximization.

Quickest way: Incremental cash flow filter

When to use it: For any conceptual question asking which item should or should not be included in project analysis.

Ask: does this cash flow change because we accept the project?
If it is already spent, it is sunk and excluded.
If it is a forgone alternative use of an asset, include it as an opportunity cost.
If it is interest or financing, exclude it because the discount rate captures it.
For price effect, divide the unanticipated NPV by shares.

Common mistakes in Common Capital Budgeting Pitfalls and Valuation Effects

Including sunk costs such as past research spending.
The money feels like part of the project.
Fix: Include only incremental future cash flows; past spending cannot change.
Deducting interest in project cash flows and also discounting at WACC.
Financing seems like a real cost.
Fix: Exclude financing costs from flows; the discount rate already captures them.
Treating accounting income as economic income.
Both are called income.
Fix: Economic income is cash flow plus change in market value, not book depreciation.
Forgetting opportunity costs and externalities.
They do not appear as cash outflows in the project's books.
Fix: Include the value of the best alternative use and effects on other products.
Assuming any positive NPV project raises the stock price by its NPV.
Ignoring what the market already expected.
Fix: Price moves only for the unanticipated part of the NPV.
Mixing nominal cash flows with a real discount rate.
Inflation treatment is overlooked.
Fix: Match nominal to nominal and real to real.

Worked examples

Example 1

A firm has 5,000,000 shares at €40 each. It announces a project with NPV of €6,000,000 that the market did not anticipate and that is fairly financed. What is the expected price change per share?

Show the solution

Price effect per share = NPV ÷ shares.
€6,000,000 ÷ 5,000,000 = €1.20.
New price ≈ €40 + €1.20 = €41.20.

Answer: The share price should rise by about €1.20 to €41.20.

Example 2

An asset generates a cash flow of $12 during the year. Its market value is $100 at the start and $95 at the end. What are its economic income and economic depreciation?

Show the solution

Economic depreciation = 100 − 95 = $5.
Change in market value = −$5.
Economic income = 12 + (−5) = $7, which equals 12 − 5.

Answer: Economic income is $7 and economic depreciation is $5.

Exam tips

Questions are three-option; usually one option includes a sunk cost or financing cost, so eliminate it first.
Know that economic income uses market value changes, while accounting income uses book depreciation.
For price effect, check wording such as already anticipated: the answer may be no change.
Read whether the discount rate matches the project's risk, not the firm's average.
Check units: NPV divided by shares gives per-share effect.

Practice questions from Capital Investments and Capital Allocation

Common Capital Budgeting Pitfalls and Valuation Effects: frequently asked questions

What is the difference between economic income and accounting income?

Economic income is cash flow plus the change in market value of the asset. Accounting income is revenue minus expenses using book rules, including historical cost depreciation. They differ when book depreciation does not match the real fall in value.

How does a capital budgeting decision affect stock price?

A positive NPV project adds value to the firm, and the gain accrues to shareholders, so price rises by about NPV per share. This holds only for the part the market had not already expected, and with no new financing effects.

What is the claims valuation approach?

It values the firm as the sum of its claims, debt plus equity. It helps show how project value is shared among claimants.

Should sunk costs be included in NPV?

No. Sunk costs are already spent and do not change with the decision. Only incremental after-tax future cash flows count.