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CFA Level I · CFA Level I Exam · Capital Investments and Capital Allocation

An analyst reviewing a manufacturer's capital budgeting process notes that managers routinely choose projects with the highest accounting earnings in the first two years, even though other projects have higher NPVs. This behavior is most likely an example of:

The behavior is an overreliance on short-term earnings. Choosing projects for early accounting earnings instead of NPV ignores long-term cash flows and can destroy value. Risk-adjusted discount rates and abandonment options are legitimate valuation tools, not pitfalls of this kind.

  1. Aoverreliance on a short-term earnings focusCorrect
  2. Bthe use of a risk-adjusted discount rate
  3. Ca real option to abandon a project

Explanation

Selecting projects by near-term accounting earnings rather than NPV is a common capital budgeting pitfall, usually driven by short-term earnings targets. Using a risk-adjusted discount rate is sound practice, and an abandonment option is a valid source of value, so neither describes this behavior.

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