Capital Investments and Capital Allocation

CFA LEVEL 1 CORPORATE ISSUERS CAPITAL INVESTMENTS AND CAPITAL ALLOCATION CLASS 1 CW CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 1 | CW Warm Up on LM 6: Capital Structure Question 1: A company is evaluating different capital structures and has gathered the following information about various debt ratios (Wd), pre tax cost of debt, and cost of equity. Calculate the weighted average cost of capital (WACC) for each structure and determine which capital structure is optimal (i.e., which has the lowest WACC). Debt Ratio (Wd) 0.2 0.5 0.8 0.9 Pre Tax Cost of Debt (%) 12 15 16 20 Cost of Equity (%) 15 18 22 25 Assume a tax rate of 30%. 1 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 1 | CW Answer: To calculate the weighted average cost of capital (WACC) for each capital structure, use the following formula: WACC = (Wd × kd × (1 − T)) + (We × ke) Where: • Wd is the proportion of debt in the capital structure. • kd is the pre-tax cost of debt. • T is the tax rate. • We is the proportion of equity in the capital structure (1−Wd). • ke is the cost of equity. 2 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 1 | CW Given that the tax rate is 30%, the calculations for each capital structure are: 1. For Wd = 0.2 WACC = (0.2×12%×(1−0.3))+(0.8×15%) = (0.2×12%×0.7)+(0.8×15%) = (0.2×8.4%)+(0.8×15%) = 1.68%+12% = 13.68% 2. For Wd = 0.5 WACC = (0.5×15%×(1−0.3))+(0.5×18%) = (0.5×15%×0.7)+(0.5×18%) = (0.5×10.5%)+(0.5×18%) = 5.25%+9% = 14.25% 3 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 1 | CW 3. For Wd = 0.8 WACC = (0.8×16%×(1−0.3))+(0.2×22%) = (0.8×16%×0.7)+(0.2×22%) = (0.8×11.2%)+(0.2×22%) = 8.96%+4.4% = 13.36% 4. For Wd = 0.9 WACC = (0.9×20%×(1−0.3))+(0.1×25%) = (0.9×20%×0.7)+(0.1×25%) = (0.9×14%)+(0.1×25%) = 12.6%+2.5% = 15.1% Optimal capital structure: The optimal capital structure is the one with the lowest WACC, which is at Wd=0.8 with a WACC of 13.36%. 4 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 1 | CW Warm Up on LM 5: Capital Investments and Capital Allocation Question 2: The firm is now evaluating the following three project which are independent, non mutually exclusive and non repetitive. We are provided with the post tax cash flows associated with these projects. These projects have the same risk as the existing risk of the firm. So, the WACC corresponding the optimal capital structure derived in question no. 1 above can be used as the hurdle rate. Calculate the IRR for each project and decide whether to accept them or reject them. Project A: • Year 0 (Initial Outflow): ₹100,000 • Year 1: ₹30,000 • Year 2: ₹40,000 • Year 3: ₹50,000 5 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 1 | CW Project B: • • • • • Year 0 (Initial Outflow): ₹150,000 Year 1: ₹40,000 Year 2: ₹50,000 Year 3: ₹60,000 Year 4: ₹70,000 Project C: • • • • • • Year 0 (Initial Outflow): ₹200,000 Year 1: ₹40,000 Year 2: ₹50,000 Year 3: ₹60,000 Year 4: ₹70,000 Year 5: ₹80,000 6 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 1 | CW Answer: To determine whether to accept or reject the projects, we calculate the internal rate of return (IRR) for each project and compare it with the WACC of 13.36% (from Question 1). If the IRR is greater than the WACC, the project should be accepted. Steps to Calculate IRR on BA II Plus: 1. Clear previous data: Press CF → 2nd → CLR WORK (This clears any previous cash flow entries). 2. Input the cash flows for each project: o 3. Press CF (Cash Flow) to begin entering the cash flows. After entering the cash flows, calculate the IRR: Press IRR → CPT to compute the IRR. 7 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 1 | CW Project A: • • • • Year 0 (Initial Outflow): ₹100,000 Year 1: ₹30,000 Year 2: ₹40,000 Year 3: ₹50,000 Steps: 1. 2. Press CF → 2nd → CLR WORK (to clear previous entries). Enter cash flows: o o o o 3. CF0 = -100000 → ENTER C01 = 30000 → ENTER C02 = 40000 → ENTER C03 = 50000 → ENTER Press IRR → CPT. Result: IRR = 8.90% Since 8.90% < 13.36% (WACC), reject Project A. 8 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 1 | CW Project B: • Year 0 (Initial Outflow): ₹150,000 • Year 1: ₹40,000 • Year 2: ₹50,000 • Year 3: ₹60,000 • Year 4: ₹70,000 Steps: 1. 2. Press CF → 2nd → CLR WORK. Enter cash flows: o CF0 = -150000 → ENTER o C01 = 40000 → ENTER o C02 = 50000 → ENTER o C03 = 60000 → ENTER o C04 = 70000 → ENTER 3. Press IRR → CPT. Result: IRR = 15.62% Since 15.62% > 13.36%, accept Project B. 9 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 1 | CW Project C: • Year 0 (Initial Outflow): ₹200,000 • Year 1: ₹40,000 • Year 2: ₹50,000 • Year 3: ₹60,000 • Year 4: ₹70,000 • Year 5: ₹80,000 Steps: 1. Press CF → 2nd → CLR WORK. 2. Enter cash flows: o CF0 = -200000 → ENTER o C01 = 40000 → ENTER o C02 = 50000 → ENTER o C03 = 60000 → ENTER o C04 = 70000 → ENTER o C05 = 80000 → ENTER 3. Press IRR → CPT. Result: IRR = 13.45% Since 13.45% > 13.36%, accept Project C. 10 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 1 | CW Question 3: Not discussed in Class 11 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 1 | CW Warm Up on LM 4: Working Capital and Liquidity Question 4: A manufacturing company, XYZ Ltd., is experiencing a liquidity crunch. The CFO is evaluating its working capital cycle to identify areas of improvement. The following data is available: • • • • • • Inventory Days: 45 days Accounts Receivable Days: 30 days Accounts Payable Days: 60 days Cost of Goods Sold (COGS): ₹500 crore Revenue: ₹800 crore Purchases: ₹400 crore 12 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 1 | CW The CFO has the opportunity to renegotiate terms with suppliers, extending Accounts Payable Days to 75 days. The company is also considering reducing Inventory Days by 5 days through better inventory management and improving cash collection by reducing Accounts Receivable Days by 3 days. 1. Calculate the current cash conversion cycle (CCC). 2. Recalculate the CCC based on the CFO's proposed improvements. 3. How would these changes impact the company’s liquidity and working capital management? 13 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 1 | CW Answer: 1. Current Cash Conversion Cycle (CCC): • CCC = Inventory Days + Receivables Days - Payables Days • CCC = 45 + 30 - 60 = 15 days 2. Proposed Changes: • New Inventory Days = 45 - 5 = 40 days • New Receivables Days = 30 - 3 = 27 days • New Payables Days = 60 + 15 = 75 days • New CCC = 40 + 27 - 75 = -8 days 3. Impact on Liquidity: The new cash conversion cycle is now negative (-8 days), meaning the company is able to pay off its suppliers after converting inventory into cash and collecting receivables. This reflects an improvement in liquidity as the company has more time to generate cash from operations before having to settle its payables. This could significantly enhance working capital management. 14 SANJAY SARAF SIR CFA LEVEL 1 CORPORATE ISSUERS CAPITAL INVESTMENTS AND CAPITAL ALLOCATION CLASS 3 CW CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Question 1: Which of the following is considered a maintenance capital investment rather than a growth capital investment? A. Acquisition B. Replace outdated facilities C. Research and development 1 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Answer: B is correct. Replacing outdated facilities is a maintenance capital investment. It is intended to ensure continued operational efficiency and compliance with safety or regulatory standards, rather than driving new growth. A is incorrect. Acquisitions are typically associated with growth capital investments because they aim to expand business operations, market reach, or capabilities. C is incorrect. Research and development is a growth capital investment as it seeks to innovate and improve the company’s offerings, potentially leading to new products or market expansion. 2 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Question 2: Which of the following types of capital investments is most likely aimed at growth rather than maintenance? A. Limited downside risk and uncertainty B. High-risk investment with potential for high returns C. Replace outdated facilities 3 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Answer: B is correct. High-risk, high-reward investments are characteristic of growth capital investments. They are aimed at expanding the company’s capabilities or market reach, often involving greater uncertainty but also the potential for significant returns. A is incorrect. This type of investment is generally associated with maintenance capital, as it focuses on stability and reducing risk rather than pursuing growth opportunities. C is incorrect. This is a maintenance investment as it focuses on keeping the current infrastructure updated and compliant, rather than expanding business operations or seeking new growth avenues. 4 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Question 3: Which of the following statements is least likely correct in the context of maintenance versus growth capital investments? A. High-risk investments with uncertain outcomes are typically associated with growth capital projects. B. Replacing outdated facilities is considered a growth investment aimed at expanding business operations. C. Acquisitions are generally pursued as part of growth strategies rather than maintenance. 5 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Answer: B is correct. This statement is least likely correct because replacing outdated facilities is generally a maintenance investment, focusing on operational continuity and compliance rather than growth. A is incorrect. High-risk investments are characteristic of growth capital projects, as they aim to drive expansion and innovation. C is incorrect. Acquisitions are typically growth-oriented investments, used to expand a company's market share, capabilities, or geographical reach. 6 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Question 4: Which of the following statements is least likely correct regarding capital investment types? A. Research and development projects are primarily aimed at maintaining current operational efficiency. B. Expanding business scope is a common goal of growth capital investments. C. Limited downside risk and regulatory compliance are typical attributes of maintenance investments. 7 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Answer: A is correct. This statement is least likely correct because research and development projects are generally aimed at growth. They focus on innovation and creating new products or services, which helps the company expand rather than simply maintain operations. B is incorrect. Growth capital investments are aimed at expanding business scope, market share, or capabilities. C is incorrect. Maintenance investments focus on stability, compliance, and reducing operational risks, ensuring the company’s current operations are safe and efficient. 8 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Question 5: A company is planning various capital investments. Which of the following best characterizes a maintenance investment? A. Funding a new project to enter an emerging market B. Upgrading existing machinery to meet new safety regulations C. Investing in research to develop innovative products 9 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Answer: B is correct. This is characteristic of a maintenance investment, which focuses on ensuring existing operations are safe, compliant, and efficient, rather than expanding the business. A is incorrect. This option represents a growth investment, as it is aimed at expanding into new markets and increasing the company’s revenue potential. C is incorrect. Research and development are associated with growth investments, as they seek to introduce new products or services that can increase the company’s market presence and profitability. 10 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Question 6: Which of the following most likely represents a growth-oriented capital investment? A. Replacing outdated equipment to maintain operational efficiency B. Acquiring another company to increase market share C. Complying with new regulatory standards by upgrading existing facilities 11 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Answer: B is correct. Acquisitions are typically growth-oriented investments, as they aim to expand the company’s market presence and operational scope. A is incorrect. This is a maintenance investment, as it focuses on keeping the company’s current operations running smoothly rather than expanding its reach or capabilities. C is incorrect. This is a maintenance investment, as it ensures the company meets required compliance standards, rather than pursuing growth. 12 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Question 7: Which of the following capital projects would most likely be classified as a regulatory or compliance investment? A. Developing a new line of computer peripherals for gamers B. Investing in solar panel production to benefit from subsidies C. Installing an advanced ventilation system in office buildings to meet air pollution regulations 13 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Answer: C is correct. This project is driven by the need to comply with stricter air pollution regulations, making it a regulatory or compliance investment. A is incorrect. This would be considered an expansion of existing business, as it involves introducing a new product line aimed at increasing market share. B is incorrect. This project would fall under new lines of business or other categories as it involves a strategic move to capitalize on subsidies, which does not directly relate to regulatory compliance. 14 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Question 8: A company is considering various capital projects. Which of the following is most likely an example of a going concern/maintenance investment? A. Migrating on-site data storage to cloud computing to improve cost efficiency B. Investing in a new product line to capture a different market segment C. Installing solar panels to leverage government subsidies 15 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Answer: A is correct. This project is classified as going concern/maintenance, as it focuses on improving the cost efficiency of existing operations rather than expanding or introducing new business lines. B is incorrect. This would be considered an expansion of existing business or a new line of business, as it aims to grow the company’s market reach by targeting a new segment. C is incorrect. This is a strategic move to take advantage of government subsidies and would be considered a growth investment or new line of business rather than maintenance. 16 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Question 9: Which of the following projects would be least likely classified as an expansion of existing business? A. A property management company upgrading ventilation systems to comply with stricter pollution regulations B. A tire producer investing in solar energy to lower operational costs and benefit from government subsidies C. An office equipment company launching a new line of gaming accessories 17 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Answer: A is correct. This project is not focused on expanding the business; rather, it is a regulatory or compliance investment to meet environmental standards. B is incorrect. While this project might have sustainability goals, it also serves as a growth investment by introducing renewable energy sources, which can contribute to cost reduction and strategic expansion. C is incorrect. This is an expansion of the business as it involves entering a new product segment, which aims to increase market presence and capture additional revenue. 18 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Question 10: Which of the following projects is most likely focused on entering a new line of business? A. A bank migrating its data storage to a cloud platform for improved efficiency B. A tire company developing an electric vehicle tire line to cater to a new market trend C. An office upgrading its HVAC system to adhere to updated health and safety standards 19 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Answer: B is correct. This represents a new line of business for the tire company, as it is expanding its product offerings to cater to the growing electric vehicle market. A is incorrect. This is a going concern or maintenance project, aimed at enhancing operational efficiency rather than entering a new business line. C is incorrect. This is a regulatory or compliance project focused on meeting updated standards rather than entering a new line of business. 20 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Question 11: Given a discount rate of 10%, the net present value (NPV) of the following investment is closest to: Time Cash flow A. A.578. B. B.605. C. C.636. 0 1 2 3 4 5 6 −1,500 300 600 1,000 200 500 300 21 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Answer: C is correct. The given cash flows are inserted into a financial calculator along with the 10% discount rate: CF 0 = −1,500, CF1 = 300, CF2 = 600, CF3 = 1,000, CF4 = 200, CF5 = 500, CF6 = 300, I = 10. Computing NPV the result is 636.32 ~ 636. Alternatively, the net present value of the project is found by discounting each cash flow by the time at which it arises, at the appropriate discount rate, as follows: A is incorrect; 578 occurs when the cash flows are discounted by one period too many (i.e., Year 0 is discounted as if it were Year 1, Year 1 is discounted as if it were Year 2, etc.): CF 1 = −1,500, CF2 = 300, CF3 = 600, CF4 = 1,000, CF5 = 200, CF6 = 500, CF7 = 300, I = 10. Computing NPV the result is 578. B is incorrect; the mistake is to use the average cash flow across the six years (483.33). Using a financial calculator: PMT = −483.33, N = 6, I/Y = 10, FV = 0. Computing PV (PV = 2,105.03) and subtracting 1,500: 2,105.03 − 1500 = 605.03 ~ 605. 22 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Question 12: Gerhardt Corporation is considering a capital investment of €50 million today that is expected to return after-tax cash flows of €16 million per year for the next four years, plus an additional €20 million in Year 5. If the required rate of return is 10%, what is the Net Present Value (NPV) of this investment? A. €10.25 million B. €13.14 million C. €15.30 million 23 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Answer: B is correct. Using the NPV formula, the calculation involves discounting each cash flow at a 10% rate and subtracting the initial investment: Performing these calculations yields an NPV of approximately €13.14 million. A is incorrect. €10.25 million would result from a calculation error or a different discount rate. C is incorrect. €15.30 million is incorrect and likely comes from using an incorrect cash flow or discount factor in the NPV calculation. 24 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Question 13: Gerhardt Corporation is considering a capital investment of €50 million today with the following estimated cash flow schedule over the next five years: Year (t) 0 1 1.5 2 3 4 5 Cash Flow (€ million) -50 10 -5 13 16 19 23 If the required rate of return is 10%, what is the Net Present Value (NPV) of this investment, and should Gerhardt make the investment? A. NPV = €3.12 million; Gerhardt should not make the investment. B. NPV = €4.78 million; Gerhardt should make the investment. C. NPV = €2.50 million; Gerhardt should make the investment. 25 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Answer: B is correct. Using the NPV formula with the given cash flows and a 10% discount rate, the NPV calculation is as follows: This results in an NPV of approximately €4.78 million. Since the NPV is positive, Gerhardt should proceed with the investment. A is incorrect. €3.12 million is an incorrect calculation and does not reflect the proper NPV for this investment. C is incorrect. €2.50 million is also incorrect and likely results from calculation errors. 26 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Question 14: Assume that Gerhardt Corporation is considering a capital investment of €50 million today, expecting to return after-tax cash flows of €16 million per year for the next four years and an additional €20 million in Year 5. What is the Internal Rate of Return (IRR) of this investment? A. 15.25% B. 19.52% C. 21.10% 27 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Answer: B is correct. Solution using BA II Plus Calculator: 1. Enter the Cash Flows: o Press CF to access the cash flow worksheet. o Enter CF0 as -50 (initial investment): Press 50, then +/−, then ENTER. o Press ↓ to go to C01, enter 16 (for cash flows in years 1 to 4), then press ENTER. o Press ↓ to go to F01 (frequency), enter 4, then press ENTER to indicate that this cash flow repeats for four periods. o Press ↓ to go to C02, enter 20 (cash flow in Year 5), then press ENTER. 2. Calculate IRR: o Press IRR, then CPT to compute the IRR. 3. Result: The calculator will display an IRR of approximately 19.52%. A is incorrect. 15.25% is incorrect and results from an error in cash flow entry or calculation. C is incorrect. 21.10% is incorrect and does not reflect the proper IRR for this cash flow series. 28 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Question 15: Assume that a corporate issuer reported after-tax operating profits of €24,395 in Year 2 and the following balance sheet information: Assets: Cash Short-term assets Long-term assets Total assets End of Year 1 4,364 40,529 287,857 332,750 End of Year 2 6,802 52,352 279,769 338,923 Liabilities and Equity: Accounts payable Short-term debt Long-term debt End of Year 1 35,221 21,142 112,257 End of Year 2 50,766 5,877 106,597 15,688 148,442 332,750 15,688 159,995 338,923 Share capital Retained earnings Total liabilities and equity Calculate the Return on Invested Capital (ROIC) for Year 2. A. 8.73% B. 9.12% C. 10.15% 29 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 3 | CW Answer: A is correct. ROIC is calculated using the formula: B is incorrect. 9.12% is incorrect, likely from a miscalculation of average invested capital. C is incorrect. 10.15% is also incorrect and does not match the given information. 30 SANJAY SARAF SIR CFA LEVEL 1 CORPORATE ISSUERS CAPITAL INVESTMENTS AND CAPITAL ALLOCATION CLASS 4 CW CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 4 | CW Question 1: Which of the following steps in the capital allocation process involves evaluating the potential profitability and risk-adjusted returns of various investment opportunities? A. Investment Analysis B. Idea Generation C. Monitoring and Post-Investment Review 1 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 4 | CW Answer: A is correct. Investment Analysis is the phase where management assesses the expected cash flows, timing, duration, and risk of an investment, which is essential for determining whether it provides a wise use of capital. B is incorrect. Idea Generation involves sourcing new investment ideas but does not focus on analyzing returns. C is incorrect. Monitoring and Post-Investment Review deals with tracking the performance of the investment after implementation rather than evaluating initial profitability. 2 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 4 | CW Question 2: In the capital allocation process, which step primarily focuses on sourcing ideas for potential investments that align with the firm’s competitive environment and capabilities? A. Investment Analysis B. Planning and Prioritization C. Idea Generation 3 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 4 | CW Answer: C is correct. Idea Generation is where management sources ideas from within the firm, based on current capabilities and competitive positioning, sometimes involving external consultants. A is incorrect. Investment Analysis is about assessing the forecasted cash flows of potential investments. B is incorrect. Planning and Prioritization focuses on selecting and organizing investments based on risk-adjusted return criteria, not on generating new ideas. 4 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 4 | CW Question 3: Which of the following statements best describes the 'Planning and Prioritization' phase in the capital allocation process? A. It involves monitoring the investment performance against projections and making necessary adjustments. B. It involves selecting and organizing investments based on their risk-adjusted return potential. C. It involves generating ideas that align with the firm's strategic direction. 5 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 4 | CW Answer: B is correct. Planning and Prioritization is the phase where management selects and ranks investment opportunities that are expected to yield returns exceeding the opportunity cost. A is incorrect. This is part of the Monitoring and Post-Investment Review phase. C is incorrect. This is part of the Idea Generation phase, not Planning and Prioritization. 6 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 4 | CW Question 4: Which step in the capital allocation process most likely involves the calculation of NPV and IRR? A. Idea generation B. Planning and prioritization C. Investment analysis 7 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 4 | CW Answer: C is correct. The investment analysis step involves forecasting the amount, timing, duration, and volatility of an investment’s expected cash flows and subsequently using NPV and IRR to determine whether the investment will be a wise use of capital. A is incorrect because during the idea generation step, management gathers ideas and chooses the most promising ones for further analysis. However, in this early phase, no forecasts or profitability analysis involving NPV or IRR is conducted. B is incorrect because during the planning and prioritization step, management selects and prioritizes profitable investment opportunities that, when considered together, are the most value enhancing on a risk-adjusted return basis. This step occurs after NPV and IRR analysis. 8 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 4 | CW The following information relates to questions 5-9 Larissa Soroka, an analyst at ABC company, has been asked to prepare cash flow forecasts for two mutually exclusive investment projects related to new products. ABC’s management asks Soroka to include the cost of market research that was recently completed as well as the potential loss of revenue from existing products that could occur if either project is undertaken. Soroka presents the forecast in Exhibit 1 and is asked to calculate IRR and NPV for both projects. Investors in ABC have a required rate of return of 8%. Exhibit 1 Time Project A Project B Cash Flow Forecast for Projects A and B 0 1 2 (18.5) 4.5 6.0 (33.5) (2.5) (1.0) 3 6.0 24.0 4 5.5 25.5 ABC’s management asks Soroka to consider in her forecast the impact of a six-month delay in all future cash flows and estimate the impact of that event on IRR and NPV. After reviewing the forecast, ABC’s management asks Soroka to estimate ABC’s ROIC for 20X2. ABC earned operating profit of $8,830, had an effective tax rate of 22%, and reported the balance sheet in Exhibit 2. 9 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 4 | CW Exhibit 2 ABC Balance Sheet (end-of-period values) Assets: Cash Short-term assets Long-term assets Total assets 20X1 1,600 30,450 60,250 92,300 20X2 1,720 29,910 62,060 93,690 Liabilities and equity: Accounts payable Short-term debt Long-term debt Share capital Retained earnings Total liabilities and equity 20X1 12,930 8,030 25,040 39,800 6,500 92,300 20X2 11,620 8,390 25,910 40,990 6,780 93,690 ABC’s management has an ROIC objective of at least 9.2% and asks Soroka for her recommendation about the projects. 10 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 4 | CW Question 5: When preparing the cash-flow forecasts for both projects, Soroka should include: A. only the cost of the market research. B. only the loss of revenue from existing products. C. both the market research cost and the loss of revenue from existing products. 11 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 4 | CW Answer: B is correct. Capital allocation analysis should include only incremental cash flows associated with a new investment. The loss of revenue from existing products is an incremental negative effect that should be included in the analysis. The market research costs in this case are a sunk cost because the research has already been completed and therefore does not affect cash-flow estimates, no matter whether ABC undertakes either of these projects or neither of them. 12 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 4 | CW Question 6: With regard to Project A and Project B, which of the following is true? A. Both projects should be invested in according to the IRR decision rule. B. Both projects should be invested in according to the NPV decision rule. C. Only Project B should be invested in according to the IRR decision rule. 13 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 4 | CW Answer: C is correct. The IRR decision rule is to invest if the IRR exceeds the required rate of return or hurdle rate. Project B’s IRR is 8.97%, which exceeds the required rate of return of 8%; however, Project A’s IRR is 7.04%, which is below the required rate of return of 8%. The NPV of both projects can be calculated as follows: 14 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 4 | CW A is incorrect because Project B’s IRR is 8.97%, which exceeds the required rate of return of 8%; however, Project A’s IRR is 7.04%, which is below the required rate of return of 8%. Consequently, only Project B meets the IRR decision rule. B is incorrect because the NPV decision rule is to invest if the NPV is greater than 0. Project B’s NPV is $1.12 million, while Project A’s NPV is –$0.38. Consequently, only Project B meets the NPV decision rule. 15 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 4 | CW Question 7: The most likely impact from the cash-flow timing considered by Soroka is that: A. both IRR and NPV would decrease. B. both IRR and NPV stay unchanged. C. only IRR would decrease but NPV would increase. 16 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 4 | CW Answer: A is correct. The forecasted timing of cash flow is an important factor affecting both projects’ IRR and NPV. In the case of delaying all future cash flows from both projects by six months, the result would be a lower IRR and a lower NPV. Given that all future cash flows are to be received six months later, their present value decreases; hence, the NPV and IRR of an entire project also decrease. B is incorrect because when cash flows from the investment projects are delayed by six months, both projects’ NPV and IRR would decrease, not stay unchanged. C is incorrect because when cash flows from the investment projects are delayed by six months, both project’s NPV and IRR would decrease. 17 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 4 | CW Question 8: Based on ABC’s balance sheet presented in Exhibit 2, Soroka should calculate: A. average invested capital of $72,510 and ROIC of 9.50%. B. average invested capital of $80,720 and ROIC of 10.94%. C. average invested capital of $92,995 and ROIC of 9.50%. 18 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 4 | CW Answer: A is correct. To calculate ROIC, we can use the following formula: 19 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 4 | CW Question 9: Considering ABC management’s ROIC-based investment criterion and the IRR and NPV of both projects, Soroka should recommend to: A. reject both projects A and B. B. invest only in Project B because it has a higher NPV. C. invest only in Project A because has positive cash flow during all four years. 20 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 4 | CW Answer: A is correct. ABC’s management aims to achieve a minimum ROIC above 9.20%, but the IRR of both projects fails to meet this investment criterion. Even though Project B has a positive NPV, if it were undertaken, it would reduce ROIC. B is incorrect because even though Project B’s NPV is $1.12 million (which increases ABC’s value to shareholders), its IRR is 8.97%, which is below the target ROIC of 9.20%. Consequently, if Project B was undertaken, it would lower ABC’s ROIC. C is incorrect because Project A’s IRR is below ABC management’s target ROIC of 9.2%. Additionally, Project A’s NPV is negative, so it decreases ABC’s shareholder value. 21 SANJAY SARAF SIR CFA LEVEL 1 CORPORATE ISSUERS CAPITAL INVESTMENTS AND CAPITAL ALLOCATION CLASS 5 CW CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Question 1 to 5: Not discussed in class Question 5: When calculating IRR, the interim cash flows are assumed to be reinvested and earn a rate of return rate that is: A. lower than IRR B. the same as IRR. C. higher than IRR. 1 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Answer: B is correct. An important assumption of IRR is that it represents only the (geometric) rate of return on the investment if interim cash flows are reinvested at the IRR. A is incorrect because if reinvestment rates are lower compared to IRR, the rate of return on the investment will be lower than the IRR. C is incorrect because if reinvestment rates are higher compared to IRR, the rate of return on the investment will be higher than the IRR. 2 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Question 6: Not discussed in class Question 7: Which of the following relationships is true? A. If IRR > Required rate of return, then NPV < 0. B. If IRR = Required rate of return, then NPV = 0. C. Required rate of return = Risk-free rate. 3 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Answer: B is correct. IRR is the required rate of return that makes an investment’s NPV equal to zero. A is incorrect because IRR is the required rate of return for which NPV = 0. If IRR is greater than the required rate of return, then NPV of cash flows discounted at the required rate of return will be greater than zero, not less than zero. C is incorrect because when calculating NPV, expected cash flows should be discounted at the required rate of return to reflect investors’ opportunity cost for similarly risky projects, not a rate that ignores risk. 4 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Question 8 & 9: Not discussed in class Question 10: The annual report of company XYZ contains the following disclosures: Disclosure 1: “XYZ’s management compensation is based on exceeding a target EPS growth rate.” Disclosure 2: “XYZ’s management does not change the required rate of return when evaluating capital projects based on whether they are financed by internal or external sources.” Disclosure 3: “When evaluating investment projects, XYZ prepares cashflow projections based on inflation-adjusted cash flows and discounts them using real rates. Which of the disclosed policies does not conform to best practices regarding capital allocation? 5 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW A. Disclosure 1 B. Disclosure 2 C. Disclosure 3 6 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Answer: A is correct. Positive-NPV investment projects can reduce, rather than increase, EPS in the near term, even though they increase shareholder value. Management compensation should incorporate a longerterm perspective and a measure that better considers required rates of return, such as ROIC. B is incorrect because internally generated capital, such as cash flow from operations, is equity financing and it could be returned to equity investors as a dividend. Regardless of the financing source, management should use appropriate risk-adjusted required rates of return to evaluate capital investments. C is incorrect because companies may perform analysis in either nominal or real terms, but the approach to cash flows and the discount rate should be consistent. That is, nominal cash flows should be discounted at a nominal discount rate, and real (inflation-adjusted) cash flows should be discounted at a real rate. 7 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Question 11: An analyst is analyzing company XYZ and has gathered annual invested capital and ROIC for each of the three XYZ business segments. Segment A B C Capital Expenditures ($ m) 20X0 20X1 20X2 264 282 303 297 318 340 211 226 242 20X0 7.50% 10.00% 6.90% ROIC 20X1 7.10% 8.90% 7.80% 20X2 6.80% 7.10% 9.00% Based on the information provided, XYZ’s management is most likely prone to which of the following biases? A. Inertia B. Sunk cost C. Pet project 8 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Answer: A is correct. Inertia can be identified by examining the level of capital investment in total, by segment, or by business line, if disclosed, and comparing it to the prior year and the return on investment. If capital investment each year is static or rising despite falling returns on investment, the analyst should question the issuer’s justification for a capital investment and whether management should consider alternative uses. In the case of XYZ, we can observe that for segments A and B, ROIC is decreasing, but both segments are getting a higher capital allocation each year. B is incorrect because sunk cost is related to the capital allocation process in determining a potential project’s profitability. Sunk costs, or those expenses that have already been incurred, should be ignored when evaluating potential projects. C is incorrect because a detailed view of individual investment projects undertaken by XYZ’s management is not provided. Identifying pet projects from outside the firm is difficult, because financial statements are aggregated and such projects may not meet the threshold of materiality. 9 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Question 12: Which of the following is considered a capital allocation pitfall? Basing investment decisions on: A. opportunity costs. B. after-tax cash flows. C. short-run accounting numbers. 10 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Answer: C is correct. One common pitfall is basing investment decisions on EPS, net income, or ROE: Companies sometimes have incentives to boost earnings per share, net income, or return on equity. Many investments, even those with strong NPVs, do not increase these accounting numbers in the short run and may even reduce them. Paying too much attention to short-run accounting numbers can result in a company choosing investments that are not in the long-run economic interests of its shareholders. A is incorrect. because not identifying the economic alternatives (real and financial) that are the opportunity costs is probably the biggest failure by companies in their analyses. Basing investments decisions on opportunity costs is the correct approach and hence not a capital allocation pitfall. B is incorrect because one of the capital allocation assumptions is that decisions must reflect the impact of taxes. Furthermore, in analyzing a complicated investment, individuals assessing the investment for the company may erroneously omit relevant cash flows, double-count cash flows, and mishandle taxes. Basing investments decisions on after-tax cash flows is the correct approach and hence not a capital allocation pitfall. 11 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Question 13: When evaluating investment projects funded using internally generated funds (e.g., cash flow from operations), what is the appropriate approach regarding the required rate of return? A. Use a lower required rate of return as internally generated funds have no cost. B. Use the same risk-adjusted required rate of return depending on the risk of the project. C. Use a higher required rate of return as internally generated funds are more uncertain. 12 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Answer: B is correct. Ignoring the cost of internal financing is a cognitive error. Internally generated capital, such as cash flow from operations, is considered equity financing as it represents capital that could be returned to equity investors through dividends or share repurchases. Internally generated funds incur the opportunity cost of equity investors. Management should use a risk-adjusted required rate of return appropriate for the investment’s risk, regardless of the financing source. A is incorrect. Internally generated funds have an opportunity cost and are not "free." C is incorrect. The required rate of return should be based on the project’s risk, not arbitrarily increased for internal funds. 13 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Question 14: Alexandra Tolonen, an investment analyst, prepares forecasts for the expansion of a car battery plant and considers the effect of rising lithium carbonate prices. She adjusts future after-tax cash flows downward to account for an expected 5% increase in lithium carbonate prices and uses real discount rates to calculate the project’s NPV. In the second year of the project, the actual lithium carbonate price increases by 10%. What is the most accurate statement regarding the project's profitability? A. The project's profitability may be impacted if actual inflation deviates from expected inflation. B. The project's profitability will remain unaffected as Tolonen used inflation-adjusted cash flows and discount rates. C. The project's profitability will increase due to higher-than-expected lithium carbonate prices. 14 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Answer: A is correct. Even though Tolonen used real cash flows and real discount rates, deviations in actual inflation from expected inflation can impact after-tax cash flows and, consequently, the project's profitability. Specifically, the unexpected increase in lithium carbonate prices would affect the costs and therefore influence cash flows, making the project sensitive to changes in inflation. B is incorrect. Inflation-adjusted cash flows and discount rates do not completely shield a project from deviations in actual inflation. C is incorrect. Higher lithium carbonate prices typically increase costs, which negatively impacts profitability. 15 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Question 15: Bradshaw, a financial analyst, prepares a forecast of future expected gross (pre-tax) cash flows for an investment project. Bradshaw also forecasts future depreciation related to that project and assumes a required rate of return of 6%. The tax rate in the jurisdiction is 18%, and depreciation is non-deductible for tax purposes. Based on the following gross cash flows and depreciation forecast, calculate the Net Present Value (NPV) of the project: Time 0 1 2 3 Gross Cash Flow -7.50 4.50 4.50 6.00 Depreciation 0.00 -1.00 -1.00 -1.00 What is the NPV of the project? A. 3.396 B. 2.894 C. 4.125 16 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Answer: A is correct. To calculate NPV for this project: 1. Calculate after-tax cash flows using the formula: After-tax cash flow = Gross cash flow × (1 − Tax rate) Time 0 1 2 3 After-Tax Cash Flow -7.50 3.69 3.69 4.92 17 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW 2. Apply the NPV formula: 3. Calculation yields: NPV = 3.396 B is incorrect. Results from incorrect discounting. C is incorrect. Overstates cash flows or applies incorrect discount factors. 18 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Question 16: Why might some managers reject projects that significantly increase shareholder value (i.e., have a high NPV)? A. High-NPV projects often fail to align with long-term company goals. B. High-NPV projects are riskier and may negatively impact shareholder confidence. C. High-NPV projects can reduce near-term accounting profitability measures, such as earnings per share or return on equity. 19 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Answer: C is correct. Managers may have an incentive to prioritize near-term accounting profitability measures, such as earnings per share, net income, or return on equity. Many high-NPV projects can reduce these measures in the short term, even though they add significant shareholder value in the long term. Instead, managers may focus on cost-cutting or share buybacks, which can immediately boost profitability metrics. A is incorrect. High-NPV projects generally align with the company's goal of maximizing shareholder value. B is incorrect. While risk may be a factor, the key reason is the potential short-term reduction in profitability measures, not risk perception. 20 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Question 17: Which of the following best describes a correct approach in capital allocation analysis? A. Include sunk costs in the analysis to ensure all costs are accounted for. B. Evaluate projects based on after-tax cash flows, considering tax benefits from non-cash deductions. C. Focus only on total cash flows without considering their timing or potential impact on the firm. 21 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Answer: B is correct. After-tax cash flows must be used in capital allocation analysis to reflect the tax implications of the project, including the benefits of non-cash deductions like depreciation and amortization. This ensures a more accurate evaluation of a project's value. A is incorrect. Sunk costs are irrelevant to the decision-making process as they have already been incurred and cannot be recovered. C is incorrect. Timing of cash flows is crucial because it affects the calculation of NPV and IRR, which are sensitive to when cash flows occur. 22 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Question 18: A company is evaluating an investment project. Which of the following practices would represent a cognitive error in the capital allocation process? A. Assuming that internally generated funds (e.g., cash flow from operations) are cost-free and assigning a lower discount rate for projects funded with these resources. B. Using excessive optimism when projecting revenues and inflating expected cash flows to secure project approval. C. Prioritizing projects that improve accounting profitability measures like return on equity, even if they have a negative NPV. 23 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Answer: A is correct. Treating internally generated funds as cost-free is a cognitive error because these funds represent equity financing and carry an opportunity cost. Projects funded with internal capital should still use a risk-adjusted required rate of return to account for this cost. Ignoring the true cost of capital can lead to incorrect project valuations. B is incorrect. This reflects behavioral bias, specifically overconfidence or optimism bias, rather than a cognitive error. C is incorrect. This is a behavioral bias, as it involves focusing on short-term accounting profitability instead of maximizing shareholder value. 24 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Question 19: Which of the following scenarios best demonstrates a cognitive error in the capital allocation process? A. Management avoids a high-NPV project because it might lower the company’s near-term earnings per share. B. A company uses nominal cash flows to evaluate a project but discounts them using a real discount rate. C. A firm invests in a “pet project” that receives preferential treatment despite failing to meet materiality thresholds. 25 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Answer: B is correct. Using nominal cash flows with a real discount rate (or vice versa) is a cognitive error because it reflects an inconsistency in the treatment of inflation. This mistake can result in incorrect project evaluations and flawed decision-making. A is incorrect. This reflects a behavioral bias, where management prioritizes accounting measures like EPS over long-term value creation. C is incorrect. This demonstrates pet project bias, a behavioral issue where investments are made based on favoritism rather than sound analysis. 26 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Question 20: A company is evaluating two potential projects: Project A and Project B. Both projects have similar NPVs, but Project B involves higher upfront costs and generates higher cash inflows in later years. Management chooses Project A to improve the company’s short-term financial performance. Which capital allocation issue does this decision highlight? A. Misjudging the impact of inflation by using inconsistent cash flow and discount rate treatments. B. Behavioral bias of short-termism, where decisions prioritize near-term results over long-term shareholder value. C. Cognitive error of ignoring incremental cash flows and focusing only on sunk costs. 27 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 5 | CW Answer: B is correct. The decision to prioritize a project based on short-term financial performance, despite both projects having similar NPVs, reflects behavioral bias of short-termism. This bias occurs when management focuses on immediate outcomes, such as improving accounting measures or reducing upfront costs, rather than maximizing long-term shareholder value. A is incorrect. There is no indication of inflation-related errors in this scenario. C is incorrect. Sunk costs are not mentioned as part of the issue; the focus is on behavioral bias, not a cognitive error. 28 SANJAY SARAF SIR CFA LEVEL 1 CORPORATE ISSUERS CAPITAL INVESTMENTS AND CAPITAL ALLOCATION CLASS 6 CW CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Question 1: TechNova Solutions is evaluating a 15-year contract to establish and operate an industrial-scale solar farm. The initial investment is $12 million, and the project is expected to generate after-tax operating cash flows of $1.2 million annually with no salvage value at the end of the contract. The required rate of return for the project is 8%. Additionally, the government has introduced a potential incentive to install advanced energy storage systems after 5 years to enhance efficiency. The installation cost for the system is $3 million, and the improved efficiency is expected to add $7 million in value. What is the Net Present Value (NPV) of the project when including the real option for installing the energy storage system? Should TechNova Solutions accept the project based on this NPV? A. NPV = $2.27 million. TechNova Solutions should accept the project. B. NPV = -$1.73 million. TechNova Solutions should reject the project. C. NPV = $1.50 million. TechNova Solutions should accept the project. 1 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Answer: A is correct. 2 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Since the NPV with the real option is positive ($2.27 million), TechNova Solutions should accept the project as it adds value to the company. 3 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Question 2: AquaSafe Waterworks is evaluating a 12-year project to establish a water desalination plant. The initial investment is $10 million, and the project is expected to generate after-tax operating cash flows of $1.1 million annually with no salvage value. The required rate of return for the project is 9%. Additionally, the government has introduced a potential option to upgrade the plant with advanced filtration technology after 6 years. The upgrade will cost $4 million, and the improved efficiency is expected to add $8 million in value due to reduced operating costs. What is the Net Present Value (NPV) of the project when including the upgrade option? Should AquaSafe Waterworks accept the project based on this NPV? A. NPV = -$2.12 million. AquaSafe Waterworks should reject the project. B. C. NPV = $0.76 million. AquaSafe Waterworks should accept the project. NPV = $1.88 million. AquaSafe Waterworks should accept the project. 4 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Answer: C is correct. 5 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Since the NPV with the real option is positive ($1.88 million), AquaSafe Waterworks should accept the project as it adds value to the company. 6 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Question 3: GreenDrive Motors is evaluating a project to manufacture hybrid vehicles under a 10-year contract. The project requires an initial investment of $15 million and is expected to generate after-tax operating cash flows of $1.8 million per year. The required rate of return for this project is 12%, and there is no salvage value at the end of the contract. Additionally, the government introduces a subsidy program to install advanced battery technology after 5 years, reducing emissions and increasing efficiency. The upgrade will cost $3.5 million, but the additional value from increased efficiency is estimated to be $9 million. What is the Net Present Value (NPV) of the project when including the upgrade option? Should GreenDrive Motors accept the project based on this NPV? A. NPV = -$4.83 million. GreenDrive Motors should reject the project. B. NPV = $2.00 million. GreenDrive Motors should accept the project. C. NPV = $0.67 million. GreenDrive Motors should accept the project. 7 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Answer: C is correct. 8 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Since the NPV with the real option is positive ($0.67 million), GreenDrive Motors should accept the project as it adds value to the company. 9 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Question 4: A company should exercise the abandonment option on an investment if the present value of the cash flows from continuing the investment is: A. lower than the cash flow from abandoning the investment. B. the same as the cash flow from abandoning the investment. C. greater than the cash flow from abandoning the investment. 10 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Answer: A is correct If the cash flow from abandoning an investment exceeds the present value of the cash flows from continuing the investment, the company should exercise the abandonment option. Conversely, if the PV of the cash flows from continuing the investment is lower than the cash flow from abandoning the investment, the company should exercise the abandonment option. B is incorrect because if the cash flow from abandoning an investment exceeds the present value of the cash flows from continuing the investment (and not when it is equal to), the company should exercise the abandonment option. C is incorrect because if the cash flow from abandoning an investment exceeds the present value of the cash flows from continuing the investment, the company should exercise the abandonment option. The PV of the cash flows from continuing the investment is greater than the cash flow from abandoning the investment, the company should not exercise the abandonment option. 11 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Question 5: Subsequent to making a capital investment, a company reacts to poor financial results from the project by abandoning it. This action alone best exemplifies the exercise of a: A. timing option. B. flexibility option. C. sizing option. 12 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Answer: C is correct. Sizing options encompass abandonment or expansion of capacity. If after investing the company can abandon the investment if the financial results are disappointing, it has an abandonment option. At some future date, if the cash flow from abandoning an investment exceeds the present value of the cash flows from continuing the investment, the company should exercise the abandonment option. Conversely, if the company can make additional investments when future financial results are strong, the company has a growth option or an expansion option. A is incorrect because timing options involve the sequencing of projects. Instead of investing now, the company can delay investing. Delaying an investment and basing the decision on hopefully improved information that you might have in, say, a year could help improve the NPV of the projects selected. Project sequencing options allow the company to defer the decision to invest in a future investment until the outcome of some or all of a current investment is known. Investments are sequenced over time, so that investing in a project creates the option to make future investments. 13 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW B is incorrect because flexibility options include operational changes possible with current capacity, such as paying overtime or adding a shift to meet excess demand. Once an investment is made, operational flexibilities besides abandonment or expansion may be available. If demand exceeds capacity, by increasing prices, the company could benefit from the excess demand, which it cannot do by increasing production. There are also production-flexibility options, which offer the operational flexibility to alter production when demand varies from what is forecast. Even though it is expensive, the company can profit from working overtime or from adding additional shifts. 14 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Question 6: Which of the following statements about real options is true? A. Using option pricing models estimates an option’s value with the highest accuracy. B. Real options allow companies to abandon an investment project if its profitability is poor. C. Real options would allow a refinery to hedge future prices of crude oil needed for production. 15 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Answer: B is correct. An abandonment option is a type of real option, which allows a company to abandon the investment after it is undertaken. A is incorrect because even though real options can be priced using option pricing models, the estimates require multiple unobservable inputs, such as probabilities of events and timing of their occurrence. The complexity does not necessarily improve accuracy. C is incorrect because real options provide companies with flexibility with regard to future decisions; however, they do not allow the hedging of commodity prices. The risk of crude oil price changes can be hedged using financial options, not real options. 16 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Question 7: Which of the following statements about real options is least likely correct? A. Real options provide companies with the flexibility to make future decisions that can enhance the value of capital investments. B. Real options are identical to financial options, as they involve the right to trade financial assets. C. Real options grant companies the right, but not the obligation, to alter their investment decisions based on future developments. 17 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Answer: B is correct. B is incorrect statement. Real options differ from financial options as they pertain to real assets, not financial instruments. Thus, this statement is least likely correct. A is correct statement. Real options enhance company value by offering flexibility in capital investment decisions, allowing adaptation to changing circumstances. C is correct statement. Real options provide companies with decision-making flexibility, granting the right without imposing an obligation. 18 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Question 8: A company decides to delay its investment in a new project to gather more information about market demand before committing funds. This decision best exemplifies the exercise of a: A. Fundamental option B. Flexibility option C. Timing option 19 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Answer: C is correct. A timing option refers to delaying an investment decision to improve the NPV by obtaining better information or waiting for favorable market conditions. A is incorrect. A fundamental option involves external factors, such as commodity prices, that influence the value of an investment, not the decision to delay it. B is incorrect. A flexibility option relates to operational changes, such as adjusting production capacity, and does not involve delaying the investment decision. 20 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Question 9: A company increases production by adding an extra shift to meet higher-than-expected demand for its product. This decision best exemplifies the exercise of a: A. Flexibility option B. Sizing option C. Fundamental option 21 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Answer: A is correct. A flexibility option allows a company to make operational changes, such as adding shifts or paying overtime, to adapt to fluctuating demand. B is incorrect. A sizing option typically refers to the abandonment or expansion of a project, not operational adjustments like adding shifts. C is incorrect. A fundamental option involves external factors like commodity prices impacting investment value, unrelated to operational adjustments. 22 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Question 10: A company invests in a gold mining project with the understanding that the project's success depends heavily on future gold prices. This scenario best represents the exercise of a: A. Fundamental option B. Sizing option C. Flexibility option 23 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Answer: A is correct. A fundamental option relates to external factors, such as commodity prices, that significantly impact the value of an investment. In this case, the project's value depends on gold prices. B is incorrect. A sizing option involves decisions like abandoning or expanding a project but does not relate to external dependencies like gold prices. C is incorrect. A flexibility option pertains to operational adjustments, such as modifying production, which is not relevant in this context. 24 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Question 11: A company facing high demand for its product decides to increase its prices to capitalize on the excess demand and maximize profitability. This decision is an example of a: A. Sizing option B. Flexibility option C. Fundamental option 25 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Answer: B is correct. A flexibility option includes operational decisions such as adjusting prices to respond to changes in demand, like increasing prices during periods of high demand. A is incorrect. A sizing option involves expanding or abandoning a project, not adjusting prices to manage demand. C is incorrect. A fundamental option is tied to external factors, like commodity prices, and does not involve internal pricing decisions. 26 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Question 12: Which of the following statements is most accurate regarding investment analysis without considering real options? A. A project with a positive NPV without considering real options should not be undertaken unless real options are factored in. B. Investment analysis without real options provides the most accurate estimate of a project's value. C. If the NPV is positive without considering real options, it represents the minimum return, and the firm should consider the investment. 27 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Answer: C is correct. A positive NPV without factoring in real options provides a baseline return. Real options can increase the NPV further, making the investment even more attractive. A is incorrect. A positive NPV without real options already indicates the project adds value. Real options can only further enhance the value but are not a requirement for making the investment decision. B is incorrect. Analysis without real options does not capture the additional value they provide, meaning it is not the most accurate estimate of a project's total value. 28 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW The following information relates to questions 13-14 Gerhardt Corporation Capital Allocation Gerhardt Corporation is considering a €500 million outlay for a capital investment in a facility to produce a new product. Gerhardt assigns a 60% probability to a successful product launch, which is expected to return €750 million in one year's time. The company has also evaluated alternative facility uses in case of a product failure, summarizing timing and probability of cash flows in the decision tree below: 29 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Gerhardt's required rate of return (r) is 10%. 30 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Question 13: Calculate the Net Present Value (NPV) of Gerhardt’s project without real options using the 10% required rate of return. A. €-90.91 million B. €181.82 million C. €90.91 million 31 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Answer: A is correct. The NPV without real options uses a probability-weighted cash flow, where future cash inflows are considered zero in case of failure. Since the NPV is negative, Gerhardt should not pursue the project. 32 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Question 14: Calculate the Net Present Value (NPV) of Gerhardt’s project with real options and a 10% required rate of return. A. €18.18 million B. €8.26 million C. €90.91 million 33 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Answer: B is correct. The NPV with real options accounts for alternative uses of the facility in the future, incorporating probability-weighted cash flows in two periods: 1. Probability-weighted t = 1 cash flow: 0.6×750=4500. 2. Probability-weighted t = 2 cash flows (conditional on product failure): • Alternative product launch: 0.4 × 0.3 × 600 = 720.4 • Sale of facility: 0.4 × 0.3 × 400 = 480.4 • Facility abandonment: 0.4 × 0.4 × 0 = 00.4 Total CF2=72+48+0=120 NPV = −500+409.09+99.17 = 8.26 Since the NPV is positive, Gerhardt should invest in the new production facility. 34 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Question 15: Company XYZ is considering expanding its distribution center in a foreign country. The local government is working on a new environmental regulation that introduces subsidies and tax breaks for investments related to renewable energy. Once the new law is approved, XYZ could upgrade the distribution center at a lower cost. If the company decides to wait for the new regulation to come into effect, it will have to bear project-related costs of $1.8 million. XYZ’s finance team estimates that if the company waits, the NPV of the project will be $9.7 million, compared to a current value of $8.9 million. A. $1.6 million B. $1.8 million C. $2.6 million 35 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Answer: C is correct. To determine the option value, we compare the project value with and without the option and additionally consider the option cost: Project NPV (with option) 9.7 Option value = Project NPV (without option) − Option cost + Option value = 8.9 − 1.8 + Option value = 9.7−8.9+1.8 = 2.6 million 36 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Question 16: Company ABC is planning to invest in a manufacturing facility that requires an initial investment of $4 million. The government is planning to introduce a new policy offering subsidies for such facilities, which will reduce the cost of the investment. If ABC waits for the policy to be enacted, it will incur additional holding costs of $0.5 million. The NPV of the project with the subsidy is estimated to be $6.5 million, while the current NPV without the subsidy is $5.4 million. Calculate the value of the option to wait. A. $1.6 million B. $1.4 million C. $2.0 million 37 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Answer: A is correct. To calculate the option value, use the formula: Project NPV (with option) 6.5 Option value = Project NPV (without option)−Holding cost + Option value = 5.4−0.5+Option value = 6.5−5.4+0.5 = 1.6 million 38 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW EXTRA QUESTION Question 1: Auvergne AquaFarms has estimated the NPV of the expected cash flows from a new processing plant to be –EUR0.40 million. Auvergne is evaluating an incremental investment of EUR0.30 million that would give the company the flexibility to switch among coal, natural gas, and oil as energy sources. The original plant relied only on coal. The option to switch to cheaper sources of energy when they are available has an estimated value of EUR1.20 million. What is the value of the new processing plant, including this real option to use alternative energy sources? A. EUR0.80 million B. EUR0.50 million C. EUR0.10 million 39 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Answer: B is correct. The NPV, including the real option, is calculated as: Project NPV = NPV (based on DCF alone) − Cost of options + Value of options Project NPV = –0.40million–0.30million+1.20million Project NPV = EUR0.50million. Without the flexibility offered by the real option, the plant is unprofitable. The real option to adapt to cheaper energy sources adds enough value to make the project viable. Hence, the company should undertake the investment. 40 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW The following information relates to questions 2-3 Ziegler Corporation Capital Allocation Using a Decision Tree Assume that Ziegler Corporation is considering a €400 million outlay for a capital investment in a facility to produce a new product. Ziegler assigns a 70% probability to a successful product launch, which is expected to return €600 million in one year. Ziegler’s finance team has also conducted an analysis of alternative facility uses, summarizing the timing and probability of cash flows associated with each real option in the following decision tree: 41 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Time t=0 t=1 t=2 €600 Successful product launch (70%) CF0 = €-400 Ziegler build a new facility €0 Product failure (30%) €500 Alternative product launch (40%) €300 Sale of facility to another firm (30%) €0 Facility abandoned (30%) Assume a 12% required rate of return. 42 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Question 2: What is the NPV of Ziegler's project without real options using a 12% required rate of return? A. €-25.00 million B. €-50.32 million C. €-55.47 million 43 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Answer: A is correct. Without real options, the NPV considers only the probability-weighted cash flows from the first stage of the decision tree. 44 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Question 3: What is the NPV of Ziegler's project with real options using a 12% required rate of return? A. €19.85 million B. €25.10 million C. €44.36 million 45 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW Answer: C is correct. The NPV calculation process remains the same: With real options, consider the cash flows from the second stage based on conditional probabilities: For Product Failure (30%): • 40% Alternative Product Launch: (0.3×0.4) × 500 = 60 • 30% Sale of Facility: (0.3×0.3) × 300=27 • 30% Facility Abandoned: (0.3×0.3) × 0 = 0 Expected cash flow in Time = 2: CF2 = 60+27+0 = 87 46 SANJAY SARAF SIR CFA LEVEL 1 | CORPORATE ISSUERS | CAPITAL INVESTMENTS AND CAPITAL ALLOCATION | CLASS 6 | CW 47 SANJAY SARAF SIR