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CIMA F3 study materials
CIMA F3 study resources

CIMA F3: Investment Appraisal and Risk

CIMA F3 · Work through your exam, one topic at a time.

All guide sections

Investment Appraisal and Risk

Domain scope

Investment appraisal and risk tests discounted cash flow, relevant cash flows, tax and inflation, and risk techniques. You must choose between NPV, IRR, payback and ARR, and adjust for risk or capital rationing.

Core rules

  • NPV = PV of incremental after-tax cash flows less initial investment, discounted at the opportunity cost of capital. It is the primary rule because it measures absolute value added.
  • Include incremental cash flows only: exclude sunk costs, allocated fixed overheads, depreciation (a non-cash accounting charge) and financing costs (already in the discount rate). Include working capital and its recovery, tax and capital allowances.
  • Match nominal cash flows with a nominal discount rate; real cash flows with a real rate. Do not mix.
  • IRR can mislead for mutually exclusive projects, multiple sign changes or scale differences. Payback ignores cash flows after the cut-off and time value; discounted payback corrects the latter. ARR uses accounting profit.
  • Risk: sensitivity, scenario, simulation, RADR, certainty equivalents, decision trees. Under single-period capital rationing with divisible projects, rank by profitability index (NPV/initial outlay).

Worked example

Project cost £400,000; expected net cash inflow £150,000 per year for four years; discount rate 10%; ignore tax. Annuity factor for 4 years at 10% = 3.170. PV of inflows = £150,000 x 3.170 = £475,500. NPV = £475,500 - £400,000 = £75,500. Sensitivity of annual inflow = NPV / PV of inflows = £75,500 / £475,500 = 15.9%. The inflow can fall by 15.9% before NPV reaches zero. Sensitivity of initial cost = £75,500 / £400,000 = 18.9%. Sensitivity is useful but examines one variable at a time and ignores probability.

Traps

  • Discounting accounting profit rather than cash.
  • Including interest payments and depreciation.
  • Forgetting tax delays and working capital recovery.
  • Using IRR ranking when projects differ in scale.
  • Mixing real and nominal figures.
  • Assuming sensitivity analysis captures correlations between variables.