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CPA PM Elective study materials
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CPA PM Elective: Investment Appraisal and Capital Allocation

CPA PM Elective · Work through your exam, one topic at a time.

All guide sections

Investment Appraisal and Capital Allocation

What the exam tests

Investment appraisal tests incremental cash flow, time value, risk, and capital allocation. Expect NPV, IRR, payback, discounted payback, ARR, profitability index, real options, capital rationing, and sensitivity.

Core rules and concepts

  • Use incremental after-tax cash flows: initial outlay, operating cash flows, working capital changes, salvage, and tax effects such as CCA tax shields in Canada. Exclude sunk costs, allocated overhead that does not change, and financing costs; the discount rate captures financing.
  • NPV = present value of cash inflows - initial outlay; accept if positive. IRR is the discount rate making NPV zero; it can mislead when comparing mutually exclusive projects or when cash flows change sign.
  • Payback ignores cash flows after payback and time value; discounted payback fixes time value but still ignores later flows. ARR uses accounting income, not cash flow.
  • Profitability index = present value of inflows / initial outlay; use it to rank under capital rationing when projects are divisible, but check total NPV.
  • Risk: use a risk-adjusted discount rate, scenario or sensitivity analysis, or real options to value flexibility.

Worked example

A machine costs $500,000, has a five-year life, and generates after-tax operating cash inflows of $140,000 per year. The required return is 10%. The annuity factor for 5 years at 10% is 3.7908, so PV of inflows = $140,000 x 3.7908 = $530,712. NPV = $530,712 - $500,000 = $30,712, so accept. Payback is $500,000 / $140,000 = 3.57 years, which is useful for liquidity but does not prove value. If the project also required $40,000 of working capital, that outflow and its recovery would be included; ignoring it would overstate NPV. If the cash inflows were risky, a higher discount rate would reduce NPV.

Traps that cost marks

  • Including sunk feasibility study costs.
  • Deducting loan interest while also discounting at the cost of capital.
  • Choosing the higher IRR project when scale differs.
  • Ignoring working capital and salvage tax effects.
  • Treating payback as a measure of profitability.