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HKICPA QP Module 7 Financial Management study materials
HKICPA QP Module 7 Financial Management study resources

HKICPA QP Module 7 Financial Management: Investment Appraisal and Capital Budgeting

HKICPA QP Module 7 Financial Management · Work through your exam, one topic at a time.

All guide sections

Investment Appraisal and Capital Budgeting

This domain tests the selection of long-term projects using discounted and non-discounted techniques. The exam expects you to identify relevant incremental cash flows, apply NPV correctly with tax and working capital, handle inflation and risk, and rank projects under capital rationing. NPV is the preferred method because it measures the change in shareholder wealth.

Core rules

  • Use incremental, after-tax cash flows, not accounting profit. Exclude sunk costs and allocated fixed overhead; include opportunity costs and incremental working capital.
  • Tax and capital allowances affect cash flows. Usually discount nominal cash flows at a nominal rate and real cash flows at a real rate; do not mix them.
  • NPV is absolute and additive. IRR can mislead with non-conventional cash flows and cannot rank mutually exclusive projects reliably. Payback ignores cash flows after the cutoff and the time value of money; discounted payback partly corrects this. ARR is accounting-based.
  • Under capital rationing, rank divisible projects by profitability index (NPV per unit of scarce capital); for indivisible projects, use trial combinations to maximise total NPV.
  • For replacement decisions, compare equivalent annual costs. For risk, use sensitivity, scenario analysis, simulation or risk-adjusted discount rates.

Worked example

A machine costs $500,000 and generates net cash inflows before tax of $200,000 annually for four years. Tax is 16.5% paid in the same year, working capital of $50,000 is required immediately and recovered at the end, and the discount rate is 10%. Ignore capital allowances. After-tax annual inflow = $200,000 x (1 - 0.165) = $167,000. Annuity factor for four years at 10% = 3.1699, so PV of inflows = $529,400. Working capital: -$50,000 now plus $50,000 x 0.683 = $34,150, a net PV cost of $15,850. NPV = -$500,000 + $529,400 - $15,850 = $13,550. Reasoning: positive NPV, so accept if risk is acceptable. The working capital recovery must not be omitted.

Traps that cost marks

  • Including sunk costs or allocated overhead that is not incremental.
  • Forgetting working capital investment and its recovery.
  • Discounting nominal cash flows at a real rate, or vice versa.
  • Using IRR to rank mutually exclusive projects.
  • Ignoring tax timing and capital allowances.