Wiley

CMAexcel Learning
System
Exam Review 2019
Part 2: Financial Decision Making
Session 11

Learning Outcome Statements (LOS) identifiers

appear on the slides as applicable to highlight
where we address each LOS within the material.

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 Session 10 Recap
Section E: Investment Decisions
• Topic 1: Capital Budgeting Process
• Topic 2: Discounted Cash Flow Analysis

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 Session 11 Overview
• Exercise 1: Capital Budgeting
• Exercise 2: Net Present Value of Two
Alternatives
• Section E, Topic 3: Payback and Discounted
Payback
• Exercise 3: Discounted Payback with Uniform
Net Cash Flow
• Section E, Topic 4: Risk Analysis in Capital
Investment

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 Session 11 Exercise 1
Capital Budgeting

Section E, Topic 2: Discounted Cash Flow

Analysis

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 Session 11 Exercise 2
Net Present Value of Two Alternatives

Section E, Topic 2: Discounted Cash Flow

Analysis

Part 2, Section E, Topic 2: Discounted Cash Flow Analysis 5

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 LOS P2.E.3.a. and c.

Question: Which Projects to

Accept/Reject
Foggy Products is evaluating two mutually exclusive projects, one requiring
a $4 million initial outlay and the other a $6 million outlay. The Finance
Department has performed an extensive analysis of each project. The chief
financial officer has indicated that there is no capital rationing in effect.
Which of the following statements are correct?
I. Both projects should be rejected if their payback periods are longer than
the company standard.
II. The project with the highest Internal Rate of Return (IRR) should be
selected (assuming both IRRs exceed the hurdle rate).
III. The project with the highest positive net present value should be
selected.
IV. Select the project with the smaller initial investment, regardless of which
evaluation method is used.
a. II and III only.
b. I, II, and IV only.

c.
c. I and III only.
Answer:
d.
PartI,2,
II Section
and III only.
E, Topic 2: Discounted Cash Flow Analysis 6
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 LOS P2.E.3.a.

Topic 3: Payback and

Discounted Payback
• Uses of the payback method
• Advantages and disadvantages of the
payback method
• Discounted payback

Part 2, Section E, Topic 3: Payback and Discounted Payback 7

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 LOS P2.E.3.a.

Payback and Discounted Payback

1. Payback method is another way to evaluate an
investment project based on time it takes to
recover the investment

2. Payback method does not discount cash flows

3. Payback method does not distinguish between

types of cash inflows

4. Firm selects a target payback period used to

evaluate each project

5. Discounted payback method addresses one

shortfall of the payback period calculation—ignoring
the
Part 2, time
Section value
E, Topic of money
3: Payback and Discounted Payback 8
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 LOS P2.E.3.a.

Question: Length of Time to

Recover Outlay
The length of time required to recover the initial
cash outlay of a capital project is determined by
using the:
a. payback method.
b. weighted net present value method.
c. net present value method.
d. discounted cash flow method.

Answer: a.

Part 2, Section E, Topic 3: Payback and Discounted Payback 9

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 LOS P2.E.3.a.

Payback Method
The payback method determines the number of years
needed to recover the net initial investment in a capital
project. This would also constitute the breakeven point
of the investment.
• The simple payback method uses cash flows that
are not discounted.
• The discounted payback method uses the present
value of net cash inflows rather than the
undiscounted cash inflows used in the simple
payback method.

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 LOS P2.E.3.a.

Question: Interpreting the

Payback Method
Which of the following statements does not
accurately describe payback method interpretation?
a. Projects that meet the target payback period
should be profitable.
b. Large initiation outlay projects typically have
longer payback periods.
c. The target payback period represents what the
firm considers to be an acceptable length of time
for a project to recoup its cost.
d. When comparing multiple projects, shorter
payback periods are generally preferable.

Answer: a.
Part 2, Section E, Topic 3: Payback and Discounted Payback 11
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 LOS P2.E.3.a.

Question: Why the Payback

Method Is Popular
Despite its shortcomings, the traditional payback
period continues to be a popular method to evaluate
investments because, in part, it:
a. furnishes information about an investment's
lifetime performance.
b. provides some insight into the risk associated with
a project.
c. ignores the time value of money.
d. focuses on income rather than cash flow.

Answer: b.

Part 2, Section E, Topic 3: Payback and Discounted Payback 12

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 LOS P2.E.3.c.

Question: Uniform Net Cash Flows—

Payback Method
Using the following formula, what is the payback period of
a $1,000,000 investment which returns $125,000
annually?
Total Initial Investment
Payback Period =
Expected Annual Net Cash Flow

Answer:
$1,000,000
Payback Period = = 8 Years
$125,000

Part 2, Section E, Topic 3: Payback and Discounted Payback 13

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 LOS P2.E.3.c.

Question: Calculate Payback No

Interpolation
What is the payback period for a capital budgeting
project where the total initial capital investment is
$900,000 and the expected annual net after-tax
cash flow is $150,000?
a. 5 years.
b. 7 years.
c. 6 years.
d. 3 years.
Answer: c.
Total Initial Investment
Payback Period =
Expected Annual Net After-tax Cash Flow
$900,000
=
$150,000
= 6 Years
Part 2, Section E, Topic 3: Payback and Discounted Payback 14
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 LOS P2.E.3.c.

Question: Calculate Payback

Period Interpolation
What is the payback period for a capital budgeting
project where the total initial capital investment is
$175,000 and the expected annual net after-tax
cash flow is $35,000?
a. 4.5 years.
b. 6 years.
c. 4 years.
d. 5 years.

Answer: d.

Part 2, Section E, Topic 3: Payback and Discounted Payback 15

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 LOS P2.E.3.c.

Payback Method: Uneven Cash Flows

To determine the payback period of an investment with
uneven cash flows, simply add each year’s net cash flow
to the next until the
break-even point is reached.

Note there will probably be a fractional year at the end.

Payback Period=
UnrecoveredCost at theBeginningof theLast Year
YearsUntil Full Recovery +
Cash Flow During theLast Year

Part 2, Section E, Topic 3: Payback and Discounted Payback 16

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 LOS P2.E.3.c.

Payback Method:
Uneven Cash Flows Examples
What is the payback period of a $30,000 investment with
annual cash flows of $10,000, $12,000, $16,000, and
$14,000?
Year Net Cash Cumulative Net Cash
Flow Flow
0 –$30,000 –$30,000
1 $10,000 –20,000
2 12,000 –8,000
3 16,000 8,000
4 14,000 22,000
 $8,000 
Payback Period= 2+  = 2.5Years
 $16,000
Part 2, Section E, Topic 3: Payback and Discounted Payback 17
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 LOS P2.E.3.a.

Payback Method Interpretation

• Target payback period (cutoff period)
• Projects with payback shorter than target payback
period are accepted; longer paybacks are rejected
• The higher the risk, the shorter the target payback
period

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 LOS P2.E.3.c.

Question: Payback Period and

Accept/Reject Decision
Eagle Company has an investment opportunity with
expected after-tax cash flows of $50,000 a year in
Years 1 and 2, $60,000 a year in Years 3 and 4, and
$75,000 in Year 5. The initial outlay of this
investment is $250,000 today. The firm uses four
years as a maximum payback criterion. Assume
cash flows occur evenly during the year. What is the
payback period for this investment and should the
firm accept the project?
a. 4.2 years; reject the project.
b. 4.4 years; reject the project.
c. 4 years;
Answer: b. accept the project.
d.
Part5
2, years;
Section E,reject the project.
Topic 3: Payback and Discounted Payback 19
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 LOS P2.E.3.b.

Payback Method

Advantages Disadvantages
• Uses a simple • Ignores the time value of
calculation money (simple payback)
• Results are easy to • Ignores cash flows
understand occurring after payback
• Provides a rough period
measure of liquidity • Provides no measure of
• Provides a rough profitability
measure of project risk • May promote short-term
projects in error if the
target payback period is too
short
• Cannot be used to rank
20
Part 2, Section E, Topic 3: Payback and Discounted Payback
projects
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 LOS P2.E.3.c.

Discounted Payback Method

What is the payback period for a $16,000 investment
with annual net cash flows of $6,000 and a desired
minimum return of 10%?

Year Net Discoun PV of Net Cumulative PV

Cash t Cash of Net Cash
Flows at 10% Flows Flows
0 0 ($16,000)
($16,000) ($16,000)

1 × 0.909 = (10,546)
Part 2, Section E, Topic 3: Payback and Discounted Payback 21
6,000
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 LOS P2.E.3.c.

Discounted Payback Method

The simple payback method produces a different
result from the discounted payback calculation.

Calculation:
Year 4 Amount Needed = $1,084
Discounted Payback Period
3 + ($1,084/$4,098) = 3.26 Years

Simple Payback Period

$16,000/$6,000 = 2.67 Years

Part 2, Section E, Topic 3: Payback and Discounted Payback 22

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 LOS P2.E.3.b.

Question: All of the Following Are

Payback Method Shortcomings
EXCEPT
Which one of the following is not a shortcoming of
the payback method?
a. It ignores the time value of money.
b. It offers no consideration of cash flows beyond
the expiration of the payback period.
c. It offers no indication of a project's liquidity.
d. It encourages establishing a short payback
period.

Answer: c.

Part 2, Section E, Topic 3: Payback and Discounted Payback 23

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 LOS P2.E.3.c.

Question: Calculating Minimum

Cost Reductions
Jasper Company has a payback goal of three years
on new equipment acquisitions. A new sorter is
being evaluated that costs $450,000 and has a five-
year life. Straight-line depreciation will be used; no
salvage is anticipated. Jasper is subject to a 40%
income tax rate. To meet the company's payback
goal, the sorter must generate reductions in equal
annual cash operating costs of at least:
a. $190,000.
b. $114,000.
c. $150,000.
a.
d. $60,000.
Answer:
Part 2, Section E, Topic 3: Payback and Discounted Payback 24
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 LOS P2.E.3.c.

Solution
Answer a is correct:
• After-tax cash flow of $150,000 = (Annual savings − $90,000)(1
− 0.4) + $90,000
• After-tax cash flow of $150,000 = (Annual savings − $90,000)
(0.6) + $90,000
• After-tax cash flow of $150,000 = 0.6 (Annual savings) −
$54,000 + $90,000
• After-tax cash flow of $150,000 = 0.6 (Annual savings) +
$36,000
• After-tax cash flow of $150,000 − $36,000 = 0.6(Annual savings)
• $114,000 = 0.6(Annual savings)
•Part
($114,000) / 0.63:=Payback
2, Section E, Topic Annualandsavings
Discounted Payback 25
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Annual © 2019, Savings = $190,000
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 Session 11 Exercise 3
Discounted Payback with Uniform
Net Cash Flow

Section E, Topic 3: Payback and Discounted

Payback

Part 2, Section E, Topic 3: Payback and Discounted Payback 26

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 Topic 4: Risk Analysis in
Capital Investment
• Sensitivity analysis
• Certainty equivalents
• Other approaches to dealing with risk
• Use of specially adjusted rates
• Qualitative considerations in capital
investments

Part 2, Section E, Topic 4: Risk Analysis in Capital Investment 27

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 LOS P2.E.4.a. and c.

Question: Using Cost of Capital

for All New Investments
Which of the following is not a potential issue when
using a firm's cost of capital as the discount rate for
all new investments?
a. Good low-risk projects may be rejected.
b. The firm's cost of capital does not effectively
measure the risk of the project.
c. The firm's cost of capital effectively measures the
risk of the project.
d. Poor high-risk projects may be accepted.
Answer: c.

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 LOS P2.E.4.c.

Question: Convert Cash Flows to

Risk-Free
Which of the following approaches to assessing
project risk converts projected cash flows into risk-
free cash flows?
a. Simulations.
b. Sensitivity analysis.
c. Capital asset pricing model.
d. Certainty equivalent approach.
Answer: d.

Part 2, Section E, Topic 4: Risk Analysis in Capital Investment 29

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 LOS P2.E.4.b.

Question: Sensitivity Analysis

What is sensitivity analysis?

Answer:
• “What-if” study evaluating how sensitive one
variable is to changes in other variables that
affect it.
• In capital budgeting, sensitivity analysis focuses
on how sensitive NPV, IRR, and other profitability
measures are to various changes in assumptions.

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 LOS P2.E.4.b.

Question: Effects from Sensitivity

Analysis
Sensitivity analysis in an investment project
proposal:
a. develops the discount rate to be used in project
evaluation.
b. calculates the change in the result due to a
change in the project’s cash flows.
c. develops probabilities for a variety of results.
d. determines
Answer: b. the firm’s cost of capital.

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 LOS P2.E.4.b.

Question: Sensitivity Analysis Effect

on EPS
Susan Hines has developed an estimate of the earnings per share
(EPS) for her firm for the next year using the following parameters.
Sales $20 million
Cost of goods sold 70% of sales
General & administrative expenses $300,000
Selling expense $100,000 plus 10% of sales
Debt outstanding $5 million @ 8% interest rate
Effective tax rate 35%
Common shares outstanding 2 million
She is now interested in the sensitivity of earnings per share to
sales forecast changes. A 10% sales increase would increase
earnings per share by:
a. 13 cents per share.
b. 10.4 cents per share.
c. 20 cents per share.
d. 7 cents per share.
Answer: a.
Part 2, Section E, Topic 4: Risk Analysis in Capital Investment 32
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 LOS P2.E.4.b.

Solution
Answer a. 13 cents per share
After 10%
Before Sales Increase
Sales $ 20,000,000 $ 22,000,000
Less Cost of goods sold (70% × Sales) 14,000,000 15,400,000
Less General expense (given) 300,000 300,000
Less Fixed selling expense (given) 100,000 100,000
Less Variable selling expense (10% × Sales)2,000,000 2,200,000
Less Interest expense (8% × 5,000,000) 400,000 400,000

Income before taxes 3,200,000 3,600,000

Less Income taxes (35% rate) 1,120,000 1,260,000

Net income $ 2,080,000 $ 2,340,000

Shares outstanding 2,000,000 2,000,000
Earnings per share $ 1.04 $ 1.17

Increase in EPS $ 0.13

Part 2, Section E, Topic 4: Risk Analysis in Capital Investment 33

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 LOS P2.E.4.b.

Question: Uses of Sensitivity

Analysis
Sensitivity analysis is used in capital budgeting to:
a. determine the amount that a variable can change
without generating unacceptable results.
b. determine the optimal contribution margin given
a set of constraints.
c. identify the required market share to make a new
product viable and produce acceptable results.
d. simulate probabilistic customer reactions to a new
product.

Answer: a.

Part 2, Section E, Topic 4: Risk Analysis in Capital Investment 34

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 LOS P2.E.4.b.

Sensitivity Analysis Example

• Annual net cash flows:

Investment A: Y1 $2,500 and Y2 $3,600
Investment B: Y1 $4,200 and Y2 $2,500
• Each has a total initial investment of $4,500
• What happens to the NPVs if the discount rate goes
from
10% to 12%?

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 LOS P2.E.4.b.

Sensitivity Analysis Example: Project

A

Project A at 10% Project A at 12%

Year Inflows 10% PV Year Inflows 12% PV
1 $2,500 × .909 = 1 $2,500 × .893 = $2,233
$2,273
2 3,600 × .797 =
2 3,600 × .826 = 2,974 2,869
Total PV of net cash inflows Total PV of net cash inflows
$5,247 $5,102
Less initial Less initial
investment 4,500 investment 4,500
NPV NPV
$747 $602

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 LOS P2.E.4.b.

Sensitivity Analysis Example: Project

B

Project B at 10% Project B at 12%

Year Inflows 10% PV Year Inflows 12% PV
1 $4,200 × .909 = 3,818 1 $4,200 × .893 =
$3,751
2 2,500 × .826 = 2,065
2 2,500 × .797 =
Total PV of net cash inflows $5,883 1,993
Less initial 4,500 Total PV of net cash inflows $5,744
investment
Less initial 4,500
NPV $1,383 investment
NPV $1,244

Part 2, Section E, Topic 4: Risk Analysis in Capital Investment 37

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 LOS P2.E.4.b.

Question: Sensitivity Analysis for

Projects A and B
Given the data on the prior three slides, which
project is more sensitive to change as measured in
dollar change and NPV percentage change?
Answer: Project A
Comparison of Projects A and B
Projec NPV NPV Dollar NPV %
t at at 12% Change Change
10%
A $747 $602 –$145 –19.41%
B $1,383 $1,244 –$139 –10.05%

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 LOS P2.E.4.c.

Certainty Equivalents (CE)

Separate cash flow timing from the project’s risk:
1. Estimate expected investment cash flows.
2. Identify certainty equivalent factors for the expected
cash flows.
3. Multiply Step 1 by Step 2 to determine certain cash
flows.
4. Find PV of certain cash flows using risk-free discount
rate.
5. Calculate NPV by subtracting initial investment from
Step 4.
6. Evaluate NPV: 0 or positive is accepted; negative is
rejected.
Part 2, Section E, Topic 4: Risk Analysis in Capital Investment 39
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 LOS P2.E.4.c.

CE
Example
• Total initial investment of $24,000
• Risk-free rate of return at 3%
Year Expected CE Factor Certain
Cash Inflows Cash Flow
1 $15,000 × 0.90 =
$13,500
2 11,000 × 0.85 =
9,350
3 9,000 × 0.70 =
6,300
4 7,000 × 0.60 =
4,200
5 6,000 × 0.45 =
Part 2, Section E, Topic 4: Risk Analysis in Capital Investment 2,700 40
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 LOS P2.E.4.c.

CE Example (cont.)
Year Certain Discount PV of
Cash Factor Certain
Inflows at 3% Cash Flow
1 $ 13,500 × 0.971 =
$13,109
2 9,350 × 0.943 =
8,817
3 6,300 × 0.915 =
5,765
4 4,200 × 0.888 =
3,730
5 2,700 × 0.863 =
2,330
Total PV of net cash inflows
$33,751
Part 2, Section E, Topic 4: Risk Analysis in Capital Investment 41
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Less initial investment (24,000)
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 LOS P2.E.4.c.

Question: Certainty Equivalents

and Signs
Consider the following scenario regarding the certainty equivalent
approach to selecting projects:
Annual net after-tax cash inflows over the life of a five-year
investment are $18,000, $14,400, $12,600, $10,800, and $9,000
Certainty equivalent factors are estimated to be 95%, 90%, 80%,
75% and 50%
The total initial investment for the project is $43,000
The risk-free rate of return is 4%
Is the project acceptable?

a. Yes, as there is a positive net present value of $5,024.

b. No, as there is a negative net present value of $48,024.
c. No, as there is a negative net present value of $5,024.
d. Yes, as there is a positive net present value of $48,024.
Answer: a.
Part 2, Section E, Topic 4: Risk Analysis in Capital Investment 42
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 LOS P2.E.4.a.

Capital Asset Pricing Model (CAPM)

CAPM in capital budgeting treats a project as if it were a
stock in a portfolio.
• Beta for project is firm’s beta or industry beta (if
investment is not typical for firm).
• Projects with higher beta are considered more risky.
E(R a ) = R f + ßa [E(R m)– R f ]
Where:
E(Ra) = required rate of return on asset (project) being
evaluated
Rf = risk-free rate
ßa = beta of asset (project)
E(Rm) = market portfolio return
Part 2, Section E, Topic 4: Risk Analysis in Capital Investment 43
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 LOS P2.E.4.b.

Simulations
• Simulations allow testing of a capital investment project
under varying financial conditions.
• Hypothetical cash flows and discount rates are assumed
and studied with a simulation model.
• Simulations can be used to approximate:
Expected NPV and IRR.
Dispersion of outcomes about an expected value.
• Monte Carlo simulation is most widely known

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 LOS P2.E.4.b.

Question: Defining Simulation

Methodologies
Which of the following broadly defines simulation
methodologies in evaluating projects?
a. Allows for the testing of a capital investment project
using hypothetical variables to approximate cash flow.
b. A separation of the timing of cash flows from their risk
to evaluate a projects success.
c. A what-if technique for evaluating how NPV, IRR, and
other indicators of the profitability of a project change if
some given variable varies from one case to another.
d. It uses repeated random sampling and computational
algorithms to calculate a range of most likely outcomes
for a project.
Answer: a.
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 LOS P2.E.4.b.

Question: Advantages of a
Simulation Model
All of the following are advantages of a simulation
model except that it:
a. generates optimal solutions to problems.
b. allows what-if type of questions.
c. does not interfere with the real world systems.
d. allows the study of the interactive effect of
variables.
Answer: a.

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 LOS P2.E.4.b.

Question: Complex Situations

Involving Uncertainty
The modeling technique that should be used in a
complex situation involving uncertainty is a(n):
a. Monte Carlo simulation.
b. program evaluation review technique.
c. Markov process.
d. expected value analysis.

Answer: a.

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Wiley CMAexcel Learning System, Part 2: Financial Decision Making
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 LOS P2.E.4.d.

Question: Using Cost of Capital

as Discount Rate
What can happen to a firm that uses its cost of
capital as an appropriate discount rate for all
proposed projects?
Answer:
• Projects with similar risk to the firm will be
appropriately assessed if risk level is accurate.
• May erroneously accept/reject a project regardless of
its risk because it offers a higher/lower rate of return
than the cost of capital:
Good, low-risk projects may be rejected.
Poor, high-risk projects may be accepted.

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Wiley CMAexcel Learning System, Part 2: Financial Decision Making
Copyright © 2019, Institute of Management Accountants. Published by John Wiley & Sons, Inc.
 LOS P2.E.4.b.

Question: Yields and Frequency

Distributions
Which of the following approaches compares high-
yield investments and allows values to be plotted on
a frequency distribution graph?
a. Linear programming.
b. Sensitivity analysis.
c. Regression analysis.
d. Simulations.

Answer: d.

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Wiley CMAexcel Learning System, Part 2: Financial Decision Making
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 LOS P2.E.4.a.

Question: Qualitative Considerations

in Investment Decisions
List examples of qualitative considerations in making
capital investment decisions.
Answer:
• Management may not have the necessary information.
• Loan provisions may limit borrowing.
• The firm may have self-imposed capital rationing limits.
• Decision-makers may be risk-averse.
• Conflict may exist between decisions to take on a project
and manager’s performance evaluation.
• A firm may not have sufficient/qualified personnel.
• Management may need to assess whether the investment
can increase customer loyalty and retention.

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 LOS P2.E.4.e.

Real Options
Real options are changes that potentially will affect
subsequent cash flows or the life of the asset after it has
already been adopted. Real options include the following:

• Expand—Make additional investment if project succeeds.

• Abandon—Terminate project early.
• Postpone—Wait and learn more before making the
investment.
• Adapt—Vary output or production methods in response to
demand.

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Wiley CMAexcel Learning System, Part 2: Financial Decision Making
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 LOS P2.E.4.e.

Question: Real Options

If a firm needs to fund a new technology with
relatively uncertain demand potential, which of the
following is the best type of real option?
a. Expand.
b. Abandon.
c. Postpone.
d. Adapt.

Answer: b.

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Wiley CMAexcel Learning System, Part 2: Financial Decision Making
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Session 11 Wrap-Up
Content covered in Session 11
• Exercise 1: Capital Budgeting
• Exercise 2: Net Present Value of Two Alternatives
• Section E, Topic 3: Payback and Discounted Payback
• Exercise 3: Discounted Payback with Uniform Net Cash
Flow
• Section E, Topic 4: Risk Analysis in Capital Investment
Content to be covered in Session 12
• Section E Practice Questions
• Section F, Topic 1: Ethical Considerations for
Management Accounting and Financial Management
Professionals
• Exercise: Ethics Scenario—Full Range, Inc.
• Section F, Topic 2: Ethical Considerations for the
Organization
Part 2: Financial Decision Making 53
• Section
Wiley
F Practice Questions
CMAexcel Learning System, Part 2: Financial Decision Making
Copyright © 2019, Institute of Management Accountants. Published by John Wiley & Sons, Inc.