{"id":1521,"date":"2019-09-12T13:33:00","date_gmt":"2019-09-12T13:33:00","guid":{"rendered":"https:\/\/analystprep.com\/cfa-level-1-exam\/?p=1521"},"modified":"2026-03-27T15:46:19","modified_gmt":"2026-03-27T15:46:19","slug":"basic-principles-capital-budgeting","status":"publish","type":"post","link":"https:\/\/analystprep.com\/cfa-level-1-exam\/corporate-finance\/basic-principles-capital-budgeting\/","title":{"rendered":"Basic Principles of Capital Budgeting"},"content":{"rendered":"\n<script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"VideoObject\",\n\n  \"name\": \"Capital Budgeting (2021 Level I CFA\u00ae Exam \u2013 Reading 32)\",\n\n  \"description\": \"This CFA Level 1 module on corporate finance explores the Capital Budgeting process, emphasising project evaluation methods like NPV, IRR, and payback period. Topics include project types, capital rationing, investment decision-making tools, cash flow analysis, and real-world implications of optimal capital allocation for shareholder wealth maximisation.\",\n\n  \"uploadDate\": \"2018-10-20T00:00:00+00:00\",\n\n  \"thumbnailUrl\": \"https:\/\/example.com\/path-to-thumbnail\/capital-budgeting-thumbnail.jpg\",\n\n  \"contentUrl\": \"https:\/\/youtu.be\/df063ciSOSg\",\n\n  \"embedUrl\": \"https:\/\/www.youtube.com\/embed\/df063ciSOSg\",\n\n  \"duration\": \"PT34M37S\",\n\n  \"publisher\": {\n    \"@type\": \"Organization\",\n    \"name\": \"AnalystPrep\",\n    \"logo\": {\n      \"@type\": \"ImageObject\",\n      \"url\": \"https:\/\/example.com\/path-to-logo\/logo.jpg\",\n      \"width\": 600,\n      \"height\": 60\n    }\n  },\n\n  \"author\": {\n    \"@type\": \"Person\",\n    \"name\": \"Professor James Forjan, PhD, CFA\"\n  }\n}\n<\/script>\n\n<script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"QAPage\",\n  \"mainEntity\": {\n    \"@type\": \"Question\",\n    \"name\": \"Which of the following statements is most likely accurate?\",\n    \"text\": \"Which of the following statements is most likely accurate?\",\n    \"answerCount\": 3,\n    \"acceptedAnswer\": {\n      \"@type\": \"Answer\",\n      \"text\": \"The timing of cash flows is crucial to the capital budgeting process.\"\n    },\n    \"suggestedAnswer\": [\n      {\n        \"@type\": \"Answer\",\n        \"text\": \"In capital budgeting, only pre-tax cash flows should be considered.\"\n      },\n      {\n        \"@type\": \"Answer\",\n        \"text\": \"A non-conventional cash flow pattern is one that has an initial cash outflow followed by a series of cash inflows.\"\n      }\n    ]\n  }\n}\n<\/script>\n\n\n\n<iframe loading=\"lazy\"\n  width=\"611\"\n  height=\"344\"\n  src=\"https:\/\/www.youtube.com\/embed\/df063ciSOSg\"\n  title=\"YouTube video player\"\n  frameborder=\"0\"\n  allow=\"accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share\"\n  referrerpolicy=\"strict-origin-when-cross-origin\"\n  allowfullscreen>\n<\/iframe>\n\n\n\n<p>Since capital budgeting describes the process by which all companies make decisions on their capital projects, it is not unusual for some fairly sophisticated techniques to be employed in its execution. Regardless of this, capital budgeting relies heavily on just a few basic principles.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><strong>Principles of Capital Budgeting<\/strong><\/h2>\n\n\n\n<p>Capital budgeting typically adopts the following principles:<\/p>\n\n\n\n<ul class=\"wp-block-list\">\n<li>decisions are based on cash flows, not accounting concepts such as net income;<\/li>\n\n\n\n<li>the timing of cash flows is critical;<\/li>\n\n\n\n<li>cash flows are based on opportunity costs. A comparison is made between the incremental cash flows that occur with investment and without the investment;<\/li>\n\n\n\n<li>cash flows are analyzed on an after-tax basis. Taxes have to be fully reflected in capital budgeting decisions;<\/li>\n\n\n\n<li>the financing costs are ignored. Financing costs are already reflected in the required rate of return and therefore including them again in the cash flows and the discount rate would lead to double counting; and<\/li>\n\n\n\n<li>the capital budgeting cash flows are not the same as accounting net income.<\/li>\n<\/ul>\n\n\n\n<div style=\"text-align: center; margin: 24px 0;\">\n  <div style=\"max-width: 680px; margin: 0 auto;\">\n    <a href=\"https:\/\/analystprep.com\/free-trial\/\" target=\"_blank\" rel=\"noopener noreferrer\"\n       style=\"display: flex; align-items: center; justify-content: center;\n       width: 100%; padding: 8px 16px;\n       border: 2px solid #2f6fed; border-radius: 999px;\n       color: #2f6fed; text-decoration: none;\n       font-size: 15px; font-weight: 500;\n       line-height: 1.2; white-space: nowrap;\">\n       Apply capital budgeting concepts through our free trial.\n    <\/a>\n  <\/div>\n<\/div>\n\n\n<h2><strong>Capital Budgeting Concepts<\/strong><\/h2>\n<p>In addition to the basic capital budgeting principles outlined above, there are several concepts that capital managers should be aware of in the capital budgeting process. These include:<\/p>\n<ul>\n<li><strong>sunk costs<\/strong>: these are costs that have already been incurred;<\/li>\n<li><strong>opportunity cost<\/strong>: this refers to what a resource is worth if it is put to its next-best use;<\/li>\n<li><strong>incremental cash flow<\/strong>: this is the cash flow that is realized because of a decision;<\/li>\n<li><strong>externality<\/strong>: this refers to the ripple effect of an investment. If possible, these effects should be part of the investment decision. Cannibalization is one example of an externality. This occurs when an investment results in customers and sales moving away from another part of a company.<\/li>\n<li><strong>conventional cash flow versus non-conventional cash flow<\/strong>: a conventional cash flow pattern has an initial cash outflow followed by a series of cash inflows. Conversely, a non-conventional cash flow pattern is one in which the initial cash outflow is not followed by cash inflows only. Instead the cash flows can flip from positive to negative again (or even change signs several times).<\/li>\n<\/ul>\n<blockquote>\n<h2><strong>Question<\/strong><\/h2>\n<p>Which of the following statements is <em>most likely<\/em> accurate?<\/p>\n<ol style=\"list-style-type: upper-alpha;\">\n<li data-tadv-p=\"keep\">In capital budgeting, only pre-tax cash flows should be considered.<\/li>\n<li data-tadv-p=\"keep\">The timing of cash flows is crucial to the capital budgeting process.<\/li>\n<li data-tadv-p=\"keep\">A non-conventional cash flow pattern is one that has an initial cash outflow followed by a series of cash inflows.<\/li>\n<\/ol>\n<p><strong>Solution<\/strong><\/p>\n<p>The correct answer is <strong>B<\/strong>.<\/p>\n<p>Capital budgeting analysts make an extraordinary effort to detail precisely when cash flows occur.<\/p>\n<p><strong>A is incorrect<\/strong> because cash flows are analyzed on an after-tax basis; taxes have to be fully reflected in capital budgeting decisions.<\/p>\n<p><strong>C is incorrect<\/strong> because a conventional cash flow pattern (not a nonconventional cash flow pattern) is the one which has an initial cash outflow followed by a series of cash inflows.<\/p>\n<\/blockquote>\n<div class=\"notes_inv\"><hr \/>\n<p><a href=\"https:\/\/analystprep.com\/cfa-level-1-exam\/corporate-finance\/learning-sessions-curriculum-corporate-finance\/\"><em>Corporate Finance &#8211; Learning Sessions<\/em><\/a><\/p>\n<\/div>\n\n\n<div style=\"text-align: center; margin: 40px 0 10px;\">\n  <a href=\"https:\/\/analystprep.com\/free-trial\/\" target=\"_blank\" rel=\"noopener noreferrer\"\n     style=\"display: inline-flex; align-items: center; justify-content: center;\n     padding: 10px 24px; border-radius: 999px;\n     font-size: 15px; font-weight: 600;\n     background-color: #4a72c9; color: #ffffff;\n     text-decoration: none; line-height: 1.2; white-space: nowrap;\">\n    Start Free Trial \u2192\n  <\/a>\n\n  <p style=\"margin: 14px auto 0; max-width: 680px; font-size: 15px; line-height: 1.6; color: #333333;\">\n    Strengthen your understanding of capital budgeting principles, incremental cash flows, and investment decision making with structured CFA Level I practice.\n  <\/p>\n<\/div>\n","protected":false},"excerpt":{"rendered":"<p>Since capital budgeting describes the process by which all companies make decisions on their capital projects, it is not unusual for some fairly sophisticated techniques to be employed in its execution. Regardless of this, capital budgeting relies heavily on just&#8230;<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[6],"tags":[],"class_list":["post-1521","post","type-post","status-publish","format-standard","hentry","category-corporate-finance","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v26.9 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Basic Principles of Capital Budgeting | CFA Level 1<\/title>\n<meta name=\"description\" content=\"Capital budgeting involves evaluating and selecting projects based on their potential returns. 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