EFN507 Advanced Capital Budgeting
The Complete Exam Bible · S2 2026EFN507 Overview
- Queensland University of Technology
- Semester 2, 2026
- Postgraduate finance unit
- Two-hour weekly lecture
- Weekly one-hour tutorial
- Closed-book final exam
EFN507 Advanced Capital Budgeting is a postgraduate unit in QUT's Master of Applied Finance about the decisions that commit a firm's money to long-lived assets for years ahead.
- Assessed by A Harvard case study report with its spreadsheet, then a closed-book final exam.
- Hardest step Pairing each definition of cash flow with the discount rate built for it.
- Most repeated skill Deriving a result from first principles, then applying it to numbers.
- How to prepare Attempt every tutorial question before class and redo the derivations unaided.
How EFN507 is assessed
| Component | Weight | Format |
|---|---|---|
| Case Study Assignment | 40% | Individual; a Harvard Business School case; written report under ten pages plus an Excel spreadsheet, submitted online through Canvas; due Week 7 |
| Final Exam | 60% | Individual; face to face in the Central Exam Period; closed book; covers all material taught in the semester |
Weights are from the unit's assessment overview and total 100%. The introductory lecture adds that the final exam is closed book, covers all the material taught in the semester and is assessed by relative evaluation, and that detailed exam information will be released later. Check the unit outline on HiQ for any pass requirements.
Current EFN507 dates
| Date | Item | Control |
|---|---|---|
| September 6, 2026 | Case Study Assignment due | Week 7; report and Excel spreadsheet |
Dates are as published in the Semester 2, 2026 introductory lecture slides. Confirm exact deadlines and submission settings in the live LMS.
What EFN507 covers
Eleven chapters follow the unit from the Fisher Separation Theorem through decision rules, cash flows and simulation to the cost of capital, imputation, capital structure and real options.
The Fisher Separation Theorem and the NPV Rule
Investment and financing decisions, the opportunity cost of capital, utility and indifference curves, the production frontier, and why managers can maximise value for every owner.Why the unit starts with Fisher
Week 1 asks why the NPV rule is the right rule at all.
- Real assets versus financial assets, investment versus financing decisions
- Why wealth maximisation beats profit maximisation as the firm's goal
- The opportunity cost of capital versus the cost of borrowing
- Budget lines, utility functions and indifference curves over two periods
- The production frontier and investing until marginal return equals the market rate
- Separation of investment from consumption and its implications
Net Present Value, Capital Rationing and Unequal Lives
Value additivity and the accept rule, NPV per dollar under a budget, linear and integer programming with shadow prices, and equivalent annual amounts for machines with different lives.NPV as the benchmark
Week 2 makes NPV the yardstick for every other rule. An asset is worth its discounted future cash flows and present values add, so taking a project raises firm value by its NPV.
- Present value additivity and the NPV accept rule
- After-tax cash flows with depreciation added back
- Ranking by NPV per dollar under a single budget
- Linear programming with Solver and shadow prices
- Integer programming when projects cannot be split
- Equivalent annual amounts and common-horizon replication
IRR, Payback and Rival Investment Rules
Payback, discounted payback and the book rate of return, IRR and its reinvestment assumption, modified IRR, multiple roots and Descartes' rule, and ranking with the incremental IRR.Judging the alternatives
The lecture tests every rival to NPV against two questions: does it respect the time value of money, and does it use cash flows?
- Payback and why it cannot rank projects
- Discounted payback as a half-built NPV
- The average book rate of return and its flaws
- IRR, the reinvestment assumption and modified IRR
- Multiple IRRs and Descartes' rule of signs
- Lending versus borrowing projects and the incremental IRR
Project Cash Flows, Inflation and Operating Leverage
Building after-tax project cash flows, depreciation tax shields and working capital, nominal versus real forecasts, and why fixed costs raise a project's beta.Getting the numerator right
Every NPV in the unit is only as good as its cash flows.
- After-tax, unlevered cash flows and the depreciation tax shield
- Sunk costs, opportunity costs, salvage and why interest is excluded
- Working capital that builds with revenue and is recovered at the end
- Nominal versus real forecasts and the matching discount rates
- Valuing revenue, variable costs and fixed costs at separate rates
- How operating leverage raises a project's beta
Sensitivity Analysis and Monte Carlo Simulation
Expected NPV across economic states, one-way and two-way sensitivity tables, abandonment value, simulated NPV distributions and correlated inputs.Beyond a single forecast
Week 3 asks how much an NPV depends on its assumptions.
- Expected NPV across states of the economy
- Option to abandon valued branch by branch
- One-way sensitivity and break-even inputs
- Two-way data tables that follow the stated distributions
- Standard deviation of NPV with independent or correlated flows
- Monte Carlo simulation and certainty equivalents
WACC, Capital Cash Flows and Adjusted Present Value
Free cash flows at the after-tax WACC, capital cash flows at the pre-tax rate, APV with the tax shield discounted separately, and the Miles and Ezzell rate under rebalancing.One identity, three methods
Week 4 derives the cost of capital from the split of operating cash flow among lenders, shareholders and the tax office.
- The cash flow identity X = XD + XE + XG and the tax on X − XD
- Deriving the after-tax WACC for free cash flows
- Capital cash flows and the pre-tax WACC
- Adjusted present value with two discount rates
- The cost of equity under MM with corporate tax
- Miles and Ezzell when debt is rebalanced to a target
Estimating the Cost of Equity with the CAPM
The security market line, betas of debt, equity and assets, levering and unlevering, comparable firms, estimation error and the choice of risk-free rate and premium.From beta to a required return
Week 5 prices risk with the CAPM: a required return equals the risk-free rate plus beta times the market risk premium, for the firm, its debt and its equity alike.
- The CAPM for debt, equity and the whole firm
- Asset beta as a value-weighted blend
- Unlevering a comparable firm and relevering for the project
- Choosing the risk-free rate and the market risk premium
- Standard errors, industry betas and thin trading
- Survey evidence on how Australian firms apply the CAPM
Dividend Imputation and the Cost of Capital
Franking credits as prepaid personal tax, the value of gamma, Officer's four cash flow definitions and their matching WACCs, and survey evidence on Australian practice.Company tax that is really personal tax
Week 6 adapts the cost of capital to Australia's dividend imputation system.
- Classical versus imputation taxation of company profit
- Franking credits as a prepayment of personal tax
- Gamma: a market value versus a simple proportion
- Officer's four cash flow definitions and their WACCs
- Dividend drop-off evidence on the value of credits
- Survey evidence on Australian capital budgeting practice
Modigliani and Miller: Does Capital Structure Matter?
Homemade leverage, Proposition I and II without taxes, repurchases and the debt ratio, wealth transfers from bondholders, and corporate tax with a fixed amount of debt.The irrelevance benchmark
Week 7 starts from Modigliani and Miller (1958): in perfect, frictionless capital markets the mix of debt and equity does not change the value of the firm or its overall cost of capital.
- Perfect-market assumptions behind irrelevance
- Homemade leverage and why it removes any premium
- Proposition II for returns and for betas
- Repurchases, earnings per share and price-earnings ratios
- Wealth transfers from existing bondholders
- Proposition I with corporate tax
Debt, Taxes and the Costs of Financial Distress
Corporate and personal taxes together, direct and indirect distress costs, games shareholders play near default, debt overhang, the tradeoff and pecking order theories.Why firms do not borrow without limit
Week 8 qualifies the tax case for debt. Myers's reading treats the corporate tax shield as an upper bound: firms are not always profitable, debt is not permanent, and personal taxes can favour equity income.
- Corporate and personal taxes on debt and equity income
- Miller's equilibrium and the evidence against a full offset
- Direct and indirect costs of financial distress
- Shareholder games near default and debt overhang
- The tradeoff theory and the profitability puzzle
- The pecking order and free cash flow theories
Real Options and Binomial Option Pricing
Options to expand, delay and abandon, risk-neutral probabilities on a binomial tree, backward induction, and the Black and Scholes formula with a dividend yield.Flexibility as an option
Weeks 9 and 10 turn to real options: the rights to expand, delay or abandon a project that static NPV ignores. Each is valued like a financial option, because it lets the firm keep good outcomes and avoid bad ones.
- Options to expand, delay and abandon
- Replication and risk-neutral probabilities
- One-step and two-step binomial valuation
- Early exercise and backward induction
- Black and Scholes with a dividend yield
- How common real options are in practice
It assumes you already know the time value of money, NPV and IRR, the cost of capital, capital structure and option pricing from earlier units, and it goes deeper rather than wider: the coordinator's stated aim is to explain why capital budgeting is done the way it is, so results you have used before, such as the WACC and the binomial option pricing formula, are derived in class.
The unit begins with the Fisher Separation Theorem, the reason managers can maximise value on behalf of owners with very different tastes for spending now or later.
It then tests NPV against payback, book returns and IRR, handles capital rationing with linear programming and machines of unequal life with equivalent annual amounts, builds project cash flows under inflation, shows how operating leverage changes a project's risk, and adds sensitivity analysis and Monte Carlo simulation.
Weeks 4 to 6 are the core: matching free cash flows, capital cash flows and adjusted present value to their own discount rates, estimating the cost of equity with the CAPM, and adapting all of it to Australia's dividend imputation system.
The second half covers Modigliani and Miller, taxes and financial distress, the tradeoff and pecking order theories, and real options valued on a binomial tree.
Assessment is a Harvard Business School case study worth 40%, a written report with a supporting spreadsheet due in Week 7, and a closed-book final exam worth 60% in the Central Exam Period.
This guide works through every taught topic with a worked example, figures drawn from the example's own numbers, and practice items with full answers.
Worked example · free
Two machines with different lives
- +1Annuity factors at 10%: (1 − 1.1−2)/0.1 = 1.735537 and (1 − 1.1−3)/0.1 = 2.486852.
- +1NPV of X = −40,000 + 26,000 × 1.735537 = $5,123.97; NPV of Y = −55,000 + 25,000 × 2.486852 = $7,171.30.
- +1Equivalent annual amounts: 5,123.97 ÷ 1.735537 = $2,952.38 for X and 7,171.30 ÷ 2.486852 = $2,883.69 for Y.
- +1Check with a six-year chain: X three times is worth $12,858 today and Y twice is worth $12,559, so X wins either way.
Key terms
- Opportunity cost of capital
- The return investors give up by putting money into this project rather than into investments of similar risk, used as the discount rate for its cash flows.
- Fisher Separation Theorem
- The result that, with a perfect capital market, a firm's best investment level depends only on the market interest rate and not on its owners' preferences for consuming now or later.
- Net present value
- The sum of a project's discounted after-tax cash flows minus the initial outlay, which is the amount by which accepting it raises firm value.
- Profitability index
- Present value of a project's inflows divided by its outlay, used to rank projects when a single budget limits investment.
- Shadow price
- The increase in the maximum attainable NPV when a binding funding constraint is relaxed by one dollar.
- Equivalent annual amount
- A project's NPV converted into a level annuity over its life, used to compare machines with different lives.
- Modified IRR
- The rate that links the present value of a project's outflows to the future value of its inflows reinvested at a stated rate.
- Operating leverage
- The degree to which a project's costs are fixed rather than variable, which magnifies the risk of its net cash flows and raises its beta.
- Adjusted present value
- Value of a project computed as its all-equity value plus the present value of financing side effects such as interest tax shields.
- Capital cash flow
- The cash flow paid to all providers of capital including the interest tax saving, discounted at the pre-tax weighted cost of capital.
- Asset beta
- The beta of a firm's operating assets, a value-weighted average of its debt and equity betas, which measures business risk alone.
- Franking credit
- A credit attached to a dividend for company tax already paid, which a resident shareholder can offset against personal tax.
- Gamma
- The proportion of company tax that is really a prepayment of personal tax because shareholders can use the imputation credits.
- Pecking order theory
- The theory that firms finance investment first with internal cash, then with debt, and issue equity only as a last resort.
- Risk-neutral probability
- The weighting of up and down outcomes on a binomial tree that lets an option's payoffs be discounted at the risk-free rate.
EFN507 FAQ
How is Advanced Capital Budgeting assessed at QUT?
There are two individual tasks. A case study assignment based on a Harvard Business School case is worth 40% and is due in Week 7; you hand in a report with its supporting Excel workbook online through Canvas. A final exam worth 60% is sat face to face in the Central Exam Period. The introductory lecture adds that the exam is closed book and covers all material taught in the semester.
What do we know about the final exam format?
The introductory lecture describes it as individual, held in the central exam period, closed book, covering everything taught during the semester and marked by relative evaluation. It also says detailed information about the exam would be released later, so the length, sections and question types are not set out in the materials available here. Watch Canvas announcements and the unit outline on HiQ.
What does the case study report need to contain?
A report under ten pages of A4, double spaced in 12-point font, plus a spreadsheet showing every computation. The report must discuss the case, state your assumptions and why you chose them, identify the concerning issues, explain the method, report results and end with a justified recommendation. The coordinator marks how convincing the analysis is, not its length.
Is there a formula sheet for this unit?
Yes, there is an EFN507 formulae sheet for 2026. It covers annuities and the quadratic formula, NPV, the profitability index and modified IRR, expected NPV and its standard deviation, the CAPM and adjusted betas, levering and unlevering betas, several WACC forms including imputation and Miles and Ezzell, the binomial and Black and Scholes models, and merger gains.
Why does the unit spend so long on the WACC?
Because the right discount rate depends on how the cash flows were defined. Free cash flows ignore the interest tax shield and need the after-tax WACC, capital cash flows include it and need a pre-tax rate, and APV values the shield separately. Under Australian imputation each definition of after-tax cash flow has its own WACC, so mixing them double counts or drops value.
Can I use AI tools for the case study assignment?
The introductory lecture tells students not to use AI for the case study. The coordinator explains that the assignment exists so you learn the material, that skipping that learning will cost you heavily in the exam, and that AI is likely to get much of the analysis wrong. Plagiarism rules apply and the report is submitted through Turnitin.
What background knowledge does the unit assume?
It assumes the earlier managerial finance units or their equivalent: the time value of money, NPV and IRR, the cost of capital, capital structure and dividend policy, and options, including European versus American options and the Black and Scholes formula. The unit then rebuilds several of these results from first principles, so revise them before Week 1.
Questions students ask in each EFN507 chapter
- Why is profit maximisation rejected as the firm's objective?
- It does not say which year's profit counts. A firm can raise future profit by cutting today's dividend and reinvesting, yet shareholders lose if that reinvestment earns less than the opportunity cost of capital. Maximising current wealth captures timing and risk, which a profit target ignores. Chapter 01 · The Fisher Separation Theorem and the NPV Rule
- Why is depreciation added back when computing NPV cash flows?
- NPV works from cash, not accounting profit. Depreciation reduces taxable income, which lowers the tax paid, but no cash leaves the firm when it is charged, so it is added back after tax is computed. Leaving it deducted understates the cash flows. Chapter 02 · Net Present Value, Capital Rationing and Unequal Lives
- Why is payback a poor way to rank projects?
- It ignores the time value of money within the payback window and ignores every cash flow after it. A project with a huge inflow just after the cutoff can be rejected in favour of one that barely recovers its cost, so payback can choose the project that destroys value. Chapter 03 · IRR, Payback and Rival Investment Rules
- Why is interest left out of project cash flows?
- Financing is captured by the discount rate. If you subtract interest from the cash flows and then discount at a weighted average cost of capital, the benefit of debt is counted twice, once in each place, and the project is overvalued. Chapter 04 · Project Cash Flows, Inflation and Operating Leverage
- Can I average scenario cash flows before computing NPV?
- Yes for a plain project, because expected NPV is linear in the cash flows. No once there is an option such as abandonment, which changes the cash flows only in some states; then each branch must be valued before averaging. Chapter 05 · Sensitivity Analysis and Monte Carlo Simulation
- Why does the after-tax WACC multiply the cost of debt by one minus the tax rate?
- Because free cash flows ignore the interest tax saving, the benefit of debt has to enter somewhere. Scaling the cost of debt down by the tax rate credits the firm with that saving through the discount rate rather than the cash flow. Chapter 06 · WACC, Capital Cash Flows and Adjusted Present Value
- Why not use a comparable firm's equity beta directly?
- Its equity beta reflects its own borrowing as well as its business risk. Unlevering removes the comparable's financing, and relevering at your project's ratio adds back the right amount; skipping both steps misprices your project whenever the debt ratios differ. Chapter 07 · Estimating the Cost of Equity with the CAPM
- Why does imputation change the cost of capital?
- Part of company tax becomes a prepayment of personal tax, so shareholders receive more than the after-tax cash dividend. Valuation must recognise those credits either in the cash flows or in the discount rate, and the WACC formulas change to match. Chapter 08 · Dividend Imputation and the Cost of Capital
- Why can't a firm create value just by borrowing in perfect markets?
- Because investors can borrow on the same terms themselves. If a levered firm traded at a premium, investors would buy the unlevered firm and borrow personally to copy the payoff more cheaply, driving the premium away. Chapter 09 · Modigliani and Miller: Does Capital Structure Matter?
- Why is the corporate tax shield only an upper bound?
- Firms are not always profitable, so the effective tax rate on interest saved is below the statutory rate. Debt is not permanent, so future tax shields are risky, and investors may pay more personal tax on interest than on equity income. Chapter 10 · Debt, Taxes and the Costs of Financial Distress
- Why does static NPV undervalue flexible projects?
- It assumes the firm commits to one path today. A real project lets managers react to news, expanding after good outcomes and stopping after bad ones, and that ability to cut off the downside has value that a single cash flow forecast leaves out. Chapter 11 · Real Options and Binomial Option Pricing
How to study for the exam
Treat EFN507 as a unit you rebuild from first principles each week. Before the lecture, revise the assumed knowledge it relies on; after it, rewrite the derivation shown in class on a blank page without notes, because the reviews ask for derivations as well as numbers. Attempt every tutorial question before the tutorial, as the coordinator advises, and only then compare with the posted solution.
Keep a single sheet that pairs each definition of cash flow with its discount rate: free cash flow with the after-tax WACC, capital cash flow with the pre-tax WACC, APV with the unlevered rate plus a separately valued tax shield, and the four imputation definitions with their own WACCs. Practise drawing the Fisher diagram to scale, plotting NPV profiles, and building a two-step binomial tree by hand.
In the final weeks, work through the 2026 formulae sheet line by line and make sure you can say what every symbol means and when each version of a formula applies.
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