Common Pitfalls in Capital Budgeting
Company managers commonly make errors when evaluating capital projects. Some of these errors include:
- The failure to account for economic reactions. If a company introduces a highly profitable product to the market, then competitors will enter the market and future profitability will deteriorate.
- Standard approaches for different capital projects. A company may use a common model to analyze all of its capital projects despite differences across all the capital projects that it considers.
- Focusing on accounting results. A company’s management may be incentivized to initiate projects that show positive short term accounting results at the expense of long term projects with high net present values.
- Utilizing IRR over NPV. IRR may not lead to optimal decision making when evaluating mutually exclusive projects. NPV is considered the superior approach.
- Pet projects. Influential company managers may initiate projects which advance their own interests but do not create company value (or even destroy it).
- Cash flow errors. Many estimates and assumptions go into forecasting cash flows and these are subject to error.
- Inappropriate discount rate. A company might use too low of a discount rate for a high risk project and overstate the project’s NPV.
- Misunderstanding sunk costs and opportunity costs. A company may incorrectly include sunk costs into its capital budgeting analysis, but exclude opportunity costs.
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- CFA Level 2: Corporate Finance Part 1 – Introduction
- Introduction to Capital Structure and Leverage
- Introductory Capital Budgeting Remarks
- Expansion Projects vs. Replacement Projects and Cash Flows
- Impacts of Depreciation Method Choice on Capital Budget Analysis
- Inflation and Capital Budgeting
- Mutually Exclusive Capital Projects with Unequal Lives
- Equivalent Annual Annuity (EAA) Approach
- Least Common Multiple of Lives Approach
- Stand Alone Risk and Capital Projects
- CAPM and a Capital Project’s Discount Rate
- Capital Projects and Real Options
- Common Pitfalls in Capital Budgeting
- Capital Budgeting Alternatives to NPV and IRR Analysis
- Modigliani-Miller and Capital Structure Theory
- Evaluating Capital Structure Policy
- International Differences in Financial Leverage
- Dividend and Share Repurchase Policies
- Factors Affecting Corporate Dividend Policy Decisions
- Signals from Dividend Policies