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.

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.