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.