These pitfalls include:
- Failing to incorporate economic responses into the analysis. For example, if a profitable project is in an industry with low barriers to entry, competitors may undertake a similar project, quickly lowering profitability.
- Misusing standardized templates. Since managers may evaluate hundreds of projects in a given year, they often create templates to streamline the analysis process. However, such a template may not be an exact match for the project, resulting in estimation errors.
- Pet projects of senior management. Projects that have the personal backing of influential members of senior management may contain overly optimistic projections that can make the project appear more profitable than it really is. In addition, the project may not be subjected to the same level of analysis as other projects.
- Basing investment decisions on EPS or ROE. Managers whose incentive compensation is tied to increasing EPS or ROE may avoid positive long-term NPV investments that have the adverse short-run effect of reducing EPS or ROE.
- Using the IRR criterion for project decisions. Using IRR may result in conflicts with the NPV approach for mutually exclusive projects. The NPV criterion is economically sound, accurately reflects the goal of maximizing shareholder wealth, and should drive the project accept/reject decision when IRR and NPV are in conflict.
- Poor cash flow estimation. For a complex project, it is easy to double count or fail to include certain cash flows in the analysis. For example, the effects of inflation must be properly accounted for.
- Misestimation of overhead costs. The cost of a project should include only the incremental overhead costs related to management time and information technology support. These costs are often difficult to quantify, and over or underestimation can lead to incorrect investment decisions.
- Using the incorrect discount rate. The required rate of return on the project should reflect the project’s risk. Simply using the company’s WACC as a discount rate without adjusting it for the risk of the project may lead to significant errors when estimating the NPV of a project.
- Politics involved with spending the entire capital budget. Many managers try to spend their entire capital budget each year and ask for an increase for the following year. In a company with a culture of maximizing shareholder value, managers will return excess funds whenever there is a lack of positive NPV projects and make a case for expanding the budget when there are multiple positive NPV opportunities.
- Failure to generate alternative investment ideas. Generating investment ideas is the most important step of the capital budgeting process. However, once a manager comes up with a “good idea”, they may go with it rather than coming up with an idea that is “better”.
- Improper handling of sunk and opportunity costs. Managers should not consider sunk costs in the evaluation of a project because they are not incremental cash flows. Managers should always consider opportunity costs because they are incremental. However, in reality, many managers do this incorrectly.
We discussed a number of pitfalls when making capital budgeting decisions.