Common Pitfalls in Capital Budgeting | CFA Level I Corporate Issuers

In this quick lesson, we’ll explore some common pitfalls managers encounter when making capital budgeting decisions.

Failing to Incorporate Economic Responses

One common mistake is failing to incorporate economic responses into the analysis. Profitable projects in industries with low barriers to entry may attract competitors, lowering profitability and causing operating cash flows to fall short of expectations.

Misuse of Standardized Templates

Another pitfall is the misuse of standardized templates for project evaluation, which may not fit all projects perfectly and result in estimation errors.

Pet Projects of Senior Management

Capital budgeting can be skewed by pet projects of senior management, which may contain overly optimistic projections and be subjected to less rigorous analysis than other projects.

Investment Decisions Based on EPS or ROE

Some managers may base investment decisions on earnings per share (EPS) or return on equity (ROE), avoiding positive long-term NPV investments that could hurt short-term EPS or ROE metrics.

Prioritizing IRR Over NPV

When conflicts arise between IRR and NPV for mutually exclusive projects, some managers prioritize IRR over NPV. The correct approach is to prioritize NPV, which accurately reflects the goal of maximizing shareholder wealth.

Inaccurate Estimates of Future Cash Flows

Inaccurate estimates of future cash flows can stem from double counting, excluding certain cash flows, underestimating or overestimating inflation effects, or misestimating overhead costs. These errors can lead to incorrect investment decisions.

Using an Incorrect Discount Rate

Using the company’s WACC as a discount rate without adjusting for project risk can lead to significant errors when estimating a project’s NPV.

Company Politics and Budget Manipulation

Some managers may spend their entire budget and argue for an increase in the following year, rather than returning excess funds to shareholders or saving cash for future opportunities.

Failure to Consider Alternative Investment Ideas

Managers who don’t think outside the box and consider alternative investment ideas may miss out on good opportunities.

Improper Handling of Sunk and Opportunity Costs

Lastly, some managers struggle to ignore sunk costs and may overlook opportunity costs, leading to suboptimal decision-making.