Capital Allocation Pitfalls

Some of the common capital allocation pitfalls or mistakes are:

Inertia

By comparing the current capital investment to the amount from the previous year and the return on investment, analysts can determine the presence of inertia. An analyst should evaluate an issuer’s justification for its capital investment. Further, they should consider if the management should contemplate alternate uses if capital spending each year is either stagnant or rising despite declining returns on investment.

Source of Capital Bias

The capital allocation process should be used for all capital investments, whether made using internally produced cash, debt, or equity. Management teams should consider all capital as having an opportunity cost, independent of its source. Some management teams may plan for internally generated cash differently and as if it is “free” from externally raised capital such as equity or debt.

Failing to Consider Investment Alternatives or the Alternative States

The most basic phase in the capital allocation process is the generation of solid investment ideas. In some organizations, however, many good alternatives are never even explored. Furthermore, many businesses overlook different real-world conditions, which should be considered through breakeven, scenario, and simulation analyses.

Pushing Pet Projects

These are projects that influential managers want the company to invest in even though they may not be profitable. Often, managers will exaggerate these projects’ profitability to ensure they are selected.

Basing Investment Decisions on EPS, Net Income, or ROE

Even for those with a high NPV, many investments do not increase earnings per share (EPS), net income, or return on equity (ROE) in the short run. Since managers often have short-term incentives, they may choose projects that do not align to a company’s long-term interests.

Internal Forecasting Errors

Companies may make internal forecasting errors that are hard, if not impossible, for external analysts to spot. Consequently, this might lead to unsuccessful investment results. A common one is using a company’s overall cost of capital rather than an investment’s required rate of return.

Question

Which of the following is most likely a common capital allocation pitfall resulting from stagnant or declining investment returns while increasing capital investments?

1. Inertia.
2. Internal forecasting errors.
3. Basing investment decisions on net income.

The correct answer is A.

This is where a company’s return on investments stays the same or declines despite an increase in capital investments. This could be due to a lack of investment opportunities.

B is incorrect. Internal forecasting errors involve internal mistakes companies make when evaluating investment opportunities. External analysts find it difficult to spot such errors. These errors may lead to investment failure.

C is incorrect. Investment decisions should not be based on EPS, net income, or ROE but NPV. In addition, managers may pick projects that aren’t beneficial to a company in the long run.