Capital Allocation Pitfalls

Here are some of the most common mistakes managers make when evaluating capital allocation decisions:

Not Incorporating Economic Responses into the Investment Analysis

Failure to incorporate economic responses into investment analysis can greatly affect the profitability of the investment. Attractive investments entice competitors to enter, consequently reducing profitability. 

Misusing Capital Allocation Templates

Individuals reviewing investments on behalf of the company sometimes utilize standardized capital allocation templates. If the template model does not fit the investment or incorrect information is employed, this circumstance poses a risk.

Pushing Pet Projects

These are projects that influential managers want the company to invest in but that may not be generally accepted as profitable. More often than not, managers will exaggerate the profitability of these projects to make sure 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 many managers sometimes have short-term incentives, they may end up choosing projects that do not align with the company’s long-term interests.

Using IRR to make Investment Decisions

Investing in mutually exclusive projects based on the IRR alone will result in managers choosing smaller projects and based on short-term profits at the expense of larger, longer-term projects with high NPVs.

Incorrectly Accounting for Cash Flows

When handling complicated projects, it is easy to overlook relevant cash flows, mishandle tax, and double-count cash flows.

Over-or Underestimating Overhead Costs

Poor investment decisions can be made when a company over- or underestimates overhead costs.

Not Using the Appropriate Risk-adjusted Discount Rate

High-risk projects should not be discounted at the company’s overall cost of capital but at its required rate of return (RRR). This is because discount rates have a huge impact on the computed NPVs of long-term projects.

Overspending and Underspending the Capital Allocation

Some managers will spend their whole budget and claim the budget was not sufficient. Remember that capital budgeting is the process of allocating resources to the most efficient uses.

Failure to Consider Investment Alternatives

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

Incorrectly Handling Sunk Costs and Opportunity Costs

The biggest failure in the analysis is when sunk costs and opportunity costs are ignored. Only opportunity costs should be included in the cost of the project, and sunk costs should be ignored. 

Question

Which of the following is the most likely effect of bad accounting of cash flows on the capital allocation process?

1. It has no significant effect on the capital allocation.
2. Mishandling of taxes and omitting relevant cash flows leads to an inaccurate NPV, thus affecting the choice of project.
3. The required rate of return is the only factor that influences the capital allocation.

Solution

The correct answer is B.

Estimating taxes and cash flows form the basis of the capital allocation process; hence, the omission of such information will result in an inaccurate NPV.

A is incorrect. Bad accounting of cash flows will affect the capital allocation process since overlooking relevant cash flows will lead to overvalued or under-valued projects.

C is incorrect. Several other factors, including the RRR, affect the capital allocation process. are all generic ambien the same analystprep.com best generic ambien manufacturer