Here are some of the most common mistakes managers make when evaluating capital budgeting decisions:
- Economic responses: 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.
- Template errors: Employees may input the wrong information into the template leading to inaccurate capital budget analysis results.
- 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.
- EPS, Net income, or ROE: Many investments, even those with a high NPV, 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.
- Basing decisions on the IRR: Investing in mutually exclusive projects based on the IRR alone will result in managers choosing projects that are smaller and based on short-term profits at the expense of larger, longer-term projects with high NPVs.
- Bad accounting of cash flows: When handling complicated projects, it easy to overlook relevant cash flows, mishandle tax, and double count cash flows.
- Overhead costs: Poor investment decisions can be made when a company over- or underestimates overhead costs.
- Discount rate errors: 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 budget: 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.
- Sunk costs and opportunity costs: The biggest failure in 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.
Which of the following is the most likely effect of bad accounting of cash flows on the capital budgeting process?
- It has no significant effect on the capital budgeting process.
- Mishandling of taxes and omitting relevant cash flows leads to an inaccurate NPV, thus affecting the choice of project.
- The required rate of return is the only factor that influences the capital budgeting process.
The correct answer is B.
Estimation of taxes and cash flows form the basis of the capital budgeting process hence omission of such information will result in an inaccurate NPV.
A is incorrect. Bad accounting of cash flows will affect the capital budgeting process since overlooking relevant cash flows will lead to a project being over valued or under-valued.
C is incorrect. Several other factors including the RRR affect the capital budgeting process.
Reading 19: Capital Budgeting
LOS 19 (f) Describe common capital budgeting pitfalls.