2024 CFA Level I Exam: CFA Study Preparation

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Here are some of the common capital allocation mistakes that managers make:

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. The analyst should evaluate the issuer's justification for its capital investment and if management should contemplate alternate uses if capital spending each year is 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 like equity or debt.

Failing to Consider Investment Alternatives or the Alternative States

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

Pet projects are projects that influential managers want the corporation to invest in. They should undergo normal capital budgeting analysis. However, sometimes insufficient analysis is performed or overly optimistic projections are used to inflate the profitability of a pet project.
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 choose projects that do not align with the company's long-term interests.
Internal forecasting errors
Companies may make internal forecasting errors that are hard, if not impossible, for outside analysts to spot, which might lead to unsuccessful investment results. The required rate of return for a project should be based on its risk, not the cost of debt, equity or weighted average of capitals involved. The longer a project's life, the bigger the impact of the discount rate errors on a project.

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