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Subject 6. Common Capital Budgeting Pitfalls PDF Download
Here are some of the common mistakes that managers make:

  • Economic Responses.

    Economic responses must be correctly anticipated when performing an investment analysis. Can competitors enter the market easily if the project turns out to be very profitable? Will vendors, suppliers and employees want to gain more from a profitable enterprise?

  • Template Errors.

    Due to large number of projects to be analyzed over time, companies have developed standardized templates for capital budgeting. Are these templates misused?

  • 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 Decisions on short-run accounting numbers.

    Investment decisions should be based on long-term EPS, Net Income or ROE.

  • Basing Decisions on the IRR.

    If projects are mutually exclusive, or they have non-conventional cash flow patterns, the IRR criterion will not be economically sound. The NPV method should be used.

  • Incorrectly Accounting for Cash Flows.

    It's easy to omit or double count cash flows, and mishandle taxes in the analysis of a complex project.

  • Overhead Costs.

    It's hard to estimate appropriate overhead costs for a project in large companies.

  • Discount Rate Errors.

    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.

  • Overspending and underspending the Capital Budget.

    Managers tend to argue, for political reasons, that their budget is small, and they tend to spend the entire investment budget just because it is available.

  • Failure to Consider Investment Alternatives.

    Many good investment alternatives are never considered.

  • Sunk Costs and Opportunity Costs.

    It is often difficult to ignore sunk costs and identifying opportunity costs.

Learning Outcome Statements

f. describe common capital budgeting pitfalls.

CFA® 2023 Level I Curriculum, Volume 3, Module 19

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