Please list five common mistakes in capital budgeting that could either overstate or understate the value of a project.Bonus: explain the relationship between the errors above and the valuation (i.e, whether the error will cause the value to be overstated or understated.
Five common mistakes that could either overstate or understate the value of the project are as follows:
- Growth rate of revenues - Management generally be over optimistic in predicting the revenue growth. They take high growth rate in future projections of revenue. This may lead to higher valuation of the company and hence may overstate the value of a project.
- Growth rate of expenses - Management generally be pessimistic in predicting the expenses growth. They take low growth rate in future projections of expenses. This may lead to higher valuation of the company and hence may overstate the value of a project.
- Not adding back depreciation to after tax revenues - Depreciation is reduced from the before tax revenues to calculate the correct tax liability. However, depreciation is not the cash outflow and people forget to add it to the after tax cash flows. This may lead to lower valuation of the company and hence may understate the value of a project.
- Using wrong discount rate - Real cash flows should be discounted at real rate of return and nominal cash flows should be discounted at nominal rate of return. People tend to confuse the real rate of return and use nominal rate of return with real cash flows. This may lead to lowering the valuation of the company and hence may understate the value of a project.
- Basing decisions on IRR - If projects are mutually exclusive, then they should be valued using NPV method and not IRR. In these scenarios, we will select projects giving high absolute return and not the percentage return. This may lead to choosing of wrong projects in absolute income terms.
- Sunk costs and opportunity costs - Companies fail to ignore sunk costs and hence this may lead to lowering the valuation of the company and hence may understate the value of a project.