Five common mistakes in capital budgeting, Finance Basics

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.
Posted Date: 9/17/2012 9:33:29 AM | Location : United States







Related Discussions:- Five common mistakes in capital budgeting, Assignment Help, Ask Question on Five common mistakes in capital budgeting, Get Answer, Expert's Help, Five common mistakes in capital budgeting Discussions

Write discussion on Five common mistakes in capital budgeting
Your posts are moderated
Related Questions
Find the costs of financing for two schedules of monthly payments on a 25-year mortgage. The cash value of the house today is $500,000. You are paying monthly at a fixed rate of 6%

Define benefit plan for the employee participants

The Bayview Investment Partners owns an office building near Shoal Creek and Anderson lane in suburban Dallas. The building is ten years old. Bayview is willing to sell the propert

Example of Earnings Yield Valuation Estimated maintainable earnings are £240,000 per annum; rate of return required is 25 percent. Calculate the value of the business. V

Clientele Effect Theory Advance via Richardson Petit in 1977.It stated such different types of groups of shareholders or clientele have different type of preferences for divid

Question 1: (a) What do you meant by the term ‘Life Insurance Contract'? (b) Many people prefer to choose Single life policies compared to Joint life policies. Why is t

Access to Capital Markets and Ownership Structure  Ownership Structure A dividend policy may be driven with Time Ownership Structure as like in small firms whereas manage

i ordered case study 1 susam and malcom. when i open the document is completely different, not the same case study an is only relivent in the usa not australia... do you have the c

What are the principles of multiunit finance?

You need cash and FAST! You jump out of your car at a location known to have one ATM, but a history of a line. Usually you can expect to wait 200 seconds from the time you arrive