Five common mistakes in capital budgeting, Finance Basics

Assignment Help:

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.

Related Discussions:- Five common mistakes in capital budgeting

Computation of weights or proportions, Computation of Weights or Proportion...

Computation of Weights or Proportions In computation of the weights or proportions of different capital components, the following values might be used like as: Mar

Cost of finance - capital structure, Cost of Finance - Capital Structure ...

Cost of Finance - Capital Structure This is the price the company pays to retail and acquire finance. To get finance a company will pay implicit costs that are commonly recogn

Actions of shareholders in agency conflict, Actions of Shareholders in Agen...

Actions of Shareholders in Agency Conflict a) Disposal of assets required like collateral for the debt in this. In this case the bondholder is exposed to more risk becaus

Rights of ordinary shareholders, Rights of Ordinary Shareholders A. Ri...

Rights of Ordinary Shareholders A. Right to vote Choose BOD Purchase/Sales of assets B. Influence decisions as: Right to residual ass

Monetary control operations, 'The most significant function of any Central ...

'The most significant function of any Central Bank is to undertake monetary control operations'.   Discuss with specific reference to the Bank of England, highlighting its current

Public finance, models of solving externalities in 1) external sector 2)pr...

models of solving externalities in 1) external sector 2)private sector

#titleMrs.., You own a two-bond portfolio. Each has a par value of $1,000. ...

You own a two-bond portfolio. Each has a par value of $1,000. Bond A matures in five years, has a coupon rate of 8 percent, and has an annual yield to maturity of 9.20 percent. Bon

Assignment, Discuss the applicabilty of an operating cycle to poultry busin...

Discuss the applicabilty of an operating cycle to poultry business(consider broilers)

Illustrate the advantages of underwriting, Illustrate the Advantages of Und...

Illustrate the Advantages of Underwriting Underwriting presumes great significance as it offers the below benefits to the issuing company: (i) Issuing company is relied f

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd