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Common Pitfalls in Capital Budgeting

There a several common mistakes made as businesses decide how to invest and budget their capital. Most business managers think that by avoiding risky investments and retaining capital they can maximize return. But some of the common pitfalls are an outcome of being too conservative in the approach to capital budgeting.

One common mistake in capital budgeting is to overestimate your cost of capital. Business managers are often conservative, so they want to screen out all but the most promising projects. The consequence of this very conservative strategy is that profitable investment projects aren’t undertaken.

Another common error is for firms to assume profit levels won’t change even if capital investment isn’t undertaken. Because rival firms are investing, the lack of investment ultimately leads to profits eroding. Estimated cash flows should reflect this incremental difference. If they don’t, new project profitability is underestimated.

Firms must also be careful not to exclude qualitative factors. Investment may enable you to decrease production time, enabling you to fill customer orders in a more timely fashion. Although this impact is difficult to quantify, there’s no doubt that it positively affects your firm’s sales and profitability.

Finally, firms typically are too cautious with ambitious projects. Smaller investments are frequently undertaken with minimal management approval, while larger projects may require several levels of management approval. As a consequence, managers have an incentive to propose smaller rather than larger projects.

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