LOS E requires us to:
describe common capital allocation pitfalls.
These are some of the common capital allocation mistakes often made by the investors in the process of capital allocation, they are:
a. Not incorporating economic responses into the investment analysis. Any successful investment plan attracts economic responses, such as increased competition, etc. And it is a very common mistake by investors not to take into account the economic response by the competitors in such a situation.
b. Misusing capital allocation templates. There are template models used for capital allocation, and there are chances that the template models do not match the requirements of the investors or the investment. If this happens or if the information used for these templates is inappropriate, the model may lead to wrong results.
c. Investing in pet projects. A pet project is a project, activity, or goal pursued as a personal favorite, rather than because it is generally accepted as necessary or important. Sometimes the companies and the directors tend to favor the pet projects instead of others without undergoing normal capital allocation analysis.
d. Basing investment decisions on EPS, net income, or ROE. These are mostly short-term economic indicators. Choosing short-term accounting numbers instead of long-term economic indicators jeopardize the economic interests of the shareholders.
e. Using IRR to make investment decisions. IRR is not an appropriate measure of returns, especially in the case of non-conventional returns, mainly because in such cases, it offers more than one solution. So it is always advisable to go for different forms of analysis such as NPV.
f. Incorrectly accounting for cash flows. There may be situations of completely omitting certain items of cash-flows or double count cash flows, etc.
g. Not using an appropriate risk-adjusted discount rate. It is extremely important to choose the correct discount rate for NPV analysis. The appropriateness of decisions made on using NPV analysis hugely depends upon the correctness of estimating the discount rates.
h. Overestimating or underestimating the overhead cost. It is extremely important to appropriately estimate the overhead and operating expenses for the correct analysis of investments.
i. Overspending and underspending the capital allocation. To maximize the value of an investment the allocated capital must be wisely allocated. It is not necessary to completely spend the same or to spend less than economically viable.
j. Failing to consider investment alternatives or alternative states. One should consider all the available investment alternatives and choose the best one out of them. One of the biggest mistakes often made by investors is discarding some alternatives without giving them due consideration.
k. Incorrectly handling sunk costs and opportunity costs. One needs to appropriately handle the sunk cost and opportunity costs.