Common Pitfalls In Capital Budgeting

Capital budgeting is a necessity in every organization irrespective of its size, this fact is well-known to financial controllers in capital-intensive industries more than any other business. A tiny mistake in budgeting for a service can be fixed during the annual pricing review, but this is not true for a utility company, where a contractual commitment may be imposed by a 20-year power purchase agreement.

In this article, I discuss common budgeting pitfalls that I have observed in the budgeting practices across many organizations over the past ten years.

Accounting vs. Finance

A common problem faced in capital budgeting is when people of accounting background first take responsibility for investment decisions, despite the inherent difference in their time horizon. In my opinion, accounting is an ex post documentation of business transactions, whereas finance is an ex ante analysis of the decision’s implication, and therefore they are fundamentally different.

In capital budgeting it is essential to maintain future focus, and avoid reverting to standard accounting policies where they don’t make much sense. Accounting for inflation and exchange rate are vital considerations in finance, but less so in accounting.

Sunk Cost

Many people find some difficulty accepting the requirement to ignore sunk cost, which is the cost already incurred before taking the decision. A sunk cost is typically the fees paid to a consultant to study the feasibility of the project. Indeed, any fees paid in the past will affect the overall project profitability, but this should not mean continue to implement a losing project just because you already incurred some cost. Sometimes, stopping loss is the best route, you should ask many stock market speculators about that!

Opportunity Cost

When an existing asset is utilized in the project, some people may fail to include its cost. It is true that it already exists, but if this project is not implemented, the company could have sold it and benefited from the proceeds, so it makes sense to consider the cost of missing opportunities to use this assets in some other way.

Discount Rates

Everyone knows the time value of money concept. We naturally understand many of financial management concepts without having formal financial education, or theoretical background, but when it comes to choosing the discount rates of future cash flows, many people stand puzzled, let alone the scary names of terms, such as “capital asset pricing models”, “levered beta” or “WACC”. It is critical to know exactly the discount rate that your company should apply on payments received in the future.

Tax Impact

Tax impact is not easily embedded in calculations, but it is of great importance in capital-intensive industries because of what is called a tax shield. A tax shield is a tax benefit given to companies based on the depreciation expense of their assets. Depreciation, although is not a cash flow per se, has real impact on cash flow, because it alters the organization’s bottom line.

Cannibalization

Cannibalization occurs when existing products lose ground to new products, for example when the company’s new menu item shifts consumption from an older item to a new one. In this case, capital budgeting should take into consideration the reduction in sales of other products as a result of shifting demand to the new one.

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