Lesson 7 of 8 · All lessons in this module
- Types of capital investments
- The capital allocation process and NPVVideo lesson
- IRR, and choosing between IRR and NPVVideo lesson
- Return on invested capital (ROIC)Video lesson
- Integrated case: three projects against a ROIC target
- Principles of capital allocation
- Capital allocation pitfalls
- Real optionsVideo lesson
Lesson 7 of 8 · 13 min
Capital allocation pitfalls
Even with good tools, capital allocation goes wrong through cognitive errors in the analysis and behavioural biases in judgement, and analysts can spot many of them from outside.
In short
- Cognitive errors: internal forecasting errors, ignoring the cost of internal financing, and inconsistent treatment of inflation.
- Internally generated cash is equity capital and carries shareholders' opportunity cost; it does not deserve a lower r.
- Discount nominal cash flows at a nominal rate and real cash flows at a real rate.
- Behavioural biases: inertia, basing decisions on accounting measures such as EPS, pet projects, and failing to consider alternatives or scenarios.
- Analysts detect them through historical and peer comparisons of capex and returns, compensation structures and corporate governance.
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