Capital allocation principles and pitfalls

Which cash flows belong in the analysis?

The net present value (NPV) and internal rate of return (IRR) tools are simple, but the inputs are easy to get wrong. Three principles keep the analysis honest.

Use after-tax cash flows

Decide on after-tax cash flows , not accounting profit. Taxes are a real cash cost, and depreciation changes them. Depreciation is a non-cash charge, so it is not an outflow. But it reduces taxable profit, and the tax it saves is cash in the company’s pocket: the depreciation tax shield .

$$CF = (\text{Revenue} - \text{Cash costs})(1-t) + \text{Depreciation}\times t$$

Count only incremental cash flows, but look broadly

Incremental cash flows are the difference between the company’s cash flows with the project and without it. That rule has two sides.

• Ignore sunk costs . Money already spent (or written off), such as last year’s feasibility study, cannot be recovered whatever you decide. It is not part of the decision.
• Include side effects on the rest of the firm. A new product that takes sales from an existing one causes cannibalization . The lost sales are a negative incremental cash flow. A project that cuts costs elsewhere has a positive one.

Cash flows for a capital decisioncount what the decision changes, nothing else

• Include Memorize incremental, after tax
  • After-tax operating cash flows with the depreciation tax saving
  • Side effects on the rest of the firm cannibalized sales (negative), cost savings (positive)
  • Working capital needed a cash outlay of the project
• Exclude Memorize not changed by the decision
  • Sunk costs already spent or written off
  • Financing costs captured in the discount rate
  • Allocated costs that will not change fixed head-office charges

Two exclusions trip people up. Financing costs such as interest are not deducted from project cash flows because the discount rate already charges for the capital. And a fixed overhead allocated to the project that the company pays whether or not it goes ahead is not incremental.

Pay attention to timing

When cash arrives matters. Moving a cash flow from year 3 to year 5 changes both NPV and IRR. Forecasts should reflect the timing, duration and volatility of the cash flows, and the direction they may move.

What mistakes do companies make?

Mistakes fall into two groups. Cognitive errors are calculation and input problems. Behavioral biases are errors of judgment and blind spots.

Pitfallsmistakes in the numbers and in the judgment

• Cognitive errors Use it calculation and input mistakes
  • Internal forecasting errors overheads, competitor reaction
  • Ignoring costs of internal financing internal cash is not free
  • Inconsistent inflation treatment nominal with nominal, real with real
• Behavioral biases Use it errors of judgment and blind spots
  • Inertia budgets anchored to last year
  • Focus on accounting measures EPS, net income, ROE (return on equity)
  • Pet projects favored without thorough analysis
  • No alternatives or scenarios breakeven, scenario, simulation skipped

Type	Pitfall	Sign an analyst can spot
Cognitive	internal forecasting errors (overheads, competitor reaction ignored)	repeated underperformance against plans
Cognitive	treating internal cash as free	reluctance to return cash; low hurdles for internally funded projects
Cognitive	inconsistent inflation treatment	mixed assumptions; sensitivity to particular input prices
Behavioral	inertia	segment capex steady or rising while the segment’s returns fall
Behavioral	managing to EPS or other accounting targets	buybacks and cost cuts favored over positive-NPV projects; pay tied to EPS
Behavioral	pet projects	concentrated control, weak board, misaligned pay
Behavioral	failing to consider alternatives or scenarios	no breakeven, scenario or simulation analysis; never a failed project

Cognitive errors in detail

Forecasting errors are hard for outsiders to see until investments underperform. Overheads such as management time and IT support are easy to underestimate, and competitors’ responses are often left out.

The costs of internal financing are ignored when managers treat operating cash flow as free but scarce, and allocate it by a budget tied to last year’s. Internally generated cash is equity financing: it could have been paid out to shareholders as a dividend, and it carries their opportunity cost. Every project needs the appropriate risk-adjusted required return, whatever the funding source.

Inflation must be treated consistently. Nominal and real cash flows differ: nominal flows include inflation, real flows have it removed. Either works, but nominal cash flows go with a nominal discount rate and real flows with a real rate. Inflation also hits prices and costs unevenly, so actual inflation different from the forecast can make cash flows better or worse than planned.

Behavioral biases in detail

Inertia means anchoring this year’s budget to last year’s. Capital spending by segment tends to track the prior year closely. An analyst looks at capital spending by segment against its return on investment, and questions steady or rising spending when returns fall.

Focusing on accounting measures such as earnings per share (EPS) distorts choices. Many high-NPV investments lower EPS in the near term, while cost cuts and share buybacks can lift it. The analyst checks how management is paid and compares capital spending with history and peers. Low spending is not always a bias: it can reflect limited opportunities.

Pet projects are projects that get preferential treatment, sometimes without thorough analysis, sometimes with overly optimistic forecasts. They rarely show up in aggregated statements, so the analyst looks for governance warning signs: a controlled company or concentrated ownership, weak board oversight, and executive pay misaligned with other stakeholders.

Failing to consider alternatives or scenarios is the last bias. Viable options are never considered, and different outcomes are not examined through breakeven, scenario or simulation analysis. It often reflects little experience of divestitures, acquisitions or failed investments.

Go deeper Why financing costs stay out of project cash flows, and what the evidence says

If you deduct interest from the cash flows and then discount at a rate that already includes the cost of debt, the financing cost is counted twice. The project’s cash flows are measured before financing and the discount rate (a blend of debt and equity costs, covered in the next module) charges for the capital.

Research on large listed companies finds that a segment’s capital budget is very highly correlated with the previous year’s, which shows how common inertia is. Budgets move far less than the opportunities do.

Exam tip Cognitive error: a number is wrong. Behavioral bias: a person is biased. For a scenario, find the sign in the table first.