Certain Practices can be the Cause of Errors in the Process of Investment Evaluation
Authors: Rosbaco J.A. 
Published: December 2007

This paper shows how certain standard practices used in the investment evaluation process may be wrong in certain circumstances, thus leading to an incorrect decision. The main reason behind these mistakes can be attributed to the routinary and inflexible use of the standard techniques, without making a prior critical analysis of them and their applicability to the project under study. Such analysis should fully contemplate the environment within which the project will take place and the objectives pursued by the evaluation.

Introduction

The evaluation of a project can be divided sequentially into the following six stages:Preparing the different forecasts involved: Investments, Productions, Prices, Expenses, Taxes, etc.Dividing the project into periods.Solving the Cash Flow Equation for each of the periods.Adopting the Form of Discounting best representing the physical reality. Calculation of the economic yardsticks.Sensitivity analysis.Submission to Management. Decision making.

In many cases, as evaluations become a routine task, some of the stages of the process receive only superficial treatment, without due careful consideration. Thus, it is possible that a division into periods that is recommendable for many projects, or a form of discounting that is usually correct, be used in circumstances where they do not represent the physical reality.

Routine is one of the main causes of conceptual errors that are sometimes made in project evaluations. Other important causes are the universal use of methods and equations originally derived for particular cases, the use of economic yardsticks with physical meanings not fully understood by the analyst, and the lack of a logical reasoning process contemplating not just the project but also its environment, the temporary circumstances of the company, and the objectives of the evaluation.

The erroneous situations that will be discussed in this paper are the following:

Case A. Failure to apply the incremental criteria to all of the elements in the evaluation. Case B. Improper duration of the periods. Case C. Improper form of discounting. Case D. Erroneous treatment of the intermediate negative cash flows when calculating the Present Value Index. Case E. Arbitrary elimination of the last periods or sequential repetition of the projects for comparison purposes. Case F. Improper tax treatment. Case G. In projects where more than one result is possible, such as in an exploration scheme, replacing the systematical evaluation of all of the alternatives and weighing the results through the Expected Value, for the analysis of just a number of particular cases. Case H. Failure to consider some inflationary effects.

Case Analysis

Case A. Failure to apply the incremental criteria to all of the elements present in the evaluation. The basic rule for analyzing the convenience of a given investment is to consider only its incremental effects, that is, to evaluate the difference between the performance of the company with the project and without the project. Because of this, incomes or disbursements that are independent of the investments being analyzed must not be included in the evaluation. The following are some examples of elements that are at times erroneously considered in an evaluation:

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