Set out frequent mistakes in capital allocation and explain real options
The idea
The recurring pitfalls are behavioural rather than technical: including sunk costs, ignoring the opportunity cost of assets the project will consume, overlooking cannibalisation of existing products, and internal politics that favour the most persuasive sponsor rather than the best project. Real options sit on the other side of the ledger — the ability to expand, abandon, defer or switch inputs has value that a single-scenario NPV omits. A project with a slightly negative NPV and a valuable option to expand may still be worth undertaking.
A practice question
Why should sunk costs be excluded from a capital investment analysis?
- Because they are not tax deductible at allWhy not: Many are deductible. The reason to exclude them is that no decision now can change them.
- Because they cannot be changed by the decision — correct
- Because they are always immaterialWhy not: They are often very large, which is exactly why the temptation to count them is so strong.
The decision can only affect future cash flows. Money already spent is the same whether the project proceeds or not, so including it distorts the comparison.
A harder one
A new product is expected to take 20% of its sales from the company's existing line. How should this be treated?
- Ignored, because total company sales still riseWhy not: Sales rise by less than the project's own figure suggests, and the difference is real lost profit.
- Added to the project's revenue as a transferWhy not: Adding it counts the same sales twice, once in the old line and once in the new.
- Deducted as cannibalisation, because only incremental company cash flow counts — correct
The relevant measure is the change in the company's cash flow, not the project's own revenue. Sales taken from an existing line are not incremental and must be netted out.
The hardest tier
Why might a project with a marginally negative NPV still be worth undertaking?
- Because a valuable real option is not captured — correct
- Because NPV is unreliable for small projectsWhy not: It applies at any scale; what a single-scenario calculation misses is flexibility.
- Because the IRR will be positiveWhy not: A positive internal rate below the cost of capital still destroys value.
A base-case NPV prices one path. The right to change course later — scale up if demand appears, walk away if it does not — has value, and when that option is material it can outweigh a small negative base case.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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