Capital budgeting is perhaps the most important task faced by financial managers and their staffs. First, a firm’s capital budgeting decisions define its strategic direction, because moves into new products, services, or markets must be preceded by capital expenditures. Second, the results of capital budgeting decisions continue for many years, reducing flexibility. Third, poor capital budgeting can have serious financial consequences. If the firm invests too much, it will incur unnecessarily high depreciation and other expenses. On the other hand, if it does not invest enough, its equipment and computer software may not be sufficiently modern to enable it to produce competitively. Also, if it has inadequate capacity, it may lose market share to rival firms, and regaining lost customers requires heavy selling expenses, price reductions, or product improvements, all of which are costly.

The same general concepts that are used in security valuation are also involved in capital budgeting. However, whereas a set of stocks and bonds exists in the securities market, and investors select from this set, capital budgeting projects are created by the firm. For example, a sales representative may report that customers are asking for a particular product that the company does not now produce. The sales manager then discusses the idea with the marketing research group to determine the size of the market for the proposed product. If it appears that a significant market does exist, cost accountants and engineers will be asked to estimate production costs. If they conclude that the product can be produced and sold at a sufficient profit, the project will be undertaken.

A firm’s growth, and even its ability to remain competitive and to survive, depends on a constant flow of ideas for new products, for ways to make existing products better, and for ways to operate at a lower cost. Accordingly, a well-managed firm will go to great lengths to encourage good capital budgeting proposals from its employees. If a firm has capable and imaginative executives and employees, and if its incentive system is working properly, many ideas for capital investment will be advanced. Some ideas will be good ones, but others will not. Therefore, companies must screen projects for those that add value

Project Classifications

Analyzing capital expenditure proposals is not a costless operation—benefits can be gained, but analysis does have a cost. For certain types of projects, a relatively detailed analysis may be warranted; for others, simpler procedures should be used. Accordingly, firms generally categorize projects and then analyze those in each category somewhat differently:

1. Replacement: maintenance of business. Replacement of worn-out or damaged equipment is necessary if the firm is to continue in business. The only issues here are (a) should this operation be continued and (b) should we continue to use the same production processes? If the answers are yes, maintenance decisions are normally made without an elaborate decision process.

2. Replacement: cost reduction. These projects lower the costs of labor, materials, and other inputs such as electricity by replacing serviceable but less efficient equipment. These decisions are discretionary, and require a detailed analysis.

3. Expansion of existing products or markets. Expenditures to increase output of existing products, or to expand retail outlets or distribution facilities in markets now being served, are included here. These decisions are more complex because they require an explicit forecast of growth in demand, so a more detailed analysis is required. Also, the final decision is generally made at a higher level within the firm.

4. Expansion into new products or markets. These projects involve strategic decisions that could change the fundamental nature of the business, and they normally require the expenditure of large sums with delayed paybacks. Invariably, a detailed analysis is required, and the final decision is generally made at the very top—by the board of directors as a part of the firm’s strategic plan.

5. Safety and/or environmental projects. Expenditures necessary to comply with government orders, labor agreements, or insurance policy terms are called mandatory investments, and they often involve nonrevenue-producing projects. How they are handled depends on their size, with small ones being treated much like the Category 1 projects described above.

6. Research and development. The expected cash flows from R & D are often too uncertain to warrant a standard discounted cash flow (DCF) analysis. Instead, decision tree analysis and the real options approach are often used.

7. Long-term contracts. Companies often make long-term contractual arrangements to provide products or services to specific customers. For example, IBM has signed agreements to handle computer services for other companies for periods of 5 to 10 years. There may or may not be much up-front investment, but costs and revenues will accrue over multiple years, and a DCF analysis should be performed before the contract is signed.

In general, relatively simple calculations and only a few supporting documents are required for replacement decisions, especially maintenance-type investments in profitable plants. A more detailed analysis is required for cost-reduction replacements, for expansion of existing product lines, and especially for investments in new products or areas. Also, within each category projects are classified by their dollar costs: Larger investments require increasingly detailed analysis and approval at a higher level within the firm. Thus, a plant manager may be authorized to approve maintenance expenditures up to $10,000 on the basis of a relatively unsophisticated analysis, but the full board of directors may have to approve decisions that involve either amounts over $1 million or expansions into new products or markets.

Note that the term “assets” encompasses more than buildings and equipment. Computer software that a firm develops to help it buy supplies and materials more efficiently, or to communicate with customers, is also an asset, as is a customer base like the one AOL developed by sending out millions of free CDs to potential customers. All of these are “intangible” as opposed to “tangible” assets, but decisions to invest in them are analyzed in the same way as decisions related to tangible assets.