Capital expenditure projects can be classified into various categories, depending on the nature of the benefits expected.
- One category includes projects that are designed to reduce costs. Like products that become obsolete, technological progress also renders plants, equipment, and production processes obsolete. Normal wear and tear makes older plants and equipment more costly to operate due, for example, to more downtime and higher maintenance costs. Obsolescence and deterioration should generate proposals to replace older facilities with new, more efficient plants and equipment.
- A second category of capital expenditures includes projects designed to improve a firm’s demand curve, or to respond to changes in that curve. If increased demand for a product line is forecast, and if the existing manufacturing and distribution facilities are inadequate to meet this demand, then the firm must develop proposals for expanding capacity for production and distribution. A firm also may make investments in advertising/product promotion campaigns in an attempt to positively influence the demand for its products. Although often not thought of as traditional capital expenditures, these promotional outlays have all the characteristics of capital investments and can be analysed in the same way.
- A third category of capital expenditure projects includes those that create future growth options for the firm. For example, investing in research and development (R&D) can be viewed as a capital expenditure that creates future growth options for the firm. Although any particular R&D project will be very difficult to justify using traditional capital expenditure analysis procedures, one must recognise that traditional procedures normally do not consider the option value created by R&D outlays. These outlays give the firm the “options,” but not the obligation, to make further outlays that are needed to bring a new product to market. Without the initial R&D outlays, the firm would not possess the options to make the second-phase expenditures and to reap the associated rewards. This experience guarantees strategic position in a competitive environment.
- A fourth type of capital expenditure includes projects designed to meet legal requirements and health and safety standards, such as proposals for pollution control outlays, ventilation, employee safety, and fire-protection equipment. At first glance it may seem that these outlays are “simply required” and thus no analysis is needed. However, managers have the choice of not making these outlays and just shutting down a plant. The decision revolves around the question of whether the remaining cash flows in a project are sufficiently large to justify the additional outlays necessary to keep the plant operating.
- The other expenditure is for corporate responsibility.
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