There are various projects in capital budgeting. Unlike small projects within a division, capital projects are long-term. They also often require expensive investments and costs. In addition, they can significantly impact future business operations and growth. Therefore, they need in-depth analysis and careful decisions.
What are these projects? Four are replacement projects, expansion projects, new product and service projects, and regulatory, safety, and environmental projects.
The replacement projects help to maintain normal operation. They may be projects to repair, replace, or rehabilitate existing buildings, machinery, and equipment. The projects aim to maintain current operating levels.
An example is a manufacturer replacing their production machine with a new one. Or a transportation company replaces its operating vehicle with a new one.
Such projects usually require less in-depth analysis. For example, if the machine is outdated, the decision to buy a new machine is usually a relatively easy one. It also does not require detailed analysis. Compare if the company has to build a new factory to increase capacity. The decision and research to build a new factory involve many processes, from site selection, land purchase, environmental analysis, etc.
More in-depth analysis may be involved when, for example, a company purchases a higher-tech machine. Even though it uses the latest technology, the company may need to become more familiar with it. This decision may require a more detailed analysis than simply replacing an outdated machine with a new one.
The expansion project aims to increase the business size. For example, a company builds a new factory. Therefore, this project contributes to increasing the existing production capacity. And therefore, it contributes to the potential for greater earnings in the future.
Building warehouses in multiple locations by retailers is another example. Or a hotel company is building a new hotel chain in several countries.
In general, expansion projects are more complex and expensive than replacement projects. For example, if, in a replacement project, we terminate an old asset and replace it with a new one, then in an expansion project, we add a new asset to add it to the current asset. Thus, unlike replacement projects, expansion projects require more careful consideration because they involve more uncertainty. Therefore, they need us to analyze it in detail.
New products and services projects
Projects to develop new products and services are highly uncertain. They require a very detailed analysis. In addition, decision-making involves more people in the process. They also require considerable planning and organization.
This project is key to business growth and profitability in the long term. For example, new product development is vital if a current product has reached a mature stage in its life cycle. That’s because by developing new products, the company ensures continuous growth.
The risks inherent in the project vary, depending on the product being developed. For example, some companies may develop new products around existing products. They develop complementary products and, therefore, sell them to their current target market. This strategy is less risky when compared to developing a new product with a different target market than the current one.
Regulatory, safety, and environmental projects
Companies sometimes launch new projects to meet government regulations or environmental requirements. The project may not contribute to revenue. Instead, it may provide other benefits, including being able to accompany other income-generating projects undertaken by the company.
Reading in this series
- Capital Budgeting: Importance, Methods For Assessing Project Feasibility
- What is the Capital Budgeting Process?
- What are the Types of Projects in Capital Budgeting?