Capital Bugeting Classification

Companies often put capital budgeting projects into some rough categories for analysis. One such classification would be: replacement projects, expansion projects, new product and service, Regulatory, safety, and environmental projects and others. The below is the details of each category.

Capital Budgeting Classification

Replacement projects. These arc among the easier capital budgeting decisions. If a piece of equipment breaks down or wears out, whether to replace it may not require careful analysis. If the expenditure is modest and if not investing has significant implications for production, operations, or sales, it would be a waste of resources to over-analyze the decision. Just make the replacement. Other replacement decisions involve replacing existing equipment with newer, more efficient equipment, or perhaps choosing one type of equipment over another. These replacement decisions are often amenable to very detailed analysis, and you might have a lot of confidence in the final decision.

Expansion projects. Instead of merely maintaining a company’s existing business activities, expansion projects increase the size of the business. These expansion decisions may involve more uncertainties than replacement decisions, and these decisions may¬† be more carefully considered.

New products and services. These investments expose the company to even more uncertainties than expansion projects. These decisions are more complex and will involve more people in the decision-making process.

Regulatory, safety, and environmental projects. These projects are frequently required by a governmental agency, an insurance company, or some other external party. They may generate no revenue and might not be undertaken by a company maximizing its own private interests. Often, the company will accept the required investment and continue to operate. Occasionally, however, the cost of the project is sufficiently high that the company would do better to cease operating altogether or to shut down any part of the business that is related to the project.

Other. The projects above are all susceptible to capital budgeting analysis, and tl1ey can be accepted or rejected using tl1e net present value (NPV) or some other criterion. Some projects escape such analysis. These are either pet projects of someone in the company (such as the CEO buying a new aircraft) or so risky that they are difficult to analyze by the usual methods (such as some research and development decisions).