Analyzing different types of capital investment projects and investing in the most profitable projects is what gives life and growth to a company. Unless a company conducts the necessary research and development to develop new products, to improve existing products or services, and to discover ways to operate more efficiently, that company and the economy in which it operates will stagnate.
Companies of any size, and entrepreneurs starting a new business, do and should have a Research and Development Department. That department, along with usually a committee composed of finance, marketing, technology, and other executives are charged with coming up with ideas to improve the company and the products and services offered by the company.
Research and development is not free to a company. It is a cost/benefit operation. Well-managed firms go to great lengths to develop good capital budgeting proposals that provide value to the firm and the economy at large.
There are numerous types of capital budgeting projects as discussed below:
1. New Projects: New products or new markets
A new capital investment project is important for the growth and expansion of a company. It is also important for the economy at large as it means research and development. This type of project is one that is either for expansion into a new product line or into a new product market, often called the target market.
A new product or a new target market could, conceivably, change the nature of the business. It should be approved by higher-ups in the business organization. A new project, either a new product or a new target market, requires a detailed financial analysis and the approval of possibly even the firm's Board of Director's.
An example of a new product would be a new medical device that is conceived, researched and developed by a company specializing in medical devices. Perhaps this medical device would tap into a target market that the company had not yet been able to reach.
2. Expansion of existing products or markets
The expansion of existing products or target markets means an expansion of the business. If a company undertakes this kind of capital budgeting product, they are effectively acknowledging a surge in growth of demand. A detailed financial analysis is required, but not as detailed as that required for the expansion of the company into new products or new target markets.
3. Replacement project necessary to continue operations as usual
An example of a replacement project necessary to continue operations as usual would be, in a manufacturing plant, replacing a worn out piece of equipment with a new piece of the same equipment designed to do the same job. This is a simple capital budgeting project to evaluate. It would be possible to use one of these simpler capital budgeting methods to evaluate this project and abide by the decision of the capital budgeting method.
The cash flows from a replacement project necessary to continue operations as usual are fairly easy to estimate, at least compared to other types of projects, because the business owner is replacing the same type of equipment and is, therefore, somewhat familiar with it.
4. Replacement project necessary to reduce business costs
During the Great Recession, many companies have been looking at this type of capital project. Sometimes, businesses need to replace some projects with others in order to reduce costs. An example would be replacing a piece of obsolete equipment with a more modern piece of equipment that is easier to have serviced. This type of capital budgeting project would require a detailed financial analysis with cash flows estimated from each piece of equipment in order to determine which generates the most in cash flows and, thus, saves money.
These are the four basic types of capital budgeting projects, although there are offshoots of each one.