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Capital Investments

process?” Since the answers to these questions are so fre- Each stage involves an investment decision at one or
quently yes, an elaborate decision-making process is not more levels of the company. At each stage, the company
needed, and typically such decisions are approved with re-estimates the value expected to be created—the NPV—
only routine review. of going ahead. With this kind of sequential appropriation
Cost savings/revenue enhancement: Projects in this class of funds, an automatic progress review is enforced,
include improvements in production technology to realize enabling early cancellation of unsuccessful projects. At
cost savings and marketing campaigns to achieve revenue each stage there are options to abandon, postpone,
enhancement. The central issue is increasing the differ- change, or continue.
ence between revenue and cost; the result must be suffi- Proposed expenditures that are larger than certain
cient to justify the investment. company-set limits generally require a written proposal
from the initiator. Typically, such limits are higher in
Capacity expansion in current businesses: Deciding to
expand the current business is inherently more difficult smaller privately owned companies, which tend to have
relatively informal organizational structures. Most compa-
than approving maintenance or cost-saving proposals.
Firms have to consider the economics of expanding or nies use standard forms, and these are often supplemented
by written memoranda for larger, more complex projects.
adding new facilities. They must also prepare demand
forecasts, keeping in mind competitors’ likely strategies. Also, there may be consulting or other studies prepared by
outside experts; for example, economic forecasts from eco-
Marketing consultants may help, but this class of projects
nomic consultants.
naturally has more uncertain return projections than do
maintenance or replacement projects. For a successful company, a maintenance project
might require only limited supporting information. In
New products and new businesses: Projects in this cate-
contrast, a new product would require extensive informa-
gory, which include R&D activities, are among the most tion gathering and analysis. At the same time, within a
difficult to evaluate. Their newness and long lead times
category, managers at each level usually have upper limits
make it very difficult to forecast product demand accu-
on their authority regarding both expenditures on indi-
rately. In many cases, the project may be of special inter-
vidual assets and the total expenditure for a budgeting
est because it would give the company an option to break period. In this way, larger projects require the approval of
into a new market. For example, a company that has a
higher authority.
proprietary technology might spend additional R&D
funds trying to develop new products based on this tech- For example, at the lowest level, a department head
may have the authority to approve $50,000 in total equip-
nology. If successful, these new products could pave the
ment purchases for the year. However, that same person
way for future profitable investment opportunities. Access
might have to obtain specific approval from higher
to such opportunities represents valuable options for the
authority to spend more than $10,000 for any single piece
company.
of equipment. A plant manager might have authorization
Meeting regulatory and policy requirements: Govern-
limits of $500,000 per year and $100,000 per piece of
ment regulations and/or company policies concerning
equipment, for example.
such things as pollution control and health or safety fac-
A system of authorization, such as illustrated in the
tors are viewed as costs. Often, the critical issue in such
preceding paragraph, requires more extensive review and a
projects is meeting the standards in the most efficient
greater number of inputs to approve larger expenditures.
manner and at the minimum cost.
The hierarchical review structure reflects the obvious fact
that misjudging a larger project is potentially more costly
Evaluating Proposals. The typical stages for the develop- than misjudging a smaller one.
ment and approval of a capital investment proposal are:
1. Approve funds for research that may result in a CAPITAL INVESTMENT IN OTHER
product idea. COMPANIES
2. Approve funds for market research that may result Sometimes companies make capital investments in other
in a product proposal. companies. In concept, these are just like any other capi-
tal investment. They range from the simple, such as buy-
3. Approve funds for product development that may
ing stock in another company in a passive investment, to
result in a usable product.
acquiring, or purchasing, another company outright or
4. Approve funds for plant and/or equipment for the merging with another company. With an acquisition or
production and sale of the new product. merger, the details connected with such things as taxes,

ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION 73