In the world of capital budgeting there are many types of
projects, each of which requires it owns special handling. The most common is the single, stand alone
investment in a new building, or in a new major machine or system, which is going to increase corporate
revenues or reduce expense. In this type of investment, assuming its not replacing an existing asset,
the process is straightforward: find the out-of-pocket cost of the investment, determine the cash flows
over the life of the project or over the proposed holding period, then apply the criteria to determine
whether the investment is acceptable. In this situation there may be more than one investment offered,
each independent of the other. In which event a determination needs to be made as to which is the most
acceptable. Here the multiple criteria of Net Present Value, Internal Rate of Return, Payback and the
Profitability Index will be invaluable.
Occasionally two projects will be offered which are mutually
dependent. for example: the purchase of a fleet of trucks to improve customer service and reduce transportation
costs, and a maintenance facility for the repair a servicing of such vehicles. Here the two projects stand
together as one major investment the combined cash flows of which must be positively related to the investment.
Frequently, a project will be a replacement project on a
major machine on system. When this occurs, side issues such as the salvage value of the old system, and
taxation based on depreciation issues such as capital gain and recapture of depreciation, can complicate
the process of determining the out-of-pocket cost of the new machine.
Occasionally, the original new investment will need to be
reinforced with new investment flows to keep the project on track. This happens frequently with major
machinery for utilities where substantial overhauls have to be done periodically. In this situation the
conventional investment with an initial major outflow and a series of positive inflows becomes a continuum
of investments over many years and has to be calculated as such.
In business planning a whole series of capital projects could
be regarded as "contingency projects" i.e. "if we get that account in Chicago we will have rebuild our
office in Kansas City" and, as such, require a scenario approach otherwise called "what if analysis".
This type of capital budgeting process is spreadsheet based and requires multiple cash flow scenarios,
and occasionally multiple investment scenarios as well.
There are, perhaps, hundreds of types of projects that fall
outside the normal pale of the typical capital project, including many involving advertising investments,
investments in personnel, investments involving internal efficiency and productivity issues which call
for special treatment, because it is difficult to ascertain cash flow benefits or projected tax implications,
or the value of a prospective takeover company.
In capital budgeting, the process, carefully executed, forces
the conclusion. Therefore it is essential that all the elements of the project type be included and incorporated,
so that the project under consideration can be carefully evaluated.