Capital investments should include all those expenditures, which are expected to produce benefits to the firm over a long period of time, and encompass both tangible and intangible assets. Thus R&D expenditure is a capital investment. Similarly, the expenditure incurred in acquiring a patent or brand is also a capital investment.
Few companies classify capital expenditures in a manner, which could provide useful information for decision-making. Their classification is ( i ) replacement, ( ii ) modernisation, ( iii ) expansion, ( iv ) new project, ( v ) research and development, ( vi ) diversification, and ( vii ) cost reduction.
Estimation of cash flows requires collection and analysis of all qualitative and quantitative data, both financial and non-financial in nature. Large companies would generally have a management information system (MIS) providing such data.
The net present value method is theoretically the most desirable criterion as it is a true measure of profitability; it generally ranks projects correctly and is consistent with the wealth maximization criterion. In practice, however, managers’ choice may be governed by other practical considerations also.
Screening and selection procedures may differ from one company to another. When large sums of capital expenditures are involved, the authority for the final approval may rest with top management. The approval authority may be delegated for certain types of investment projects.
Senior management tightly control capital spending. Budgetary control is also exercised rigidly. The expected capital expenditure proposals invariably become a part of the annual capital budget in all companies .
Vision of judgement of the future plays an important role.
The opportunities and constraints of selecting a project, its evaluation of qualitative and quantitative factors, and the weightage on every bit of pros and cons, cost-benefit analysis, etc., are essential elements of judgement.
Judgement and intuition should definitely be used when a decision of choice has to be made between two or more, closely beneficial projects, or when it involves changing the long-term strategy of the company. For routine matters, liquidity and profits should be preferred over judgement.
It (judgement) plays a very important role in determining the reliability of figures with the help of qualitative methods as well as other known financial matters affecting the projects.
Strategy provides the decision-maker with a central theme or a big picture to keep in mind at all times as a guideline for effectively allocating corporate financial resources.
As argued by a chief financial officer—Allocating resources to investments without a sound concept of divisional and corporate strategy is a lot like throwing darts in a dark room.
Strategic framework provides a higher-level screening and an integrating perspective to the whole system of capital expenditure planning and control. Once strategic questions have been answered, investment proposals may be subjected to the DCF evaluation.
Real options are those strategic elements in investments that help creating flexibility of operations, or that have the potential of generating profitable opportunities in the future for the firm.
Real options provide discretion to managers to take certain investment decisions, without any obligation, for a given price.
Real options are not confined to real assets only. Patent, R&D, brands etc. are examples of assets that have a value to the owner.
The capital investments should be viewed as strategic investments that incorporate real options. Hence the value of a capital investment will also include the value of the strategic elements in the investment.
For planning and control purposes, three levels of decision-making have been identified:
Keeping in view the different decision-making levels, capital expenditures could be classified in a way, which would reflect the appropriate managerial efforts to be placed in planning and controlling them .
One useful classification could be:
( i ) strategic projects,
( ii ) expansion in the new line of business,
( iii ) general replacement projects,
( iv ) expansion in the existing line of business, and