100 Financial Management
industries. R&D projects are characterized by numerous uncertainties and typically
involve sequential decision-making. Hence the standard DCF analysis is not applicable
to them. Such projects are decided on the basis of managerial judgment. Firms, which
rely more on quantitative methods, use decision tree analysis and option analysis to
evaluate R&D projects.
Miscellaneous Projects This is a catch-all category that includes items like interior
Decoration, recreational facilities, executive aircrafts, landscaped gardens, and so on.
There is no standard approach for evaluating these projects and decisions regarding
them are based on personal preferences of top management.
Rationale
The rationale underlying the capital budgeting decision is efficiency. Thus, a firm must
replace worn and obsolete plants and machinery, acquire fixed assets for current and
new products and make strategic investment decisions. This will enable the firm to
achieve its objective of maximizing profits either by way of increased revenues or cost
reductions. The quality of these decisions is improved by capital budgeting. Capital
budgeting decision can be of two types: (i) those which expand revenues, and (ii) those
which reduce costs.
Investment Decision Affecting Revenues. Such investment decisions are expected
to bring in additional revenue, thereby raising the size of the firmís total revenue.
They can be the result of either expansion of present operations or the development
of new product lines. Both types of investment decisions involve acquisition of
new fixed assets and are income-expansionary in nature in the case of manufacturing
firms.
Investment Decisions Reducing Costs Such decisions, by reducing costs, add to the
earnings of firm. A classic example of such investment decisions is the replacement
proposals when an asset wears out or becomes outdated. The firm must decide
whether to continue with the existing assets or replace them. The firm evaluates the
benefits from the new machine in terms of lower operating cost and the outlay that
would be needed to replace the machine. An expenditure on a new machine may be
quite justifiable in the light of the total cost savings that result.
A fundamental difference between the above two categories of investment decision
lies in the fact that cost-reduction investment decisions are subject to less uncertainty
in comparison to the revenue-affecting investment decisions. This is so because the
firm has a better ëfeelí for potential cost savings as it can examine past production and
cost data. However, it is difficult to precisely estimate the revenues and costs resulting
from a new product line, particularly when the firm, knows relatively little about the
same.