Types of Capital Investments

Capital investments (or capital projects) have a life of one or more years and are presented on the balance sheet as long-term assets.

There are four main types of capital investments:

1. Going concern (or maintenance) projects.
2. Regulatory or compliance projects.
3. Expansion projects.
4. New lines of business and other projects.

While growth projects and other projects are initiated to develop a firm strategically, going concern (or maintenance) projects and regulatory or compliance projects ensure business continuation.

Going Concern Projects

These are projects required to sustain current operations, keep a firm at its current size, or boost business efficiency. Infrastructure improvement is an example of a going concern project. Firm management quickly assesses going concern projects since the expenses they attract are mostly lower than the production or business interruption costs that may arise from failure to invest.

Managers frequently attempt to align financing to an asset’s lifespan to pay for these projects (match funding). For instance, to finance equipment replacement with a 20-year projected useful life, a business may issue a 20-year bond.

Corporations do not disclose capital expenditure costs related to going concern projects in financial statements. Analysts often use the depreciation and amortization expense shown on the income statement as a proxy for going concern capital expenditure.

Regulatory or Compliance Projects

These projects are usually undertaken due to a requirement by a governmental agency, insurance company, or some other external party. They often do not generate revenue for a company. Instead, however, they generate regulatory or compliance expenditures. This can be an obstacle to entry into a market, which could benefit incumbents. Nevertheless, in some instances, it may be more prudent to shut down part of the business related to the project, e.g., factory pollution control installation.

Expansion Projects

Projects that increase a firm’s size come with higher risk and uncertainty than going-concern projects. An example would be a merger and acquisition. There are two significant risks with acquisitions: the difficulty in integrating the business operations of the acquirer and the target. In addition, there is the risk of overpaying.

Companies with a track record of successful expansions are more likely to use debt to finance their expansion projects. Capital investment is necessary when an established company expands its size by introducing a new product line, service, etc. The business scope expansion often takes advantage of the existing ability to meet the needs of different customers.

When gauging the probability of success, analysts and investors look at the past performance of peers executing the same strategy and the company’s competitive position.

New Lines of Business and Other Projects

Projects beyond a company’s traditional business areas include high-risk investments and new growth efforts, e.g., innovation projects. These initiatives are probably on the riskier end of the capital investment spectrum.

Question

Which of the following projects is most likely considered the riskiest?

1. Other projects.
2. Regulatory projects.
3. Going concern projects.

The correct answer is A.

Other projects are considered the riskiest. These projects are beyond a company’s traditional business area and include high-risk investments and new growth efforts, e.g., exploration investments into innovations.

B is incorrect. Regulatory or compliance projects are undertaken due to a regulator or government agency requirement. They do not generate any revenue for a company. However, it incurs compliance expenditure.

C is incorrect. Going concern projects are required to sustain current operations. This involves keeping the firm at its current size or boosting efficiency. These projects are not risky since they are already in operation.