Project Classifications
Analyzing capital expenditure proposals is not a costless operation—benefits can be
gained, but analysis does have a cost. For certain types of projects, a relatively detailed
analysis may be warranted; for others, simpler procedures should be used. Accord-
ingly, firms generally categorize projects and then analyze those in each category
somewhat differently:
1.Replacement: maintenance of business.Replacement of worn-out or damaged
equipment is necessary if the firm is to continue in business. The only issues here
are (a) should this operation be continued and (b) should we continue to use the
same production processes? If the answers are yes, maintenance decisions are nor-
mally made without an elaborate decision process.
2.Replacement: cost reduction.These projects lower the costs of labor, materials,
and other inputs such as electricity by replacing serviceable but less efficient equip-
ment. These decisions are discretionary, and require a detailed analysis.
3.Expansion of existing products or markets.Expenditures to increase output of
existing products, or to expand retail outlets or distribution facilities in markets
now being served, are included here. These decisions are more complex because
they require an explicit forecast of growth in demand, so a more detailed analysis is
required. Also, the final decision is generally made at a higher level within the firm.
4.Expansion into new products or markets.These projects involve strategic deci-
sions that could change the fundamental nature of the business, and they normally
require the expenditure of large sums with delayed paybacks. Invariably, a detailed
analysis is required, and the final decision is generally made at the very top—by the
board of directors as a part of the firm’s strategic plan.
5.Safety and/or environmental projects.Expenditures necessary to comply with
government orders, labor agreements, or insurance policy terms are called manda-
tory investments,and they often involve nonrevenue-producing projects.How they are
handled depends on their size, with small ones being treated much like the Category
1 projects described above.
6.Research and development. The expected cash flows from R & D are often too un-
certain to warrant a standard discounted cash flow (DCF) analysis. Instead, decision
tree analysis and the real options approach discussed in Chapter 17 are often used.
7.Long-term contracts.Companies often make long-term contractual arrange-
ments to provide products or services to specific customers. For example, IBM has
signed agreements to handle computer services for other companies for periods of
5 to 10 years. There may or may not be much up-front investment, but costs and
revenues will accrue over multiple years, and a DCF analysis should be performed
before the contract is signed.
In general, relatively simple calculations and only a few supporting documents are
required for replacement decisions, especially maintenance-type investments in prof-
itable plants. A more detailed analysis is required for cost-reduction replacements, for
expansion of existing product lines, and especially for investments in new products or
areas. Also, within each category projects are classified by their dollar costs: Larger in-
vestments require increasingly detailed analysis and approval at a higher level within
the firm. Thus, a plant manager may be authorized to approve maintenance expendi-
tures up to $10,000 on the basis of a relatively unsophisticated analysis, but the full
board of directors may have to approve decisions that involve either amounts over $1
million or expansions into new products or markets.
Project Classifications 261
The Basics of Capital Budgeting: Evaluating Cash Flows 259
