Project classification in financial management
Time and effort are needed for project analysis. The costs of this exercise must be justified by the advantages that it provides. Certain projects may require a thorough analysis due to their scope and size, while others may only require a basic analysis. As a result, businesses typically divide programmes into various groups. After that, each group is examined in a unique way.
Table of Content
- 1 Project classification in financial management
- 2 Project Classification on the Basis of Interrelationships
- 3 Project Classification Based on Nature
- 4 Factors Affecting the Evaluation and Selection of Capital Projects
Project Classification on the Basis of Interrelationships
Project classification on the basis of interrelationships among projects are as follows:
- Mutually exclusive projects
- Independent projects
- Contingent projects
Mutually Exclusive Projects
Mutually exclusive projects are capital projects which compete directly with each other. For example, if a manager has a choice to make between undertaking projects X and Y, and must choose either of the two and not both, then projects X and Y are said to be mutually exclusive.
This scenario differs from independent projects which are those projects whose cash flows are independent of each other and can, therefore, be undertaken together. There are expenses that must be made to meet legislative requirements. Pollution control devices, medical dispensaries, and firefighting equipment in manufacturing premises are examples of such investments. These are frequently non-profitable investments.
A project whose acceptance or rejection is independent of the acceptance or rejection of other projects. The aim of these investments is to increase the capacity of and/or expand the distribution network. Such investments necessitate a specific growth forecast. Since expansion projects are riskier and more complicated than replacement projects, they usually need a more thorough review. The top management is in charge of making decisions about such programmes.
Contingent projects are ventures that are dependent on one another; making one projects involves making one or more others. If a corporation decides to create a factory in a rural, underdeveloped area, it may need to spend on residences, roads, hospitals, and other infrastructure. For firms to recruit workers, plant construction also necessitates investment in employee facilities. The total cost will be treated as though it were a single investment.
Project Classification Based on Nature
Project classification based on nature are as follows:
- Replacement projects
- Expansion projects
- Modernisation projects
- Diversification projects
- Research and development projects
Firms routinely invest in equipment to replace obsolete and inefficient equipment, even if it is still in good working order. The goal of such investments is to lower labour, raw material, and electricity costs while increasing yield and improving quality. Replacement projects can be assessed in a relatively simple manner, while the analysis may be extremely detailed at times.
The purpose of these investments is to improve capacity and/or expand the distribution network. Such investments necessitate a specific growth estimate. Because expansion projects are riskier and more complex than replacement projects, they usually require more thorough analysis. The top management is in charge of making decisions about such programmes. These projects are for installing capacity to increase the volume of production/service.
A modernisation project means an economic activity that is performed by a business to retool or upgrade production equipment to meet contemporary technology standards and that results in improving existing employees’ job skills to enhance competitiveness for future growth and development. These projects are for technical up gradation of production plant and /or process.
These investments will be used to develop new products or services, as well as expand into new geographic areas. Diversification efforts frequently entail significant risks, enormous outlays, and a great deal of administrative time and attention. Given their strategic relevance, such programmes necessitate a rigorous quantitative and qualitative evaluation. They also necessitate extensive participation from the board of directors.
Research and Development Projects
fraction of the capital expenditure. Things, on the other hand, are changing. Companies are increasingly investing large sums of money to R&D projects, particularly in knowledge-intensive industries. Numerous uncertainties characterise R&D projects, which usually necessitate sequential decision-making. As a result, the typical DCF analysis does not apply to them. Managerial judgement is used to decide on such projects. Decision tree analysis and option analysis are used by firms that rely increasingly on quantitative methods to evaluate R&D initiatives.
Factors Affecting the Evaluation and Selection of Capital Projects
The decision maker needs certain techniques to translate the cash outflows and cash inflows of a project into meaningful yardsticks that can calculate the economic worthiness of projects to make a reasonable decision about capital expenditure proposals.
Some factors affecting the evaluation and selection of capital projects are availability of funds, working capital, structure of capital, capital return, management decisions, need of the project, accounting methods, government policy, taxation policy, earnings, lending terms of financial institutions and economic value of the project, etc.
Some other additional factors affecting the evaluation and selection of capital projects are as follows:
Before taking capital budgeting decision, management must undertake in-depth study of cost of new product /equipment as well productive efficiencies of new as well as old equipment.
Project sequencing is one of the groups. In certain cases, tasks must be completed in a specific order. The decision to conduct the second project becomes available after the first project is completed and found to be profitable. In other words, the second project will not be introduced until the first one has been completed and proven profitable before moving on to the next.
The interconnection between projects will make cash flow analysis for capital decisions difficult. When assessing and choosing projects, the finance manager must consider a variety of factors. Although all capital projects are thoroughly examined, different categories may influence capital project assessment and selection.
Type of Management
If management is innovative, firm may go for new equipment’s/ investment as compared to conservative management.