When companies consider taking on major new investment projects, they often go through a detailed capital allocation process to determine if the project is worth pursuing. Some types of projects that typically require more rigorous evaluation include expansion projects to grow the business, new product or market development, and replacement projects for cost reduction.
Expansion projects require forecasting future demand
One category of investment projects that requires careful analysis is expansion projects undertaken to grow the company’s business. These decisions involve explicitly forecasting future demand if the expanded capacity is put in place. Because the projections contain substantial uncertainty, management must conduct a detailed financial analysis to determine expected cash flows and whether they justify the required investment outlays.
New product development has high uncertainty
Another scenario requiring diligent capital allocation analysis is new product or market development projects. These investments aim to expand the company’s offerings into new areas, but often have very unclear outcomes. The uncertainty surrounding the potential cash flows and profitability means management should do an in-depth evaluation of the expected risks and returns before deciding to move forward.
Replacement projects balance cost vs. benefits
Replacement projects also necessitate careful financial analysis by companies. Though replacing obsolete equipment can reduce costs, management must compare the expected cost savings to the required cash outlays for the new assets. Determining the incremental impacts on cash flow and calculating metrics like return on investment or net present value allows an informed decision about proceeding.
In summary, major investment projects like expansions, new product development, and replacements often compel companies to undertake detailed capital allocation analysis to determine expected profitability and support the decision to invest funds.