by Capital budgeting is a multi-step process businesses use to determine how worthwhile a project or investment will be. A company might use capital budgeting to figure out if it should expand its warehouse facilities, invest in new equipment, or spend money on specialized employee training.
Capital budgeting process consists of five steps:
- Identify and evaluate potential opportunities
The process begins by exploring available opportunities. For any given initiative, a company will probably have multiple options to consider. For example, if a company is seeking to expand its warehousing facilities, it might choose between adding on to its current building or purchasing a larger space in a new location. As such, each option must be evaluated to see what makes the most financial and logistical sense. Once the most feasible opportunity is identified, a company should determine the right time to pursue it, keeping in mind factors such as business need and upfront costs.
- Estimate operating and implementation costs
The next step involves estimating how much it will cost to bring the project to fruition. This process may require both internal and external research. If a company is looking to upgrade its computer equipment, for instance, it might ask its IT department how much it would cost to buy new memory for its existing machines while simultaneously pricing out the cost of new computers from an outside source. The company should then attempt to further narrow down the cost of implementing whichever option it chooses.
- Estimate cash flow or benefit
Now we determine how much cash flow the project in question is expected to generate. One way to arrive at this figure is to review data on similar projects that have proved successful in the past. If the project won’t directly generate cash flow, such as the upgrading of computer equipment for more efficient operations, the company must do its best to assign an estimated cost savings or benefit to see if the initiative makes sense financially.
- Assess risk
This step involves estimating the risk associated with the project, including the amount of money the company stands to lose if the project fails or can’t produce its previously anticipated results. Once a degree of risk is determined, the company can evaluate it against its estimated cash flow or benefit to see if it makes sense to pursue implementation.
- Implement
If a company chooses to move forward with a project, it will need an implementation plan. The plan should include a means of paying for the project at hand, a method for tracking costs, and a process for recording cash flows or benefits the project generates. The implementation plan should also include a timeline with key project milestones, including an end date if applicable.
The capital budgeting process consists of three main steps:
(i) Deciding on the amount of capital expenditure needed.
(ii) Ascertaining the availability of capital.
(iii) Deciding on how to allocate the available capital among alternative investment proposals.
Search for Investment Opportunities:
As already stated, the first step in the capital budgeting process is a survey of the need for capital in the enterprise. Usually, at the beginning of each period, top management invites proposals for investment projects from the different operating units of the organisation.
This may form a part of the annual budget exercise or of general development plans stretching over a few years. In either case, these numerous suggestions coming from the lower echelons of the decision-making ladder are integrated by the management into a comprehensive list of investment opportunities open before the company.
These are the three main points that need to be looked into in any sensible system of capital budgeting.
The problem of deciding on the required amount of capital is referred to as the problem of demand for capital. Since the capital expenditures are undertaken with a view to netting in additional profits, this step involves a survey of investment opportunities and a process of screening them from the point of view of prospective profitability.
The second step referred to above is essentially the process of determining the supply of capital. This involves ascertaining how much capital can be raised by the firm internally and from external sources.
The third step is the crucial one of determining which proposed projects among the competing ones are to be undertaken. Our main task will be to elaborate on each of these three steps in the capital budgeting process.
