Capital Budgeting Process

Process of Capital Budgeting

The Capital Budgeting process is the process of planning which is used to evaluate the potential investments or expenditures whose amount is significant. It helps in determining the company’s investment in the long term fixed assets such as investment in the addition or replacement of the plant & machinery, new equipment, Research & development, etc. This process the decision regarding the sources of finance and then calculating the return that can be earned from the investment done.

Capital-budgeting-Process

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Source: Capital Budgeting Process (wallstreetmojo.com)

Six Steps to Capital Budgeting Process

#1 – To Identify Investment Opportunities

The first step is to explore the available investment opportunities. The organization’s capital budgeting committee is required to identify the expected sales in the near future. After that, they make the identification of the investment opportunities keeping in mind the sales target set up by them. There are points which are needed to be taken care of before starting the search for the best investment opportunities. It includes monitoring of the external environment regularly to get an idea about the new opportunities of investment. Defining the corporate strategy, which is based on the organization’s SWOT analysis, i.e., analysis of its strength, weakness, opportunity, and threat, and also seeking suggestions from the organization’s employees by discussing the strategies and objectives with them.

Example:

Identification of the underlying trends of the market, which can be based on the most reliable information before selecting a specific investment. For instance, before choosing the investment to be made in the company involved in the gold mining, firstly, the underlying commodity’s future direction is needed to be determined; whether the analysts believe that there are more chances of price getting declined or the chances of price rise is much higher than its declination.

#2 – Gathering of the Investment Proposals

After the identification of the investment opportunities, the second process in capital budgeting is to gather investment proposals. Before reaching the committee of the capital budgeting process, these proposals are seen by various authorized persons in the organization to check whether the proposals given are according to the requirements and then the classification of the investment is done based on the different categories such as expansion, replacement, welfare investment, etc. This classification into the various categories is done to make the decision-making process more comfortable and also to facilitate the process of budgeting and control.

Example:

The real estate company identified two lands where they can build their project. Out of the two lands, one land is to be finalized. So the proposals from all the departments will be submitted, and the same will be seen by various authorized persons in the organization to check whether the proposals given are according to the various requirements. Also, the same will then be classified for a better decision making process.

#3 – Decision Making Process in Capital Budgeting

Decision making is the third step. In the stage of decision making, the executives will have to decide which investment is needed to be done from the investment opportunities available, keeping in mind the sanctioning power available to them.

Example:

For instance, the managers at the lower level of management like work managers, plant superintendent, etc. may have the power to sanction the investment up to the limit of $10,000 beyond that the permission of the board of directors or the senior management is required. If the investment limit extends, then the lower management has to involve the top management for the approval of the investment proposal.

#4 – Capital Budget Preparations and Appropriations

After the step of the decision making the next step is the classification of the investment outlays into the higher value and the smaller value investment.

Example:

When the value of an investment is lower and is approved by the lower level of management, then for getting speedy actions, they are generally covered with the blanket appropriations. But if the investment outlay is of higher value, then it will become part of the capital budgetCapital BudgetCapital budgeting is the planning process for the long-term investment that determines whether the projects are fruitful for the business and will provide the required returns in the future years or not. It is essential because capital expenditure requires a considerable amount of funds.read more after taking the necessary approvals. The motive behind these appropriations is to analyze the investment performance during its implementation.

#5 – Implementation

After the completion of all the above steps, the investment proposal under consideration is implemented, i.e., put into a concrete project. There are several challenges that can be faced by the management personnel while implementing the projects as it can be time-consuming. For the implementation at the reasonable cost and expeditiously, the following things could be helpful:

Example:

For prompt processing, the committee of capital budgeting must ensure that management has adequately done the homework on the preliminary studies and the compendious formulation of the project before its implementation. After that, the project is implemented efficiently.

#6 – Review of Performance

Review of performance is the last step in the capital budgeting. In this, the management is required to compare the actual results with that of the projected results. The correct time to make this comparison is when the operations get stabilized.

Example:

With this review, the capital budgeting committee concludes on the following points:

  • To what extent the assumptions were realistic.
  • The efficiency of the decision making
  • If there are any judgmental biases
  • Whether the hopes of the sponsors of the project are fulfilled;

Thus, the process is a complex one comprising of the various steps that are required to be followed strictly before the finalization of the project.

Conclusion

Capital Budgeting is used by the companies for making the decisions related to the long term investment. It starts with the identification of different investment opportunities. Then collecting and evaluating various investment proposals; then deciding for selecting the best profitable investment after that decision for Capital Budgeting and the apportionment is to be taken. Lastly, the decision taken is to be implemented, and performance is to be reviewed timely.

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