Capital budgeting process

By: Rashid Javed | Updated on: January 26th, 2023

Companies must possess enough capital or long-term assets to run their operations successfully. Smart companies continuously invest in new long-term productive and cost efficient assets. It helps them grow, expand and be competitive in the industry. Running operations with obsolete and less efficient assets has many competitive disadvantages, including increased costs and less productivity.

Capital budgeting process is a six-step process that companies follow to determine the potential benefit of a capital or long-term asset and finally decide weather or not to invest in that asset. This is mainly done through the use of one or more capital budgeting techniques that we would talk about later in this article.

In capital budgeting process, managers carefully evaluate different investment opportunities that are identified and proposed at various levels of organization and select the ones that look most viable and promise the largest financial benefit in future.

Capital budgeting process - a 6-step process

A capital budgeting process must be carried out with extreme care and delicacy because the assets that pass through the process largely impact the company’s future performance and growth.

Steps in capital budgeting process

A capital budgeting process comprises of the following six steps:

  1. Identification of opportunity
  2. Forecasting cash flows and estimating project risk
  3. Profitability evaluation of project
  4. Preparation of capital budget
  5. Implementation of project
  6. Post audit of project

Let’s briefly elaborate these sequential steps in rest of this article.

1. Identification of opportunity

The capital budgeting process starts with the identification of an investment opportunity which may come from any level of management serving within the organization. If an opportunity is identified and proposed by a lower-level manager, the process is named as bottom-up capital budgeting. A production manager, for example, is in a better position to understand the benefits of replacing an existing machine with its upgraded version. Similarly, an attendance manager can better explain the convenience of having a computerized system to keep record of employees’ attendance.

If, on the other hand, a proposal is identified by a top level manager, it is named as top-bottom capital budgeting. For example, acquiring a new business to enter a new market or start a different product or service is a strategic level investment decision, which requires initiative from senior management.

2. Forecasting cash flows and project risk

Once a project opportunity has been identified and proposed, the company needs to estimate its future cash flows and any potential risk to evaluate its profitability. The cash flows of a project mainly depend on company’s own operational capabilities as well as a broad range of macroeconomic factors including rate of inflation, rate of interest, employment level, fiscal policy, gross domestic product (GDP) and national income and worldwide trading activities. Since all these factors may impact a project’s ability to generate cash in future, companies must gather updates on them as their capital budgeting process moves forward.

Project risk means one or multiple uncertain events that, if occur, can impact the basic objectives of the project. It is crucial that companies incorporate project risk in capital budgeting process to make sure that their cash flow forecasting is not overly optimistic. For this purpose, they can apply various risk analysis techniques like certainty equivalent cash flow, sensitivity analysis, scenario analysis and risk adjusted discount rate etc.

3. Profitability evaluation of project

There are several capital budgeting techniques that companies can use to evaluate a proposed project. Six popular ones are listed below:

  1. Net present value (NPV) method
  2. Profitability index (PI) method
  3. Internal rate of return (IRR) method
  4. Simple payback method
  5. Discounted payback method
  6. Accounting rate of return (ARR)

The first five techniques are based on cash flows whereas the last one uses incremental accounting income or loss (i.e., the income or loss contributed by the project) rather than cash flows.

For each specific technique in above list, companies have predetermined criteria against which they compare the project’s expected results provided by the technique to make their acceptance or rejection decision. For example, if a company applies NPV technique, It must have a predefined net present value that the project must meet or exceed to be accepted. Similarly, if a company uses payback method for screening a project, it must have a predetermined period within which the project must recover its initial investment.

Since companies have diverse business requirements, they can’t apply a single capital budgeting technique to evaluate all projects. Which technique makes the most sense for a particular situation depends on the nature of the project as well as financial objectives of the company. In practice, many projects are evaluated using a combination of these techniques before they are finally accepted for investment. The NPV, PI and IRR work well and are often relied upon because they are all based on time value of money.

At the end of this step, a project is either accepted or rejected for investment. The projects that pass profitability test in this step are marked as accepted and the ones that fail are rejected. Only accepted projects qualify for the next step – preparation of capital budget.

4. Preparation of capital budget

After identifying all feasible projects in step 3 above, the companies rank them on the basis of their profitability and funds available for investment. This ranking is done through a process known as capital rationing process or project ranking process. Once the rationing process is completed, the projects are approved to be added in the company’s annual capital budget. A company’s annual capital budget contains all the projects that it can be funded during the year.

Individual managers serving at various levels of organization can approve projects only if they fall within the size of investment they are authorized to approve. Generally, the higher the level of a manager, the larger the size of project he can approve. For example, a production manager may be authorized to decide about a project that can be started with an initial investment of $100K only. Similarly, a project requiring an initial outlay of $1 million or higher may require an approval from chief executive officer (CEO).

5. Implementation of project

After a project has been approved for funding, the initial capital is released for its implementation and project specific responsibilities are assigned to relevant managers who take initial steps for smooth progress of the project.

If more than one projects have been approved and listed in the capital budget, then the implementation follows the preference ranking made in step 4.

6. Post audit of project

After a project has been implemented, a post audit is conducted to check whether or not the estimated results are actually obtained. The post audit is a key step in capital budgeting process. It helps minimize the chances of downplaying the costs or artificially inflating the profitability of a project, and thereby helps keep managers fair and honest in their investment proposals. It also reveals opportunity to invest more in successful projects and to cut losses on stranded ones.

A company should use the same capital budgeting technique in its post audit analysis as it used at the time of approving the project. For example, if management uses NPV method to approve a particular project, it should use the same NPV method while performing the post audit of that project. However, the numbers used in post audit should come from the actual or observed data rather than estimated data. This allows managers to perform a side-by-side comparison of actual and estimated numbers and see how successfully the project has been implemented and is moving forward.

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