Understanding Capital Budgeting

Capital budgeting, also known as investment appraisal, is the method to plan the process and determine whether the long-term investments of the organization are with funding of cash through the capitalization structure of the firm which includes any retained earnings, debt or equity. The investments could be buying new machinery, new products or a new plant or spending money on research and development. The goal of a firm that is opting for capital budgeting is to increase the firm’s value to the shareholders.

The method uses the incremental cash flow from each of the project or investment. The techniques of accounting earnings and accounting rules are used sometimes. Some of the hybrid methods like payback period and discounted payback period methods are also used.

Identification and generation of project

The first step involves generating an investment proposal. There are many reasons why business needs investment. It could be because a new product is added or if the business line needs to be expanded. There could be other reasons too like increasing production or reducing the output costs.

Screening and valuation of the project

In this step, all the correct criteria are selected to justify that the process is desirable. This needs to match the firm’s objectives in order to maximize the market value. The time value of money is used in this step. The estimation of costs and benefits are also done at this stage. The total of cash inflow and the cash outflow along with any uncertainty and risk that is associated needs to be analyzed and there is also a need to do provisioning that is appropriate.

Selecting the project

There is no defined way to select the investment proposal as there are different businesses and each business could have a different requirement. This is the reason why the approval is done based on the criteria of selection and this is different for each firm. After this, there are alternatives ways to raise or acquire the funds and this step is known as preparing the capital budget.

Implementation

Money gets spent and the proposal gets implemented. The different steps of implementing the proposal, completing the project and reducing cost are allotted. Then the process of monitoring is done.

Review of performance

In the final stage, the actual result is compared with the standard one. The unfavorable ones are then identified and removed which helps in the future selection of the proposal and also its execution.