Question

Capital Budgeting is one of the crucial decisions of the financial management. Explain the significant process of capital budgeting at the time of implementing a new project.

Answer 1

Capital budgeting is a step by step process that businesses use to determine the merits of an investment project. The decision of whether to accept or deny an investment project as part of a company's growth initiatives, involves determining the investment rate of return that such a project will generate. However, what rate of return is deemed acceptable or unacceptable is influenced by other factors that are specific to the company as well as the project.

Capital budgeting is important because it creates accountability and measurability. Any business that seeks to invest its resources in a project, without understanding the risks and returns involved, would be held as irresponsible by its owners or shareholders.if a business has no way of measuring the effectiveness of its investment decisions, chances are that the business will have little chance of surviving in the competitive marketplace.

Capital Budgeting Process:--

The capital budgeting process includes identifying and then evaluating capital projects for the company.

The capital budgeting process has the following four steps:

• Generation of Ideas: The generation of good quality project ideas is the most important capital budgeting step. Ideas can be generated from a number of sources like senior management, employees and functional divisions or even from outside the company.

• Analysis of Proposals: The basis of accepting or rejecting a capital project is the project’s expected cash flows in the future. Hence, all the project proposals are analyzed by forecasting their cash flows to determine expected the profitability of each project.

• Creating the Corporate Capital Budget: Once the profitable projects are shortlisted, they are prioritized according to the available company resources, a timing of the cash flows of the project and the overall strategic plan of the company. Some projects may be attractive on their own, but may not be a fit to the overall strategy.

• Monitoring and Post-Audit: A follow up on all decisions is equally important in the capital budgeting process. The analysts compare the actual results of the projects to the projected ones and the project managers are responsible if the projections match or do not match the actual results. A post-audit to recognize systematic errors in the cash flow forecasting process is also essential as the capital budgeting process is as good as the inputs’ estimates into the forecasting model.

• Conclusion: Capital budgeting process is an amalgamation of very complex decisions and their assessments. A single project can easily harm or enable the company to a large extent. Hence, an analyst needs to understand all the steps involved as well as the basic principles of the capital budgeting process.