Capital budgeting is the process that a business uses to determine which proposed fixed asset purchases it should accept, and which should be declined. This process is used to create a quantitative view of each proposed fixed asset investment, thereby giving a rational basis for making a judgment.
There are stages in the investment decision/capital budgeting process.
1. Investment screening and selection: Projects consistent with the corporate strategy are identified by the production, marketing and research, and development management of the firm. Once identified, projects are evaluated and screened by estimating how they affect the future cash flows of the firm and, hence, the value of the firm.
2. The capital budget proposal: A capital budget is proposed for the projects surviving the screening and selection process. The budget lists the recommended projects and the dollar amount of investment needed for each. This proposal may start as an estimate of expected revenues and costs, but as the project analysis is refined, data from marketing, purchasing, engineering, accounting, and finance functions are put together.
3. Budgeting approval and authorization: Projects included in the capital budget are authorized, allowing further fact-gathering and analysis, and approved, allowing expenditures for the projects. In some firms, the projects are authorized and approved at the same time. In others, a project must first be authorized, requiring more research before it can be formally approved. Formal authorization and approval procedures are typically used on larger expenditures; smaller expenditures are at the discretion of management.
4. Project tracking: After a project is approved, work on it begins. The manager reports periodically on its expenditures, as well as on any revenues associated with it. This is referred to as project tracking, the communication link between the decision-makers and the operating management of the firm.
5. Post-completion audit: Following a period of time, perhaps two or three years after approval, projects are reviewed to see whether they should be continued. This re-evaluation is referred to as a post-completion audit. Thorough post-completion audits are typically performed on selected projects, usually the largest projects in a given year’s budget for the firm or each division. Post-completion audits show the firm’s management how well the cashflows realized correspond with the cash flow forecasted several years earlier.
Factors Influencing Capital Budgeting
1. Availability of Funds: All the projects are not requiring the same level of investments. Some projects require a huge amount and have high profitability. If the company does not have adequate funds, such projects may be given up.
2. Minimum Rate of Return on Investment: Every management expects a minimum rate of return or cut-off rate on capital investment. It refers to the point below which a project would not be accepted.
3. Future Earnings: The future earnings may be uniform or fluctuating. Even though, the company expects guaranteed future earnings in total which affects the choice of a project.
4. Degree of Risk and Uncertainty: Every proposal involves certain risks and uncertainty due to economic conditions, competition, demand and supply conditions, consumer preferences, etc. The degree of risk and uncertainty affects the profitability of the project. Hence, the degree of risk and uncertainty of the project is taken into consideration for selection.
5. Urgency: A project may be selected immediately due to an emergency or urgency. The reason is that such immediate selection saves the life of the company i.e. survival of a company is the primary importance than other factors.