Capital Budgeting Process (2022)

Process of Capital Budgeting

The capital budgeting process is the process of planning used to evaluate the potential investments or expenditures whose amount is significant. It helps determine the company’s investment in the long-term fixed assets such as the addition or replacement of the plant and machinery, new equipment, research, development, etc. This process is the decision regarding the sources of finance and then calculating the return earned from the investment.

Table of contents
  • Process of Capital Budgeting
    • Six Steps to Capital Budgeting Process
      • #1 – To Identify Investment Opportunities
        • Example:
      • #2 – Gathering of the Investment Proposals
        • Example:
      • #3 – Decision Making Process in Capital Budgeting
        • Example:
      • #4 – Capital Budget Preparations and Appropriations
        • Example:
      • #5 – Implementation
        • Example:
      • #6 – Review of Performance
        • Example:
    • Conclusion
    • Recommended Articles
Capital Budgeting Process (1)

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Six Steps to Capital Budgeting Process

#1 – To Identify Investment Opportunities

The first step is to explore the available investment opportunities. Next, the organization’s capital budgeting committee must identify the expected sales shortly. After that, they recognize the investment opportunities keeping in mind the sales target set up by them. One must consider some points before searching for the best investment opportunities. It includes regularly monitoring the external environment to get an idea about new investment opportunities. Then, define the corporate strategy based on the organization’s SWOT analysis SWOT AnalysisSWOT Analysis is an analytical tool to identify and evaluate an entity’s strengths, weaknesses, opportunities, and threats.read more, i.e., analysis of its strength, weakness, opportunity, and threat, and seek suggestions from its 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 gold mining, firstly, the underlying commodity’s future direction needs 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 identifying the investment opportunities, the second process in capital budgeting is to collect 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 bids given are according to the requirements. 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 types makes decision-making more comfortable and facilitates budgeting and control.

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Example:

The real estate company identified two lands where they could build their project. Out of the two lands, one land is to be finalized. So, one will submit the proposals from all the departments. Then, various authorized persons will see the same in the organization to check whether the bids are multiple 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 decision-making stage, the executives will have to decide which investment needs to be made from the available investment opportunities, keeping in mind the sanctioning power open to them.

Example:

For instance, the managers at the lower level of management, like work managers, plant superintendents, etc., may have the power to sanction the investment up to the limit of $10,000 beyond the permission of the board of directorsBoard Of DirectorsBoard of Directors (BOD) refers to a corporate body comprising a group of elected people who represent the interest of a company’s stockholders. The board forms the top layer of the hierarchy and focuses on ensuring that the company efficiently achieves its goals.read more or senior management required. If the investment limit extends, the lower management must involve the top management to approve the investment proposal.

(Video) Introduction to Capital Budgeting

#4 – Capital Budget Preparations and Appropriations

After the decision-making step, the next step is to classify the investment outlays into higher and smaller value investments.

Example:

When the value of an investment is lower and approved by the lower management level, then for getting speedy actions, they are generally covered with blanket appropriations. But, if the investment outlay is of higher value, 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. These appropriations aim to analyze the investment performance during its implementation.

#5 – Implementation

After completing all the above steps, it implements the investment proposal, i.e., put into a concrete project. Several challenges can be faced by the management personnel while executing the tasks as they can be time-consuming. For the implementation at a reasonable cost and expeditiously, the following things could be helpful: –

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  • Formulation of the project adequately: Inadequate formulation is one of the main reasons for the delay. So, the concerned person should consider all the necessary details in advance and one should do a proper analysis well to avoid any delay in the project implementation., the concerned person should consider all the necessary details in advance, and one should do a proper analysis well to avoid any delay in the project implementation.
  • Use responsibility accountingResponsibility AccountingResponsibility accounting is a system of accounting where specific persons are made responsible for the accounting of particular areas and cost control. In this type of accounting system, responsibility is assigned based on a person’s knowledge and skills.read more principle: For the expeditious execution of the various tasks and the cost control, one should assign specific responsibilities to the project managers, i.e., the timely completion of the project within the specified cost limits.
  • Network technique use: Several network techniques like the Critical Path Method (CPM) and Program Evaluation and Review Technique (PERT) are available for project planning and control, which will help monitor the projects properly and efficiently.
Example:

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

#6 – Review of Performance

A review of performance is the last step in capital budgeting. But, the management must first compare the actual results with 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: –

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  • To what extent the assumptions were realistic.
  • The efficiency of the decision-making.
  • Suppose there are any judgmental biases.
  • Either it fulfills the hopes of the sponsors of the project.

Thus, the process is complex, consisting of the various steps required to be followed strictly before finalizing the project.

Conclusion

The companies use capital budgeting to make decisions related to long-term investment. It starts with the identification of different investment opportunities. Then, after collecting and evaluating various investment proposals and selecting the best profitable investment, the decision for capital budgeting and apportionment is to be taken. Lastly, one should implement the decision taken and review the performance timely.

Recommended Articles

This article is a guide to Capital Budgeting Process. Here, we provide the top capital budgeting process steps and examples of each. You may learn more about corporate finance from the following articles: –

(Video) 🔴 Capital Budgeting in 10 min., Capital Budgeting Techniques Decisions NPV Net Present Value

  • Importance of Capital Budgeting
  • Techniques of Capital Budgeting
  • Examples of Capital Budgeting
  • Budgeting vs. Forecasting

FAQs

What are the 5 capital budgeting techniques? ›

There are several capital budgeting analysis methods that can be used to determine the economic feasibility of a capital investment. They include the Payback Period, Discounted Payment Period, Net Present Value, Profitability Index, Internal Rate of Return, and Modified Internal Rate of Return.

What are the 3 methods of capital budgeting? ›

Capital budgeting is the process by which investors determine the value of a potential investment project. The three most common approaches to project selection are payback period (PB), internal rate of return (IRR), and net present value (NPV).

What is capital budgeting cycle? ›

Capital budgeting is a process of evaluating investments and huge expenses in order to obtain the best returns on investment. An organization is often faced with the challenges of selecting between two projects/investments or the buy vs replace decision.

What are the 5 stages of budget? ›

Capital budgeting can be broadly categorized into the following five steps.
  • Identification of Investment Opportunities. ...
  • Development and Forecast of Benefits and Costs. ...
  • Evaluation of Net Benefits. ...
  • Authorization for Progressing and Spending Capital Expenditure. ...
  • Control of Capital Projects.
3 Dec 2021

What are the 4 main capital budgeting techniques? ›

Payback Period, Net Present Value Method, Internal Rate of Return, and Profitability Index are the methods to carry out capital budgeting.

What are the 7 types of budgeting? ›

The 7 different types of budgeting used by companies are strategic plan budget, cash budget, master budget, labor budget, capital budget, financial budget, operating budget.

What are the 7 types of capital? ›

The seven community capitals are natural, cultural, human, social, political, financial, and built. Natural Capital includes all natural aspects of community. Assets of clean water, clean air, wildlife, parks, lakes, good soil, landscape – all are examples of natural capital.

What are the 5 sources of capital? ›

  • Personal Savings.
  • Friends and Relatives.
  • Angels.
  • Corporations.
  • Venture Capitalists (VCs)
  • Going Public (IPOs)

What are 2 capital budgeting techniques? ›

The process involves analyzing a project's cash inflows and outflows to determine whether the expected return meets a set benchmark. The major methods of capital budgeting include discounted cash flow, payback, and throughput analyses.

What are the 6 forms of capital? ›

It defines the six capitals which are: financial capital; manufacturing capital; human capital; social and relationship capital; intellectual capital and, natural capital.

What are the types of capital budgeting? ›

Following are the different methods of capital budgeting:
  • Payback Period. It is the time needed for recovering the cost of investment. ...
  • Accounting rate of return (ARR) ...
  • Discounted Cash Flow Method. ...
  • Net present value (NPV) ...
  • Internal Rate of Return (IRR) ...
  • Profitability Index (PI)
14 Oct 2022

What are the six phases of budgeting? ›

Definition. The budget cycle consists of different phases: preparation and formulation, approbation by a vote, execution, revision, and control of the budget. The budget refers to a fiscal year, and, sometimes, the budget covers a period larger than the fiscal year (multi-year budget).

What is budget and its stages? ›

The budget has four stages viz., (1) estimates of expenditures and revenues, (2) first estimate of deficit, (3) narrowing of deficit and (4) presentation and approval of budget. Stage 1: Estimates of expenditures and revenues.

What are the 8 types of budget? ›

Top 8 Types of Budget – Explained!
  • Sales Budget:
  • Selling and Distribution Cost Budget:
  • Production Budget:
  • Cost of Production Budget:
  • Materials Budget:
  • Direct Labour Budget:
  • Manufacturing Overhead Cost Budget:
  • Cash Budget:

What are the 9 steps of the budget process? ›

9 Steps to Building a Budget
  • Step 1: Schedule a Time to Start. ...
  • Step 2: Get a Grip on Your Income. ...
  • Step 3: Figure Out Your Expenses. ...
  • Step 4: Track Your Spending. ...
  • Step 5: Assess the Month. ...
  • Step 6: Pick Out What to Cut. ...
  • Step 7: Categorize Your Budget. ...
  • Step 8: Start Spending – and Keep Recording!
15 Nov 2018

What are the 4 types of capital? ›

Key Takeaways

The four major types of capital include working capital, debt, equity, and trading capital. Trading capital is used by brokerages and other financial institutions.

What are the 3 sources of capital? ›

Some of the top ways to raise capital are through angel investors, venture capitalists, government grants, and small business loans.

What are the 3 parts of a budget? ›

The federal budget comprises three primary components: revenues, discretionary spending, and direct spending.

What are 2 types of capital? ›

In business and economics, the two most common types of capital are financial and human.

How do you calculate capital? ›

Working capital = current assets – current liabilities. Net working capital = current assets (minus cash) - current liabilities (minus debt). Operating working capital = current assets – non-operating current assets. Non-cash working capital = (current assets – cash) – current liabilities.

What are the two main sources of capital? ›

The two main sources of capital are debt and equity.

What are the two parts of balance sheet? ›

Assets = Liabilities + Shareholders' Equity

The balance sheet is broken into two main areas. Assets are on the top or left, and below them or to the right are the company's liabilities and shareholders' equity.

What is capital function? ›

The most important function of the capital is to promote the economic growth of the country. For the satisfactory development of the country, adequate funds are very essential.

What are the 10 sources of finance? ›

10 Most Common Ways to Finance Your Business
  • 1 1. Personal savings/ Owner's fund/ Owner's equity.
  • 2 2. Family and friends.
  • 3 3. Bank credit.
  • 4 4. Partnership.
  • 5 5. Money Lenders.
  • 6 6. Angel investors.
  • 7 7. Venture Capitalist.
  • 8 8. Customers.

What is the best tool for capital budgeting? ›

Net present value (NPV) methodology is the most common tool used for making capital budgeting decisions. It follows this process: Ascertain exactly how much is needed for investment in the project. Calculate the annual cash flows received from the project.

What is NPV & IRR? ›

What Are NPV and IRR? Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. By contrast, the internal rate of return (IRR) is a calculation used to estimate the profitability of potential investments.

What is the importance of capital budgeting? ›

Why is capital budgeting important? Capital budgeting is a valuable tool because it provides a means for evaluating and measuring a project's value throughout its life cycle. It allows you to assess and rank the value of projects or investments that require a large capital investment.

What is capital in balance sheet? ›

Capital on a balance sheet refers to any financial assets a company has. This is not limited to cash—rather, it includes cash equivalents as well, such as stocks and investments. Capital can also include a company's facilities and equipment.

What are the instrument of capital? ›

What Instruments Are Used in the Capital Market? Mutual funds, treasury bonds, private sector bonds, stocks, private sector bills, asset-guaranteed securities, asset-backed securities, options, lease certificates, and the futures contract instruments are used in the capital markets.

What are the five purposes of budgeting? ›

A budget can set you on the right path to achieving your financial goals, spending within your means, saving for retirement, building an emergency fund, and analyzing your spending habits.

What is the budgeting process? ›

The budgeting process lets an organization plan and prepare its budgets for a set period. It involves reviewing past budgets, identifying and forecasting revenue for the coming period, and assigning amounts to spend on a company's various costs.

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