7.2 Capital budgeting process

The capital budgeting process is a systematic approach used by companies to evaluate and select investment projects that require significant financial resources. It involves analyzing potential investment opportunities, estimating their financial implications, and making informed decisions about which projects to pursue. The capital budgeting process typically consists of the following steps:

1. Identification and Generation of Investment Proposals: The first step in the capital budgeting process is to identify and generate potential investment proposals. This can come from various sources, such as internal ideas, market research, customer demands, technological advancements, or industry trends. The goal is to gather a pool of investment opportunities for further evaluation.
2. Project Evaluation and Initial Screening: In this step, the identified investment proposals are evaluated and screened based on predetermined criteria and strategic alignment. The initial screening helps filter out projects that do not meet the company’s objectives or fail to provide sufficient potential returns. Common evaluation criteria include financial viability, market demand, technical feasibility, risk assessment, and strategic fit.
3. Cash Flow Estimation: For the investment proposals that pass the initial screening, the next step is to estimate the cash flows associated with each project. This involves forecasting the expected inflows and outflows of cash over the project’s life. Cash flows may include initial investment costs, operating cash flows, salvage value, working capital requirements, and any incremental cash flows resulting from the project.
4. Risk Assessment and Analysis: In this step, the risks associated with each investment proposal are assessed and analyzed. This involves evaluating factors such as market risk, operational risk, regulatory risk, competitive risk, and financial risk. Various techniques, including sensitivity analysis, scenario analysis, and Monte Carlo simulation, can be used to understand the potential impact of risks on project outcomes.
5. Capital Budgeting Techniques: Capital budgeting techniques are applied to assess the financial viability and profitability of investment proposals. Common techniques include:a) Net Present Value (NPV): NPV calculates the present value of expected cash inflows and outflows, taking into account the time value of money. A positive NPV indicates that the project is expected to generate more value than the initial investment.

   b) Internal Rate of Return (IRR): IRR is the discount rate at which the NPV of an investment becomes zero. It represents the project’s expected rate of return. If the IRR exceeds the company’s required rate of return, the project is considered acceptable.

   c) Payback Period: The payback period measures the time required for the investment to recover its initial cost. Projects with shorter payback periods are generally preferred, although this technique does not consider the time value of money.

   d) Profitability Index: The profitability index compares the present value of cash inflows to the present value of cash outflows. A profitability index greater than 1 indicates a favorable investment.

6. Decision-Making and Selection: Based on the evaluation of investment proposals using capital budgeting techniques, management makes decisions about which projects to pursue. Projects with positive NPV, high IRR, favorable payback period, and profitability index greater than 1 are typically given priority. However, other factors such as strategic importance, resource availability, and risk tolerance also influence the final selection.
7. Implementation and Monitoring: Once the investment projects are selected, they are implemented and closely monitored. Project implementation involves securing funding, allocating resources, setting up project teams, and tracking progress. Regular monitoring and evaluation are essential to ensure that the projects stay on track and deliver the expected benefits.