Capital budgeting is a scientific process of identifying, analyzing, selecting and implementing investment projects with returns that are expected to span over more than one year. Capital budgeting is also referred to as investment appraisal. The importance of capital budgeting in the process of investing cannot be over emphasized as capital budgeting gives a calculated insight into what is going to happen if investments are made.
THE CAPITAL BUDGETING PROCESS
One thing I would like to point out here is that capital budgeting is a process and not a destination. This is so because of the loopy process of investment appraisal.
CREATION OF CAPITAL BUDGET: a capital budget is a long term document that contains a company’s overall strategic plan. Capital budget normally prepared to cover longer periods than sales, production and resource budgets as it usually ranges from three to five years. A good practice is to break this down into shorter periods to match other budgets. Capital budget must be a three dimensional document as it has to take into account the current production budget, future expected production level and the overall long-term development of the organization, and industry as a whole. Capital budget should be made to be flexible enough to allow for ongoing change.
INVESTMENT DECISION MAKING PROCESS: because of the fact that capital investment involves the outlay of large sum of fund, care is taken to make sure that the best mix of projects are selected. Investment decision making process has four steps that needs to be taken to fully get the best
- Origination of proposals: you don’t just wake up one morning and find investment opportunities knocking at your door. Investment opportunities have to be actively sought. When found, proposals should be prepared to this effect.
- Screening of projects: there is no way all identified projects can be profitably executed. A sort of selection and screening has to be done to invest in the best possible project.
- Analyzing and accepting projects: analytical tools like the ones you are probably seeing on this site are used to analyse investment opportunities and certain acceptance or rejection rules followed.
- Monitoring and reviewing of projects: you will quickly lose motivation and the zeal to succeed immediately you stop monitoring your progress. You will get vital information from this process. This is applicable also to investments.
An important concept that is very important to mention here. For a capital budget to be complete, care should be taken to ensure that only relevant cash flows are imputed into the process. I will make a detailed post on this next, so keep a date. Financial analysis is also a vital aspect that must be seriously taken into consideration.
I hope you will now agree with my initial assertion that capital budgeting is a process and not a procedure, just like the name implies.
You can buy any of the books displayed below for more on capital budgeting: