See Also: Capital Budgeting Methods
Capital Budgeting Phases
The phases of the capital budgeting process include the following:
- Description of the need or opportunity
- Identification of alternatives
- Evaluation of the options and the relevant cash flows of each
- Selection of best alternative
- Conducting a post-completion audit of the projects.
To identify capital projects, refer to functional needs or opportunities. Although many are also identified as a result of risk evaluation or strategic planning. Some typical long-term decisions include whether or not to:
- Buy new office equipment, cars or trucks
- Add to or renovate existing facilities, including the purchase of new capital equipment/machinery
- Expand plant or process operations
- Invest in facilities for a new product line or to expand services
- Continue or discontinue an existing product line
- Replace existing capital equipment/machinery with new equipment/machinery
- Invest in software to meet technology-based needs or systems designed to help improve process and/or efficiency
- Invest in R&D or intangible assets
- Build or expanding a foreign or satellite operation
- Reorganize assets or services
- Acquire another company.
Refer to capital investment (expenditure) decisions as capital budgeting decisions. They involve resource allocation, particularly for the production of future goods and services, and the determination of cash out-flows and cash-inflows, which need to be planned and budgeted over a long period of time. Because of the complexity of this accounting issues, get involved yourself right from the beginning. Guide them through the whole process.
Develop an objective methodology with the upper management. Then evaluate alternate capital projects on a reasonable basis. Consider both quantitative and qualitative issues and use the whole organization as a resource.
Marketing should provide data on sales trends, new demand and opportunities for new products. Managers at every level should be identifying resources that are available to upper-management that may lead to the use of existing facilities to resolve the need/take advantage of the opportunity. They should also be communicating any needs they/their departments or divisions have that should be part of the capital decision.
Financial analysts should also identify the target cost of capital, the evaluation of startup costs, and the calculation of cash flows for those projects chosen for evaluation purposes. If your financial analysts are absent, then refer to qualified external financial experts. By calculating the appropriate discount rate and calculating conservative cash flows, you are contributing to a critical part of this process. As a result, have an independent accounting firm look at the project/these issues impartially. Estimation bias can be dangerous.
Evaluate (predict) how well each capital asset alternative will do. Then, determine whether the net benefits are consistent with the required capital allocation. When doing this, consider that most firms face the scarcity of resources.