The extent to which the capital budgeting process needs to be formalized and systematic procedures established depends on the size of the organization, number of projects to be considered, direct financial benefit of each project considered by itself, the composition of the firm's existing assets and management's desire to change that composition, timing of expenditures associated with the that are finally accepted.
1. Planning
The capital budgeting process begins with the identification of potential investment opportunities. The opportunity then enters the planning phase when the potential effect on the firm's fortunes is assessed and the ability of the management of the firm to exploit the opportunity is determined. Opportunities having little merit are rejected and promising opportunities are advanced in the form of a proposal to enter the evaluation phase.
2. Evaluation
This phase involves the determination of proposal and its investments, inflows and outflows. Investment appraisal techniques, ranging from the simple pay back method and accounting rate of return to the more sophisticated discounted cash flow techniques, are used to appraise the proposals. The technique selected should be the one that enables the manager to make the best decision in the light of prevailing circumstances.
3. Selection
Considering the returns and risk associated with the individual project as well as the cost of capital to the organization, the organization will choose among projects so as to maximize shareholders wealth.
4. Implementation
When the final selection has been made, the firm must acquire the necessary funds, purchase the assets, and begin the implementation of the project.
5. Control
The progress of the project is monitored with the aid of feedback reports. These reports will include capital expenditure progress reports, performance reports comparing actual performance against plans set and post completion audits.
6. Review
When a project terminates, or even before, the organization should review the entire project to explain its success or failure. This phase may have implication for forms planning and evaluation procedures. Further, the review may produce ideas for new proposal to be undertaken in the future.
In brief, capital budgeting processes include:
A. Estimation of initial investment
B. Estimation of cash inflows
C. Evaluation of projects
D. Selection of projects
