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Capital budgeting is the method used to compare and make an analysis on the future investments and expenses that the company will make to come up with the best project that is worthwhile (Dean, 1969). In addition to this, it is basically the process the management identifies the best capital project which will eventually give the largest return and outputs when they are compared with the amount of money invested on the project. This means that the company ranks each and every project according to its future potential returns thereby create a room of choosing the best project that comes first.
The following are the main five steps that capital budgeting process entails;
Identification and Evaluation of potential opportunities. The capital budgeting begins with exploring the opportunities that are available for venturing into. In this regard, it is always good for a company to have some multiple options to choose from. Let us take an example of a company that wants to expand on its warehousing facilities. The company will have to choose from expanding the current building that they have or buy a larger space that they will construct another warehouse.
Estimation of operating and the implementation costs is the next step so as to ensure that the project comes to fruition. However, in this step a lot of internal consultation and external research is done so that the best project is chosen. In this regard, if a company wants to make an upgrade on computer equipment, it will make some inquires on the IT department on cost of purchasing new memories of existing machines or rather buy new computers from the market. However, when the best decision is made, they should make sure that they narrow down on costs on implementation.
Thirdly, the next step on the capital budgeting process will be on estimating the benefit or cash flow the project is going to generate. To achieve this, an evaluation can be done on projects that became successful in the past. However, when the project won’t be able to generate cash flow directly, the management must do all it takes to ensure that they see the initiative they take make some senses in terms of finances.
The next step will be on the assessment on the risk that are associated with project. It is also very essential to make a consideration on the amount of money the company will spend and can stand to lose if there are possibility at which the project might fail or can’t be in a position to produce the much-anticipated results and outcome. In this regard the company will not go on with a riskier project but rather a project whose degree in risk is low in terms of cost. The company will thereafter evaluate the project against the anticipated cash flow or the fruitful outcome so as to ensure that they pursue sense in the implementation process.
Lastly, the fifth step is to make an implementation on the project it has chosen. Moreover, this will require a comprehensive implementation plan which must include areas such as means of payment of the project, a formula of cost tracking, and a method of recording the benefits or cashflows that the project generates. To achieve the best results, one should ensure that the implementation plan has a timeline where key milestones of the project are entailed including its end date if it will be applicable.
The Net Present Value(NPV) is defined as the difference that lies between the current value in cash inflows and the present value in cash inflows calculated over a particular period of time. This value is usually used in analysis of profitability a project has in capital budgeting (Ross, 1995). When a company want to use NPV to choose among various projects, the first step is calculating the NPV of each project. It is usually taken that all the projects with NPV greater than 0 will be accepted. In some cases, when there are problems related with financial constraints, the projects with the highest NPV will be selected first. When there are multiple projects that have mutual inclusivity and limitation in capital investment, arrangement is done with projects with highest NPV coming first.
Dean, J. (1969). Capital budgeting: top-management policy on plant, equipment and product development. Columbia University Press.
Ross, S. A. (1995). Uses, abuses, and alternatives to the net-present-value rule. Financial management, 24(3), 96-102.
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