Capital Budgeting Process
Capital Budgeting Process is a process of identifying and evaluating projects where businesses are expected to receive cash flows over a period longer than one year. Any corporate capital budgeting decisions that can affect future earnings can be evaluated using this framework.
Examples of Capital Budgeting Decisions:
For example, decisions about whether to buy a new coffee processor, replacing old bottling machine, acquisition of other businesses, business expansion in other countries, and introduction of new product in the market, introduction of old product in the new market, to name a few, can be examined using capital budgeting techniques and investment analysis.
The core objective of capital budgeting analysis is to make sure that the project would ultimately contribute to maximizing the shareholder value.
Generating a good project idea is the starting point of the capital budgeting process. An idea can come from the upper management, research and development team, employees, customers and emerging trends in the market. Good ideas always attract finances.
Evaluation of Capital budgeting project involves six steps:
- First, the cost of that particular project must be known.
- Second, estimates the expected cash outflows from the project, including residual value of the asset at the end of its useful life.
- Third, the riskiness of the cash flows must be estimated. This requires information about the probability distribution of the cash outflows.
- Based on project’s riskiness, Management finds outs the cost of capital at which the cash outflows should be discounted.
- Next, determine the present value of expected cash flows.
- Finally, compare the present value of expected cash flows with the required outlay. If the present value of the cash flows is greater than the cost, the project should be taken. Otherwise, it should be rejected.
- If the expected rate of return on the project exceeds its cost of capital, that project is worth taking.
Firm’s stock price directly depends on how effective are the firm’s capital budgeting procedures. If the firm finds or creates an investment opportunity with a present value higher than its cost of capital, this would affect the firm’s value positively.