Identifying the capital budgeting process and techniques is important for business organizations to discover the most profitable project or the investment out of all the available options. The capital budgeting process and techniques explain the steps an organization should follow in order to identify the project options through thoroughly analyzing the budget for the project and the expected return on investment.
Since the ultimate expectation of most business organizations is to generate the maximum possible profit, it is important for the management of the business to invest their limited capital on a project that can provide a maximum return on investment.
The capital budgeting process and techniques that are used throughout the process can explain as below.
– Identifying investment opportunities
The business organization has to initially identify the investment or project opportunities available for them. Investment opportunities can be anything from the implementation of a new business line to expanding the existing production process by adding a new asset to the current production process. For example, the business can either start producing a new product or can add a new set of machinery to expand the current production process.
– Evaluate the available investment/ project proposals
Once the available project/ investment opportunities are identified, the business should evaluate the investment options for those projects or investments. In simple terms, once the business has decided to add a new item/ expand the production process of the business, they have to make a decision on how they are going to execute the addition. There can be multiple ways of acquiring a new addition to the business. Below mentioned are a few examples.
– Manufacture in-house by the business itself
– Outsource the manufacturing process and get it manufactured
– Purchase from the market
– Selecting a profitable investment
Once the project and investment proposals are evaluated, the business organization needs to decide the most profitable investment/ project option out of all the available proposals. When selecting the most suitable project, the organization should use the technique of capital rationing to rank the projects according to the returns and select the most suitable option available.
– Capital Budgeting and apportionment
Once the ideal project or the investment for the business organization is selected, the managers need to decide on funding the project. The business has to identify the sources that can be used to fund the project and allocate the sources accordingly. The usually used fund sources are investments, reserves, loans, etc.
– Performance review
This can be considered the final step of the capital budgeting process. Once the project is decided and the funds are allocated to the project activities accordingly, the project can start the activities. The organization has to continuously compare the expected performance of the project and the actual performance of the project.
This comparison should happen at multiple levels of the project to check whether there are any discrepancies between the actual performance and the expectation. If the actual performance is lower than the expected performance, immediate actions should be taken to rectify any issues that cause the adverse performance.
When discussing the capital budgeting process and techniques, the techniques that are used by the business organizations to find the most suitable project take special importance.
Net Present Value (NPV) – This is calculated by taking the difference between the present cash inflows value and the present cash outflows value over a certain period of time. The project with the highest NPV value should be considered for implementation.
Payback period method – According to the payback period method, the business calculates the time required to earn the initial investment of the project. The project with the shortest earn-back time should be considered favorable.
Accounting Rate of Return – According to the Accounting rate of return, the total net income of the project is divided by the initial or average investment to identify the most profitable investment.