Capital budgeting is a process where companies evaluate potential long-term investments. The steps include identifying and evaluating opportunities, reviewing cash flows, and selecting a capital mix to pay for projects that increase revenue, profit, and shareholder value. The final step is to compare cash flows with initial costs to determine the best project.
Capital budgeting is a process in which companies evaluate major projects that may be valuable long-term investments. The steps in capital budgeting follow a particular process for a company to ensure that each potential project receives due attention. The most common steps in capital budgeting include identifying and evaluating opportunities, reviewing the cash flows of each project, and selecting a capital mix to pay for the selected projects. A company often pursues any project that will improve revenue, profit, and shareholder value. Therefore, capital budgeting is a reduction process that allows a company to select only those projects that increase the wealth of the company.
Identifying and evaluating opportunities is the starting point for all steps in the capital budgeting processes. Here, owners, executives, and managers find new opportunities in which a company can increase shareholder wealth. Once a group of new opportunities is identified, each one must be evaluated. This process determines if each project is realistic, feasible, has long-term viability, and will be a reliable source of income for some time. The final projects selected in this step then move through the capital budgeting process; all others are archived for the time being.
The next steps in the capital budgeting processes are to review the cash flows for each project in the final selection pool. Accountants or financial analysts analyze current economic conditions and make cash flow estimates for each project over a set period of time. These people can create an upper bound and a lower bound for expectations, assuming that economic conditions can improve or deteriorate over time. In some cases, the number of years for planned cash flows may be three, five, or seven, which are common measures in which a company prefers to receive reimbursement for money spent on a project. All cash flows must be in annual periods.
The final steps in capital budgeting include finding a capital mix that allows the company to pay for a project with other people’s money. Different attributes of an equity mix include various loans, bonds, and equity financing that pays for all of the startup costs associated with a project. The cost of capital for this combination is the average of all the interest rates for the different methods used to pay for the project. Accountants and financial analysts then compare the cash flows with the initial costs. The project whose net present value of future cash flows is greater than the initial costs is usually the best one.
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