An Overview of the Capital Budgeting Process

There are often moments when your business needs to invest in a project to help your company grow and increase its profits. If your shareholders are investing in this project, they need to approve it through a capital budgeting process. Learn more about what capital budgeting is, common methods of this process and an overview of how it all works. 

 

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What is capital budgeting?

Capital budgeting is the process of analyzing potential projects as you decide which one is a valuable investment and will provide your business with a high return on your funds. The projects you’re analyzing during the capital budgeting process are usually large projects that cost a significant amount of your business’ budget. Possible projects include purchasing new machinery, acquiring land, expanding to a new location or introducing a new product line.

If the project requires a large investment of your business’ funds, it usually undergoes the capital budgeting process to choose projects from which your shareholders are more likely to receive a strong income from the investment. The capital budgeting process involves assessing the inflows and outflows of the project to decide whether it will generate returns that reach the target benchmark laid out in the capital budgeting approval process.

Related: Balance Sheets: An Intro for Business Owners (With Examples)

 

How the capital budgeting process works

Capital budgeting is a formal process used to closely evaluate potential projects and determine which ones are more likely to maximize the company’s future profits. Here’s an overview of how the capital budgeting process works: 

 

Identifying opportunities and creating proposals for potential projects

Great ideas for potential projects can come from anyone in your business, from administrative employees to your executive team. If you believe these ideas could be valuable to invest in, note them as a potential project idea. There are a variety of projects that require approval through the capital budgeting process, like research and development, market research or industrial engineering. Evaluate potential projects by preparing a capital expenditure proposal. This proposal details a project’s: 

  • Initial cost
  • Estimated revenue it will eventually generate
  • Expenses during the construction or implementation period 
  • Total cash inflow and outflow 
  • Any uncertainties or risks that could occur by investing in the project

 

Selecting a project 

After your proposal is built, it’ll go through its first stage of the approval process. Shareholders analyze and rank each project to determine which to invest in. The most common methods to help determine the best project for your business include:

  • Net present value: This approach involves discounting the cash flows after taxes by the weighted average cost of capital. This helps investors better understand how profitable a project will be when comparing it to other alternatives. Most investors accept projects with positive net present values and reject negative ones.
  • Payback analysis: This step of the decision-making process involves calculating how long it should take to recoup investment costs. It’s calculated by dividing the initial project investment by the average yearly cash inflow that the project is estimated to generate.
  • Internal rate of return: This is the estimated return investors expect to receive on a project. Investors determine if it’s a worthwhile project if the rate of return is higher than the cost of capital. The internal rate of return is the discount rate that results in a net present value of zero. If your project’s discount rate heightens, then future cash flow will be more uncertain, making the project less viable. 

 

Implementing your proposal

Once your project both your investors and financial advisors approve a project, you’ll begin the proposal implementation process. Your plan describes how you’ll pay for the project, track costs and record incoming cash flows. Your implementation plan should also feature a timeline that projects key milestones and your estimated end date for the project. 

Once you implement this plan, your management team will oversee and delegate the tasks to the respective employees to ensure everything gets completed on time. 

Related: How to Hire a Director of Finance

 

Undergoing the performance review 

When the project is complete, you’ll conduct a performance review with your financial professionals and shareholders to compare your final results with the projections. You’ll identify where you underperformed and explain why the actual result was different than what you estimated to help you better understand how to more accurately estimate expenses and outcomes for future projects.
 

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